Uncertainty Shocks and Balance Sheet Recessions

Sebastian Di Tella

Journal of Political Economy, 2017, vol. 125, issue 6, 2038 - 2081

Abstract: This paper investigates the origin and propagation of balance sheet recessions. I first show that in standard models driven by TFP shocks, the balance sheet channel disappears when agents can write contracts on the aggregate state of the economy. Optimal contracts sever the link between leverage and aggregate risk sharing, eliminating the concentration of aggregate risk that drives balance sheet recessions. I then show that uncertainty shocks can help explain this concentration of aggregate risk and drive balance sheet recessions, even with contracts on aggregate shocks. The mechanism is quantitatively important, and I explore implications for financial regulation.

Date: 2017
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