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Financial crises as global sunspots

Author(s): Roger Farmer

From my Economic Window:

I have just written a new working paper, 'Global Sunspots and Asset Prices in a Monetary Model', that is available on the NBER website here. The paper is a continuation of research on financial markets that I began in 2002, (2002a, 2002b) and it provides intellectual ammunition to support a proposition that I put before the UK parliament in April of 2012. We must develop a new institution that is designed to counter financial market volatility. 

My paper explains three asset pricing puzzles that are difficult to reconcile with the now standard representative agent approach to macroeconomics. First, asset prices are volatile and persistent and price dividend ratios are predictable. Second, long lived risky assets earn 5% more on average than short term government debt. And third, the volatility of asset prices changes through time. I argue that all of these puzzles are caused by the simple fact that we cannot buy insurance over the state of the world we are born into.

Why do market economies go through bouts of expansion and contraction? In the early 1980s, researchers at the University of Pennsylvania came up with a novel explanation. Even when all prices are perfectly flexible and there are no impediments to trade of any kind, financial markets still do a very poor job of allocating resources across different periods in time.  How can that be?

Dave Cass and Karl Shell, in their pathbreaking paper, "Do Sunspots Matter?",  showed that the problem with financial markets is simple but fundamental. We cannot trade in asset markets that take place before we are born.  That simple fact is sufficient to invalidate the central proposition of welfare economics: that free trade in competitive markets leads to outcomes that cannot be improved upon by government intervention.

The University of Pennsylvania, in the early 1980s, was an exciting place to be. The Cass-Shell paper relied on the idea that general equilibrium models typically have multiple equilibria.  Costas Azariadis, exploiting the same idea, wrote a seminal paper, "Self-fulfilling Prophecies", in which he showed that sunspot equilibria are endemic to overlapping generations models and I wrote a joint paper with Michael Woodford which combined this idea with monetary models (where there is always a vast multiplicity of equilibria) to show how sunspots drive business cycles.  My paper with Mike was very close to the model that had been developed by Robert Lucas to introduce the idea of rational expectations.  But in contrast to Lucas' paper, where equilibrium was unique, we showed that there could be an infinite dimensional continuum of equilibria.

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