The Social Cost of Near-Rational Investment
(with Thomas M. Mertens), July 2016.
Resubmitted to The American Economic Review
Abstract: We show that the stock market may fail to aggregate
information even if it appears to be efficient, and that the resulting decrease
in the information content of prices may drastically reduce welfare. We solve a
macroeconomic model in which information about fundamentals is dispersed and households
make small, correlated errors when forming expectations about future
productivity. As information aggregates in the market, these errors amplify and
crowd out the information content of stock prices. When prices reflect less
information, the conditional variance of stock returns rises, causing an
increase in uncertainty and costly distortions in consumption, capital
accumulation, and labor supply.
(with Rui Mano), April 2015
Under revision for The Quarterly Journal of Economics
Abstract: Separate literatures study violations of uncovered interest parity using regression-based and portfolio-based methods. We propose a decomposition of these violations into a cross-currency, a between-time-and-currency, and a cross-time component that allows us to analytically relate regression-based and portfolio-based anomalies, to test whether they are empirically distinct, and to estimate the joint restrictions they place on models of currency returns. We find that the forward premium puzzle (FPP) and the ``dollar trade'' anomaly are intimately linked. Both anomalies are almost exclusively driven by the cross-time component. By contrast, the ``carry trade'' anomaly is driven largely by the cross-currency component. Our decomposition also reveals a large upward bias in standard quantifications of the FPP. Once we correct for this bias, the puzzle is significantly diminished---to the point that it does not require a systematic association between currency risk premia and expected depreciations. The simplest model that the data do not reject features a highly persistent asymmetry that makes some currencies pay higher expected returns than others, and a more elastic expected return on the US dollar than on other currencies.
Resubmitted to The Review of Financial Studies
During Egypt's Arab Spring, unprecedented popular
mobilization and protests brought down Hosni Mubarak's government and ushered
in an era of competition between three groups: elites associated with Mubarak's
National Democratic Party (NDP), the military, and the Islamist Muslim
Brotherhood. Street protests continued to play an important role during this
power struggle. We show that these protests are associated with differential
stock market returns for firms connected to the three groups. Using daily
variation in the number of protesters, we document that more intense protests
in Tahrir Square are associated with lower stock market valuations for firms
connected to the group currently in power relative to non-connected firms, but
have no impact on the relative valuations of firms connected to other powerful
groups. We further show that activity on social media may have played an
important role in mobilizing protesters, but had no direct effect on relative
valuations. According to our preferred interpretation, these events provide
evidence that, under weak institutions, popular mobilization and protests have
a role in restricting the ability of connected firms to capture excess rents.
(with Konrad Burchardi and Thomas Chaney), December 2015 [Slides]
Abstract: We use 130 years of data on historical migrations to the US to show a causal effect of the ancestry composition of U.S. counties on foreign direct investment (FDI) sent and received by firms within these counties. To isolate the causal effect of ancestry on FDI, we build a simple reduced form model of migrations: migrations from a foreign country towards a US county at a given time depend on (i) a push factor, causing emigration from that foreign country to the whole US, and (ii) a pull factor, causing immigration from the whole world into that US county. The interaction between time-series variation in country-specific push factors with time-series variation in the county-level pull factors generates quasi-random variation in the allocation of migrants across U.S. counties. We find that a doubling of the number of residents with ancestry from a given foreign country relative to the mean increases the probability that at least one local firm invests in that country by 4.2 percentage points, and increases the number of employees at domestic recipients of FDI from that country by 32%.The size of these effects increases with the ethnic diversity of the local population and the geographic distance to the origin country.
(with Thomas Mertens and Tony Zhang), Preliminary and Incomplete, December 2015 [Slides]
Abstract: We propose a novel, risk-based, transmission mechanism for the effects of currency manipulation: Policies that systematically induce a country's currency to appreciate in bad times lower its risk premium in international markets. As a result, these policies lower the country's risk-free interest rate and increase domestic capital accumulation and wages. Currency manipulations by large countries also have external effects on foreign interest rates and capital accumulation. Applying this logic to policies that lower the variance of the bilateral exchange rate relative to some target country ("currency pegs''), we find that a small economy pegging its currency to a large economy increases domestic capital accumulation and wages. The size of this effect increases with the size of the target country, offering a potential explanation why the vast majority of currency pegs in the data are to the US dollar, the currency of the largest economy in the world. A large economy (such as China) pegging to a larger economy (such as the US) diverts capital accumulation from the target country to itself, increasing domestic wages while decreasing wages in the target country.
(with Stephan Hollander, Laurence van Lent, and Ahmed Tahoun), Preliminary and Incomplete, September 2016 [Slides]
Abstract: We propose a new measure of political risk faced by individual US-firms based on textual analysis of earnings conference call transcripts: the share of the conversation between management and analysts that is devoted to political topics. Our measure correlates significantly with firm-level stock return volatility, even after controlling for firm and time fixed effects. We find that increases in idiosyncratic political risk are associated with decreases in investment and hiring, and that the dispersion of idiosyncratic political risk tends to increase significantly in times of high aggregate political risk. About two thirds of the variation in political risk is idiosyncratic in the sense that it is neither captured by firm or time fixed effects, nor by heterogeneous exposure of individual firms to aggregate political risk. Further decomposing our measure by political topic, we find that discussion of risk associated with corporate regulation and health care is associated with the largest decreases in investment. We also find that firms actively manage political risk through lobbying: firms that devote more time to discussing the risk associated with a given political topic tend to increase lobbying expenses on that topic that quarter. These effects are most pronounced for large firms and firms headquartered in states that are associated with higher levels of political corruption.
Published and Forthcoming Papers
Natural Experiments in Macroeconomics
(with Nicola Fuchs-Schündeln), March 2015
[local copy] [online appendix] [Slides] [Teaching Materials: Slides, Handout, Latex Code]
Handbook of Macroeconomics, forthcoming
A growing literature relies on natural experiments to establish causal effects in macroeconomics. In diverse applications, natural experiments have been used to verify underlying assumptions of conventional models, quantify specific model parameters, and identify mechanisms that have major effects on macroeconomic quantities but are absent from conventional models. We discuss and compare the use of natural experiments across these different applications and summarize what they have taught us about such diverse subjects as the validity of the permanent income hypothesis, the size of the fiscal multiplier, and about the effects of institutions, social structure, and culture on economic growth. We also outline challenges for future work in each of these fields, give guidance for identifying useful natural experiments, and discuss the strengths and weaknesses of the approach.
(with Thomas Mertens and Tony Zhang), July 2015
Journal of International Economics (2016) 99, S43-S57
We investigate the link between stochastic properties of exchange rates and differences in capital-output ratios across industrialized countries. To this end, we endogenize capital accumulation within a standard model of exchange rate determination with nontraded goods. The model predicts that currencies of countries that are more systemic for the world economy (countries that face particularly volatile shocks or account for a large share of world GDP) appreciate when the marginal utility of traded goods is high. These ``safe haven'' currencies are better hedges against consumption risk faced by international investors because they appreciate in ``bad'' states of the world. As a consequence, these countries face a lower cost of capital, accumulate more capital per worker, and pay higher wages than less systemic countries. We estimate our model using data from seven industrialized countries with freely floating exchange rate regimes 1984-2010 and show that cross-currency variation in the stochastic properties of exchange rates accounts for 72% of the cross-country variation in capital-output ratios. In this sense, the stochastic properties of exchange rates map to fundamentals in the way predicted by the model.
Information Aggregation in a DSGE Model(with Thomas M. Mertens), March 2014.
NBER Macroeconomics Annual 2014, forthcoming
We introduce the information microstructure of a canonical noisy rational expectations
model (Hellwig, 1980) into the framework of a conventional real business cycle model. Each household receives a private signal about future productivity. In equilibrium, the stock price serves to aggregate and transmit this information. We find that dispersed information about future productivity affects the quantitative properties of our real business cycle model in three dimensions. First, households' ability to learn about the future affects their consumption-savings decision. The equity premium falls and the risk-free interest rate rises when the stock price perfectly reveals innovations to future productivity. Second, when noise trader demand shocks limit the stock market's capacity to aggregate information, households hold heterogeneous expectations in equilibrium. However, for a reasonable size of noise trader demand shocks the model cannot generate the kind of disagreement observed in the data. Third, even moderate heterogeneity in the equilibrium expectations held by households has a sizable effect on the level of all economic aggregates and on the correlations and standard deviations produced by the model. For example, the correlation between consumption and investment growth is 0.29 when households have no information about the future, but 0.41 when information is dispersed.
The Journal of Finance (2013) 68.6, 2269-2308.
Winner of the Austrian Central Bank's 2009 Klaus Liebscher Award for best paper on European Monetary Union and Integration Issues
Winner of the Leo Melamed Prize for Outstanding Research in Finance
Abstract: Differences in real interest rates across developed economies are puzzlingly large and persistent. I propose a simple explanation: Bonds issued in the currencies of larger economies are expensive because they insure against shocks that affect a larger fraction of the world economy. I show that differences in the size of economies indeed explain a large fraction of the cross-sectional variation in currency returns. The data also support a number of additional implications of the model: The introduction of a currency union lowers interest rates in participating countries and stocks in the non-traded sector of larger economies pay lower expected returns.
The Quarterly Journal of Economics (2013) 128(3), 1219-1271
Abstract: We use the fall of the Berlin Wall in 1989 to show that personal relationships which individuals maintain for non-economic reasons can be an important determinant of regional economic growth. We show that West German households who have social ties to East Germany in 1989 experience a persistent rise in their personal incomes after the fall of the Berlin Wall. Moreover, the presence of these households significantly affects economic performance at the regional level: it increases the returns to entrepreneurial activity, the share of households who become entrepreneurs, and the likelihood that firms based within a given West German region invest in East Germany. As a result, West German regions which (for idiosyncratic reasons) have a high concentration of households with social ties to the East exhibit substantially higher growth in income per capita in the early 1990s. A one standard deviation rise in the share of households with social ties to East Germany in 1989 is associated with a 4.6 percentage point rise in income per capita over six years. We interpret our findings as evidence of a causal link between social ties and regional economic development.
(with Daron Acemoglu and James A. Robinson)
The Quarterly Journal of Economics (2011) 126(2), 895-946.
Abstract: We document a statistical association between the severity of the mass murder of Jews (the Holocaust) by the Nazis during World War II and long-run economic and political outcomes within Russia. Cities that experienced the Holocaust most intensely have grown less and administrative districts (oblasts) where the Holocaust had the largest impact have lower urban populations, GDP per capita and lower average wages today. In addition these same cities and oblasts exhibit a higher vote share for Communist candidates since the collapse of the Soviet Union. Although we cannot rule out the possibility that these statistical relationships are caused by other factors, the overall patterns appear generally robust. We provide evidence on one possible mechanism that we hypothesize may link the Holocaust to the present---the change it induced in the social structure, in particular the size of the middle class, across different regions of Russia. Before World War II, Russian Jews were predominantly in white collar (middle class) occupations and the Holocaust appears to have had a direct negative effect on the size of the middle class after the war.
The American Economic Review (2011) 101(2), Papers and Proceedings, 402-405.
Abstract: We present a model with dispersed information in which investors decide whether or to what degree they want to allow their behavior to be influenced by "market sentiment". Investors who choose to insulate their decision from market sentiment earn higher expected returns, but incur a small mental cost. We show that if information is moderately dispersed across investors, even a very small mental cost (on the order of 0.001% of consumption) may generate a significant amount of sentiment in equilibrium: Individuals who choose to be swayed by sentiment increase uncertainty about the future and make it less costly for others to be swayed by sentiment as well. Market sentiment thus emerges as a tragedy of the commons.