Stability of expectations and severity of crises

Abstract

We show that the severity of banking and debt crises is negatively related to the volatility of GDP growth expectations. Series of expectations are built by using a stochastic-gain learning algorithm whose predictions match survey data on output growth expectations well. We construct several measures of severity of crises that capture output growth losses associated with crises. Our empirical analysis addresses Hyman Minsky’s theoretical conjecture (part of his so-called Financial Instability Hypothesis) that macroeconomic stability is conducive to high leverage, which in turn makes a crisis more severe once it happens.