Person:

Simsek, Alp

We present a model of investment hangover motivated by the Great Recession. In our model, overbuilding of residential capital requires a reallocation of productive resources to nonresidential sectors, which is facilitated by a reduction in the real interest rate. If the fall in the interest rate is limited by the zero lower bound and nominal rigidities, then the economy enters a liquidity trap with limited reallocation and low output. The drop in output reduces nonresidential investment through a mechanism similar to the acceleration principle of investment. The burst in nonresidential investment is followed by an even greater boom due to low interest rates during the liquidity trap. The boom in nonresidential investment induces a partial and asymmetric recovery in which the residential sector is left behind, consistent with the broad trends of the Great Recession.

Belief disagreements have been suggested as a major contributing factor to the recent financial crisis. This paper theoretically evaluates this hypothesis. I assume that optimists have limited wealth and take on leverage in order to take positions in line with their beliefs. To have a significant effect on asset prices, they need to borrow from traders with pessimistic beliefs using loans collateralized by the asset itself. Since pessimists do not value the collateral as much as optimists do, they are reluctant to lend, which provides an endogenous constraint on optimist's ability to borrow and to influence asset prices. I demonstrate that the tightness of this constraint depends on the nature of belief disagreements. Optimism concerning the probability of downside states has no or little effect on asset prices because these types of optimism are disciplined by this constraint. Instead, optimism concerning the relative probability of upside states could have significant effects on asset prices. This asymmetric disciplining effect is robust to allowing for short selling because pessimists that borrow the asset face a similar endogenous constraint. These results emphasize that what investors disagree about matters for asset prices, to a greater extent than the level of disagreements. When richer contracts are available, insurance contracts (similar to credit default swaps) endogenously emerge to facilitate betting. Richer contracts moderate the effect of belief disagreements on asset prices because the medium of betting shifts from buying (or shorting) the asset to trading alternative contracts.