Lessons from the Crisis for Macroeconomics

Julian Kozlowski, New York University, and Laura Veldkamp and Venky Venkateswaran, New York University and NBER

The Tail that Wags the Economy: Belief-Driven Business Cycles and Persistent Stagnation

The "Great Recession" was a deep downturn with long-lasting effects on credit markets, labor markets and output. Kozlowski, Veldkamp, and Venkateswaran explore a simple explanation: This recession has been more persistent than others because it was perceived as an extremely unlikely event before 2007. Observing such an episode led all agents to re-assess macro risk, in particular, the probability of tail events. Since changes in beliefs endure long after the event itself has passed and through its effects on prices and choices, it produces long-lasting effects on investment, employment and output. To model this idea, the researchers study a production economy with agents who use standard econometric tools to estimate the distribution of aggregate shocks. When they observe a new shock, they re-estimate the distribution from which it was drawn. Even transitory shocks have persistent effects because, once observed, they stay forever in the agents' data set. The authors feed a time-series of U.S. macro data into their model and show that their belief revision mechanism can explain the 12% downward shift in U.S. trend output.

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David Berger and Guido Lorenzoni, Northwestern University and NBER, and Veronica Guerrieri and Joseph Vavra, University of Chicago and NBER

House Prices and Consumer Spending (NBER Working Paper No. 21007)

Recent empirical work shows large consumption responses to house price movements. Can consumption theory explain these responses? Berger, Guerrieri, Lorenzoni, and Vavra consider a variety of consumption models with uninsurable income risk and show that consumption responses to permanent house price shocks can be approximated by a simple "sufficient-statistic" formula: the marginal propensity to consume out of temporary income times the value of housing. Calibrated versions of the models generate house price effects that are both large and sensitive to the level of household debt in the economy. The researchers apply their formula to micro data to provide a new measure of house price effects.

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Christopher House and Linda Tesar, University of Michigan and NBER, and Christian Pröbsting, University of Michigan

Austerity in the Aftermath of the Great Recession

In this paper, House, Proebsting, and Tesar examine the effects of austerity on economic performance since the Great Recession. The analysis proceeds in two steps. The first step is to construct measures of "austerity" shocks in the 2010-2013 period in a sample of 29 countries including the U.S., the U.K., Switzerland, countries in the euro area and central and eastern Europe. In the data set, austerity — a reduction in government spending that is larger than that implied by reduced-form forecasting regressions — is statistically associated with lower real per capita GDP, lower GDP growth, lower inflation and higher net exports. The second stage develops a multi-country DSGE model to make direct comparisons between the observed empirical relationships and the model predictions. The model is calibrated to reflect relative country size, trade and financial linkages, and the country's exchange rate regime. The model incorporates austerity shocks, shocks to the cost of credit and monetary policy shocks. Preliminary findings suggest that the benchmark model generates predictions that are qualitatively in line with those seen in the data.

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Òscar Jordà, Federal Reserve Bank of San Francisco; Moritz Schularick, University of Bonn; and Alan Taylor, University of California, Davis and NBER

Leveraged Bubbles (NBER Working Paper No. 21486)

What risks do asset price bubbles pose for the economy? This paper studies bubbles in housing and equity markets in 17 countries over the past 140 years. History shows that not all bubbles are alike. Some have enormous costs for the economy, while others blow over. Jordà, Schularick, and Taylor demonstrate that what makes some bubbles more dangerous than others is credit. When fueled by credit booms, asset price bubbles increase financial crisis risks; upon collapse they tend to be followed by deeper recessions and slower recoveries. Credit-financed housing price bubbles have emerged as a particularly dangerous phenomenon.

Atif Mian, Princeton University and NBER; Amir Sufi, University of Chicago and NBER; and Emil Verner, Princeton University

Household Debt and Business Cycles Worldwide

A rise in the household debt to GDP ratio predicts lower output growth and higher unemployment over the medium-run, contrary to standard macroeconomic models. GDP forecasts by the IMF and OECD underestimate the importance of a rise in household debt to GDP, giving the change in household debt to GDP ratio of a country the ability to predict growth forecasting errors. Mian, Sufi, and Verner use lower credit spreads and increases in risky debt issuance as instruments for the rise in household debt to GDP to argue that their results are supportive of recent models where debt growth is driven by changes in credit supply, borrowing constraints, or risk premia. They also show that a rise in household debt to GDP is associated contemporaneously with a rising consumption share of output, a worsening of the current account balance, and a rise in the share of consumption goods within imports. This is followed by strong external adjustment when the economy slows as the current account reverses and net exports increase due to a sharp fall in imports. Finally, an increase in global household debt to GDP also predicts lower global output growth. The pre-2000 predicted relationship between global household debt changes and subsequent global growth matches closely the actual decline in global growth after 2007 given the large increase in household debt during the early to mid-2000s.

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Danny Yagan, University of California, Berkeley and NBER

Which Americans Have Jobs? The Enduring Impact of Great Recession Location

Over the Great Recession, the employment rate in some U.S. cities declined by more than twice the aggregate decline. To what extent did the ability to migrate insure workers against these idiosyncratic local shocks? Yagan answers this question using geo-coded administrative panel data on the universe of U.S. males from years 2000-2011. He finds that despite migration flows that were in principle large enough to provide full insurance, migration has provided only 7% insurance: the 2006 residents of the average local area have borne 93% of the area's idiosyncratic Great Recession labor demand shock. He finds similarly small degrees of insurance across specifications, demographic groups, and labor market outcomes. Insurance was three times greater over the 2001 recession, driven entirely by greater insurance for above-average earners. The relative failure of migratory insurance over the Great Recession is attributable to unusually small employment gains for those migrating from heavily-shocked areas to lightly-shocked areas, rather than to a decline in migration rates. The results imply large spatial adjustment frictions in the U.S. labor market and indicate that past location may be a powerful tag for directing social insurance.

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Robert Hall, Stanford University and NBER

Macroeconomics of Persistent Slumps

In modern economies, sharp increases in unemployment from major adverse shocks result in long periods of abnormal unemployment and low output. This chapter investigates the processes that account for these persistent slumps. The data are from the economy of the United States, and the discussion emphasizes the financial crisis of 2008 and the ensuing slump. The framework starts by discerning driving forces set in motion by the initial shock. These are agency frictions in capital markets resulting in tighter lending standards, higher discounts applied by decision makers (possibly related to a loss of confidence), withdrawal of potential workers from the labor market, and diminished productivity growth. Most of the driving forces are less persistent than unemployment and output. The next step is to study how driving forces influence general equilibrium, both at the time of the initial shock and later as its effects persist. Some of the effects propagate the effects of the shock — they contribute to poor performance even after the driving force itself has subsided. Depletion of the capital stock is one of the most important of these propagation mechanisms. Another is the borrowing power of households. Hall uses a medium-frequency dynamic equilibrium model to gain some notion of the magnitudes of responses and propagation.