Tail Risk and the Missing Recovery

Typically, post-World War II recessions followed a standard pattern: a drop in economic activity followed by a sharp rebound. The Great Recession, however, bucked this trend. It exhibited the sharp drop, but real gross domestic product remained below trend—12% below in 2015.

In the second part of a series, St. Louis Fed Economist Julian Kozlowski examined how tail risk may have played a part in the so-called missing recovery.

Firms and Investment

Kozlowski gave an example of a firm deciding whether to invest its capital in a project. “The return of the project depends not only on the actions of the firm, but also on the overall performance of the macroeconomy and its associated risks,” he wrote.

Tail risk is the risk that the economy will suffer extreme negative shocks (more than two standard deviations from the mean), he explained. Prior to the Great Recession, the probability of a tail event occurring was much lower, so firms would have planned their projections accordingly.

As Kozlowski noted: “This small probability of tail risk led firms to make large investments, ultimately generating economic growth until 2008.”

Increase in Tail Risk

However, following the Great Recession, the probability of abnormally low returns was much higher, which in turn impacted firms’ investment plans. “Consequently, investors reassessed their investment plans and decided to cut investment,” the author wrote. “As a result, economic growth is lower now than before the Financial Crisis.”

Modeling the Effects

Kozlowski discussed his working paper—co-authored with Laura Veldkamp and Venky Venkateswaran—which involved constructing a model to measure the impact of the increase in tail risk.Kozlowski, Julian; Veldkamp, Laura; and Venkateswaran, Venky. “The Tail That Wags the Economy: Beliefs and Persistent Stagnation.” Federal Reserve Bank of St. Louis Working Paper 2019-006B, February 2019.

Their model showed that capital, employment and output would have dropped 17%, 8% and 12%, respectively, following the financial crisis. “It shows a pattern of prolonged stagnation, and the economy never recovers from the negative shocks in 2008-09,” Kozlowski wrote in the Economic Synopses essay.

The final post in this series will discuss the effects on the returns from safe and liquid assets.

Notes and References

¹ Kozlowski, Julian; Veldkamp, Laura; and Venkateswaran, Venky. “The Tail That Wags the Economy: Beliefs and Persistent Stagnation.” Federal Reserve Bank of St. Louis Working Paper 2019-006B, February 2019.

Additional Resources

• Economic Synopses: Tail Risk: Part 2, The Missing Recovery After the Great Recession
• Working Papers: The Tail That Wags the Economy: Beliefs and Persistent Stagnation