Faculty Digest Spring 2009

Housing Prices The Trust Crisis Rethinking Poverty

In the He adlines

The system is clearly broken, and fixing it should be a high priority. However, moving swiftly to put in place a new regulatory system now would be a serious mistake.

Anil Kashyap, in “Put Out the Fire Before Fixing the Sprinkler,” a Financial Times article he coauthored with Frederic Mishkin of Columbia University in March.

Kashyap and Mishkin said that focusing on financial regulatory system reform will divert attention from the more crucial task of promoting financial recovery, and that “how the crisis plays out will inform us how to proceed.” Kashyap is Edward Eagle Brown Professor of Economics and Finance and co-director of the Initiative on Global Markets. To read the full story, visit ChicagoBooth.edu/ontheweb and enter the keyword “sprinkler.”

Beth Rooney

Spring 2OO9 Chicago Booth Magazine

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Faculty Digest

Implications of the Trust Crisis

Between rising unemployment, tumbling housing prices, and shrinking retirement plans, American consumers’ trust in financial institutions took a nosedive in recent months. But what are the financial implications? According to research by Luigi Zingales, an absence of trust “can bring even the richest, most advanced economies to a grinding halt.”

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n 2006, the economy was booming: The stock market and the housing market were roaring. But it all collapsed last fall, and the United States—and the rest of the world—slid into a recession. What happened? The banking system collapsed, and with it, consumers’ trust in the entire financial system.

While it’s fundamental to any business transaction, trust is an asset crucial to production, particularly in financial markets, said Zingales, Robert C. McCormack Professor of Entrepreneurship and Finance and David G. Booth Faculty Fellow. “People depart with their money in exchange for promises that aren’t worth the paper they’re written on if there is no trust,” he said.

To determine how recent events have undermined Americans’ trust in the stock market and institutions in general, Zingales and coauthor Paola Sapienza of Northwestern University developed the Financial Trust Index, a quarterly survey of more than 1,000 households in the United States.

In a survey conducted at the end of last year, they found Only 22 percent of those surveyed currently trust the financial system.

Only 12 percent of people trust the stock market. This trust is a strong predictor of individuals’ intentions to increase or decrease their investment in the stock market over the next few months.

Some 11 percent of the respondents withdrew money from the bank and kept it in cash during the crisis.

This behavior is highly correlated with the individuals’ trust in banks.

They also found that trust in the financial sector has declined sharply over the last few months. When asked how their trust had changed over the past three months, respondents indicated a decrease across all categories, with perceptions of the stock market most soured.

Zingales said one of the goals of this research was to determine to what extent the perception of current events

No Faith in Finance: Only 22 percent of those surveyed trust the financial system, according to research by Luigi Zingales.

and government policy affect the trust people have in financial markets. Respondents who identified the main cause of the 2008 financial crisis as lax government oversight (16 percent) or regulation (15 percent) exhibited the least trust in the market. And levels of trust were also low among those who blamed companies, citing poor corporate governance (15 percent) or managerial greed (36 percent).

While the heavy financial losses suffered can in part explain this reduced trust, a crucial factor seems to be the way in which the government has intervened. The study showed that even among investors who are ideologically favorable to government intervention in financial markets, three out of four have been made less confident by the way the government has intervened.

“One of the key factors undermining trust is the perception that the rules have changed in the middle of the game,” Zingales said. “The government has done exactly this. What is most shocking is how deeply this has affected the trust of the average American.”—P.H. To see the index, including a March update, and learn more, visit financialtrustindex.org/.

Faculty Digest abstracts

Rajan Was Right, WSJ Reports

Better Ways to Boost the Economy

Eric J. Gleacher Distinguished Service Professor of Finance, presented the paper “Has Financial Development Made the World Riskier?”

His answer was yes.

Criticized at the time, Rajan was vindicated for his prescient outlook in a Wall Street Journal story in January.

“Incentives were horribly skewed in the financial sector, with workers reaping rich rewards for making money, but being only lightly penalized for losses, Mr. Rajan argued. That encouraged financial firms to invest in complex products with potentially big payoffs, which could on occasion fail spectacularly,” the Journal wrote.

Pointing to securities such as credit default swaps, Rajan said insurers and others were generating big returns selling them but apparently taking on little risk. The truth was that a lot of risk was being retained on financial institution balance sheets. “As a result, under some conditions, economies may be more exposed to financialsector-induced turmoil than in the past,” he wrote.

And because banks were holding a portion of the credit securities they created on their books, if those securities ran into trouble, the banking system itself would be at risk. “The interbank market could freeze up, and one could well have a full-blown financial crisis,” he wrote.

“Two years later,” the Journal said, “that’s essentially what happened.”—P.H. Raghuram Rajan

John Cochrane,

Myron S. Scholes Professor of Finance, John Cochrane analyzed other ways to reinvigorate the economy.

“We are experiencing a strong portfolio and precautionary demand for government debt, along with a credit crunch. People want to hold less private debt, to save, and to hold Treasuries, money, or governmentguaranteed debt,” he said in a position paper. “However, that demand can be satisfied in far greater quantity, more quickly, more reversibly, and without the danger of a fiscal collapse and inflation down the road if the Fed and Treasury expand their operations of issuing Treasury debt and money in exchange for highquality private debt and especially new securitized debt,” Cochrane said.

The main focus must be to rebuild private credit markets, first by stopping chaotic interventions. “Who would buy bank stock, lend long term, or buy securitized debt, knowing the government might rewrite the rules at any point?” Cochrane said. Second, policy must ensure new savings can flow to new borrowing, regardless of who takes the hit for old bad loans.

Many of the bailout proposals were “chaotic” and broke both rules.

Cochrane also outlined why “stimulus” spending financed by government borrowing will not help the economy.—P.H.

Beth Rooney

Raghuram Rajan,

A strong opponent of the bailout plan and stimulus bill, Beth Rooney

Dan Dry

In 2005 at a gathering honoring Fed chairman Alan Greenspan,

Housing Prices Were Misperceived One of the causes of the current recession was the misperception of housing price dynamics by finanErik Hurst cial institutions, according to Erik Hurst, V. Duane Rath Professor of Economics and Neubauer Family Faculty Fellow.

Speaking at an alumni Entrepreneurial Roundtable, Hurst showed that housing booms are always followed by substantial housing busts, which erode most of the previous gains.

When housing prices get too high in one area, buyers move elsewhere or developers are induced to build in other areas, Hurst said. “Demand for housing goes up and drives up the price for housing, because supply is fixed in the short run. As supply adjusts, it pulls the prices back down toward an equilibrium level.” During the housing boom in the late 1990s and 2000s, lenders incorrectly assumed housing prices would remain high and loaned to people with high probability of default. When the bubble burst, lenders were left with assets worth much less than they were loaned for.

Despite the grim state of the economy, there is a silver lining.

Hurst conceded that the current recession will not be worse than the Great Depression. “It will be deep, but policy might be able to mitigate how deep the recession is.”—A.C. To read Hurst’s complete remarks or access Rajan’s or Cochrane’s papers, visit Chicago Booth.edu/magazine/facultylinks.

Spring 2OO9 Chicago Booth Magazine

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Faculty Digest F ello w ship S

A w ar d S

A ppointments

Rajan, Goolsbee Named to Government Advising Positions As the global financial crisis continues, two Chicago Booth professors have been named to government advisory positions. Raghuram Rajan, Eric J. Gleacher Distinguished Service Professor of Finance, has been selected to counsel Indian prime minister Manmohan Singh, and Austan Goolsbee, Robert P. Gwinn Professor of Economics, will serve in several capacities for President Barack Obama.

Rajan’s role as an honorary economic advisor holds the rank of a secretary to the government of India. Prior to his appointment, he submitted a report as the head of a panel on reforms to the country’s financial sector, which

16 Chicago Booth Magazine Spring 2OO9

focused on a hundred small steps that could make the Indian financial sector both efficient and inclusive.

An economic advisor to Obama since 2004, Goolsbee will take on the responsibilities of staff director and chief economist of the Economic Recovery Advisory Board. The newly created department will provide the president with analysis and information to form plans for economic recovery, with Goolsbee serving as primary liaison between the board and the administration. He also received Senate approval for his nomination as one of three members to the Council of Economic Advisors.—K.F.

Beth Rooney

Associate professor of economics and Neubauer Family Faculty Fellow Matthew Gentzkow was named an Alfred P. Sloan Research Fellow for 2009, making him the sixth Chicago Booth faculty member to receive the award. “The Sloan Research Fellowships support the work of exceptional young researchers early in their academic careers, and often at pivotal stages in their work,” said Paul Joskow, president of the Alfred P. Sloan Foundation.

Matthew Gentzkow A faculty member since 2004, Gentzkow studies empirical industrial organization with a specific focus on media industries. He is one of 118 Sloan Fellows for 2009. The winners include scientists, mathematicians, and economists at 61 colleges and universities in the United States and Canada who are conducting research in physics, chemistry, computational and evolutionary molecular biology, computer science, economics, mathematics, and neuroscience. Grants of $50,000 for a two-year period are administered by each Fellow’s institution.

Other Chicago Booth faculty who have been named Sloan Fellows include Marianne Bertrand, Fred G. Steingraber/A.T. Kearney Professor of Economics; Austan Goolsbee, Robert P. Gwinn Professor of Economics; Anil Kashyap, Edward Eagle Brown Professor of Economics and Finance; Kevin Murphy, George J. Stigler Distinguished Service Professor of Economics; and Lars Stole, Eli B. and Harriet B. Williams Professor of Economics.—A.F.

Epley Receives 2008 Theoretical Innovation Award Professor of behavioral science and Neubauer Family Faculty Fellow Nicholas Epley is the first Chicago Booth faculty member Nicholas Epley to win the Theoretical Innovation Award.

Epley was chosen for the paper “On Seeing Human: A Three-Factor Theory of Anthropomorphism,” which examines when people are likely to ascribe human characteristics to nonhuman objects; it also applies when people deny humanlike characteristics in others. The research was published in Psychological Review in October 2007.

The Society of Personality and Social Psychology selects research likely to generate new hypotheses for thinking about social and personality psychology.

Epley shares the honor with coauthors John Cacioppo, Tiffany and Margaret Blake Distinguished Service Professor in the department of psychology in the College; and Adam Waytz, doctoral student in the University of Chicago’s social psychology program.—K.F.

Fama Receives Onassis Prize Eugene Fama, Robert

Michael Girard

Beth Rooney

Gentzkow Named Sloan Fellow

R. McCormick Distinguished Service Professor of Finance, has won the Cass Business School’s Eugene Fama inaugural Onassis Prize. Sponsored by the Onassis Public Benefit Foundation, the award is given biennially in recognition of achievements in finance, shipping, and trade, and carries a stipend of $250,000.

Faculty Digest “Professor Fama’s contribution to the area of finance has changed the way of thinking about stock market fluctuations and his theories are known all over the world,” said Costas Grammenos, who initiated the prize and served on the selection committee that picked Fama. The formal presentation was set for April at Guildhall in London.—K.F.

Chris Lake

American Accounting Association Recognizes Gao In recognition of his paper “Disclosure Quality, Cost of Capital, and Investors’ Welfare,” assistant professor of accountPingyang Gao ing Pingyang Gao received the 2008 Competitive Manuscript Award. The American Accounting Association selects winners who are the sole authors of outstanding research written within five years of completing a PhD. Gao earned his PhD from Yale University in 2008 and teaches financial accounting in the Evening and Weekend MBA programs.—K.F. To read more about these professors’ research, visit ChicagoBooth.edu/magazine/ facultylinks.

rea d ing S

Shaping New Applications of Economics

Reevaluating Measures of Poverty

Personnel Economics in Practice (Wiley,

Why the Garden Club Couldn’t Save

2008), Michael Gibbs, clinical professor

Youngstown: The Transformation of the

of economics, and Edward Lazear

Rust Belt (Harvard University Press, 2009), Sean Safford, assistant professor of organi-

In the field of human resource management, work based on empirical investigation and rigorous theory is being shaped into new material, an area known as personnel economics. In Personnel Economics in Practice, Michael Gibbs and Edward Lazear explore this connection between business and the modern approach to human resources and apply economics to general management tips.

Divided into three sections, the textbook covers fundamental concepts and uses current real-world examples of the application of personnel and organizational models. The authors draw on data from their own research, but the content is written at a level appropriate for both MBA students and undergraduate economics majors. Personnel Economics in Practice serves as a second edition to Lazear’s Personnel Economics for Managers (1997), but the authors have revised and updated the text substantially.

The range of topics covered reveals how far personnel economics has come in influencing day-to-day business since Lazear helped pioneer the subject. Starting with recruitment strategies and the best investment in human capital before examining organizational structure and performance evaluation, the text has a lot to offer those interested in labor economics, industrial relations, and human resource management.—K.F.

zations and strategy

Both Allentown, Pennsylvania, and Youngstown, Ohio, have a place in American history as steel-producing towns. After the mills shut down 20 years ago, Allentown’s economy rebounded, transforming existing companies, building an entrepreneurial sector, and attracting inward investment. Although Youngstown had a similar industrial history, labor force, and other important variables, it failed to rebound.

In Why the Garden Club Couldn’t Save Youngstown, Sean Safford provides a probing historical explanation for the decline, fall, and unlikely rejuvenation of the Rust Belt: the structure of social networks among the cities’ economic, political, and civic leaders. Social networks shape action, determine access to and control over information and resources, define the contexts in which problems are viewed, and enable collective action in the face of externally generated crises, he writes.

Safford’s book, which challenges various theoretical perspectives on regional socioeconomic change, points toward present-day policy prescriptions for the ongoing plight of mature industrial regions in the United States and abroad—and implications for the current economic crisis—P.H.

Spring 2OO9 Chicago Booth Magazine

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Faculty Digest bookshelf

Kroszner Returns to Chicago Booth

From Post-Apocalyptic Comic Books to the History of Newspapers: What Faculty Are Reading

Norman R. Bobins Professor of Economics Randall Kroszner stepped down from the Board of Governors of the Federal Randall Kroszner Reserve System in January, returning to the classroom at Chicago Booth. Kroszner had served since March 1, 2006. “I am particularly pleased with our accomplishments in monetary policy, innovative liquidity facilities, banking and financial regulatory policy, and in strengthening consumer protection,” he wrote in his resignation letter to then-president George W. Bush.

Federal Reserve Chairman Ben Bernanke called Kroszner’s contributions “invaluable.” He said, “We have greatly benefited from the intellectual rigor he brought to the consideration of both monetary and regulatory policy.

In particular, he ably oversaw the completion of significant new regulations protecting mortgage borrowers and credit card customers.”

In addition to serving on the Federal Reserve Board, Kroszner served as a member of the President’s Council of Economic Advisers from 2001 to 2003.—P.H.

Faculty read more than research in their areas of interest. Here’s a look at what

To read a Critical Dialogues story featuring Kroszner that appeared in Chicago Booth Magazine, visit ChicagoBooth.edu/ontheweb and enter the keyword “Kroszner CD.”

Jesse Shapiro, assistant professor of economics and Neubauer Family Faculty Fellow, had on his bookshelf recently.

Beth Rooney

Katie Gaspard

appointments

Jesse Shapiro

Haroun and the Sea of Stories, Salman

Assistant professor of

Rushdie (Penguin Group, 1990)

economics and Neubauer

The Ground Beneath Her Feet, Salman

Family Faculty Fellow

Rushdie (Henry Holt, 1999)

E.W. Scripps and the Business of Newspapers, Gerald Baldasty (University of Illinois Press, 1999)

“This book is a gem. It’s an excellent history, but also a great management book. Newspapers were a competitive business and Scripps was a successful competitor. The book shows you why.

“Matt Gentzkow and I are supervising a large research project on American newspapers in the 19th and early 20th centuries, so we are trying to read what historians and others have written about that period. It’s possible to learn a lot about the thinking behind Scripps’ decisions because once-secret telegrams and other correspondence are no longer so secret.”

“I’m a huge Rushdie fan, but somehow it took me until last Thanksgiving to get around to reading Haroun and the Sea of Stories. I liked it, but it was a little too linear for me. I really liked The Ground Beneath Her Feet, even though it seems like no one else did.”

Y: The Last Man, Brian Vaughan (author) and Pia Guerra (illustrator) (DC Comics, 2003)

“I read a lot of comic books. Last summer, I finished up the excellent series Y: The Last Man. It tells the story of Yorick and his pet monkey, the only surviving male mammals on earth.

They travel a post-apocalyptic earth, hoping to rebuild humanity.”

The Chief: The Life of William Randolph Hearst, David Nasaw (Houghton Mifflin, 2000)

“Another book about a towering newspaperman, it differs from the Scripps book in being less of a management history and more of a straight biography. Hearst’s persistent efforts to catch up politically with his college rival, Teddy Roosevelt, make for an entertaining read.”

Spring 2OO9 Chicago Booth Magazine

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