An expectations-driven interpretation of the “Great Recession”

•We link the boom that preceded the "Great Recession" and the eventual bust together.•Expected gains from financial innovations may have been too optimistic.•We use a financial-accelerator framework in a real DGE model to study news-shocks.•Changes in expectations about future default costs generate a boom-bust cycle.•A boom in asset prices and leverage, accompany a countercyclical credit spread.

The boom-years preceding the “great recession” were a time of rapid innovation in the financial industry. We explore the idea that both the boom and eventual bust emerged from overoptimistic expectations of efficiency-gains in the financial sector. We treat the bankruptcy costs facing intermediaries in a costly state verification problem as a stochastic process, and model the boom-bust in terms of an unfulfilled news-shock where the expected fall in costs are eventually not realized. In response to a change in expectations only, the model generates a boom-bust cycle in aggregate activity, asset prices and leverage, and a countercyclical credit spread.