Posts filed under ‘Financial Markets’
| Peter Klein |
Central to the “Austrian” understanding of business cycles is the idea that monetary expansion — in Wicksellian terms, money printing that pushes interest rates below their “natural” levels — leads to overinvestment in long-term, capital-intensive projects and long-lived, durable assets (and underinvestment in other types of projects, hence the more general term “malinvestment”). As one example, Austrians interpret asset price bubbles — such as the US housing price bubble of the 1990s and 2000s, the tech bubble of the 1990s, the farmland bubble that may now be going on — as the result, at least partly, of loose monetary policy coming from the central bank. In contrast, some financial economists, such as Laureate Fama, deny that bubbles exist (or can even be defined), while others, such as Laureate Shiller, see bubbles as endemic but unrelated to government policy, resulting simply from irrationality on the part of market participants.
Michael Bordo and John Landon-Lane have released two new working papers on monetary policy and asset price bubbles, “Does Expansionary Monetary Policy Cause Asset Price Booms; Some Historical and Empirical Evidence,” and “What Explains House Price Booms?: History and Empirical Evidence.” (Both are gated by NBER, unfortunately, but there may be ungated copies floating around.) These are technical, time-series econometrics papers, but in both cases, the conclusions are straightforward: easy money is a main cause of asset price bubbles. Other factors are also important, particularly regarding the recent US housing bubble (I suspect that housing regulation shows up in their residual terms), but the link between monetary policy and bubbles is very clear. To be sure, Bordo and Landon-Lane don’t define easy money in exactly the Austrian-Wicksellian way, which references natural rates (the rates that reflect the time preferences of borrowers and savers), but as interest rates below (or money growth rates above) the targets set by policymakers. Still, the general recognition that bubbles are not random, or endogenous to financial markets, but connected to specific government policies designed to stimulate the economy, is a very important result that will hopefully influence current economic policy debates.
| Peter Klein |
1. I didn’t win.
2. The award is for asset pricing — Gene Fama’s work that underlies the efficient markets hypothesis, Robert Shiller’s contributions to behavioral finance, and Lars Hansen’s development of the Generalized Method of Moments (GMM) regression technique, which is often used in studies of asset prices. (I feel bad for Kenneth French, who could also have won with Fama.)
3. Many people had anticipated a possible Fama-Shiller award, recognizing two people working in the same field but using very different approaches and reaching radically different conclusions, much like the Hayek-Myrdal award of 1974. (Hansen was on the short list for an econometrics award, but not usually bundled with Fama and Shiller.)
4. Fama holds that markets are “rational” and bubbles can’t exist. Shiller holds that markets are irrational and that bubbles are common, resulting from “animal spirits.” As usual, the Austrians take the balanced, reasonable, middle ground, holding that asset bubbles do exist, not because of irrational exuberance, but because of central-bank manipulation of the money supply and interest rates. Down with extremists!
5. Fama’s work on agency theory, while less well known than the efficient markets hypothesis, should be of particular interest to O&M readers. His “Agency Problems and the Theory of the Firm” (1980) argued that competition among managers (current and potential) can help mitigate discretionary behavior, and his “Separation of Ownership and Control” (1983, with Mike Jensen) pointed out that contracts can sometimes substitute for equity ownership in reducing agency costs.
6. I’m not a huge fan of Shiller, but I appreciate his position here:
“Economists seem to miss things that are important” because they’re so busy. “Specialization coupled with strong competitive pressures within academia leads to a situation in which academics often feel that they just do not have time to ponder broad issues and learn even basic simple facts outside their specialty,” the Shiller paper says. “Their general knowledge may be embarrassingly limited, and so they may retreat into their own specialty and produce research which contributes in small ways to the development of the field, but fails to pay attention to the larger picture.”
Update: Here’s a detailed explanation of Fama’s contributions from his Chicago colleague John Cochrane.
| Peter Klein |
One doesn’t have to be a strict methodological individualist to appreciate that collectives don’t think, act, and choose. Yet one of the standard tropes of financial journalism is the idea that the stock market, like your broker or your Aunt Sally, “reacts” to this or that bit of economic news. “Stocks Soar on Summers Withdrawal,” screams this morning’s Reuters headline. This reporter has some serious powers of discernment: trading Friday “was subdued ahead of the Federal Reserve’s expected reduction of stimulus measures next week.” “In reaction to the withdrawal of Mr. Summers, the dollar slipped to a near four-week low against a basket of currencies.” And: “Further whetting risk appetite were signs of progress in Syria following a Russian-brokered deal aimed at averting United States military action.”
Of course, this is all pure invention on the part of the reporter. Nobody knows for certain why a stock-price average goes up or down. Think about it. The prices of individual stocks reflect expectations of future dividends and future price movements, and they go up and down as new information is revealed about the firm and its competitors. We can never know for certain what makes people buy and sell particular shares but, in the case of an individual firm, we can reasonably infer that shareholders as a group are reacting to new information about the firm. The firm announces quarterly earnings below analysts’ expectations, the share price tends to fall. A competitor announces bankruptcy, the share price tends to rise. Event studies are a popular technique for quantifying investor reactions to news and events related to particular firms.
But the stock market as a whole doesn’t work this way. Stock prices go up and down, and indexes like the S&P 500 and DJIA go up and down according to the performance of their member stocks. Sometimes the average rises, sometimes it falls. Duh. The idea that movements in the index necessarily embody the reaction of the market as a whole to some piece of aggregate economic news reflects a failure to grasp the concept of an average. Of course, it’s always possible that investors’ beliefs about the prospects for particular stocks reflect shared concerns about the economy as a whole. If the government announces an increase in the corporate income tax rate, the prices of many stocks will likely fall. But this applies only to the most obvious cases. Did lots of investors care about Larry Summers’s withdrawal from the Fed race, enough to make them start buying stocks? Who knows? Clearly financial journalists — who are paid to write about such things — care a lot about the next Fed chair. But we have absolutely no idea how much investors care, and no way at all to attribute this morning’s rise in US equity prices to the Summers announcement or any other piece of economic news.
So please, can we stop taking such pronouncements seriously? The stock market is a social institution, an aggregate of individual trades and traders. Let’s stop anthropomorphizing it.
| Peter Klein |
O&Mers attending the AoM conference may find these Professional Development Workshops, sponsored by the Academy of Management Perspectives and based on recent AMP symposia, of particular interest:
The first PDW is on “Private Equity” and features presentations on the managerial, strategic, and public policy implications of private equity transactions. Presenters include Robert Hoskisson (Rice University), Nick Bacon (City University London), Mike Wright (Imperial College London), and Peter Klein (University of Missouri). The private equity session takes place Saturday, Aug 10, 2013 from 11:30AM – 12:30PM at WDW Dolphin Resort in Oceanic 5.
The second is on “Microfoundations of Management,” and features presentations from Nicolai Foss (Copenhagen Business School), Henrich Greve (INSEAD), Sidney Winter (Wharton), Jay Barney (Utah), Teppo Felin (Oxford), Andrew Van de Ven (Minnesota), and Arik Lifschitz (Minnesota). The microfoundations session takes place Monday, Aug 12, 2013 from 9:00AM
– 10:30AM at WDW Dolphin Resort in Oceanic 5
| Peter Klein |
Microfinance and microenterprise have been touted as a new model for economic development, a way to encourage investment, innovation, and business creation and raise living standards without having to go through large-scale industrialization. We’ve tended to be skeptical, however, particularly about the most touted microfinance providers such as the Grameen Bank. Theoretically, the kinds of repayment plays that make microfinance feasible (high interest rates, strong peer monitoring) seem to limit its scope; besides, not everyone wants to be a business owner. The empirical evidence has not been encouraging — microfinance may achieve some social goals, like a sense of empowerment among microenterprise owners, but does not seem to have much impact on overall economic activity. It may not be possible to jump from a largely rural, agrarian society to an entrepreneurial capitalist one without going through a period of large-scale industrial development.
These musings are inspired by a new NBER working paper from the J-PAL group which uses a randomized controlled trial to study the effects of microfinance in an urban Indian setting. The results confirm the suspicions above: access to microfinance brings about some changes in behavior, but has no noticeable effect on standards of living or overall economic performance. Here’s the info:
The Miracle of Microfinance? Evidence from a Randomized Evaluation
Esther Duflo, Abhijit Banerjee, Rachel Glennerster, Cynthia G. Kinnan
NBER Working Paper No. 18950, May 2013
This paper reports on the first randomized evaluation of the impact of introducing the standard microcredit group-based lending product in a new market. In 2005, half of 104 slums in Hyderabad, India were randomly selected for opening of a branch of a particular microfinance institution (Spandana) while the remainder were not, although other MFIs were free to enter those slums. Fifteen to 18 months after Spandana began lending in treated areas, households were 8.8 percentage points more likely to have a microcredit loan. They were no more likely to start any new business, although they were more likely to start several at once, and they invested more in their existing businesses. There was no effect on average monthly expenditure per capita. Expenditure on durable goods increased in treated areas, while expenditures on “temptation goods” declined. Three to four years after the initial expansion (after many of the control slums had started getting credit from Spandana and other MFIs ), the probability of borrowing from an MFI in treatment and comparison slums was the same, but on average households in treatment slums had been borrowing for longer and in larger amounts. Consumption was still no different in treatment areas, and the average business was still no more profitable, although we find an increase in profits at the top end. We found no changes in any of the development outcomes that are often believed to be affected by microfinance, including health, education, and women’s empowerment. The results of this study are largely consistent with those of four other evaluations of similar programs in different contexts.
| Peter Klein |
The new issue of the Academy of Management Perspectives features a symposium, edited by Mike Wright, on “Private Equity: Managerial and Policy Implications.” The symposium includes “Private Equity, HRM, and Employment” by Mike with Nick Bacon, Rod Ball, and Miguel Meuleman; “The Evolution and Strategic Positioning of Private Equity Firms” by Robert E. Hoskisson, Wei Shi, Xiwei Yi, and Jing Jin; and “Private Equity and Entrepreneurial Governance: Time for a Balanced View” by John L. Chapman, Mario P. Mondelli, and me. The symposium came out very nicely, if I may say so, covering a variety of strategic, entrepreneurial, and organizational issues related to private equity firms and companies receiving private equity finance.
In his introduction Mike highlights five main contributions:
First, the papers address the need to consider the systematic evidence on the managerial and strategic aspects of PE, in relation to both portfolio firms and PE firms, which has been largely fragmented if not nonexistent. Second, the papers analyze the impact of PE during economic downturns and demonstrate the underlying resilience of PE-backed portfolio firms. Third, the symposium provides an opportunity to develop insights that compare the managerial impact of PE with different forms of ownership and governance. Fourth, the articles in this symposium highlight the heterogeneity of the private equity phenomenon. Finally, in the context of continuing public attention to PE, which has been heightened by the U.S. presidential race and the global recession, the evidence presented in this symposium paints a rather more positive view than the hyperbole of some of the industry’s critics would suggest. Taken together, these contributions indicate a need for caution in attempts to tighten the regulation of PE lest the economic, financial, and social benefits be lost.
| Peter Klein |
From my colleague John Howe. Here’s the news item:
MarketWatch (June 20, Orol), meanwhile, has learned that “regulatory observers urged policy makers on Wednesday to require companies to make road-show discussions available to the broader public.” Among them was Ann Sherman, associate professor of finance at DePaul University. She spoke at the Senate Banking Committee hearing that was devoted to whether the IPO process was working for ordinary investors and stated: “It is very important that we try to give everyone the same information.” Lise Buyer, founder of Class V Group LLC, a firm that guides IPO-bound companies, agreed with Sherman. She added that one way to improve the flow of information would be to require companies on a road show to hold a scheduled “Ask the Management” Q&A session via the Internet.
Do people actually think we can level the information playing field? Not only is that naive (stupid), but it leads small/individual investors to the wrong conclusion — that they are not at a comparative disadvantage in the financial markets. They are, and they’re better off knowing it.
| Peter Klein |
Reminder: Proposals for the Managerial and Decision Economics special issue on “Effects of Alternative Investments on Entrepreneurship, Innovation, and Growth” are due 15 June 2012. Don Siegel, Nick Wilson, Mike Wright, and I are editing the special issue and organizing a paper-development conference 29 October 2012 at the SUNY Global Center in Manhattan. Click the link above or go here for further details. We look forward to your submissions!
| Peter Klein |
Two years ago I was in D.C. on Hayek-Klein day and found myself on an elevator with Ben Bernanke, upon which I persuaded him to sing me a few bars of Happy Birthday. True story. This year I was in D.C. again, this time to give an organizational economist’s perspective on the Federal Reserve System to the House Financial Services Committee’s Subcommittee on Domestic Monetary Policy and Technology. You can read my written testimony here and see the oral remarks at C-SPAN which has archived the event.
That’s Jeff Herbener to my right and John Taylor to my left, with Jamie Galbraith by Taylor. The one on the end is not Yoda, but Alice Rivlin.
Because the hearing was televised, I can truthfully say, “I’m not a macroeconomist, but I play one on TV.”
| Peter Klein |
Along with Don Siegel, Nick Wilson, and Mike Wright, I am guest editing a special issue of Managerial and Decision Economics on the “Effects of Alternative Investments on Entrepreneurship, Innovation, and Growth.” Proposals are due 15 June 2011. A special issue conference for developing the papers is planned for 29 October 2011 at the SUNY Global Center in Manhattan. The conference is jointly sponsored by the SUNY-Albany School of Business, the Centre for Private Equity Research at Imperial College Business School, and the McQuinn Center for Entrepreneurial Leadership. Further details and submission guidelines are below the fold. (more…)
| Peter Klein |
Raghu Rajan’s AFA presidential address is now online as an NBER working paper:
The nature of the firm and its financing are closely interlinked. To produce significant net present value, an entrepreneur has to transform her enterprise into one that is differentiated from the ordinary. To achieve the control that will allow her to execute this strategy, she needs to have substantial ownership, and thus financing. But it is hard to raise finance against differentiated assets. So an entrepreneur has to commit to undertake a second transformation, standardization, that will make the human capital in the firm, including her own, replaceable, so that outside financiers obtain rights over going-concern surplus. I argue that the availability of a vibrant stock market helps the entrepreneur commit to these two transformations in a way that a debt market would not. This helps explain why the nature of firms and the extent of innovation differ so much in different financing environments.
| Peter Klein |
Mitt Romney’s time as head of Bain Capital has put private equity in the public spotlight. Jonathan Macey gave a vigorous defense of PE in Friday’s WSJ. I am certainly a fan, though of course PE as a governance mechanism has benefits and costs, like all organizational structures. For a great overview of the industry and its role in job creation and economic growth, listen to last Thursday’s Diane Rehm show, where Steve Kaplan gave a terrific presentation emphasizing the data and challenging popular myths about takeovers and layoffs.
| Peter Klein |
According to the latest Kauffman Foundation survey of “top” economics bloggers. (I participate, so it’s not that exclusive a club.)
Full report available here. As Kauffman’s Tim Kane notes, “The economics blogging community has proven to be very insightful with rich and diverse viewpoints, but by nature they understand the importance of entrepreneurship because that’s ultimately who they are.” I agree, with the caveat that many of us don’t exactly have a lot of skin in the game. . . .
| Peter Klein |
Two recent review-type papers from NBER:
Behavioral Corporate Finance: An Updated Survey
Malcolm Baker, Jeffrey Wurgler
NBER Working Paper No. 17333
Issued in August 2011
We survey the theory and evidence of behavioral corporate finance, which generally takes one of two approaches. The market timing and catering approach views managerial financing and investment decisions as rational managerial responses to securities mispricing. The managerial biases approach studies the direct effects of managers’ biases and nonstandard preferences on their decisions. We review relevant psychology, economic theory and predictions, empirical challenges, empirical evidence, new directions such as behavioral signaling, and open questions.
A Brief History of Regulations Regarding Financial Markets in the United States: 1789 to 2009
Alejandro Komai, Gary Richardson
NBER Working Paper No. 17443
Issued in September 2011
In the United States today, the system of financial regulation is complex and fragmented. Responsibility to regulate the financial services industry is split between about a dozen federal agencies, hundreds of state agencies, and numerous industry-sponsored self-governing associations. Regulatory jurisdictions often overlap, so that most financial firms report to multiple regulators; but gaps exist in the supervisory structure, so that some firms report to few, and at times, no regulator. The overlapping jumble of standards; laws; and federal, state, and private jurisdictions can confuse even the most sophisticated student of the system. This article explains how that confusion arose. The story begins with the Constitutional Convention and the foundation of our nation. Our founding fathers fragmented authority over financial markets between federal and state governments. That legacy survives today, complicating efforts to create a financial system that can function effectively during the twenty-first century.
| Peter Klein |
The idea of a renegotiation-proof equilibrium — a situation in which all commitments are credible such that no party has an incentive to alter the arrangement — became popular in the game-theoretic contract literature in the 1980s. A recent paper by Michael Roberts shows that renegotiation is much more common in bank lending than is commonly recognized (by academics), suggesting that in many cases, formal financial contracting arrangements should be seen as starting points for future negotiation, not equilibrium agreements.
We show that bank loans are repeatedly renegotiated by the borrower in an effort to loosen contractual constraints designed to mitigate information asymmetry. The typical loan is renegotiated every eight months, or four times during the life of the contract. The frequency of renegotiation is closely linked to the restrictiveness of the initial contact and the degree of information asymmetry between borrower and lender. In addition to significantly altering the terms of the contract, renegotiation reduces the speed of information revelation – more anticipated renegotiation rounds lead to longer durations between those renegotiations as information evolves more slowly. Consequently, later renegotiation rounds are more sensitive to new information regarding the borrower and their outside options than early rounds. An important by-product of our study is to show that many of the observations in the Dealscan database correspond to renegotiations of the same credit agreement, as opposed to originations of new loans.
| Peter Lewin |
From management professor Richard Rumelt. This is very interesting.
Today, households carry a much greater relative debt burden than they did in 1929, largely due to a 25-year mortgage binge. Between 1980 and 2007, disposable income grew at 5.9% per year while household indebtedness grew at 8.7% per year — a clearly unsustainable situation. As in 1939, this hangover of debt blocks new rounds of consumption and dulls the impact of fiscal and monetary stimuli.
From today’s WSJ: here.
| Peter Klein |
Frivolous commentary on the US debt crisis (like this) attributes to opponents of raising the debt ceiling the view that “defaults don’t matter.” Sensible people recognize, of course, that default (and even repudiation) are policy options that have benefits and costs, just as continuing to borrow and increasing the debt have benefits and costs. Reasonable people can disagree about the relevant magnitudes, but comparative institutional analysis is obviously the way to go here. (Unfortunately, most of the academic discussion has focused entirely on the possible short-term costs of default, with almost no attention paid to the almost certain long-term costs of continued borrowing.)
I’m a bit surprised no one has brought up William English’s 1996 AER paper, “Understanding the Costs of Sovereign Default: American State Debts in the 1840′s,” which provides very interesting evidence on US state defaults. It’s not a natural experiment, exactly, but does a nice job exploring the variety of default and repudiation practices among states that were otherwise pretty similar. Here’s the meat:
Between 1841 and 1843 eight states and one territory defaulted on their obligations, and by the end of the decade four states and one territory had repudiated all or part of their debts. These debts are properly seen as sovereign debts both because the United States Constitution precludes suits against states to enforce the payment of debts, and because most of the state debts were held by residents of other states and other countries (primarily Britain). . . .
In spite of the inability of the foreign creditors to impose direct sanctions, most U.S. states repaid their debts. It appears that states repaid in order to maintain their access to international capital markets, much like in reputational models. The states that repaid were able to borrow more in the years leading up to the Civil War. while those that did not repav were, for the most part, unable to do so. States that defaulted temporarily were able to regain access to the credit market by settling their old debts. More surprisingly, two states that repudiated a part of their debt were able to regain access to capital markets after servicing the remainder of their debt for a time.
Amazingly, the earth did not crash into the sun, nor did the citizens of the delinquent states experience locusts, boils, or Nancy Grace. Bond yields of course rose in the repudiating, defaulting, and partially defaulting states, but not to “catastrophic” levels. There were complex restructuring deals and other transactions to try to mitigate harms.
A recent CNBC story on Europe cited “the realization that sovereign risk, and particularly developed market sovereign risk exists, because most developed world sovereign was basically treated as entirely risk free,” quoting a principal at BlackRock Investment Institute. “With hindsight, we can say . . . that they have never been risk free, it’s just that we have been living in a quiet time over the last 20 years.” Doesn’t sound like Apocalypse to me.
| Peter Klein |
“What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom,” Adam Smith famously observed. I noted in an earlier post on raising the debt ceiling that restructuring US government securities is hardly the “nuclear” option it’s portrayed in the pundit world; bankrupt firms, like bankrupt families and firms, restructure their debt obligations all the time. The notion of T-Bills as a sort of sacred relic, to be once and forever “risk-free,” seems more like religion than economics to me.
But, more important, there is another option for entities struggling to make their interest payments: asset sales. Just in the last couple days Bob Murphy, David Friedman, and Steve Horwitz have made this point. Public discussion on the US debt crisis assumes that the only options for meeting US debt obligations are increasing taxes, cutting spending, or both. But asset sales are another viable option. There’s a huge literature on this in corporate finance (e.g., Shleifer and Vishny, 1992; Brown, James, and Mooradian, 1994; John and Ofek, 1995), exploring the benefits and costs of asset sales as a source of liquidity for financially distressed firms. Of course, selling assets under dire circumstances, at fire-sale prices, is far from a first-best option but, as this literature points out, often better than bankruptcy or liquidation. (One of the best-known results, from John and Ofek, is that asset sales tend to increase firm value when they result in an increase in focus. Would it really be so bad if the US government sold off some foreign treasuries and currency, the strategic petroleum reserve, its vast holdings of commercial land, and other elements of a highly diversified, and unaccountably bloated, portfolio?)
| Peter Klein |
Not surprisingly — private interests:
Coups, Corporations, and Classified Information
Arindrajit Dube, Ethan Kaplan, Suresh Naidu
NBER Working Paper No. 16952, April 2011
We estimate the impact of coups and top-secret coup authorizations on asset prices of partially nationalized multinational companies that stood to benefit from US-backed coups. Stock returns of highly exposed firms reacted to coup authorizations classified as top-secret. The average cumulative abnormal return to a coup authorization was 9% over 4 days for a fully nationalized company, rising to more than 13% over sixteen days. Pre-coup authorizations accounted for a larger share of stock price increases than the actual coup events themselves.There is no effect in the case of the widely publicized, poorly executed Cuban operations, consistent with abnormal returns to coup authorizations reflecting credible private information. We also introduce two new intuitive and easy to implement nonparametric tests that do not rely on asymptotic justifications.
In what can only be a pure coincidence, the following item appeared just below the NBER paper in my RSS reader: “Halliburton Profit More Than Doubles.”
| Peter Klein |
Matching Firms, Managers, and Incentives
Oriana Bandiera, Andrea Prat, Luigi Guiso, Raffaella Sadun
We exploit a unique combination of administrative sources and survey data to study the match between firms and managers. The data includes manager characteristics, such as risk aversion and talent; firm characteristics, such as ownership; detailed measures of managerial practices relative to incentives, dismissals and promotions; and measurable outcomes, for the firm and for the manager. A parsimonious model of matching and incentive provision generates an array of implications that can be tested with our data. Our contribution is twofold. We disentangle the role of risk-aversion and talent in determining how firms select and motivate managers. In particular, risk-averse managers are matched with firms that offer low-powered contracts. We also show that empirical findings linking governance, incentives, and performance that are typically observed in isolation, can instead be interpreted within a simple unified matching framework.
Business Failures by Industry in the United States, 1895 to 1939: A Statistical History
Gary Richardson, Michael Gou
Dun’s Review began publishing monthly data on bankruptcies by branch of business during the 1890s. This essay reconstructs that series, links it to its successors, and discusses how it can be used for economic analysis.
The Consequences of Financial Innovation: A Counterfactual Research Agenda
Josh Lerner, Peter Tufano
Financial innovation has been both praised as the engine of growth of society and castigated for being the source of the weakness of the economy. In this paper, we review the literature on financial innovation and highlight the similarities and differences between financial innovation and other forms of innovation. We also propose a research agenda to systematically address the social welfare implications of financial innovation. To complement existing empirical and theoretical methods, we propose that scholars examine case studies of systemic (widely adopted) innovations, explicitly considering counterfactual histories had the innovations never been invented or adopted.