Aggregate demand externality and self-fulfilling default cycles

Research Question. Why do corporate defaults cluster in recurring episodes rather than occurring smoothly? The paper asks whether observable fundamental factors — firm characteristics and macroeconomic variables — are sufficient to account for the clustered default patterns documented in the data, and, if not, what theoretical mechanism can explain them.

Empirical Motivation. Using Moody’s historical default rate data, the authors document that the long-run average corporate bond default rate during 1866–2008 was approximately 1.50%, yet defaults were highly episodic: the worst three-year period during the Great Depression totaled 12.88%, and the three-year period 1873–1875 after the railroad boom reached 35.80%. A Markov switching regression on post-war default rate data (1951–2017) strongly rejects a linear no-switch model in favor of a two-regime model across all information criteria (AIC, HQ, SC, and log-likelihood). The estimated high-default regime has a mean default rate of 1.93% (unconditional mean µ/(1−ρ)) — roughly eight times the 0.23% mean of the low-default regime — and a standard deviation nearly six times larger. The high-default regime persists on average 5.81 years (transition probability of staying ≈ 0.83), while the low-default regime lasts approximately 7.52 years (staying probability ≈ 0.87).

Turbulent business cycles

Firm-level evidence shows that recessions are characterized not just by aggregate downturns but by a sharp rise in turbulence—a reshuffling of firms’ productivity rankings in which high-productivity firms are less likely to maintain their relative standing. This paper documents four stylized facts about the macroeconomic and cross-sectional effects of turbulence (measured as one minus the Spearman rank correlation of firm-level TFP between adjacent years in Compustat data): turbulence is countercyclical; increases in turbulence reallocate labor and capital from high- to low-productivity firms; turbulence is negatively correlated with aggregate manufacturing TFP and the aggregate stock market; and an increase in turbulence is associated with persistent declines in real GDP, consumption, investment, and employment. To explain the mechanism, the authors build a real business cycle model with heterogeneous firms and financial frictions: when turbulence rises, high-productivity firms’ expected equity values fall because their productivity is less likely to persist, which tightens their borrowing constraints relative to low-productivity firms, inducing reallocation that reduces aggregate TFP. Crucially, turbulence differs from uncertainty shocks because it changes both the conditional mean and variance of the firm productivity distribution, enabling it to generate synchronized recessions with declining aggregate activity.

Pengfei Wang | Macro Paper Warehouse

Aggregate demand externality and self-fulfilling default cycles

Turbulent business cycles