Endogenous Uncertainty and Credit Crunches

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 can explain why financial crises can result in long-lasting recessions. 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 explains a considerable fraction of the slow recovery after the 08/09 crisis.

Fiscal and Monetary Policies after the Crises

“…Important contributions include Lorenzoni (2009), Angeletos and La'O (2013) and Hellwig and Venkateswaran (2014). Similar investment-information dynamics are analysed by Straub and Ulbricht (2014). 35.…”

Financial Markets, the Real Economy, and Self‐Fulfilling Uncertainties

“…On the other hand, the accounting literature emphasizes the opposite direction of learning—arguing that firm managers typically know more than financial market participants—and focuses on studying how firm managers (i.e., insiders) disclose information to the capital market, based on which financial speculators trade and security prices are formed. Our paper advances these two bodies of literature by introducing and studying mutual (two‐way) learning between the real sector and financial markets, similar to Sockin (), Straub and Ulbricht (), and Wu, Miao, and Young (). The two‐way learning mechanism sheds light on important questions, such as how a financial price is formed, where the information comes from, and how the different sources of information interact.…”

A New Way to Quantify the Effect of Uncertainty

“…Another segment examines the implications of incomplete information. Some of the papers feature learning with aggregate shocks [Fajgelbaum et al (2017); Saijo (2017); Van Nieuwerburgh and Veldkamp (2006)], while others focus on firm-specific shocks [Ilut and Saijo (2016); Straub and Ulbricht (2015)]. In these models, an adverse shock under asymmetric learning lowers economic activity and makes it harder for households to learn about the economy, which amplifies the effects of first moment shocks.…”