Sunday, September 11, 2016

Interesting secstag idea


This is very interesting:

Vox EU - secular stagnation and the fat tail. Quote:

Existing theories about why the crisis took place assume that the shocks that triggered it were persistent. Yet such shocks in previous business cycle episodes were not so persistent. This differential in persistence is just as puzzling as the origin of the crisis. What most explanations of the Great Recession miss is a mechanism that takes some large, transitory shocks and then transforms them into long-lived economic responses.

Perhaps the fact that this recession has been more persistent than others is because, before it took place, it was perceived as an extremely unlikely event. Today, the question of whether the financial crisis might repeat itself arises frequently. Financial panic is a new reality that was never perceived as a possibility before.

Our explanation for persistently low output hinges on people’s assessment of tail risk.

Basically, their thesis is that the financial crisis resulted in a permanent re-evaluation of tail risk, and this should be expected to last for years in any part of the economy where finance is important.

One important reason why tail risk has such large aggregate effects is the fact that firms finance investment, at least in part, by issuing debt. Debt inflicts bankruptcy costs in the event of default. The cost of issuing debt, the credit spread, depends on the probability of default. Default risk depends on the likelihood of large aggregate shocks, or tail events. Thus, when the probability of a left tail event rises, financing investment with debt becomes less attractive. As a result, when tail risk rises, an economy with more highly-leveraged (indebted) firms experiences a larger drop in long-run investment and output. We show that the extent to which debt amplifies bad shocks is greater for large tail shocks than it is for events closer to the mean. Thus, debt financing interacts with tail risk to accentuate the difference between extreme recessions and their milder counterparts.

And that's where they include their "gotcha!" chart, the Skew:





And that does seem to back up their thesis, no?


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