Exchange rate commitment always beats capital controls

The recent financial crisis has scared a lot of countries into adopting so called macro-prudential policies that introduce frictions into capital market that can be best summarized as capital controls. The idea is that you want to make sure that market participants are constrained in a way that makes them consider the consequences of their actions onto others. The IMF has encouraged a lot of countries to adopt such policies, in stark contrast to previous stances. And this is backed up by a recent literature that shows these policies are welfare-enhancing.

Gianluca Benigno, Huigang Cheng, Christopher Otrok, Alessandro Rebucci and Eric Young show this is right but suffers from the absence of other policy options. Specifically, once you add a policy to the mix that would be to stabilize the real exchange rate of the local currency in times of crisis, then macro-prudential policies are dominated. I suppose one could then even imagine better policies or policy combinations. But the point is that you need to expand the set of policy options. Why is this exchange rate commitment better? Capital controls act like Pigovian taxation that applies always and leads to a constraint-efficient outcome. A commitment to a real exchange rate applies only at particular times and leads to a conditionally-efficient outcome. That flexibility is key.

All that financial innovation has not lead to more transparency

What is the purpose of financial innovation? I would say it is to find new ways to insure against risk, to finance projects and to allocate funds optimally. We are taught that generally the price mechanism is the best way to do the latter, as long as it is contains all the available information. Thus, a good way to measure whether financial innovation has improved things is to measure whether prices have become more transparent.

Jennie Bai, Thomas Philippon and Alexi Savov take the idea that stock and bond prices should contain information about future earnings. Thus if you regress future earnings on current valuation (and some controls), errors should become smaller over time, because information costs have decreased and we have become more efficient at allocating financial resources. But over the last 50 years, no progress is to report. No matter how you decompose the errors, there is nothing to write home about. That is quite disappointing after all the increased financial sophistication of the financial industry. Or did this sophistication lead to more obfuscation?

Reported returns on investment for artwork are too high

Art is something one may like to have for the enjoyment of it, but it is also often touted as an investment vehicle. Quite obviously, you would need to diversify heavily. "Experts" claim that art gets a good return on average and that it is viable investment option.

Arthur Korteweg, Roman Kräussl and Patrick Verwijmeren say it is not. The issue is that all the indexes out there are based on transactions, and art items that have higher returns tend to have a higher turnover. The resulting selection bias is not negligible: 7% instead of 11%. Given that high amount of risk, it thus does not look like art is a good investment, unless you enjoy it, of course.

Pioneers of the static interest rate

When an author describes his work in the abstract or the introduction, it is common to highlight what is "new," "novel," "unique," an "improvement," or "better." But you do not write that your paper is "pioneering" or "seminal," as this can only be established by others in hindsight.

That does not stop Sarbajit Chaudhuri and Manash Ranjan Gupta, who start their abstract with "This paper makes a pioneering attempt to provide a theory of determination of interest rate in the informal credit market in a less developed economy in terms of a three-sector static deterministic general equilibrium model." OK. So we have a static model to determine the interest rate. That is pioneering. I always thought the interest rate was tied to the relative price of commodities in different periods. I guess the genius here is that with a static model, one needs not to worry about future shocks and even current shocks are instantaneously resolved so the model is also deterministic! This allows to simplify everything to a great extend, but apparently still provides a major improvement of Gupta (1997), that was, however, already pioneering the static determination of the interest rate. So the pioneership of this paper must lie elsewhere. I think the pioneering aspect is rather in the assumption that there is no flow across regional informal markets and moneylenders have a local monopoly. Imagine the pioneering strides we are now making towards a closed-form solution of the model!

High Japanese debt will become a problem

Japan has been able to sustain unusually high debt levels for a long time, even when other countries were facing debt crises despite having lower debt to GDP ratios, and more sustained GDP growth. What makes Japan so different, and what does this imply for the sustainability of Japan's debt?

Charles Yuji Horioka, Takaaki Nomoto and Akiko Terada-Hagiwara analyze the recent evolution of Japanese debt and have a grim outlook. Up to a few years ago, the debt was largely financed by Japanese households saving towards retirement. But as Japan is continuing through its demographic transition toward an older population, this source of funding is going to quickly dry up, if not reverse itself as an older population requires more transfer payments. During the few last years, an increasing share of debt was bought from abroad by investors looking for safe alternatives during times of financial turmoil. This temporary funding allows to mask the underlying drying up of internal funding. This foreign debt also carries a shorter maturity, so we may expect soon some problems in Japan, especially if other investment opportunities start looking better. Unless the Japanese government gets its fiscal house quickly in order, we may see again a country struggling with its debt.

Self-delusion in Basel II

The Second Basel Accord was put in place to more effectively prevent bank failures. The first one imposed some rather rigid rules that where not taking into account the true risk exposure of the banks, which obviously varies according to the particular activities of the bank and overall economic conditions. Basel II is more flexible in that it allows banks to used their risk models and scenarios to determine how much capital they need to secure. The goal is to have sufficient capital in 99.9% of cases of unexpected losses, or a failure once every 1000 years. That is pretty safe.

Except it is not. The first exhibit is of course what happened during the last recession. The second is a paper by Ilkka Kiema and Esa Jokivuolle that shows that in fact only a fraction of the regulatory capital needs to be loss absorbing capital. Indeed, half can be subordinated debt and thus not available when needed. According to the authors, this means that the true risk of bank failure is every 20 to 100 years. Not very reassuring, and Basel III does not seem to really address this.

The price of long-run risk

In dynamic stochastic models, standard utility function specifications imply that the curvature of this function determines directly both the risk aversion and the elasticity of intertemporal substitution. When calibrating this, modelers have a tendency to be waving hands a bit too much, as they focus more on one than the other. In addition, their calibration seems to be immune to changes in data frequency. Those who are careful about this use Epstein-Zin preferences which disentangle risk aversion and the elasticity of intertemporal substitution. They think they have done all they could to address a proper calibration.

Well, not quite. Larry Epstein, Emmanuel Farhi and Tomasz Strzalecki show there is a third dimension in play, the temporal resolution of long-run risk. Indeed, the interaction of risk aversion and elasticity determines whether economic agents prefer early or late resolution of risk. This matters. Indeed, long-run risk is priced by markets differently than short-term risk, typically higher. Indeed, people are willing to pay to know uncertain outcomes earlier. But we do not know how much so far. An opportunity for additional research.

The brain drain from financial liberalization

The financial sector is not riding high in popularity polls lately. First, compensation is deemed excessive. Second, the general public often does not perceive the benefits of a financial industry. The most common error there is the idea that finance plays a zero-sum game: anything it gains is necessarily taken away from others. Finance allows a better reallocation of resources and funds to the most productive businesses, and this raises overall productivity. But as it is well rewarded for this, it seems to be attracting perhaps an excessive number of top talents who could, at the margin, be more productive in other sectors. This brings us to a third issue: the financial sector is hiring away the best people from other sectors.

Christiane Kneer studies this inter-sectoral brain drain by looking at the consequences of financial deregulation on sectoral productivity. The assumption here is that financial deregulation attracts top talent to the financial industry because it allows the design and management of new and complex financial instruments. She finds that industries that rely the most on human capital are hurt: after an episode of financial liberalization, they have lower labor productivity, lower value added growth and lower total factor productivity. This is what happens when, for example, a software engineer moves to finance to exploit arbitrage in trade by gaining micro-second advantages over competitors. The social benefit of this arbitrage is close to zero, and some industry lost a great software engineer.

The price of producing in a sinful sector

Many people avoid investing in certain types of firms they associate with unethical or sinful behavior. That would include tobacco companies, high polluters, alcohol, fire arms and defense industry, etc. That should lower the stock market return of these firms, but there is of course some arbitrage that negates these return differentials. Yet, is there some way in which being in a sinful sector is detrimental?

Stergios Leventis, Iftekhar Hasan and Emmanouil Dedoulis found one, and that is the cost of auditing. Auditing firms are extremely sensitive to their own reputations, and who they do business with is part of their reputation. The authors also argues that auditing firms perceive that sin firms bear higher business risk, perhaps because they deviate from social norms and require more scrutiny (risk of litigation, need for higher cash reserves). In the US, such companies end up paying a whooping 20% more in auditing and consultancy fees. I wonder where else they face higher costs (it is known they have higher capital costs). This means that their stock price should still be affected despite arbitrage.

How to increase savings: add a lottery!

Households with low incomes save little. In one way, this should not surprise us, as their propensity to consume is high because the marginal utility of consumption is high. If they temporarily have low income, this is not a problem at all. However, if you have persistent low income, then you absolutely need to accumulate some savings to supplement any retirement pension income. This does not seem to be happening, and a frightening share of the population is hitting retirement age with little in the bank. Even worse, the use of lotteries and other gambling operations seems to be rather popular for lower incomes. While one can rationalize playing an actuarially unfair lottery under some circumstances (see here), it is generally considered to be a poor use of scarce income. Now, could one use the temptation of lotteries to get low income households to save more?

Kadir Atalay, Fayzan Bakhtiar, Stephen Cheung and Robert Slonim show one can combine saving accounts effectively with lottery jackpots. In an experiment conducted online in the US, they had participant allocate funds under various savings schemes. While this is not quite like the real world, it still reveals some interesting findings. Introducing a jackpot lottery does indeed increase savings, and significantly so (the authors find a 12 percentage point boost). These savings come both from delayed consumption and reduced lottery participation outside of the savings account. And all these effects are stronger among those with lower incomes. Can we believe those results? After all, the jackpots in savings lotteries are supposed to be "life changing", something that such an experiment cannot simulate. But it is encouraging to still see a strong impact.

Taylor rules with assets and credit

One thing we have learned from the last recession is that the financial sector is quite important, that its dysfunction can have important consequences, and this can happen even in the most financially elaborate economy. Some thus call for the health of the financial sector to become a component of every policy maker's dashboard. From a dashboard it is only a small step to include the financial sector into a policy formula such as the Taylor Rule.

Leonardo Gambacorta and Federico Signoretti take that step by deriving from a DSGE model a Taylor Rule that includes asset prices and the amount of credit. So far so good, but why not also include the exchange rate? And more indicators? This is not the purpose of the Taylor Rule. It was devised to be a simple guide to policy, from which you want to deviate when circumstances call you to do so, for example with unconventional policies that cannot be captured with a Taylor Rule, simple or not. The best example is when the Taylor Rule calls for negative nominal interest rates. Would anybody blindly follow this? Of course not, and this is why we should stop thinking in terms of a single equation, especially when one has several policy goals. You needs at least as many instruments as goals. The policy interest rate cannot do everything.

Political connections pay off in the US

It is no secret that political connections help your business. The more more regulated or corrupt your economy, the more likely this is to be true. How much this helps is difficult to quantify. For one, political connections cannot be measured on some sort of scale, and gathering such data would be very difficult as people usually try to hide such connections from the public. And second, how would you measure the impact of of these connections.

Yen-Teik Lee, Bang Dang Nguyen and Quoc-Anh Do find a way by first looking at the university networks among CEOs and candidates to US state governor races and then looking at the stock valuation of firms around the time of close gubernatorial contests. Firms connected to the right candidate gain 1.36% right after the election, and the bump persists. Imagine how large this can become in countries where such patronage is less scrutinized and where regulation is more prevalent.

Superstitions and markets

The game of heads and tails with a coin toss is universally recognized as a game where the odds of each outcome are exactly 50%. In monetary terms and in expectation, nothing can be gained from this gamble, and in utility terms (again in expectation) one can only lose. Yet, people keep playing it for gain.

Silvia Bou, Jordi Brandts, Magda Cayón and Pablo Guillén devise a laboratory experiment where after an initial phase of five coin toss guesses, some students are asked to bet who will get the most guesses right in a second round of tosses. The subtlety of the experiment is that by default, the students are assigned the worst guesser of the first phase, and switching to another one is expensive. Yet almost all switched. This means that they were thinking that a lucky streak of right guesses in the first phase would continue in the second. And these were finance students, who should really know better.

More financial education could lead to more market instability

At least part of the blame for the last crisis was put on the lack of financial literacy of some borrowers who accepted mortgages they could not reasonably pay back. More generally, the lack of financial literacy is blamed for the widespread less than optimal funding for retirement and for excessive fluctuations in asset prices, a prime example being gold.

Mario Padula and Yuri Pettinicchi use some theory to understand how financial literacy can have an impact of markets, in particular market fluctuations and instability. In their model, one suffers some dis-utility cost from becoming more financially literate, but this lowers the cost of buying a more precise signal. The policy variable is the effectiveness of becoming financially literate. Beyond the utility/signal trade-off, the model highlights important general equilibrium effects. Indeed, once it becomes too easy to be literate, people stop buying signals because the market advantage of the signal has vanished: too many people share the information, and the benefit from asymmetric information is too small. The proportion of well-informed people is U-shaped as financial literacy is more easily accessible, as so is market volatility. Cheap information may not be worth acquiring.

PS: it looks like the paper has been removed from IDEAS. It is, however, still available here (pdf)

The option of suicide

Suicide is a trigger strategy and when to pull the trigger is a decision that involves forming expectations over future outcomes. It is a difficult decision, as future outcomes are very uncertain, if not difficult to quantify.

Shin Ikeda models the suicide decision as the decision to exercise an American option on future wages. Seen this way, the suicide option is straightforward to quantify once you have wage profiles of suicide candidates (to determine timing) and non-candidates (to determine future wage profiles, their distribution and how they may differ form suicide candidates). From anecdotal evidence, anxiety seems to be an important factor, thus modeling at least risk aversion right is very important, as well as bankruptcy. Unfortunately, this is not at all how the paper proceeds. Individuals are risk neutral, but returns are adjusted for market risk. Individuals hold no assets or debt, except their human capital. The wage process is identical for everybody. It is then no surprise that the results are not realistic, indicating that the strike price corresponds to 90% of the average initial wage in perpetuity, meaning that a majority of workers is at suicide risk at some point during their life. Any study in the value of life literature gives numbers much higher than this value, and this is because people value more than just wages. Instead of only looking at money flows, one needs to consider concepts like utility and preferences...

The social pressure of overborrowing

The recent financial crisis has highlighted the sometimes very poor financial choices of households, in particular overborrowing. What leads people to borrow beyond their means or to take excessive risk of default or bankruptcy? Is it because of predatory lending with perverse incentives for loan underwriters? Plain stupidity of the borrowers? Or rational exuberance?

Dimitris Georgarakos Michael Haliassos and Giacomo Pasini look at Dutch data and find rather something that looks like social pressure. Indeed, they find that borrowing is heavier among those who consider themselves poorer than their peers. In other words, they are trying to keep up with the Jones in the sense that they want to display the same material wellbeing as their peers, on a borrowed dime. I do not know how much peer pressure there is in the Netherlands, but I can imagine a series of countries where such pressures would be important, where you need to fit in by having the right car or the right house, or by taking the right vacations. And it seems unavoidable that some people will overextend themselves in such an environment.

Why is financial education unpopular?

People make dumb financial choices often because they miss some of the most elementary notions of finance, and they even realize that. Yet, it is extremely difficult to get them to sit down and learn something about elementary finance? Why? Is it because their is a stigma? Because it is horribly boring? Because they have better things to do? Because they do not see the point of it?

Miriam Bruhn, Gabriel Lara Ibarra and David McKenzie tried to coax people into a financial education class in Mexico and found it very difficult. They tried with substantial monetary incentives and still achieved little. Even more disheartening, those they managed to get through the door retained very little: they saved more, but only for a little time, and their borrowing effort was unaffected. Sad.

I wonder whether there is comparable data for developed economies that were recently rattled by the financial crisis. People must have realized that financial education matters. Did they improve their financial literacy? Give me some hope.

Mortgage refinancing is not that hard

We continuously take economic decisions. Most of the time, they are trivial. Sometimes they are important, and any sensible person thinks hard before settling on an option. Purchasing a home is complex, for example. Can one afford it? Is it the right price? How will it evolve? How is the financing? Comparatively, refinancing a mortgage is relatively easy: what is the interest saving? What are the fix costs? How long does one expect to hold this mortgage?

Yet, it appears a substantial fraction of those refinancing their home mortgage make lightheaded mistakes, according to Sumit Agarwal, Richard J. Rosen and Vincent Yao. Using a dataset that covers homeowners who only refinance to reduce mortgage payments, they find that 52% pick the wrong interest rate (off by at least 50 basis points) and 17% wait at least six months too long, likely because they do not monitor rates. That could be excused by inattention, but when you consider the amounts involved, they would need to have some very lucrative alternative uses of their time. That is quite disappointing for those who model optimizing agents.

Savings and religion II

Various religions have different prescription on how rich people should be. Early Christians advocated low wealth and much redistribution, modern American Protestants seem to lean more towards wealth accumulation and little redistribution, to cite some extremes. What impact does religion have on savings behavior? Of course, nowadays it matters how religious people are. Conditional on a high level of religiosity, the religious affiliation should then matter. Earlier work using the PSID yields results that are puzzling to me: atheists save less.

Can new work by the same author, now going by the name of Anja Köbrich León, with the same dataset be illuminating? Well, not quite. In fact, the results do not seem to be robust across econometric methods, indicating some serious endogeneity issues, as has been hinted in the comments of the first post. So there, I had good reason to be puzzled.

PS: the earlier work is not cited in the extensive literature review. Is Anja hiding something here?

Risk management four centuries ago

I tend to think that financial management, and especially risk management, are modern creations that came about after the introduction of analytic accounting, information technology, and the rise of new financial instruments. In other words, you look one century back at firms and individual, they would have laughable financial setups by todays standards. How about some data?

Ann Carlos, Erin Fletcher and Larry Neal look at the financial marketplace four centuries ago in London. They look at firms that were discussed in the financial press at that time and reverse-engineer their ownership structure. Quite remarkably, they find that investors in those old times were not very financially literate. While there is no doubt they were among a very small elite of the population and should have known better, they were very poorly diversified. About 80% of them were investing in a single company, while there were ample opportunities to diversify. The authors think this may also have to do with shareholder voting rules, which required a minimum number of shares to be allowed to vote. But I think such rules could only emerge if shareholders were not aware of the benefits of diversification, which must have been quite large.