Reconciling Business cycles with Flight to Safety

uncertainty accounts for a third of the fall in capital investment during 2008-10. However, uncertainty also seems to increase spending in R&D. Many new ventures are undertaken in uncertain times because there are more avenues for growth but less certainty about which avenues would be successful. The surge in R&D activity in 2020 to devise a vaccine that could eradicate the Covid-19 virus is one example.

7.5 Reconciling Business cycles with Flight to Safety

In a nutshell, various attempts undertaken over the past three decades to explain the co-movement in macroeconomic variables through business cycles have been successful in some parts. They have led to inconsistencies and puzzles in oth-ers. Neutral technology shocks explain most of the fluctuations for output and consumption but do not account for their co-movement with hours. Investment-related technology shocks using real frictions in the transformation of raw capital into meaningful capital can break the Barro-King (1984) curse, explain most of the output fluctuations, and reconcile hours to business cycles, but the results diminish in the presence of financial frictions. Agency cost, collateral constraints, asymmetric information, and risk-based models explain co-movements in busi-ness cycles. However, there is difficulty in specifying structural shocks robust to modest changes in these financial frictions. Expectations and uncertainty shocks are promising indicators of the future economic climate and driving economic fluctuations, but their impact on business cycles is mostly limited to the short run.

As presented in this chapter, the research on business cycles showcases - Flight to Safety - shocks as the major driver of economic fluctuations in the long run.

There is a striking similarity between an increase in uncertainty and Flight to Safety. An increase in uncertainty leads to precautionary savings, which reduces consumption (Bansal and Yaron, 2004) and leads to Flight to Safety. Some of this increase in savings also flies abroad, as Fernández-Villaverde et al. (2009) show that an increase in uncertainty can lead to a flight of capital from small and open economies to larger and more closed ones, such as the United States.

Greater uncertainty leads to higher default risk, an increase in risk premia, and makes ambiguity averse investors (Hansen, Sargent, and Tallarini, 1999) act as if the worst possible outcome is expected to occur. If uncertainty led expectations are the key drivers of investment rationale and business cycles fluctuations, then

one mechanism where the impact of uncertainty is immediately reflected is FTS.

Measures of uncertainty developed in the last decade are at best proxies of the central phenomenon; one additional potent measure to that list could be FTS.

Figure 22 on page 95 describes the growth of US investment series that can be explained by shocks to other comparable series. These alternate time-series are similar to the Price of risk developed in this chapter in containing information about Flight to Safety and which have been explored in literature for capturing sentiments, uncertainty, and risk aversion pertaining to investments.

The thick solid lines in that figure represent variables that closely resemble the contribution to Investment growth made by FTS shocks. Shocks to investment-related variables series that are used in investment-specific TFP shocks literature, such as the TFP in Equipment and Durables consumption [TFP(EqDur)], and the Relative price of Investment and Durables Consumption to price of Consumption of Non-Durables and Services (Rel.Px Inv+DurC). These shocks exhibit higher contribution to deviation in investment growth. In comparison shocks related to consumer sentiment and liquidity spread between 1-year and 10-year yields (1y-10y) show lower contribution. There is also a similarity in results from the corporate bond spread (Baa-Aaa) and economic policy uncertainty (EPU) as both these series reflect the impact of Flight to Safety. The significant Granger causality (which we have already noticed in table 5 on page 80) running from Price of Risk series to these alternate series reassures the faith in pursuing Flight to Safety as germane to understanding the nature of business cycles.

The main finding of this paper is to show that Flight to Safety has a long term impact on the economy. Flight to Safety shocks can also provide additional fillip of generating a long-term impact on the economy, which is missing in the uncertainty based literature. It would be interesting to establish the relevance of Flight to Safety through an estimated DSGE model, which has a safe and risky investment technology and a precautionary mechanism for investors to allocate between those two. That would be a fascinating avenue for future research.

7 . 5 R e c o n c i l i n g B u s i n e s s c y c l e s w i t h F l i g h t t o S a f e t y 95

Figure 22: Contribution from sentiment variables

Notes: Investment growth in data (thin solid line in all charts, %y/y) in comparison with the investment series fitted with shocks identified from Sign and Zero restrictions discussed in Strategy 1. Data: 1985:Q1 to 2019:Q3. The benchmark configuration of the model identifies

‘FTS’ shocks as disturbances to ‘Price of Risk’ series. In other iterations of the model this is replaced with other interesting proxies for consumer expectations/sentiment and results from shocks to that replacement series of interest are reported. Such as: ‘EPU’ is Baker, Bloom and Davis (2016) Economic Policy Uncertainty index. ‘1y-10y spread’ is liquidity spread on US 1 year and10 year T-bills. ‘Rel.Px Cons to Eq.’ is Relative price of Consumption to price of Equipment. ‘Util-Adj TFP (Eq+Dur)’ is the Utilisation-adjusted TFP in producing Equipment and Consumer Durables. ‘Baa-Aaa’ is the spread on corporate bonds rated Aaa and Baa. ‘Rel.Px Inv+DurCons’ is the Relative price of Durables Consumption and Investment to Consumption of Non-Durables and Services. ‘Eq.+Dur’ share is the share of Equipment and Consumer Durables to Output. ‘Cons. Sentiment’ is US Consumer Sentiment indicator.