The Tail that Wags the Economy: Beliefs and Persistent Stagnation Julian Kozlowski Laura Veldkamp Venky Venkateswaran∗ NYU NYU Stern, CEPR, NBER NYU Stern, NBER March 22, 2018 Abstract The Great Recession was a deep downturn with long-lasting effects on credit, employ- ment 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 quantified 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. JEL Classifications: D84, E32 Keywords: Stagnation, tail risk, propagation, belief-driven business cycles ∗
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[email protected]. We thank our four anonymous referees and our Editor, Harald Uhlig, as well as Mark Gertler, Mike Golosov, Mike Chernov, Francois Gourio, Christian Hellwig and participants at the Paris Conference on Economic Uncertainty, IMF Secular Stagnation confer- ence, Einaudi, SED and NBER summer institute for helpful comments and Philippe Andrade, Jennifer La'O, Franck Portier and Robert Ulbricht for their insightful discussions. Veldkamp and Venkateswaran gratefully acknowledge financial support from the NYU Stern Center for Global Economy and Business. The Great Recession was a deep downturn with long-lasting effects on credit markets, labor markets and output. Why did output remain below trend long after financial markets had calmed and uncertainty diminished? This recession missed the usual business cycle recovery.