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Neglected Risks: The Psychology of Financial Crises
We model a financial market in which investor beliefs are shaped by representativeness. Investors overreact to a series of good news, because such a series is representative of a good state. A few bad news do not change investor minds because the good state is still representative, but enough bad news leads to a radical change in beliefs and a financial crisis. The model generates debt over-issuance, “this time is different” beliefs, neglect of tail risks, under- and over-reaction to information, boom-bust cycles, and excess volatility of prices in a unified psychological model of expectations.
Journal Article
Evidence for Countercyclical Risk Aversion: An Experiment with Financial Professionals
Countercyclical Risk Aversion Can Explain Major Puzzles Such as the High Volatility of Asset Prices. Evidence for its Existence is However, Scarce Because of the Host of Factors that Simultaneously Change During Financial Cycles. We Circumvent these Problems by Priming Financial Professionals with Either a Boom or a Bust Scenario. Subjects Primed with a Financial Bust were Substantially More Fearful and Risk Averse than those Primed with a Boom, Suggesting that fear may play an Important Role in Countercyclical Risk Aversion. The Mechanism Described here is Relevant for Theory and may Explain Self-reinforcing Processes That Amplify Market Dynamics.
Journal Article
Putting the Cycle Back into Business Cycle Analysis
Are business cycles mainly a response to persistent exogenous shocks, or do they instead reflect a strong endogenous mechanism which produces recurrent boom-bust phenomena? In this paper we present evidence in favor of the second interpretation and we highlight the set of key elements that influence our answer. The elements that tend to favor this type of interpretation of business cycles are (i) slightly extending the frequency window one associates with business cycle phenomena, (ii) allowing for strategic complementarities across agents that arise due to financial frictions, and (iii) allowing for a locally unstable steady state in estimation.
Journal Article
Understanding Booms and Busts in Housing Markets
Some booms in housing prices are followed by busts. Others are not. It is generally difficult to find observable fundamentals that are useful for predicting whether a boom will turn into a bust or not. We develop a model consistent with these observations. Agents have heterogeneous expectations about long-run fundamentals but change their views because of “social dynamics.” Agents with tighter priors are more likely to convert others to their beliefs. Boom-bust episodes typically occur when skeptical agents happen to be correct. The booms that are not followed by busts typically occur when optimistic agents happen to be correct.
Journal Article
Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870–—2008
The financial crisis has refocused attention on money and credit fluctuations, financial crises, and policy responses. We study the behavior of money, credit, and macroeconomic indicators over the long run based on a new historical dataset for 14 countries over the years 1870–2008. Total credit has increased strongly relative to output and money in the second half of the twentieth century. Monetary policy responses to financial crises have also been more aggressive, but the output costs of crises have remained large. Credit growth is a powerful predictor of financial crises, suggesting that policymakers ignore credit at their peril. JEL: E32, E44, E52, G01, N10, N20
Journal Article
European settlement demography
In this paper we compare multiple types of domestic settlements from different chronological periods in prehistoric continental Europe to inform occupancy patterns and demographic trends. We focus in particular on the evidence of a boom and bust pattern that appears to be constant across all the sites studied. We find evidence of a growth plateau after 200 to 300 years of existence. But because the number of sites used is small, due to the quality restrictions of the data, the results still need to be confirmed by further investigations. V prispevku primerjamo več vrst naselbin iz različnih časovnih obdobij v prazgodovini v celinski Evropi, da bi pridobili informacije o vzorcih poseljenosti in demografskih trendih. Osredotočamo se na podatke sistema o rasti in upadu, ki se zdi konstanten v vseh naselbinah. Našli smo namreč dokaze o doseženem platoju rasti po 200 do 300 letih obstoja. A ker je zaradi slabe kakovosti podatkov število naselbin majhno in so zato podatki omejeni, je treba rezultate z nadaljnjimi preiskavami še potrditi.
Journal Article
Overreaction and Diagnostic Expectations in Macroeconomics
We present the case for the centrality of overreaction in expectations for addressing important challenges in finance and macroeconomics. First, non-rational expectations by market participants can be measured and modeled in ways that address some of the key challenges posed by the rational expectations revolution, most importantly the idea that economic agents are forward-looking. Second, belief overreaction can account for many long-standing empirical puzzles in macro and finance, which emphasize the extreme volatility and boom-bust dynamics of key time series, such as stock prices, credit, and investment. Third, overreaction relies on psychology and is disciplined by survey data on expectations. This suggests that relaxing the assumption of rational expectations is a promising strategy, helps theory and evidence go together, and promises a unified view of a great deal of data.
Journal Article
SEARCH FOR YIELD
We present a model of the relationship between real interest rates, credit spreads, and the structure and risk of the banking system. Banks intermediate between entrepreneurs and investors, and can monitor entrepreneurs' projects. We characterize the equilibrium for a fixed aggregate supply of savings, showing that safer entrepreneurs will be funded by nonmonitoring banks and riskier entrepreneurs by monitoring banks. We show that an increase in savings reduces interest rates and spreads, and increases the relative size of the nonmonitoring banking system and the probability of failure of monitoring banks. We also show that the dynamic version of the model exhibits endogenous boom and bust cycles, and rationalizes the existence of countercyclical risk premia and the connection between low interest rates, tight credit spreads, and the buildup of risks during booms.
Journal Article