Credit Expansion and Neglected Crash Risk

Baron, Matthew; Xiong, Wei

doi:10.3386/w22695

Cited by 92 publications

(177 citation statements)

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“…Losses are neglected because they are not representative of the good news that market participants have observed. This is a form of "this time is different syndrome": the good news creates too much faith in good fundamentals, which leads to neglect of risk and excessive debt issuance, as in Baron and Xiong (2014). Extrapolation of good times and the neglect of downside risk are part of the same psychological mechanism of representativeness.…”

Section: The Boom Under Thinking Through Representativenessmentioning

confidence: 99%

Neglected Risks: The Psychology of Financial Crises

Gennaioli

Shleifer

Vishny

2015

American Economic Review

140

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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.

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Section: The Boom Under Thinking Through Representativenessmentioning

confidence: 99%

Neglected Risks: The Psychology of Financial Crises

Gennaioli

Shleifer

Vishny

2015

American Economic Review

140

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“…s 3 in hand, we can then identify 22 Many other researchers have used a three to four year horizon of private credit changes to examine the effect of credit expansion on outcomes, e.g., Mian and Sufi (2014), King (1994), Baron and Xiong (2016), Jordà et al (2014a). We believe we are the first to justify this horizon in a VAR setting.…”

Section: Proxy Svarmentioning

confidence: 99%

“…Baron and Xiong (2016) show that a large increase in bank credit to GDP predicts lower equity returns, and Cecchetti and Kharroubi (2015) find that the growth in the financial sector is correlated with lower productivity growth. Cecchetti et al (2011) estimate country-level panel regressions relating economic growth from t to t + 5 to the level of government, firm, and household debt in year t. They do not find strong evidence that the level of private debt predicts growth.…”

Section: Introductionmentioning

confidence: 99%

Household Debt and Business Cycles Worldwide

2015

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An increase in the household debt to GDP ratio in the medium run predicts lower subsequent GDP growth, higher unemployment, and negative growth forecasting errors in a panel of 30 countries from 1960 to 2012. Consistent with the "credit supply hypothesis," we show that low mortgage spreads predict an increase in the household debt to GDP ratio and a decline in subsequent GDP growth when used as an instrument. The negative relation between the change in household debt to GDP and subsequent output growth is stronger for countries that face stricter monetary policy constraints as measured by a less flexible exchange rate regime, proximity to the zero lower bound, or more external borrowing. A rise in the household debt to GDP ratio is contemporaneously associated with a consumption boom followed by a reversal in the trade deficit as imports collapse. We also uncover a global household debt cycle that partly predicts the severity of the global growth slowdown after 2007. Countries with a household debt cycle more correlated with the global household debt cycle experience a sharper decline in growth after an increase in domestic household debt. The Great Recession has sparked new questions about the relation between household debt and the macroeconomy. Recent theoretical and empirical research recognizes that a sudden and large increase in household debt could lower subsequent output growth in the presence of monetary and fiscal policy constraints. Moreover, households may not internalize the macroeconomic effects of their own borrowing, making the economy susceptible to "excessive" credit growth. 1 However, empirical evidence on increases in household debt and subsequent economic performance is largely limited to the United States and the most recent global recession. A more systematic evaluation of the empirical relation between household debt and business cycles worldwide is needed in order to understand if recent events are representative of a broader pattern. This is important given the dramatic rise in household debt to GDP ratios over the last 50 years documented by Jordà et al. (2014a). This paper compiles data for 30 countries from 1960 to 2012 and provides several new results that highlight the importance of household credit shocks in driving business cycles worldwide.There are two broad hypotheses that relate household debt to business cycles. The "credit demand hypothesis" posits a positive relationship between current household borrowing and future income. Household borrowing in this view is driven by productivity or technology shocks that increase expected future income, spurring higher consumption and borrowing in anticipation. On the other hand, the "credit supply hypothesis" holds that higher household borrowing is driven by an expansion in the availability of credit. If there are plausible frictions such as nominal rigidities or monetary policy constraints, then households may borrow excessively which leads to an eventual slowdown in GDP growth.Distinguishing the credit demand and credit sup...

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“…3,4 Substantial evidence suggests that bank credit expansions play a particular role with respect to financial crises. Using data on bank equity prices, Baron and Xiong (2017) argue that such credit expansions are driven by waves of optimism. Krishnamurthy and Muir (2017) show that credit spreads are unusually low in the run-up phase to a crisis and that a change in credit spreads around financial crises forecasts well the subsequent severity.…”

Section: Introductionmentioning

confidence: 99%

Historical Patterns of Inequality and Productivity around Financial Crises

Paul¹

2020

ERWP

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To understand the determinants of financial crises, previous research focused on developments closely related to financial markets. In contrast, this paper considers changes originating in the real economy as drivers of financial instability. To this end, I assemble a novel data set of long-run measures of income inequality, productivity, and other macrofinancial indicators for advanced economies. I find that rising top income inequality and low productivity growth are robust predictors of crises, and their slowmoving trend components largely explain these relations. Moreover, recessions that are preceded by such developments are deeper than recessions without such ex-ante trends.

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Credit Expansion and Neglected Crash Risk

Cited by 92 publications

References 0 publications

Neglected Risks: The Psychology of Financial Crises

Neglected Risks: The Psychology of Financial Crises

Household Debt and Business Cycles Worldwide

Historical Patterns of Inequality and Productivity around Financial Crises

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