The Tail That Wags the Economy: Beliefs and Persistent Stagnation

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 GDP below pre-crisis trends remains puzzling. We propose a simple persistence mechanism that can be quantfied and combined with existing models. Our key premise is that agents don't know the true distribution of shocks, but use data to estimate it non-parametrically. 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.

Climate Risk and Beliefs in New York Floodplains

“…The model is static, supposing an agent whose beliefs are stationary in the absence of parameter shocks. Such stationarity could come from inattention (Sims, 2006;Kahneman, 2003) or myopia (Thaler et al, 1997), coupled with the type of permanent updating in response to large shocks described by Kozlowski et al (2017). This type of updating is one possible explanation for the large divergences between flood beliefs and objective risks documented in Botzen et al (2015).…”

Secular Stagnation and Low Interest Rates Under the Fear of a Government Debt Crisis

“…Consequently, a growing risk of a government debt crisis persistently depresses not only the level but also the growth rate of output. The latter result is a novel contribution to the literature, because previous studies have tended to find that a constant risk of disaster reduces the level of output only (e.g., Kozlowski, Veldkamp, and Venkateswaran, 2015).…”

“…Kozlowski, Veldkamp, and Venkateswaran (2015) assume that expectations on tail events are formed by learning from history.3 Health and natural disasters are the top two reasons, followed by concerns about public services. This worry is also considered to be related to the accumulation of government debt, which may prevent the government from providing sufficient public services in the future, such as pensions, medical services, and investment in infrastructure resilient to disasters.…”

Rare Disasters, the Natural Interest Rate and Monetary Policy

“…van den Berg et al 2009;Cameron and Shah 2015;Cassar et al 2017) it is not hard to imagine that also in OECD countries risk attitudes might change in the aftermath of natural disasters. Without referring to natural disasters, Kozlowski et al (2020) show that one a rare event occurs, it permanently enters agents' information set and the tail of the shock distribution becomes larger, e.g. they attach a larger probability to the tail event because they believe it will materialize again.…”