Alp Simsek

Working Papers

"When Optimists Need Credit: Asymmetric Disciplining of Optimism and Implications for Asset Prices," May 2010 [Download]

Heterogeneity of beliefs has been suggested as a major contributing factor to the recent financial crisis. This paper theoretically evaluates this hypothesis. Similar to Geanakoplos (2009), I assume that optimists have limited wealth and take on leverage in order to take positions in line with their beliefs. To have a significant effect on asset prices, they need to borrow from traders with moderate beliefs using loans collateralized by the asset itself. Since moderate lenders do not value the collateral as much as optimists do, they are reluctant to lend, which provides an endogenous constraint on optimists' ability to leverage and to influence asset prices. I demonstrate that optimism concerning the likelihood of bad events has no or little effect on asset prices because these types of optimism are disciplined by this constraint. Instead, optimism concerning the relative likelihood of good events could have significant effects on asset prices. This asymmetric disciplining of optimism is robust to allowing for state contingent loans and short selling of the asset. These results emphasize that what investors disagree about matters for asset prices, to a greater extent than the level of disagreement.

I then use a dynamic extension to show how the asymmetric disciplining result interacts with the speculative component of asset prices identified in Harrison and Kreps (1978). When optimists have limited wealth, belief heterogeneity can lead to speculative asset price "bubbles" but only if it concerns the relative likelihood of good events. The asymmetric disciplining result shows that the size of the bubble depends on the type of belief heterogeneity, and that bubbles can come to an end because of a shift in belief heterogeneity towards the likelihood of bad events.

Ricardo Caballero and Alp Simsek, "Fire Sales in a Model of Complexity", July 2010 [Download]

In this paper we present a model of fire sales and market breakdowns, and of the financial amplification mechanism that follows from them. The distinctive feature of our model is the central role played by endogenous complexity: As asset prices implode, more "banks" within the financial network become distressed, which increases each (non-distressed) bank's likelihood of being hit by an indirect shock. As this happens, banks face an increasingly complex environment since they need to understand more and more interlinkages in making their financial decisions. This complexity brings about confusion and uncertainty, which makes relatively healthy banks, and hence potential asset buyers, reluctant to buy since they now fear becoming embroiled in a cascade they do not control or understand. The liquidity of the market quickly vanishes and a financial crisis ensues.

Daron Acemoglu and Alp Simsek, "Moral Hazard in General Equilibrium with Anonymous Trading," April 2010 [Download]

A "folk theorem" originating, among others, in the work of Stiglitz maintains that competitive equilibria are always or "generically" inefficient (unless contracts directly specify consumption levels as in Prescott and Townsend, thus bypassing trading in anonymous markets). This paper critically reevaluates these claims in the context of a general equilibrium economy with moral hazard. We first formalize this folk theorem. Firms offer contracts to workers who choose an effort level that is private information and that affects worker productivity. To clarify the importance of trading in anonymous markets, we introduce a monitoring partition such that employment contracts can specify expenditures over subsets in the partition, but cannot regulate how this expenditure is subdivided among the commodities within a subset. We say that preferences are nonseparable (or more accurately, not weakly separable) when the marginal rate of substitution across commodities within a subset in the partition depends on the effort level, and that preferences are weakly separable when there exists no such subset. We prove that the equilibrium is always inefficient when a competitive equilibrium allocation involves less than full insurance and preferences are nonseparable. This result appears to support the conclusion of the above-mentioned folk theorem. Nevertheless, our main result highlights its limitations. Most common-used preference structures do not satisfy the nonseparability condition. We show that when preferences are weakly separable, competitive equilibria with moral hazard are constrained optimal, in the sense that a social planner who can monitor all consumption levels cannot improve over competitive allocations. Moreover, we establish ε-optimality when there are only small deviations from weak separability. These results suggest that considerable care is necessary in invoking the folk theorem about the inefficiency of competitive equilibria with private information.