Essays on uncertainty in economics

Abstract

This thesis consists of four essays about "uncertainty" and how markets deal with it. Uncertainty is about subjective beliefs, and thus it often comes with heterogeneous beliefs that may be present temporarily or even forever. The first essay analyzes the effect of uncertainty, and the associated belief heterogeneity, on financial contracts and asset prices. I assume that optimists have limited wealth and take on leverage in order to take positions in line with their beliefs. To have a significant effect on asset prices, they need to borrow from traders with moderate beliefs using loans collateralized by the asset itself. Since moderate lenders do not value the collateral as much as optimists do, they are reluctant to lend, which provides an endogenous constraint on optimists' ability to leverage and to influence asset prices. I demonstrate that optimism is asymmetrically disciplined by this constraint, in the sense that optimism concerning the likelihood of bad events has no or little effect on asset prices, while optimism concerning the relative likelihood of good events could have significant effects. This result emphasizes that what investors disagree about matters for asset prices, to a greater extent than the level of disagreement. New financial assets are often associated with much uncertainty and belief heterogeneity, especially because they do not have a long track record. While the traditional view of financial innovation emphasizes the risk sharing role of new assets, belief heterogeneity about these assets naturally leads to speculation, which represents a powerful economic force in the opposite direction. The second essay analyzes the effect of financial innovation on the allocation of risks when both the risk sharing and the speculation forces are present. I demonstrate that speculation on new assets is amplified by the hedge-more/bet-more effect: Traders make bets on new assets which they then hedge by taking complementary positions on existing assets, which in turn enables them to place larger bets and take on greater risks. This effect suggests that, as asset markets get more complete, they become more susceptible to speculation and further financial innovation is more likely to be destabilizing. The third essay, joint with Ricardo Caballero, concerns the sources of uncertainty. We present a model in which uncertainty suddenly and endogenously rises in response to an increase in the complexity of the economic environment. In our model, banks normally collect information about their trading partners which assures them of the soundness of these relationships. However, when acute financial distress emerges in parts of the financial network, it is not enough to be informed about these partners, as it also becomes important to learn about the health of their trading partners. As conditions continue to deteriorate, banks must

(cont.) learn about the health of the trading partners of the trading partners of the trading partners, and so on. At some point, the cost of information gathering becomes too unmanageable for banks, uncertainty spikes, and they have no option but to withdraw from loan commitments and illiquid positions. A flight-to-quality ensues, and the financial crisis spreads. The fourth essay, joint with Daron Acemoglu, analyzes the effect of uncertainty of a special kind, that involves economic agents' private actions and anonymous market transactions, on the functioning and efficiency of competitive markets. Despite a sizeable literature, how competitive markets deal with this type of uncertainty remains unclear. A "folk theorem" originating, among others, in the work of Stiglitz maintains that competitive equilibria are always or "generically" inefficient (unless contracts directly specify consumption levels as in Prescott and Townsend, thus bypassing trading in anonymous markets). This essay critically reevaluates these claims in the context of a general equilibrium economy with moral hazard. Our results delineate a range of benchmark situations in which equilibria have very strong optimality properties. They also suggest that considerable care is necessary in invoking the folk theorem about the inefficiency of competitive equilibria with private information.