Just over five years ago, the United States entered a period of economic decline that would become known as the Great Recession. Although essentially nothing had changed in the country’s productive capacity, it experienced a sharp drop in output, employment, and consumer consumption. And though there is widespread agreement that some contraction was inevitable in the housing sector, questions remain about how the crisis spread to manufacturing and throughout the broader economy.
New research by Professor Saki Bigio addresses these issues. Bigio sees recessions as periods of great uncertainty — in particular, uncertainty in the realm of how banks value a company’s assets. “In general, someone inside a company is thought to know more about the company’s assets than the banker on the outside,” Bigio explains. “But you can have a situation in which there’s a shock to the economy, and suddenly everyone who is lending money is facing even greater uncertainty about how a particular company’s assets will be affected.” The shock might be a decline in construction, or an increase in the price of oil, or a political crisis in a certain region of the world. But the result is the same: an increase of asymmetric information, between insiders and outsiders, about the value of a company’s assets.
However, high levels of asymmetric information do not inevitably lead to recession. Some assets may fare better than others during times of uncertainty, and the performance of assets that increase in value may compensate for those that decline. But problems arise when the financial sector, which is continuously valuing assets, is less able to make accurate assessments. And when a company tries to pledge its assets — whether in the form of a new property it has acquired, a new client it has secured, or even a new marketing strategy it has developed — it may find itself unable to obtain financing. “You can have a recession simply because it’s harder for banks to assess the value of assets,” Bigio says. “And that greater uncertainty begins to spread across the economy.”
Bigio tested this theory against the recent crisis in an attempt to determine whether uncertainty alone could have caused the recession’s magnitude. His first step was using the documented uncertainty about the value of stocks during the crisis, through measures such as volatility, as a proxy for banks’ uncertainty about collateral. Second, based on others’ recent research on the link between employment and lending, he theorized that companies were pledging their collateral in order to obtain financing to pay workers. His computer model showed that this amount of uncertainty could cause a drop in funding that could explain the extent of the crisis.
Bigio’s research was not aimed at proving that uncertainty in the form of asymmetric information was the actual cause of the crisis, but that it could have been responsible — and without any other contributing factors. “And in fact, it could have, very easily,” he says. “Perhaps the knowledge that asymmetric information could alone cause such a crisis will lead to actions to alleviate the risks. For example, it may be important to strengthen bank regulations. Furthermore, firms may want to develop trade and credit relationships with their partners so they are less dependent on external funding in the event of a downturn.”
This study explores a sharply different narrative than other attempts to explain the recession. Rather than hypothesizing that the crisis was caused by households that took on enormous debt that they could not repay, which in turn led to a drop in consumer spending, Bigio’s research explores whether banks’ unwillingness to lend, amidst this greater uncertainty, caused the crisis.
Before the recent recession, research on the effects of asymmetric information had gone somewhat out of style, Bigio notes. “The idea got some attention in the 1980s and early 1990s, and after that, it was completely abandoned as a topic in macroeconomics,” he says. “Now there is a lot more interest in this issue, even if exploring the idea in a practical form is very complicated.” By coming up with a model that others can use and adapt, Bigio hopes that further research will explore other realms in which asymmetric information may contribute to economic risks.
Saki Bigio is assistant professor of finance and economics at Columbia Business School.
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