Thread by @Noahpinion

Hi, everybody! Today's @bopinion post is about some economists who are thinking up a whole new theory of recessions.

bloomberg.com/view/articles/…

Every time there's an economic crisis, macroeconomics reinvents itself.

Except this time. The Great Recession has produced evolution, not revolution.

This would probably surprise most people outside the macroeconomic world.

Most people probably buy some version of the Hyman Minsky theory - that irrational exuberance causes excessive borrowing, leading inevitably to a bust.

But a few economists are working on a more revolutionary theory - one that would change the fundamental way macroeconomists think about recessions.

Here is a presentation by Gennaioli and Shleifer laying out the basic ideas:
papers.nber.org/conf_papers/f1…

The new idea draws on an increasing body of empirical research that finds a link between debt and recessions.

For example, here is research by Greenwood and Hanson showing that credit market booms and busts are predictable: people.hbs.edu/shanson/Issuer…

And here's a paper by Baron and Xiong showing something similar for bank lending:

princeton.edu/~wxiong/papers…

And here's a paper showing you can see the warning signs of a recession 2 years in advance (!!) by looking at credit market sentiment: nber.org/papers/w21879

And there are other papers drawing links between debt and recessions, e.g. aeaweb.org/articles?id=10… and nber.org/papers/w21581

Now the question is: WHY?

If overly exuberant credit markets predict recessions TWO YEARS in advance, why don't people cut back on lending as soon as they see this happening?

Gennaioli and Shleifer's explanation: EXTRAPOLATIVE EXPECTATIONS.

The idea of extrapolative expectations is still rare in economics, but more research is being done on it.

Examples:
1. scholar.harvard.edu/shleifer/publi…
2. scholar.harvard.edu/files/shleifer…
3. faculty.som.yale.edu/jameschoi/extr…
4. research.hks.harvard.edu/publications/g…
5. newyorkfed.org/medialibrary/m…
6. sites.uci.edu/dhirshle/files…

The Gennaioli-Shleifer model of recessions would be a true revolution in macroeconomics.

It would vindicate (but also formalize) Minsky' story.

And it might allow us to prevent recessions from happening, by observing human psychology at work.

So far, this sort of theory isn't taking macroeconomics by storm.

The dominant paradigm remains overwhelmingly grounded in A) rational expectations modeling, and B) the idea that recessions are unpredictable.

But under the radar, some folks are working on an alternative.

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