Working Paper: NBER ID: w10518
Authors: Ricardo Caballero; Emmanuel Farhi; Mohamad L. Hammour
Abstract: We propose a framework for understanding recurrent historical episodes of vigorous economic expansion accompanied by extreme asset valuations, as exhibited by the U.S. in the 1990s. We interpret this phenomenon as a high-valuation equilibrium with a low effective cost of capital based on optimism about the future availability of funds for investment. The key to the sustainability of such an equilibrium is feedback from increased growth to an increase in the supply of effective funding. We show that such feedback arises naturally when an expansion comes with technological progress in the capital producing sector, when fiscal rules generate sustained fiscal surpluses, when the rest of the world has lower expansion potential, and when financial constraints are relaxed by the expansion itself. Arguably, these ingredients were all simultaneously present in the U.S. during the 1990s. We also show that such expansions can be welfare improving but they can crash. The latter is more likely if bubbles develop along the expansionary path. These (rational) bubbles can emerge even when the interest rate exceeds the rate of growth of the economy.
Keywords: speculative growth; US economy; asset valuations; economic expansion; fiscal policy
JEL Codes: D0; D9; E2; E3; G1; H3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increased economic growth (O49) | greater availability of funding (I22) |
| greater availability of funding (I22) | lower effective cost of capital (G31) |
| technological progress (O33) | increased economic growth (O49) |
| fiscal rules generating sustained surpluses (E62) | greater availability of funding (I22) |
| speculative bubbles (D84) | negative outcomes (I12) |
| increased economic growth (O49) | lower effective cost of capital (G31) |