Risk shocks and divergence between the Euro area and the US in the aftermath of the Great Recession

By Thomas Brand and Fabien Tripier

http://d.repec.org/n?u=RePEc:cpm:docweb:2101&r=dge

Highly synchronized during the Great Recession of 2008-2009, the Euro area and the US have diverged in the period that followed. To explain this divergence, we provide a structural interpretation of these episodes through the estimation for both economies of a business cycle model with financial frictions and risk shocks, measured as the volatility of idiosyncratic uncertainty in the financial sector. Our results show that risk shocks have stimulated US growth in the aftermath of the Great Recession and have been the main driver of the double-dip recession in the Euro area. They play a positive role in the Euro area only after 2015. Risk shocks therefore seem well suited to account for the consequences of the sovereign debt crisis in Europe and the subsequent positive effects of unconventional monetary policies, notably the ECB’s Asset Purchase Programme (APP).

This shows how the Great Recession was different form previous recessions: risk was the major factor, and it mattered foremost in the subsequent recovery (or lack thereof). If every new recession now requires a new type of shock, we will be in constant need of rethinking the economic models (soon after, a pandemic hits…).

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