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Why the Post-Recession Economy Still Sputters

Veldkamp-Venkateswaran_article

After seeing how fragile our financial sector is, market participants will never think about tail risk in the same way again

Economists puzzling over the protracted downturn following the recent “Great Recession” may wish to examine the hard-to-quantify impact of collective belief, according to new research by NYU Stern Economics Professors Laura Veldkamp and Venky Venkateswaran.
 
In “The Tail that Wags the Economy: Belief-Driven Business Cycles and Persistent Stagnation,” Professors Veldkamp and Venkateswaran, along with co-author Julian Kozlowski, an economics PhD candidate at NYU, use macroeconomic data to measure how the financial crisis changed beliefs about the possibility of future crises.  According to their new model, this estimated change in sentiment correlates with economic activity. They show that the doubt produced by the 2008 financial crisis can explain the 12 percent downward shift in US output since then.
 
The authors analyzed data collected since World War II on investment, employment, and output and observed the economy’s rebounds from less severe, shorter downturns.  “Even transitory shocks have persistent effects,” they noted, “because once observed, they stay forever in the data set.” However, smaller downturns produce smaller effects, while shocks like that of the 2007-2008 period are still reverberating.
 
When debt is low, the authors write, the economy is not very sensitive to tail risk – the chance that investment returns will be considerably less than expected – and economic shocks will be more transient.  However, in 2007-2008, with high debt levels and a shock that was extreme, tail risk surged, investment fell and doubt increased – and even today output continues to be depressed in a persistent way.
 
The authors’ model shows that shock from the Great Recession led people to reassess macro risk in a major way, and that the probability of rare, or tail, events still haunts their belief systems and depresses the economy. “After seeing how fragile our financial sector is, market participants will never think about tail risk in the same way again,” they conclude.