Economic Disasters: frequency, determinants and effects

Summary:

The term economic disaster is used in the literature to distinguish especially large economic crises, defined in Barro and Ursúa (2008, 2012) as a cumulative decline in output or aggregate consumption over one or more years of at least 10 percent. Inclusion of economic disasters in both theoretical and empirical models have significantly contributed to solving a number of puzzles in financial economics. In an early contribution, Rietz (1988) showed that one of the most important puzzles, the equity premium puzzle could be solved by introducing the low-probability of economic disasters into an asset-pricing model. The idea is that the return on equities is high, compared to the return on government bonds, to compensate investors for the risk of low-probability events with a large negative economic effects. Two decades later, the original Rietz’s (1988) insight was renewed by Barro (2006). He showed that such type of models could account for the equity premium puzzle when the probability of economic disaster is calibrated from the twentieth century data on GDP for 35 countries.

After the recent financial and COVID-19 crises a number of researchers had built on Rietz’s (1988) and Barro’s (2006) insights, to construct models of asset pricing and macroeconomic dynamics that include small probability of large economic disasters. A number of recent studies suggest that rare-disaster models are useful in modelling many other financial phenomena. Examples include the low risk-free rate (Gabaix, 2012), the predictability of excess equity returns (Watcher, 2013), the volatility of equity returns (Barro and Jin, 2018), the corporate bond spreads that are higher than expected credit losses (Gabaix, 2012 and Gourio, 2013), the excess volatility of exchange rates and failure of uncovered interest rate parity (Farhi and Gabaix, 2016), and the option prices (Barro and Liao, 2016 and Seo and Wachter 2019). A growing literature suggests that economic disasters might also have important effects on the real economy (for example, Gourio 2012, 2013; Isore and Szczerbowicz 2017; Rebelo et. al. 2018; Barro 2009). Ćorić (2017) provides empirical evidence in line with the hypothesized negative relationship between economic disasters and long-run output growth. The empirical relationship between economic disasters, saving, and aggregate investment is tested by Aizenman and Noy (2015) and Ćorić and Šimić (2019), respectively.

Our research project, on the other hand, focuses on the effects of economic disasters on the real sector of economy. This is the area that has remained largely uninvestigated by the recent literature on economic disasters.

The contributions of our project can be identified through the following four lines of inquiry. Our first line of enquiry will comprise the construction of the new database on economic disasters and the analysis of the frequency and characteristics of economic disasters across countries and over time. Our second line of enquiry will comprise an investigation of the determinants of variations in the frequency of economic disasters. Particularly, we plan to investigate the question of why the number of economic disasters radically declined in developed economies after the WWII compared to the developing economies, and why in the post WWII period economic disasters appear only in relatively small, developed countries. Our third line of inquiry will comprise an investigation of the effects of economic disasters on saving and international capital flows. Finally, the fourth line of inquiry will comprise an investigation of the effects of economic disasters on sustainable development.

Ovaj rad je financirala Hrvatska zaklada za znanost projektom IP-2020-02-9710