We develop a theory of endogenous uncertainty where the ability of investors to learn about firm-level fundamentals declines during financial crises. At the same time, higher uncertainty reinforces financial distress of firms, giving rise to “belief traps”—a persistent cycle of uncertainty, pessimistic expectations, and financial constraints, through which a temporary shortage of funds can develop into a long-lasting funding problem for firms. At the macro-level, belief traps can explain why financial crises can result in long-lasting recessions. In our model, financial crises are characterized by high levels of credit misallocation, an increased cross-sectional dispersion of growth rates, endogenously increased pessimism, uncertainty and disagreement among investors, highly volatile asset prices, and high risk premia. A calibration of our model to U.S. micro data on investor beliefs explains a considerable fraction of the slow recovery after the 08/09 crisis.
Belief traps; credit crunches; dispersed information; endogenous uncertainty; internal persistence of financial shocks; resource misallocation;
- D83: Search • Learning • Information and Knowledge • Communication • Belief
- E32: Business Fluctuations • Cycles
- E44: Financial Markets and the Macroeconomy
TSE Working Paper, n. 15-604, October 1, 2015, revised March 28, 2017