Nickell Bias in Panel Local Projection: Financial Crises Are Worse Than You Think

Abstract: Local Projection is widely used for impulse response estimation, with the Fixed Effect (FE) estimator being the default for panel data. This paper highlights the presence of Nickell bias for all regressors in the FE estimator, even if lagged dependent variables are absent in the regression. This bias is the consequence of the inherent panel predictive specification. We recommend using the split-panel jackknife estimator to eliminate the asymptotic bias and restore the standard statistical inference. Revisiting three macro-finance studies on the linkage between financial crises and economic contraction, we find that the FE estimator substantially underestimates the post-crisis economic losses.