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Risky Business Cycles

Susanto Basu, Giacomo Candian, Ryan Chahrour & Rosen Valchev National Bureau of Economic Research

Date Posted:: April 27, 2021
Is Database:: Database

Research by @SusantoBasu @GiacomoCandian @RyanChahrour @RosenValchev finds shifting savings into less risky investments can amplify or cause business cycles, as safe savings vehicles with low marginal products drive larger aggregate contractions.

The paper identifies a shock that accounts for around 90% of equity risk-premium fluctuations, significantly impacting macroeconomic variables. This shock leads to a rise in the equity premium, resulting in substantial declines in output, consumption, investment, employment, and stock returns, with minimal changes in real interest rates. The shock explains over half of the unconditional fluctuations in these macro aggregates and a larger portion of their covariance. Notably, it causes a shift from full-time to part-time employment, challenging standard macroeconomic models. The findings suggest that reallocating savings into less risky investments can amplify or cause business cycles, as safe savings vehicles with low marginal products drive larger aggregate contractions.

NBER argues that shocks that drive changes in equity risk premia also explains most business-cycle comovements in aggregates, "... We identify a shock that explains the bulk of fluctuations in equity risk premia, and show that the shock also explains a large fraction of the business-cycle comovements of output, consumption, employment, and investment. Recessions induced by the shock are associated with reallocation away from full-time permanent positions, towards part-time and flexible contract workers. A real model with labor market frictions and fluctuations in risk appetite can explain all of these facts, both qualitatively and quantitatively. The size of risk-driven fluctuations depends on the relationship between the riskiness and productivity of different stores of value: if safe savings vehicles have relatively low marginal products, then a flight to safety will drive a larger aggregate contraction...."

Core of paper, "....The identified shock explains the vast majority (around 90%) of unconditional equity risk-premium fluctuations and drives persistent changes in expected excess returns with a half-life of roughly four years. Having isolated the major source of risk premium fluctuations in the data, we next examine the effects of this shock on several important macroeconomic quantities and prices. We find that an increase in the equity premium, driven by our shock, is also associated with substantial falls in output, consumption, investment, employment, and stock returns, and only a small change in real interest rates.2 Thus,our shock generates the type of comovement across macro quantities (and a “smooth” risk-free rate) that is consistent with the main stylized facts about business cycles.The identified shock also explains a substantial proportion of the overall fluctuations in macro aggregates - including over half of the unconditional fluctuations in output, consumption, investment, employment, and stock returns. Furthermore, the shock we identify explains an even greater portion of the covariance in the key variables of interest. For example, we find that the covariance of output and stock returns driven by our shock is even larger than the unconditional covariance between these two variables, implying that all other shocks in the data jointly drive these variables in opposite directions. In addition to the main business cycle variables described above, we explore the effects of our shock on a set of additional variables that are not commonly included in businesscycle studies. In particular, we show that the identified shock, while causing a fall in aggregate hours and in total employment, leads part-time employment to rise significantly, both in absolute terms and as a share of total employment. This fact poses a particular challenge for many standard macroeconomic models which, whether driven by aggregate demand or aggregate supply shocks, generally imply that different types of labor should move in the same direction...."

Susanto Basu, Giacomo Candian, Ryan Chahrour & Rosen Valchev, "Risky Business Cycles," National Bureau Of Economic Research, April 2021, https://www.nber.org/papers/w28693

Ed Comment 1/2: This seems to parallels my view. Private sector gradually expands to the outer limits of the private sector’s willingness and capacity to bear risk. Shock destroys equity and causes a reassessment of the risk upward. Economy contracts to compensate. And then gradually searches for a new optimal reallocation of resources, which takes time.
Ben Comment 1/2:Seems like the paper nods in the direction of Ed’s thinking but doesn’t really go there. Ed’s thinking (as I understand it): people take more and more risks. As those risks pile up, it becomes more likely one of those risks comes up bad. When that risk comes up bad, people pull back on their whole risk budget. The analogy is the mouse in the field who keeps going farther afield to find food. Importantly, there is a link between the amount of risk being taken and the subsequent shock to the risk budget. This paper shocks the risk parameter directly but that shock is decoupled from whatever risks might have built up in the economy. So while the paper does work through shocking a risk taking parameter, the cause of the shock is exogenous (while Ed’s thinking, as laid out above) has endogenous risk taking shocks. What I mean is, there’s no sense in which the expansion leads to the decline in risk taking. The decline in risk taking is much closer to “animal spirits” than anything Ed’s said (at least to me). Additionally, the shocks in this paper work through the labor market and not through business start ups or additional risk underwriting. Essentially, long term labor contracts are risky, so in this model when risks aversion goes up, companies substitute long term employees with short term employees. These short termers are less productive, so output goes down, investment goes down and consumption goes down. They match the facts of the world in aggregate but the mechanisms they work through are significantly different. Maybe you could interpret these long term labor relationships as risk underwriting, but to me they seem to fall into a different category. From an empirical point of view, I don’t think these guys have very much. They’re hiding a principle component analysis in their VAR (eq 8) and then saying they’ve found something. But what they’ve found is a statistical artifact that is highly correlated (by construction!) with the data series they’re interested and given it a name. Fine, that’s a thing to do but I’m not sure how much insight it gives you, especially with economic and financial data. Structural VAR models are hard and mostly aren’t structural because they end up projecting things we see in the economy in more convenient ways. They get answers but I’m not sure they get insights.
Ed Comment 2/2:It seems to me all shocks are in part exogenous at least from our "inside the economy" perspective. That is, we don’t see them coming. So while I do think that increased risk-taking (and misallocations) increases the probability of undesirable risky outcomes manifesting themselves, the triggering is sort of exogenous. My view that private sector risk-taking gradually rises to the privates sector's willingness and capacity to bear risk is somewhat different than my view about rats overreacting and scurrying back to the den. The rat story is about the logic of over-reacting to intermittent data samples. Perhaps one could argue that the only reason we aren't optimally maximizing risk is because we have overreacted in fear. But that seems too simplistic to me. what if we are taking too much risk at the end of the cycle? Clearly we would be doing that for a different reason (that fear). So I think end of cycle risk-taking might be driven by different dynamics that rat-scurrying. On the other hand one might say the same rat-like think is the very thing cause us to take too much risk, namely that we just keep taking more until bad things happen. That's say we might be taking less and less (more) for secondary reasons. Risk-taking crosses a spectrum from saving but not investing (Keynesian paradox of thrift in recession when everyone is scared), to consuming more (equilibrium), to investing more (heading to an higher equilibrium), to investing more in risky investments (heading there faster), and, possibly to consuming more. I think that if the financial markets grow and I grow more confident and buy art/a jet/second home (I save and invest less) that somehow I'm taking more risk.
Ben Comment 2/2: Thanks for clarifying. It still reads to me like there’s a link between the overall quantity of risk and the pull back in risk taking - that link is missing from the paper. I also think a lot of people are going to look at this paper pretty askance. Directly shocking a deep parameter gives your model so much flexibility that it’s hard to interpret the results in a meaningful way. This is where things start looking more like behavioral economics. Not a bad thing but there are a lot of economists who don’t really go in for it. Just my take

3% vs. 60%

Torsten Sløk Apollo

Date Posted:: April 8, 2026
Is Database:: Database

Torsten Sløk notes the direct lending market is ~$2T or 3% of household and non-financial debt outstanding. To provide context, he shows that in 2006, on the eve of the crisis, mortgages accounted for ~60% of such debt.

The direct lending market is roughly $2 trillion, or about 3% of total debt outstanding for US households and businesses. By comparison, mortgages accounted for about 60% of total household and corporate debt at the peak of the housing bubble in 2006.

Takeaways by Macro Roundup^® AI

Direct lending represents a small but growing alternative to traditional bank financing for businesses and households.
The mortgage market’s dominance has shifted dramatically since the 2006 housing peak, reducing systemic risk concentration.
Non-bank lenders now capture meaningful market share in credit provision across the economy.

Top 10% of Earners Drive a Growing Share of US Consumer Spending

Jonnelle Marte Bloomberg

Date Posted:: September 17, 2025
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Mark Zandi finds Americans in the top 10% of the income distribution accounted for 49.2% of consumer spending in Q2, the highest level since 1989.

Consumers in the top 10% of the income distribution accounted for 49.2% of total spending in the second quarter, up from 48.5% in the first quarter, reaching the highest level in data going back to 1989, according to an analysis of Federal Reserve data by Mark Zandi, chief economist for Moody’s Analytics. In contrast, the bottom 80% of the income distribution, or consumers making less than roughly $175,000 a year, have seen their spending merely keep pace with inflation since the pandemic.

Litigation Nation, Engineering Empire

Jonathon Sine Cogitations

Date Posted:: September 2, 2025
Is Database:: Database
Is Important:: Important

Jonathon Sine argues China “is moving beyond its breakneck industrial prime, facing similar dilemmas to those America confronted in the 1960s and 70s.” The ratio of science/engineering to humanities undergraduate majors is 2:1 in both the PRC and US.

Dan Wang’s “big idea” [is] “China is an engineering state, building big at breakneck speed, in contrast to the United States’ lawyerly society, blocking everything it can, good and bad.” I re-group US college majors according to Chinese disciplines to allow for rough comparison. Surprisingly, the ratio of science/engineering to humanities/social sciences is 2:1, the same as in China (if one groups management with science/engineering, as I also do for China). As with China today, America’s breakneck building phase was decidedly winding down by the 1960s. Urbanization went from 40% in 1900 to 70% by 1960, and grew much more incrementally over the next 60 years to 85% by 2020. The country simply did not need to continue building dams, expressways, and energy production facilities at breakneck pace. It became much more a matter of maintaining and upgrading (which has not gone well, at least according to the American Society of Civil Engineers’ report card). The American [building/investment slowdown that started after the 1970s] may be more about structural economic shifts than lawyers.

How America’s AI Boom Is Squeezing The Rest Of The Economy

Economist Staff The Economist

Date Posted:: August 19, 2025
Is Database:: Database
Is Important:: Important

As AI-related investment has risen since 2023, residential and nonresidential investment have declined or flatlined. This may suggest that a relatively rate-insensitive AI buildout is crowding out more interest-sensitive forms of investment.

Something like a sixth of the 2% rise in American real GDP over the past year has come from investments in computer and communications equipment, including chips, and data centres. Add in the grid upgrades to power AI models, plus the intellectual-property value of the software itself, and one estimate puts the boom’s contribution to real GDP growth at 40%. The trouble is that the very sector powering so much of America’s economic growth is squeezing the rest of its output. Housebuilders, for instance, cannot afford to be blithe about higher borrowing costs. Data centres have also constrained the rest of the economy by keeping energy prices high. Average American electricity bills have risen by 7% so far in 2025, at least in part due to the extra strain data centres have put on the grid. Real consumption has flatlined since December. Housebuilding has slumped, as has non-AI business investment.

Is it Over?

Joseph Wang Fed Guy Blog

Date Posted:: August 18, 2025
Is Database:: Database

Following tepid reactions to the release of GTP-5, Joe Wang observes, “It is looking more like companies are spending hundreds of billions on rapidly depreciating GPUs that produce a commoditized product that most clients only modestly benefit from.”

GPT-5 users widely expressed disappointment in the capabilities of the new release, which seemed in some ways a step back. This sentiment is reflected in benchmarks that show a modest improvement in capabilities since the significant improvement in version 4 released two years ago. In addition, the benchmarks suggest a broader convergence in the capabilities of AI models. Commentary suggests this could be due to inherent limitations in the LLM technology and exhaustion of new training data. AI is fascinating technology, but it may not justify the enormous sums spent in its pursuit. It is looking more like companies are spending hundreds of billions on rapidly depreciating GPUs that produce a commoditized product that most clients only modestly benefit from. The entire macro landscape would look very different without the support of the AI boom.

US Households and Firms Are in Great Shape

Torsten Sløk Apollo

Date Posted:: March 31, 2025
Is Database:: Database

Torsten Sløk notes that US household and banking sector debt has fallen to its lowest level in decades as a % of GDP, while corporate leverage has moved sideways. “The bottom line is that the private sector in the US is in incredibly good shape.”

Household sector leverage and banking sector leverage have declined significantly since 2008. Over the same period, federal government leverage has increased significantly, and corporate leverage has moved sideways. The bottom line is that the private sector in the US is in incredibly good shape.

Research by @SusantoBasu @GiacomoCandian @RyanChahrour @RosenValchev finds shifting savings into less risky investments can amplify or cause business cycles, as safe savings vehicles with low marginal products drive larger aggregate contractions.

Torsten Sløk notes the direct lending market is ~$2T or 3% of household and non-financial debt outstanding. To provide context, he shows that in 2006, on the eve of the crisis, mortgages accounted for ~60% of such debt.

Takeaways by Macro Roundup® AI

Related Articles:

Mark Zandi finds Americans in the top 10% of the income distribution accounted for 49.2% of consumer spending in Q2, the highest level since 1989.

Related Articles:

Jonathon Sine argues China “is moving beyond its breakneck industrial prime, facing similar dilemmas to those America confronted in the 1960s and 70s.” The ratio of science/engineering to humanities undergraduate majors is 2:1 in both the PRC and US.

Related Articles:

As AI-related investment has risen since 2023, residential and nonresidential investment have declined or flatlined. This may suggest that a relatively rate-insensitive AI buildout is crowding out more interest-sensitive forms of investment.

Related Articles:

Following tepid reactions to the release of GTP-5, Joe Wang observes, “It is looking more like companies are spending hundreds of billions on rapidly depreciating GPUs that produce a commoditized product that most clients only modestly benefit from.”

Related Articles:

​​Torsten Sløk notes that US household and banking sector debt has fallen to its lowest level in decades as a % of GDP, while corporate leverage has moved sideways. “The bottom line is that the private sector in the US is in incredibly good shape.”

Related Articles:

Takeaways by Macro Roundup^® AI

Torsten Sløk notes that US household and banking sector debt has fallen to its lowest level in decades as a % of GDP, while corporate leverage has moved sideways. “The bottom line is that the private sector in the US is in incredibly good shape.”