Beliefs, Tail Risk, and Secular Stagnation

A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Veldkamp, Laura Article Beliefs, tail risk, and secular stagnation NBER Reporter Provided in Cooperation with: National Bureau of Economic Research (NBER), Cambridge, Mass. Suggested Citation: Veldkamp, Laura (2019) : Beliefs, tail risk, and secular stagnation, NBER Reporter, National Bureau of Economic Research (NBER), Cambridge, MA, Iss. 3, pp. 7-10 This Version is available at: http://hdl.handle.net/10419/219440 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. 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Much of the time, they lie in the rates, volatile equity prices, and secular background of our economic models. stagnation. We often assume that everyone knows everything that has happened in the Belief Formation past, as well as the true probabilities of all future events. The concept of ratio- There are two broad approaches to Laura Veldkamp is a research associate nal expectations means that the true explaining belief formation. The first is in the NBER’s Economic Fluctuations and distribution of future outcomes and the a behavioral approach, which departs Growth Program and is the Cooperman believed distribution of future outcomes from rational expectations by directly Professor of Economics and Finance at are the same. stating some belief formation rule that Columbia University. She is a co-editor of If the rational expectations assump- explains the phenomenon at hand. the Journal of Economic Theory, the first tion were true, there would be no need Such assumptions are often supported woman to hold that role. She also serves on for economists. If everyone knew all with survey or experimental data. These the Economic Advisory Panel of the Federal covariances, we would not need any assumptions may be right, but they Reserve Bank of New York and is the author empirical work. If everyone knew the rarely provide a reason for the agents’ of the Ph.D. textbook, Information Choice true model of the economy and could beliefs. If we don’t understand why the in Macroeconomics and Finance. reason through it, we would not need rule holds, we don’t know in what cir- Veldkamp’s research explores the role theorists. Luckily for us, the rational cumstances the rule will continue to of information in the aggregate economy. expectations assumption is not correct. hold. While such approaches provide Her topics range from business cycles and Yet most of the time it is a useful insights, there is more to be discovered. mutual fund performance to home bias and simplification. We have seen enough The second approach to belief for- female labor force participation. A unifying economic booms and recessions, firm mation is an imperfect-information theme of her work is that treating informa- and bank failures to have a reason- approach. Agents have finite data to esti- tion, or the ability to process information, as able estimate of their true probability. mate states and distributions. Despite a scarce and valuable resource helps to rem- However, when studying rare events, the limited information, they estimate edy many failures of full-information, ratio- often referred to as “tail events,” assum- efficiently, given the data they have, or nal expectations frameworks. Her recent ing rational expectations can lead econ- the information they have optimally work uses these information tools to under- omists astray. Because these events are chosen to acquire, attend to, or pro- stand the aggregate consequences of the dig- rare, data on them are scarce, and our cess. Agents in these models do what ital economy. estimates of their true probability are economists would do if we were in their Veldkamp received a B.A. in unlikely to be accurate. In these circum- place: They collect data and use stan- applied mathematics and economics stances, understanding belief formation dard econometrics to estimate features from Northwestern University and her becomes particularly important. of their environment. When a new out- Ph.D. in economic analysis and policy My research focuses on how indi- come is observed, they re-estimate their from Stanford University. She joined the viduals, investors, and firms get their model in real time. Columbia faculty in 2018 after teaching at information, how that information The imperfect-information New York University for 15 years. affects the decisions they make, and how approach overcomes one of the main A native of Lexington, Massachusetts, those decisions affect the macroecon- challenges of working on beliefs — the Veldkamp met her husband, Stijn Van omy and asset prices. It also examines fact that beliefs are hard to observe Nieuwerburgh, while at Stanford. She how people form beliefs about tail risk or measure. Survey data are informa- enjoys playing the viola, playing squash and how learning about tails, or disas- tive in many circumstances, but report- with her two boys, and sculling. NBER Reporter • No. 3, September 2019 7 ing accurate probabilities of rare events Kozlowski and Venky Venkateswaran, we Tail Risks, Low Interest is particularly difficult, and surveys are explore this scarring effect as an explana- Rates, and Inflation rarely designed to elicit these beliefs. Also, tion for the slow rebound of investment, when beliefs change on short notice, cap- labor, and output, as well as tail risk-sensi- In follow-up work, we use a much turing this change with surveys is usually tive options prices.1 simpler economic environment to speak infeasible because of the costly and time- While logical, this effect could be to the persistently low interest rates on consuming nature of survey administra- tiny. To assess whether this is a plausi- safe assets.3 To create a link between tion. In contrast, when we model agents ble explanation for the persistence of the heightened tail risk and the interest rate, as econometricians, we can estimate their post-crisis output loss, we embed learn- or yield, on safe assets, we focus on two beliefs in real time with publicly observ- ing in a dynamic stochastic general equi- standard mechanisms. able data and standard econometrics. librium model. For our purposes, this First, faced with more risk, agents model needs two features. First, it needs want to save more. But not every agent Tail Risks, Secular Stagnation, to have shocks that had extreme (tail) can save more. The bond market has to and the Scarring Effect outcomes in the financial crisis. Second, clear. Therefore, the return on bonds the model needs enough non-linearity declines in order to clear that market. Tail risk beliefs have three proper- so that unlikely tail events can have some This force explains about a third of the ties that are helpful in explaining puzzling aggregate effect. For this purpose, we use decline in the interest rate. The sec- macroeconomic phenomena. They help an augmented version of a model devel- ond force at work is that safe assets explain persistent reactions to rare events, oped by François Gourio.2 In this model, offer liquidity that is particularly valu- biased expectations, and, in environments shocks have large initial effects, but there able in very bad conditions. When the where uncertainty matters, strong reac- is no guarantee of any persistent effects probability of these tail events rises, liq- tions to seemingly innocuous events. from transitory shocks. uid assets are more valuable and their One macroeconomic puzzle that tail The predictions of this model teach yield declines, clearing the market. That risk can help explain is the persistent us some new lessons. First, the change in liquidity effect explains the other two- aftermath of the 2008 financial crisis, beliefs is large enough to make the drop thirds of the persistent interest rate gap often referred to as secular stagnation, in in output a highly persistent level effect. from the pre-crisis period. which the real effects of that financial cri- This doesn’t mean that the positive shocks If re-estimating distributions with sis persisted long after the financial condi- in recent years cannot return the economy real-time data can make actions persis- tions that triggered it had been remedied. to trend. It does mean that, without the tently different following a crisis, does it Some of this persistence seems to come Great Recession, incomes today would matter how we estimate those distribu- from a scarring effect on beliefs. have been higher. Second, the equilib- tions? For some purposes, no. For oth- Consider this: In 2006, before the rium effects are surprising. Some econo- ers, yes. In the secular stagnation paper, financial crisis, were economists con- mists asserted that persistent economic the magnitude of stagnation depended cerned with financial stability, bank runs, responses to the Great Recession could on the size of the increase in tail risk. and systemic risk? Mostly not.

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