I've read a couple excellent articles in the last two days. First, a piece by Nobel Laureate Vernon Smith and Steven Gjerstad in the Wall Street Journal. And today, a fine work by Mario Rizzo of NYU.
Gjerstad and Smith outline how the increase in consumer debt that results from a fall in home prices can lead to huge losses for the financial sector and severe recessions. They point out how the losses from the stock market couldn't have caused the Great Depression (the timing wasn't right), but how the fall in home prices caused many banks to fail. They also ask the great question- how did a $10 trillion fall in equity values from the Dot-com bubble not result in financial troubles even close to the levels we've seen after a $3 trillion dollar fail in home values? Their conclusion is basically that homes are much more leveraged than stocks and thus the financial sector takes huge losses when home values fall.
Gjerstad and Smith outline how the increase in consumer debt that results from a fall in home prices can lead to huge losses for the financial sector and severe recessions. They point out how the losses from the stock market couldn't have caused the Great Depression (the timing wasn't right), but how the fall in home prices caused many banks to fail. They also ask the great question- how did a $10 trillion fall in equity values from the Dot-com bubble not result in financial troubles even close to the levels we've seen after a $3 trillion dollar fail in home values? Their conclusion is basically that homes are much more leveraged than stocks and thus the financial sector takes huge losses when home values fall.
Rizzo discusses the allocative aspects of business cycles. That the
primary driver of most economic fluctuations is not a change in
aggregate demand, but sectoral shift. That is, the microeconomics of
the economy- changes in relative prices- are key. He highlights the
fact that policy makers need to be mindful of these allocational causes
when prescribing stabilization policies.
After reading Rizzo, I want to write down some complicated multi-sector RBC model where a shock to one sector can lead to an economic downturn as resources move to more productive areas. But it's really hard to think of such a model with the frictions necessary to get the co-movement we see in the data. That is, how do you make all sectors decline after a bad shock to just one?
I still don't know how to write this model down. But I do think the ideas in the Gjerstad and Smith piece point in the right direction- to the financial sector. Unfortunately, current macroeconomic models deal with the finacial sector in a very primative way. Let's hope that researchers (as well as policy makers) learn from this economic experience and try to understand the microeconomics of business cycles.
Some ideas for a model to play with: Two productive sectors, households, financial sector. Households own shares in the firms, lend to firms, and can hold a risk free asset. Each sector is made up of an infinite number of firms each producing a homogenous good and financing capital purchases with debt, equity, and earnings. There are costs to adjusting capital and costs to external finance (these frictions will be important as they will prevent capital from being reallocated too quickly). There will be a sectoral shock and idiosyncratic shocks to the firms within each sector. Entry and exit are possible (bankruptcy is likely to be important). The financial sector links the two goods producing sectors by equilibrium conditions on the prices of debt and equity. This is the difficult part. But think of something like a negative shock to a sector producing a rash of bankruptcies. The frictions (e.g. irreversibilities in capital) mean that these bankruptcies lead to a loss in capital in the aggregate. This pushes up the cost of capital and thus hurts the other sector.
I'm sure there are holes in this model, but I think something like this is the way to go. When I get some time, I'll have to put this in Matlab and see if it can generate anything insightful.
After reading Rizzo, I want to write down some complicated multi-sector RBC model where a shock to one sector can lead to an economic downturn as resources move to more productive areas. But it's really hard to think of such a model with the frictions necessary to get the co-movement we see in the data. That is, how do you make all sectors decline after a bad shock to just one?
I still don't know how to write this model down. But I do think the ideas in the Gjerstad and Smith piece point in the right direction- to the financial sector. Unfortunately, current macroeconomic models deal with the finacial sector in a very primative way. Let's hope that researchers (as well as policy makers) learn from this economic experience and try to understand the microeconomics of business cycles.
Some ideas for a model to play with: Two productive sectors, households, financial sector. Households own shares in the firms, lend to firms, and can hold a risk free asset. Each sector is made up of an infinite number of firms each producing a homogenous good and financing capital purchases with debt, equity, and earnings. There are costs to adjusting capital and costs to external finance (these frictions will be important as they will prevent capital from being reallocated too quickly). There will be a sectoral shock and idiosyncratic shocks to the firms within each sector. Entry and exit are possible (bankruptcy is likely to be important). The financial sector links the two goods producing sectors by equilibrium conditions on the prices of debt and equity. This is the difficult part. But think of something like a negative shock to a sector producing a rash of bankruptcies. The frictions (e.g. irreversibilities in capital) mean that these bankruptcies lead to a loss in capital in the aggregate. This pushes up the cost of capital and thus hurts the other sector.
I'm sure there are holes in this model, but I think something like this is the way to go. When I get some time, I'll have to put this in Matlab and see if it can generate anything insightful.
