Working Paper: CEPR ID: DP7967
Authors: Emine Boz; Enrique G. Mendoza
Abstract: Uncertainty about the riskiness of a new financial environment was an important factor behind the U.S. credit crisis. We show that a boom-bust cycle in debt, asset prices and consumption characterizes the equilibrium dynamics of a model with a collateral constraint in which agents learn "by observation" the true riskiness of the new environment. Early realizations of states with high ability to leverage assets into debt turn agents overly optimistic about the probability of persistence of a high-leverage regime. Conversely, the first realization of the low-leverage state turns agents unduly pessimistic about future credit prospects. These effects interact with the Fisherian deflation mechanism, resulting in changes in debt, leverage, and asset prices larger than predicted under either rational expectations without learning or with learning but without Fisherian de°ation. The model can account for 69 percent of the rise in net household debt and 53 percent of the rise in residential land prices between 1997 and 2006, and it predicts a sharp collapse in 2007.
Keywords: asset prices; credit crisis; financial innovation; fisherian deflation; imperfect information; learning
JEL Codes: D82; E44; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Financial Innovation (G29) | Underpricing of Risk (G19) |
| Underpricing of Risk (G19) | Boom in Credit and Asset Prices (E32) |
| Financial Innovation (G29) | Boom in Credit and Asset Prices (E32) |
| Learning about Risk (D81) | Changes in Debt Leverage and Asset Prices (G19) |
| Learning Process + Collateral Constraints (D29) | Amplification of Effects on Macroeconomic Aggregates (E19) |
| Fisherian Debt-Deflation Mechanism (E43) | Changes in Debt Leverage and Asset Prices (G19) |
| Learning Process + Fisherian Deflation Mechanism (D83) | Boom-Bust Cycles in Credit and Land Prices (E32) |
| Financial Innovation + Learning Process (G19) | Boom in Credit and Asset Prices (E32) |