And where does aggregate risk come from? The basis for many real business cycle models is an aggregate shock to the technology parameter of the aggregate production function. This shock has to have large persistence in order to match the moments of various economic parameters. Unresolved is the source of aggregate shock. Various multi-sector models have not been able to generate the persistence required and have been abandoned.
One possible source of technology shock is an increase in risk so that the shock parameter is interpreted as an increase in uncertainty as measured by its standard deviation. Existing literature shows that large persistence needs to be assumed for this to work. This persistence using multi-sector models is revisited not as different sectors of the real economy (as was in early multi-sector models) but as different sectors of an economy that chooses to adopt a new innovation e.g. early versus late adopters on a continuous time scale.
Two innovations are considered: just-in-time inventory and financial innovations. Advances in computer technology and communications have made the adoption of just-in-time inventory easier. Early adopters benefit when it works. These early adopters take on the most risks and hence bear the fruits of early adoption. They are also the guinea pigs in the sense that these early adopters face idiosyncratic shocks to their production functions as they iron out the early difficulties. In the early stages, these random shocks only affect the early adopters and not the entire economy.
The gains by early adopters provide an incentive for more firms to shift into the new technology. As more firms adopt just-in-time inventory, they become more interconnected. Consider an idiosyncratic shock that affects for instance, the software provider of a small segment of the economy that is interlinked by just-in-time inventory management. While this shock is idiosyncratic in a sense that it only affects the firms that use the software provider, the interconnectedness of the economy is now such that a ripple effect is created as inventories in one sector affects that of another even though they do not share the same software provider. In this sense, an idiosyncratic shock has resulted in a systemic problem for the economy. A small shock can thus have a large propagation mechanism.
Consider the role of financial innovations in the current economic crisis. Assume that securitization has made some securities safer. Early adopters that buy and sell these securities reap large gains providing the incentives for firms to enter the market. Now throw in the additional wrinkle that the fact that these securities are deemed safe (even though they may not be) provide incentives for all firms (early and late adopters) to take on additional risks by buying more of these securities. As more and more firms adopt the financial innovation an idiosyncratic risk to one firm now becomes a correlated or systemic risk as they become more interconnected. Thus aggregate risks increase as more firms adopt an innovation.
Why haven't risks from adopting JIT translated into an economic crisis. An Economist survey points to several examples where they almost did yet the scale of these problems tend to remain localized in time and space and did not spread, i.e. the shocks were not persistent. What is the difference? Both innovations allow firms to take on more risks. JIT adopters run lean inventories and this increases the risk of stock outs. In a systemic crisis there would be economy wide shortages.
One may be tempted to say that firms can hoard inventory as soon as a shortage is likely. The best analogy to hoarding in the financial sector is short-selling and thus the ability to hoard is likely not the major difference. As most commentators have pointed out, the most likely culprit is leverage or excessive leverage. Consider a firm that funds its day to day operations from sales and pays for its inventories out of sales. A prudent firm might continue operating in this fashion or it might borrow a little in order to take advantage of the next cycle of inventories that it thinks might make it first to market for a new product. As long as the firm does not borrow too much, an idiosyncratic shock is likely to remain just that - at worst it may translate into a systemic shock but with little persistence. As long as only small numbers of firms take this risk and on different goods the problem of failure will remain local. But when all firms borrow heavily and take greater risks then this can lead to a systemic problem.
The insight from this is not too great - but it provides the link between innovation and how it mass adoption can make the economy more vulnerable. Some experts in the Economist survey claim that it is only a matter of time before JIT leads to large problems but perhaps there is a chance that it will not. What then the role of leverage and adoption of new financial products in the current crisis? Should the Fed regulate adoption or leverage or both? One can argue that the innovation was NOT really the product that firms were buying into but the ability to increase leverage. Should financial innovations that increase leverage be more regulated than others? And what of JIT? Should the government increase its oversight into this as well?
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