Managerial Incentives, Misreporting, and the Timing of Social Learning: A Theory of Slow Booms and Rapid Recessions

This paper presents a theory of gradual booms and rapid recessions that is motivated by the experience of the US economy over the last decade. The dynamics of the economy are driven by the speed at which agents learn about the unobserved aggregate state. Agents learn from the observed performance of firms. Each firm is controlled by a manager whose compensation is based upon the observed performance of their firm. If a manager is given short-term incentives, she will try to hide weak short-term performance. This makes the short-term performance of a firm less informative for the aggregate state, delaying the release of information until the long-term results of the firm are realized. In equilibrium, when the belief about the aggregate state is high, managers will be given short-term incentives, delaying the release of information. When the belief about the aggregate state is low, long-term incentives will be prevalent and information will be released without delay. This produces asymmetric learning dynamics for the economy, with gradual booms and rapid recessions. In a boom the belief about the aggregate state increases, information is pushed off into the future, and learning is slow. In a recession the belief is falling, triggering a switch to long-term incentives, that brings forward the release of information and accelerates learning.