Persistence of gross domestic product below precrisis trends remains puzzling; transitory events, especially extreme ones, generate persistent changes in beliefs and macro outcomes

The Tail That Wags the Economy: Beliefs and Persistent Stagnation. Julian Kozlowski, Laura Veldkamp, Venky Venkateswaran. Journal of Political Economy, Volume 128, Number 8, August 2020 (June 10, 2020). https://www.journals.uchicago.edu/doi/abs/10.1086/707735

Abstract: The Great Recession was a deep downturn with long-lasting effects on credit, employment, and output. While narratives about its causes abound, the persistence of gross domestic product below precrisis trends remains puzzling. We propose a simple persistence mechanism that can be quantified and combined with existing models. Our key premise is that agents do not know the true distribution of shocks but use data to estimate it nonparametrically. Then, transitory events, especially extreme ones, generate persistent changes in beliefs and macro outcomes. Embedding this mechanism in a neoclassical model, we find that it endogenously generates persistent drops in economic activity after tail events.


5 Conclusion

Economists typically assume that agents in their models know the distribution of shocks. In this paper, we showed that relaxing this assumption introduces persistent economic responses to tail events. The agents in our model behave like classical econometricians, re-estimating distributions as new data arrives. Under these conditions, observing a tail event like the 2008- 09 Great Recession in the US, causes agents to assign larger weights to similar events in the future, depressing investment and output. Crucially, these effects last for a long time, even when the underlying shocks are transitory. The rarer the event that is observed, the larger and more persistent the revision in beliefs. The effects on economic activity are amplified when investments are financed with debt. This is because debt payoffs (and therefore, borrowing costs) are particularly sensitive to the probability of extreme negative outcomes. When this mechanism is quantified using data for the US economy, the predictions of the model resemble observed macro and asset market outcomes in the wake of the Great Recession, suggesting that the persistent nature of the recent stagnation is due, at least partly, to the fact that the events of 2008-09 changed the way market participants think about tail risk.