Abstract
We develop a theory of endogenous uncertainty where the ability of investors to learn about firm-level fundamentals declines during financial crises. At the same time, higher uncertainty reinforces financial distress of firms, giving rise to “belief traps” — a persistent cycle of uncertainty, pessimistic expectations, and financial constraints, through which a temporary shortage of funds can develop into a long-lasting funding problem for firms. At the macro-level, belief traps provide a rationale for the long-lasting recessions that typically entail financial crises. In our model, financial crises are characterized by high levels of credit misallocation, an increased cross-sectional dispersion of growth rates, endogenously increased pessimism, uncertainty and disagreement among investors, highly volatile asset prices, and high risk premia. A calibration of our model to U.S. micro data on investor beliefs matches the slow recovery after the 08/09 crisis remarkably well.
Highlights
Financial crises often entail deep and long-lasting recessions (Reinhart and Rogoff, 2009; Hall, 2014; Ball, 2014)
The theory is consistent with a number of stylized facts regarding the 2008/09 recession: (i) increased resource misallocation, accounted for by an increase in the labor wedge and a drop in measured productivity; (ii) highly volatile asset prices and high risk-premia; (iii) an increased cross-sectional dispersion of firm growth-rates (e.g., Bloom et al 2014; Salgado, Guvenen and Bloom 2015); (iv) the contemporaneous increase in measured uncertainty2 ; and (v) forecasts and expectations marked by high levels of pessimism as well as high levels of disagreement among forecasters (Senga, 2015)
Starting from the stochastic steady state, we simulate a sequence {χt+s }, log χt+s = log χ − ∆s, follows because the endogenous tightening of credit limits caused by pessimism and uncertainty for islands in a belief trap is large compared to the direct effect of the financial shock
Summary
Financial crises often entail deep and long-lasting recessions (Reinhart and Rogoff, 2009; Hall, 2014; Ball, 2014). Two other related strands of the literature study the propagation of exogenous uncertainty through real options as in Bloom (2009), Bloom et al (2014), and Bachmann and Bayer (2009, 2013), and through risk premia as in the time-varying (disaster) risk literature (e.g., Gabaix, 2012; Gourio, 2012) Related to the latter, Kozlowski, Veldkamp and Venkateswaran (2015) explore a model where agents learn about tail-risks and where belief revisions after short-lived financial shocks can have long-lasting effects. To complete the description of the model, we need to specify the pricing of firms’ revenues that determine the credit limits Āi,t To this end, we introduce a continuum of one-period-lived investors of mass m that trade a fraction m of each firms’ current period revenues in an island-specific financial market.
Sign-in/Register to view highlights & summary Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
