Working Paper: NBER ID: w16020
Authors: Emine Boz; Enrique G. Mendoza
Abstract: Financial innovation and overconfidence about asset values and the riskiness of new financial products were important factors 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 a new financial environment. Early realizations of states with high ability to leverage assets into debt turn agents overly optimistic about the persistence probability of a high-leverage regime. Conversely, the first realization of a 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 deflation. The model predicts a large, sustained increase in net household debt and in residential land prices between 1997 and 2006, followed by a sharp collapse in 2007.
Keywords: financial innovation; credit crisis; overconfidence; risk; collateral constraints
JEL Codes: D83; E44; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial innovation + overconfidence about asset values (G19) | increase in household debt (G51) |
| financial innovation + overconfidence about asset values (G19) | increase in asset prices (G19) |
| optimistic beliefs about leverage (G41) | higher asset prices (G19) |
| optimistic beliefs about leverage (G41) | increased borrowing (H74) |
| increased borrowing (H74) | collapse when low-leverage state is realized (G33) |
| low-leverage regime realization (G19) | decline in credit and asset prices (E44) |
| interaction between learning dynamics and collateral constraints (D29) | effects on debt and asset prices (E44) |