IGM Report 2009

2008–09 Annual Report

IGM Initiative on Global Markets 2008–09 Annual Report

IGM Initiative on Global Markets

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Executive Director

Brian Barry Clinical Professor of Economics Faculty Directors

Anil Kashyap, Co-director Edward Eagle Brown Professor of Economics and Finance Richard N. Rosett Faculty Fellow Christian Leuz, Co-director Joseph Sondheimer Professor of International Economics, Finance, and Accounting Neubauer Family Faculty Fellow Matthew Gentzkow Professor of Economics Neubauer Family Faculty Fellow Tobias Moskowitz Fama Family Professor of Finance Luigi Zingales Robert C. McCormack Professor of Entrepreneurship and Finance David G. Booth Faculty Fellow Administration

Jennifer Williams, Assistant Director Janice Luce, Assistant Director Peggy Eppink, Research Professional

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Our Purpose The massive global movements of capital, products, and talent in the modern economy have fundamentally changed the nature of business in the 21st century.

They have also generated confusion among policy makers and the public.

The University of Chicago Booth School of Business continues its role as a thought leader on how these markets work, their effects, and the way they interact with policies and institutions.

rapidly changing business environment, and fosters an exchange of ideas with policy makers and leading international companies about the biggest issues facing the global economy.

The Initiative on Global Markets organizes these efforts. It supports original research

by Chicago Booth faculty, prepares our students to make good decisions in a

The Initiative on Global Markets spans three broad areas: (1) international business, (2) financial markets, and (3) the role of policies and institutions.

Thank You The Initiative on Global Markets is grateful for the generous support provided by the Chicago Mercantile Exchange (CME) Group Foundation; by our corporate partners, AQR Capital Management, Barclays, John Deere and Company, and Northern Trust; and by Myron Scholes, MBA ’64, PhD ’70; Eugene Fama, MBA ’63, PhD ’64; Ramsey Frank, ’86; and John Meriwether, ’73.

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Letter from the Director When the global credit crisis struck in the fall of 2008, Chicago Booth’s faculty were glad that we had the Initiative on Global Markets to help organize our response. We launched the IGM in mid-2006 to foster deeper insights into how global markets work, and to promote better debate and decision-making by sharing those insights with executives, policy makers and the public. During our third year, the turmoil in the global economy made the importance of such efforts even more clear.

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Financial and economic crisis

Brian Barry Executive Director, IGM Clinical Professor of Economics

One way the IGM’s faculty responded was by sharing our analyses and views frequently and extensively with the public. This included an extraordinary series of lectures and panel discussions in which members of our faculty explained—as the crisis unfolded in October and November of 2008—what was happening, why, and what could sensibly be done about it. These events drew overflow audiences, as our MBA students and members of the public poured in to listen and ask questions.

Summaries of these lectures, which were part of the IGM’s Myron Scholes Global Markets Forum, can be found in the Scholes Forum section of this report, along with descriptions of talks by our other distinguished Scholes Forum speakers in 2008–09.

Videos of the complete talks are available on the IGM Forum website (igmchicago.org), which we set up as the crisis was unfolding. The website also features a large collection of articles that our faculty have written in the past year to examine and comment on the crisis.

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Political economy To improve policies and institutions, it also helps to understand how the public’s view of alternative policies also takes shape, and why policy makers often make decisions that are not in the broad public interest. The IGM promotes research into political economy issues such as these. For example, three members of our faculty—Atif Mian, Amir Sufi, and Francesco Trebbi—examined congressional voting patterns in the fall of 2008, when Congress considered bills related to the worsening crisis. Their research into “The Political Economy of the U.S. Mortgage Default Crisis” is described on page 43.

In addition, our first Global Market Series report, “Big Challenges for Big Business,” highlighted important strands that connect past research on political economy and corporate governance with the current political pressures facing big firms. It can be found on the IGM Forum website.

Economic development The IGM also promotes research on issues facing poor and emerging economies. Last year we hosted a conference of the Bureau for Research and Economic Analysis of Development, (BREAD), a non-profit body dedicated to research on economic development, and led by some of the world’s top scholars in the field.

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The China Summer Institute, which the IGM cofounded to foster high-quality research on China’s economy, met for the second time, in Beijing, in June 2009. The China Summer Institute offers a setting in which promising young scholars can interact with established experts in development economics. It is quickly gaining a reputation as an important annual gathering for researchers studying China.

The IGM has also teamed up with the London School of Economics, Oxford University, and others to collaborate on the International Growth Centre. The London-based IGC coordinates independent research to help some of the poorest countries in Africa and South Asia “find their own solutions to economic growth problems.” Economies that have asked for policy advice include Bangladesh, Ethiopia, Ghana, Pakistan, Tanzania, and the Indian state of Bihar.

This report summarizes these activities and others. We also encourage you to visit the IGM Forum: igmchicago.org

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Conferences Scholes Forum Visiting Fellows Research D203872 body.indd 5

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The Initiative on Global Markets organizes and supports conferences for scholars doing high-quality research in their fields. Some of these gatherings also draw on the insights of leading practitioners. In 2008–09, the IGM sponsored six conferences.

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U.S. Monetary Policy Forum

The IGM held its third annual U.S. Monetary Policy Forum (USMPF) in New York in February 2009. The USMPF brings together academic researchers, market economists, and policy makers. A standing group of academic and private sector economists reports on a critical medium-term issue confronting the Federal Open Market Committee (FOMC).

The topic of this year’s USMPF main report was “Oil and the Macroeconomy: Lessons for Monetary Policy.” Ethan Harris of Barclays Capital, Bruce Kasman of JP Morgan Chase, Matthew Shapiro of the University of Michigan, and Kenneth West of the University of Wisconsin wrote the report, which focused on the causes, effects, and policy consequences of oil shocks.

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The authors emphasized that oil-price changes have uneven effects across countries and pose different challenges for central banks around the world. This variation depends partly on the extent to which oil is imported and the extent to which petro-dollars are recycled. They find little impact of oil prices on core inflation, but argue that oil prices may be important for affecting inflation expectations. Two FOMC members presented their views on the report: president Janet Yellen from the Federal Reserve Bank of San Francisco and president James Bullard from the Federal Reserve Bank of St. Louis.

Christina Romer gave her first public speech as chairman of President Obama’s Council of Economic Advisors, which was entitled “The Case for Fiscal Stimulus: The Likely Effects of the American Recovery and Reinvestment Act.” The conference ended with a panel discussion on making monetary policy during a financial crisis.

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It featured two FOMC members—president Charles Plosser, Federal Reserve Bank of Philadelphia, and president Eric Rosengren, Federal Reserve Bank of Boston—as well as Frederic Mishkin, Columbia University. Kim Schoenholtz of New York University moderated the discussion.

Plosser argued that the Federal Reserve should take steps to strengthen its credibility and commitment to its mandate.

He advocated reinforcing a commitment to providing a nominal anchor for the economy, clarifying criteria under which the Fed steps in as a lender of last resort, and drawing a clearer distinction between monetary policy and fiscal policy. Rosengren summarized recent monetary policy actions, focusing on the non-standard tools that had been deployed.

He argued that these actions should help pull the economy out of recession. Mishkin argued that financial crises are times when monetary policy can be especially powerful and failing to use it is a mistake. He also explained why adopting an explicit numerical objective for inflation would be desirable in the current context.

Bureau Research and Economic Analysis of

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Development (BREAD)

The China Summer Institute: Creating a Global Network of China scholars

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In September 2008, the IGM sponsored BREAD’s 14th conference on development economics. The Bureau for Research and Economic Analysis of Development (BREAD) is a nonprofit organization. Its members are a select set of researchers at top universities around the world who have made substantial contributions to development economics, with a focus on microeconomic issues. The research papers presented at the conference covered a variety of topics, including education in Africa, household finance in India, and nutrition in China. A full program as well as drafts of presented papers can be found at ipl.econ.duke.edu/bread/ conferences/conf_2008.09.htm. The conference was combined with a Myron Scholes Global Markets Forum, in which some BREAD members joined World Bank representatives to discuss the bank’s recent report, Growth Comission Report: Strategies for Sustained Growth and Inclusive Development.

The goal of the China Summer Institute is to enhance economic research on China by helping promising researchers to interact with experienced scholars who know the country well and gain insights into important institutional characteristics of China’s economy. The CSI held its second annual conference in Beijing in June 2009, and is quickly becoming recognized as a highquality gathering for good scholars.

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Japan’s Bubble, Deflation, and Long-term Stagnation

Political Economy in the Chicago Area (PECA)

In December 2008, the IGM cosponsored a conference on “Japan’s Bubble, Deflation, and Long-term Stagnation” with the Economic and Social Research Institute of Japan, part of the Japanese government’s cabinet office, and the Center on Japanese Economy and Business at Columbia Business School. The conference, hosted by the Federal Reserve Bank of San Francisco, brought together leading experts on Japan’s economy to discuss lessons for academics and policy makers, in Japan and elsewhere, from Japan’s lost decade. Papers for the conference were commissioned by the cabinet office of Japan’s government, and drafts are available on the IGM Forum blog. Final versions of the papers will appear in a book to be published by MIT Press in 2010 and edited by Koichi Hamada of Yale University, Anil Kashyap of Chicago Booth, and David Weinstein of Columbia University.

In February 2009, the IGM renewed its sponsorship of the Political Economy in the Chicago Area (PECA) conference for the second year. The conference was held at the Northwestern University Kellogg School of Management’s Allen Center in Evanston, Illinois, and was cosponsored by the Ford Center for Global Citizenship and the University of Chicago Harris School of Public Policy.

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The conference is an annual event held to encourage collaboration across political economy research groups in the Chicago area.

Presenters included: professor of economics and Nobel laureate Roger Myerson of the University of Chicago Department of Economics, professor Sandeep Baliga of Northwestern University Kellogg School of Management, and assistant professor of political science Christopher Berry of the University of Chicago Harris School of Public Policy Studies.

Saving the Financial System

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In March 2009, the IGM organized a small, high-level meeting on “Saving the Financial System.” Participants included Brian Barry, Douglas Diamond, Anil Kashyap, and Raghuram Rajan from Chicago Booth, and other academics, central bank officials, and senior managers of global financial institutions.

Topics included: resolution procedures of large financial institutions, capital regulation reform, information disclosure policies for systemically relevant institutions, reform of the credit default swap market, accounting reform, revival of the shadow banking system, and monetary policy options when interest rates are zero.

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Conferences Scholes Forum Visiting Fellows Research D203872 body.indd 11

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In the Myron Scholes Global Markets Forum, business leaders, policy makers, and distinguished scholars speak publicly on issues of current interest. In the past year, topics have included the credit crisis and global financial regulations, the outlook for U.S. policy under a new president, and policies that could promote growth in poor and emerging economies.

IGM events take various forms, including discussion panels, political debates, and lectures by individuals. Featured speakers range from members of our faculty to global economic leaders. These events, often held at

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Chicago Booth’s downtown Gleacher Center or the Chicago Mercantile Exchange, are open to the public. They are generously sponsored

by Myron Scholes, MBA ’64, PhD ’70.

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Credit Crisis Faculty Lecture Series October and November 2008

When the financial turmoil reached crisis proportions in the autumn of 2008, the IGM responded with a special series of Chicago Booth faculty lectures as part of its Myron Scholes Global Markets Forum. Held in Hyde Park and attracting overflow audiences, the five-part series examined the run-up phase of the crisis—during which U.S. mortgage lending was expanded and financial firms got themselves into trouble; the policy efforts taken to deal with the crisis; perspectives on where the economy and financial system were headed; and advice on what was required to fix the problem. Two of the lectures, by Amir Sufi and Amit Seru, explained their IGM-funded research on the causes of the crisis. Douglas Diamond’s lecture provided a framework for examining the role played by short-term debt in all financial crises. Anil Kashyap, an IGM co-director, discussed the U.S. policy response and drew parallels to Japan’s financial troubles and long stagnation. In the final session, John Cochrane, Steven Kaplan, and Raghuram Rajan offered their views on what to expect in the aftermath of the crisis and on the reforms needed.

The Consequences of Mortgage Credit Expansion: Subprime Lending and the Mortgage Default Crisis Amir Sufi Associate Professor of Finance

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To open the credit crisis series, Amir Sufi analyzed the expansion of subprime mortgage lending in the United States between 2002 and 2005, and its contribution to the crisis. Much of his talk focused on research done in collaboration with Chicago Booth associate professor of finance Atif Mian, which was funded by the IGM. Mian and Sufi used thorough data on mortgage lending by ZIP code to explore what was happening with subprime borrowers at a detailed level.

For 20 large cities, they compared each ZIP code based on the credit ratings of its borrowers before the subprime boom started, and then compared groups of ZIP codes with low scores (lots of subprime borrowers) to those with relatively high scores (lots of prime borrowers). This analysis shows that the mortgage-driven boom in housing prices was not confined to a few American cities or fast-growing regions.

Instead, it reflects a sharp, relative expansion of lending to subprime areas throughout the country. This skewed expansion of lending, toward subprime areas from 2002 to 2005, coincided with much higher defaults in subprime areas from 2005 to 2007.

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Although mortgage lending and debt levels expanded much more rapidly in subprime areas, Sufi noted that economic conditions in these areas were not improving relative to prime areas—in many cases, they performed much worse. It is unlikely, therefore, that lenders favored these areas because they expected economic conditions to improve—and house prices to rise—relative to other areas. Instead, Sufi said, the pattern of increased lending to subprime areas, combined with other data, suggests that greater securitization of subprime mortgages made it easier to lend in subprime areas, leading to a rapid expansion of mortgage credit from 2002 to 2005, which was followed by rising defaults from 2005 to 2007. Mian and Sufi also found that the problem was concentrated in areas where lenders sold the securitized loans to nonbank financial firms, rather than keeping them on their own books or selling them to other banks. This suggested a problem with incentives in the subprime mortgage market, according to Sufi. Subprime loans were being extended too easily in these neighborhoods, with subsequent negative results.

Amit Seru provided more detailed evidence on the incentive problem in another talk in the series.

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Securitization, Screening, and Failure of Default Models to Predict Default Amit Seru Assistant Professor of Finance

As securitized mortgage lending expanded in recent years, many people made a crucial error that led them to underestimate the risk of these assets, Amit Seru explained.

The spread of securitization led to changed incentives in the mortgage industry, which affected the interaction between loan originators and the investors who bought the loans. Because these shifting incentives hinged on what each party knew about borrowers’ riskiness, it altered the relationship between a loan bundle’s outward characteristics and its underlying risks. The changed relationship between available information and risk meant, in turn, that it was no longer possible to forecast default ratios accurately by relying only on the outward characteristics and historical data.

Seru explained the research that he and his coauthors used to uncover this large flaw in historical default models. His research also shows that rating agencies did not appear to account for this problem when evaluating mortgage-backed securities. Furthermore, investors seemed unaware of the shortcomings of those flawed ratings.

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Because much of the information that banks could use to screen potential borrowers is difficult for outsiders to see, Seru and his coauthors exploited some rules of thumb in the mortgage lending market involving cutoff points in borrowers’ credit scores. Loans to borrowers with scores above 620, for example, could more easily be repackaged and sold as securities to investors because that was an industry norm. Loans to borrowers with scores below the cutoff, however, were much harder to securitize, so banks had to proceed as though they were much more likely to hold those loans themselves—and bear the risks—if they lent to those borrowers.

Looking at the pattern of lending to borrowers on either side of this cutoff, Seru found that default risks were substantially higher for borrowers just above the threshold. This suggests that these loans were riskier for reasons that could not be detected solely from the credit scores. Compared with the investors who bought these loan portfolios, the banks originating the loans were in a much better position to collect “soft” information on these borrowers as a way to supplement the hard credit scores and better gauge their riskiness.

However, the spread of securitization gave banks incentives to shirk on this dimension and concentrate on issuing loans that would meet the observable cutoff. Once Seru analyzed the data in a way that could detect this informationrelated problem, a clear pattern emerged, showing that the default risks of securitized loans were being systematically underestimated based on historical data. Importantly, this problem was much less pronounced in areas where loan originators faced competition.

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The Current Financial Crisis, Other Recent Crises, and the Role of Short-term Debt Douglas Diamond Merton H. Miller Distinguished Service Professor of Finance Neubauer Family Faculty Fellow

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In a crucial way, financial crises are basically all the same: they are “everywhere and always due to problems of shortterm debt,” said Douglas Diamond. An expert on financial intermediation and liquidity, Diamond went on to explain the role of short-term debt in the banking system and how that role relates to the origins—and potential solutions—of the current crisis.

A key to understanding crises like the current one, he argued, was focusing on “the strategic role of short-term debt.” This is the role that short-term debt plays in imposing discipline on a financial firm that gets close to its borrowing limits. “When you’re using the last little bit of your debt capacity, when you’re trying to borrow close to 100 percent of the amount anybody will lend to you…that last little bit has to be short-term debt,” said Diamond. “Short-term debt keeps the borrower on the straight and narrow more than anything else because the lender can always say ‘No, I want my money back tomorrow.’”

This strategic use of short-term debt is crucial in disciplining financial firms, said Diamond, but the obvious downside is that it can lead to a run when losses leave a bank low on capital, thus prompting its short-term lenders to worry about its solvency. If assets are illiquid, “fear of losses can cause runs and fear of runs can cause losses,” said Diamond. It also means that in some circumstances, when everyone knows that banks will have to dump assets quickly to avoid a run, the mere anticipation of lower prices in the near future can keep liquid potential buyers on the sidelines and waiting for the cheap “fire-sale” prices instead of coming in sooner to buy assets and stabilize the situation.

“That’s a form of contagion, and it’s a form of contagion that’s going on this week,” Diamond said, as the crisis grew in October 2008.

To stem financial crises like this one, said Diamond, it is essential to understand the nature of the short-term debt that’s involved and then to “find the first-come, first-serve element that gives people an incentive to rush for the exits” in the case at hand.

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Policy Responses to the Crisis Anil Kashyap Edward Eagle Brown Professor of Economics and Finance Richard N. Rosett Faculty Fellow

Having studied Japan’s financial crisis and long economic stagnation in detail, Anil Kashyap shed light on the U.S. problem by comparing U.S. policy responses to the current crisis with those previously tried in Japan. Although the two crises are different in important ways, including the larger scale in Japan’s case, “with each week that goes by, I see the differences becoming less important and the similarities becoming more so,” said Kashyap. In particular, the U.S. treasury department’s two preferred approaches to handling the crisis—purchasing bad assets and injecting capital into banks—repeats what Japan did a decade earlier.

Japan’s crisis, which also started with financial intermediaries and falling property prices, similarly reached a point (in 1997) at which several financial firms failed suddenly, and the government scrambled to shore up others. As in the United States, Japan faced the problem of getting some banks—which needed equity injections—to accept them without singling them out from stronger banks that did not need or want new capital.

The government also had to deal with mounting public anger over the cumulative injections of taxpayer money into the banking system to deal with the problem. As with the United States, Kashyap argued, Japan’s politicians faced great pressure to show that these bailouts also benefited “Main Street.” In Japan’s case, that included cajoling the banks to lend money to lots of small- and medium-sized enterprises and other nonfinancial employers, even though these loans did not make commercial sense. An important effect of this policy, Kashyap said, was that these weak firms continued to distort the competitive landscape in several domestic Japanese sectors, making it harder for more productive firms to expand and help the economy.

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It is crucial, Kashyap said, to make sure that enough U.S. banks really do end up with enough capital to get the system working again, despite the public outcry, and regardless of whether the relevant banks resist raising more capital.

Allowing them to continue paying dividends, for example, was a mistake, Kashyap said. Regarding nonfinancial firms that might be propped up for political reasons, Kashyap did not think U.S. banks would behave like those in Japan. “But,” he warned, “we might cut out the middleman and let the government do it.”

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What the Effects Will Be and What Should be Done Faculty Panel with John Cochrane AQR Capital Management Professor of Finance Steven Kaplan Neubauer Family Professor of Entrepreneurship and Finance Raghuram Rajan

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Eric J. Gleacher Distinguished Service Professor of Finance

Three faculty members wrapped up the Myron Scholes Forum credit crisis series by assessing the outlook and discussing what should be done next. “The key issue,” said Steven Kaplan, “is what are the loans worth?” He used a stylized bank balance sheet to show the audience what happened to banks’ debt and equity as the value of loan assets fell, and showed that the right policy approach depended on just how much a bank’s balance sheet had been affected. The treasury’s first approach—using taxpayer money to buy bad loans as a way to shore up the asset side of banks’ balance sheets—would only have made sense if the assets had not fallen very much, Kaplan said. However, because asset values had fallen sharply enough to wipe out a lot of banks’ equity, the treasury’s second crack at a Troubled Asset Relief Program made more sense. Recapitalizing them and reviving interbank lending by guaranteeing short-term debt was a more effective way to keep them solvent.

Although Kaplan thought the capital injections helped, he did not think they were enough and worried that the problem would get worse before it got better. One problem was that the economy had continued to deteriorate badly in the fourth quarter of 2008, which would further hammer banks’ asset values and make more of them insolvent.

John Cochrane, who studies capital markets, evaluated the system’s capacity for meeting the demand for new loans. The supply of risky debt had fallen, he said, but it was important to be clear about how much of this reflected risk aversion and how much stemmed from perceptions that the probability of default had risen (i.e., risk had gone up). He also argued that it was important to distinguish between banks—important intermediaries, but not the only financial institutions in the system—and the ultimate suppliers of capital, who could find ways to supply loans if the perceived risks and rewards were worth it. The core problem was not that banks had cut back lending; it was that the entire market for securitized mortgage markets had “fallen apart,” Cochrane said.

Key issues going forward, according to Cochrane, included the extent to which nonbank intermediaries would step in to supply loans that were demanded and whether individuals would eventually be willing to supply this capital to borrowers—such as home buyers—with less intermediation by the banks.

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Looking at the future of financial regulation, Raghuram Rajan argued that “problems can emerge from anywhere in the system and can spill over.” Although many used to believe that it was possible to regulate one part of the system while giving others more leeway, according to Rajan, policy makers and regulators need to realize that “liquidity ties everything together…. In that sense, illiquidity is contagious. At least you need to know what’s going on in the rest of the system, if not actually regulating it.”

Rajan argued that, time after time, crises have shown that managers do not always have control over risks, and that risk management systems tend to be ignored after a long rise in asset prices, making them ineffective when they are most needed. Regulators need to expect failures, therefore, and plan better for dealing with them without leading to contagion or putting taxpayers’ money at risk every time.

“There should be much more emphasis on anticipating the fact that banks will get into trouble periodically,” Rajan said.

He was skeptical about dealing with the problem through higher capital regulations, since this would likely lead banks to compensate for higher capital costs by seeking riskier assets. Rajan did not think that varying the capital requirements in good times and bad times would help much. Instead, he described a plan he had previously put forth, with fellow Chicago Booth professor Anil Kashyap and Jeremy Stein of Harvard University, to require banks to buy well-designed insurance for contingencies that were likely to cause systemic trouble.

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All three panelists, Kaplan, Cochrane, and Rajan, agreed that such nonfinancial companies as General Motors should not be bailed out. Although taxpayers’ money was needed to prevent the current crisis from getting worse, they said, that money was necessary because aspects of the financial system make contagion a real risk. The same forces do not apply to industrial firms. They also worried about poor regulation and regulatory uncertainty emerging from the crisis. Cochrane added that rising public debt and resulting inflation was a big risk. “There are ways,” he said, “to make this much, much worse.”

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Scholes Forum Other Distinguished Speakers, 2008–09

The Growth Commission Report: Strategies for Sustained Growth and Inclusive Development Danny Leipziger Vice President for Poverty Reduction and Economic Management, World Bank Abhijit Banerjee Ford Foundation International Professor of Economics, MIT Raghuram Rajan

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Eric J. Gleacher Distinguished Service Professor of Finance September 2008

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The BREAD conference brings together many of the world’s leading researchers on economic development. The IGM hosted this conference in September 2008, and while these experts were in Chicago, we pulled together three of them for a public discussion of what researchers have learned about economic growth and how governments can take advantage of these lessons. Danny Leipziger, vice president for poverty reduction and economic management at the World Bank, gave an overview of the Growth Commission Report, written by high-level policy makers in concert with academic researchers. He noted that the report “reaffirms the centrality of growth as the main driver for welfare improvements,” and it highlights the advantages of international markets for poor countries.

Abhijit Banerjee, Ford Foundation Professor of International Economics at MIT, and head of MIT’s Poverty Action Lab, liked the report largely because of what it did not say. It could have listed a bunch of policies that promote free markets and stable economies, and said “let her rip,” he argued, but instead it listed many roles for active governments. Raghuram Rajan also agreed with much of the report, but pointed out that clear economic frameworks are often needed as complements to pragmatic policies. All three panelists agreed that growth should be “inclusive,” not just to spread the benefits to the poor, but also to maintain political support for high-growth policies.

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History of the Theory and Evidence on the Efficient Markets Hypothesis Eugene Fama Robert R. McCormick Distinguished Service Professor of Finance October 2008

Post-communist Transition in a Comparative Perspective Leszek Balcerowicz Professor of Economics at the Warsaw School of Economics November 2008

The IGM teamed up with the American Finance Association to host a talk by Eugene Fama, who described how the efficient markets theory, for which he is famous, was developed. In addition to laying out the ideas of the theory, Fama described the atmosphere and interactions that took place among University of Chicago finance researchers between the 1950s and 1970s. “Basically, finance didn’t exist in the middle of the 1950s,” said Fama. Not until Nobel laureate Harry Markowitz provided “the first really rigorous definition of risk of securities in terms of portfolios” did modern finance exist. Nor had asset-pricing models really evolved when research on efficient markets began. Fama explained the links between his research on efficient markets and the breakthroughs made in these other areas, and described some of his interactions with colleagues during the period.

Leszek Balcerowicz is the architect of the economic reforms initiated by Poland in 1989 and has been at the center of the country’s economic and political life since the fall of communism. Among his worldwide honors, Balcerowicz was awarded Poland’s highest decoration, Order of the White Eagle, in 2005 for his contribution to transforming the country’s economic system. In introducing professor Balcerowicz to the Scholes Forum audience, Chicago Booth’s Raghuram Rajan praised him as “one of the great practical economists of the 20th, and continuing into the 21st, century.”

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Balcerowicz compared the post-communist transitions of central and eastern Europe’s economies, highlighting the wide differences that emerged in growth and other outcomes. He then described how the global financial crisis affected the region, causing a fall in exports to trading partners and creating credit difficulties when weak financial institutions in Europe and elsewhere got into trouble.

He concluded with predictions on what the transition economies would do after the crisis has passed. Those that wanted to continue catching up quickly to developed countries, he argued, would need to press ahead with further supply-side reforms, such as increasing the flexibility of labor markets.

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When Hyde Park Rules America David Brooks New York Times columnist and commentator on “The NewsHour with Jim Lehrer” December 2008

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A month after Barack Obama’s election as U.S. president, David Brooks offered his thoughts on the prospects for the new administration and for American politics generally.

Brooks suggested that the United States had reached the end of several overlapping eras and was pivoting toward something new in each case. These changes included the role of race; the end of the long economic boom that began in the early 1980s; the collapse of conservative dominance; and a generational shift in which the ideological battles fought by baby boomers no longer drive political debate. Brooks argued that it is harder to know what sort of era is beginning.

“At the moment it’s an incredibly malleable country,” he said. “There’s a great readiness for shift and really it’s all in Obama’s hands.”

Based on his experience covering presidential campaigns, Brooks reckoned that President Obama’s “mental landscape” would matter more than anything else, and he tried to sum up that landscape for the Scholes Forum audience.

The most important positive aspects, he said, included perceptiveness, intellectual depth, and calmness. The negatives included his poor Senate record (Brooks argued that he did not take tough votes or do nitty-gritty work on hard issues); the “sojourner” nature of his ambition; and his “incredible self-confidence,” even by the standards of typical presidential candidates. Brooks considered this last attribute as the most serious cause for worry. One result of this, Brooks suggested, was an early tendency, even when naming cabinet appointments and special advisors, “to really run amok, or run all over the normal institutions of executive power,” both in economic and foreign policy.

Brooks also predicted the shape the economic stimulus plan would take and worried that it would be overrun by lobbyists, congressmen, and interest groups, becoming unfocused and ineffective as a result. He concluded by arguing that trends in the new era looked bad for the Republican Party and conservatives in general. He called heavily losing support among college educated voters a “catastrophe” for the party.

One of conservatives’ biggest mistakes, he said, was that their “disdain for liberal intellectuals drifted over into a disdain for intellectuals of all sorts.” Conservatism, Brooks said, “became a less intellectually serious thing and ran out of ideas.”

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Evaluating Obama’s Proposed Stimulus Package Faculty panel discussion with John Huizinga Walter David “Bud” Fackler Distinguished Service Professor of Economics Robert Lucas John Dewey Distinguished Service Professor of Economics, University of Chicago Kevin Murphy George J. Stigler Distinguished Service Professor of Economics January 2009

A few days before Barack Obama’s inauguration, the IGM gathered three of the university’s distinguished service professors to discuss the economic stimulus package proposed by the president-elect (and signed into law in a somewhat amended form a month later). John Huizinga started by sharing what he used to tell students: it was the predominant view among macroeconomists that fighting recessions with fiscal policy was a bad idea. “I still think in general that it is a bad idea,” he told the audience, “but I’m less convinced than I used to be that that’s the predominant view…. I’ve been surprised by how many economists have come out in support of this.” He then listed possibilities that may have led many economists to change their views.

The main reason, he said, was that many believed we were in extraordinary times. So Huizinga tried to compare this recession with previous postwar downturns.

One important factor he noted was the fall in employment.

Although the drop through the end of 2008 did not look out of line with other postwar recessions, Huizinga said, proponents of the stimulus in the Obama camp were forecasting a long period—perhaps 36 months—of falling employment, which would be more than the length of time that employment had fallen in any previous postwar recession. Still, he said, it was important to think about benefits and costs when evaluating stimulus plans.

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A big cost to consider is the effect on future economic activity. The same models that predict fiscal policy will increase output also imply that national savings must fall. If the stimulus “works” by boosting output in the short term, a consequence will either be lower investment or a larger current account deficit in the future. “Budget deficits aren’t free. You pay for them,” Huizinga said.

Kevin Murphy sketched out a simple equation—into which anyone could easily plug their own assumptions—to compare the benefits and costs of stimulus spending. The advantage, he argued, is the equation helps everyone to be clear about exactly what they are assuming and why it supports their approach to the stimulus. According to Murphy, the main items everyone should be clear about are: the fraction of the economy’s resources that are idle; the value of keeping those resources idle (e.g., most people value their time, and will not work without compensation); the deadweight loss from raising taxes in the future to pay for the spending; and the cost of allocating spending through government, if it is

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allocated less efficiently as a result (this can be negative —i.e., a benefit—if government is better than the private sector at allocating resources).

Murphy did not consider the stimulus a good proposal, but he explained how his assumptions about each element of his framework differed from those of president-elect Obama’s team. “It’s easy to see what you have to assume in order to make the stimulus make sense,” Murphy said.

Regarding the tax cut measures in the stimulus plan, Murphy thought they were designed in an especially inefficient way. Since marginal tax rates are what matter for incentives, he argued, it was not helpful that the Obama plan would give tax cuts in the form of direct credits to certain taxpayers without lowering rates. That the president would likely address the resulting deficit by raising rates in the future would exacerbate the problem.

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Robert Lucas pointed out that the U.S. economy was already four percent below its long-term trend level in January 2008.

In addition, consensus forecasts—which “mean a lot” over short horizons such as a year—suggested the economy would be eight percent below after another year. This would be larger than any other postwar recession, though nowhere near as bad as the 30 percent gap in the 1930s. “It’s not the worst in my lifetime, but it’s the worst in Obama’s,” Lucas said, “and it would be foolish not to take some actions to deal with it.”

Monetary measures to deal with the recession make a lot of sense, said Lucas, who added that many of the Fed’s actions were beneficial. The trouble was the fiscal stimulus did not seem designed to deal with the real problem. A good approach, Lucas said, would be to use the fiscal stimulus “as another way of getting cash into circulation in the private sector.” He mentioned hypothetical examples that Milton Friedman—dropping money from helicopters—and John Maynard Keynes—paying people to dig and refill ditches— had posed as ways of achieving this. “If fiscal stimuli are designed to be effective, they’re going to be effective because they carry along a monetary policy of the sort that raises the dollar spending level,” Lucas said.

Based on the plans and information he had seen from president-elect Obama’s advisors, however, Lucas said that this did not seem to be what the new administration was planning. Instead, he said, “all they’re talking about is transferring resources, additional levels of spending,

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from one use to another,” which, he argued, would have no substantial effect on the average level of spending and thus would not help fight the recession.

Fixing the Global Economy Martin Wolf Associate Editor the Financial Times March 2009

Focusing on “the emergence of extraordinary global imbalances” over the past decade or so, Martin Wolf gave his views on the current economic and financial crisis. He argued that although two explanations for the crisis widely heard in the United States—failures of regulation and excessively loose monetary policy—were important aspects of the problem, they could not explain “a catastrophe of this magnitude.” Wolf focused particularly on three trends that helped lead to the crisis: global imbalances, a credit boom that accelerated under the influence of those imbalances, and the way financial innovation worked.

Wolf argued that the Asian crisis a decade earlier was an important contributor to global imbalances because it led policy makers in emerging economies to conclude that “running very large current-account deficits to support large investment booms was sensationally dangerous,” especially when the deficits are financed by relatively short-term, foreign-currency borrowing. Over the decade leading up to the current crisis, therefore, many emerging economies, particularly in Asia, shifted to new policy regimes that included aggressively accumulating foreign reserves.

The result was a “monstrous recycling of capital inflows and current account surpluses,” Wolf said, with foreign reserves held by emerging economies rising sharply. It also “amounted to a massive flow of capital from poor countries to the richest country in the world,” he added. Asset bubbles, especially in housing, started emerging across much of the developed world, Wolf said. Particularly in the United States, household debt rose sharply because of the capital inflows.

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In addition, Wolf argued, these imbalances “came on top of what was already an astonishingly rapid credit expansion across the developed world, which had started in the early 1980s, when debt ratios to GDP were extremely low, and accelerated rapidly.” The third trend he highlighted was that, in an environment of low returns for safe assets, investors demanded higher returns for safe investments. Innovators in the financial system found ways to meet this demand, which eventually helped lead to the financial crisis.

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Rebuilding the Global Architecture of Financial Regulation Malcolm Knight Vice Chairman Deutsche Bank Group April 2009

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“How can we build a global financial system that’s resilient to shocks and still gives appropriate scope for competition and innovation in the financial marketplace?” Malcolm Knight posed this as a crucial question to consider when reforming financial regulation. In light of the current crisis, he offered some answers. Knight began by summarizing some of the causes of the crisis, including an “astonishing degree of complacency about counterparty risk,” and a “complex web of misaligned incentives and market failures.”

Knight then identified three broad weaknesses in financial regulation that contributed to the problem. One was the failure of private risk managers and public regulators to take account of system-wide risks. A second was regulatory gaps arising from both different approaches across national jurisdictions and uneven treatment of different markets and institutions within countries. A third weakness, Knight argued, was a failure to handle properly the interactions between financial institutions and markets, including a “lack of transparency for the valuation and disclosure of financial instruments.”

To deal with these regulatory shortcomings, Knight proposed several reforms, among them: harmonizing financial regulation internationally; ensuring that one agency in each economy is responsible for monitoring and handling system-wide risks; and devising better ways to handle capital requirements, possibly including capital surcharges on institutions that pose bigger systemic risks as they grow larger and more interconnected. Knight also argued that the system needs to be agile, and noted that incorporating such flexibility can be politically difficult.

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The Initiative on Global Markets sponsors extended visits by prominent faculty from other institutions to contribute to the research environment at the University of Chicago Booth School of Business. The IGM hosted 10 visiting fellows in the 2008– 09 academic year.

Andrew Abel Ronald A. Rosenfeld Professor of Finance

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and Economics Wharton May 18–29, 2009

Andrew Abel was an IGM visiting scholar in May 2009. Abel works on problems at the boundaries of macroeconomics and finance and is one of the leading scholars of his generation. Abel presented his research on “Optimal Inattention to the Stock Market with Information Costs and Transactions Costs” in the Finance Workshop. He also participated in the Macro and International Workshop, the Money and Banking Workshop, and the Finance Brown Bag Lunch. He met with numerous Chicago Booth faculty and with many of our colleagues in the university’s Department of Economics.

Viral Acharya’s research interests are in the areas of financial contracting, corporate governance, liquidity, bank management, and crisis prevention. He is currently working on analyzing the plunge in liquidity in inter-bank markets during the current crisis.

Viral Acharya Professor of Finance New York University Stern School of Business May 18–29, 2009

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During his visit, Acharya interacted with faculty from the finance group, including junior faculty, to discuss his and their work. He also worked with Chicago Booth’s Raghuram Rajan to explore new research ideas, specifically relating to management behavior within corporations.

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Manuel Amador Assistant Professor at the Department of Economics Stanford University May 18–29, 2009

Michael Greenstone 3M Professor of Environmental Economics Massachusetts Institute of Technology December 1–12, 2008

Peter Kondor Assistant Professor Central European University March 30–April 17, 2009

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Manuel Amador visited Chicago Booth for two weeks in the spring quarter. During his visit, Amador actively interacted with various faculty members at Chicago Booth, including Veronica Guerrieri, Erik Hurst, Anil Kashyap, and Stavros Panageas, and met with Fernando Alvarez, William Fuchs, Robert Shimer, and Nancy Stokey in the Department of Economics. Amador also attended various seminars, lunches, and dinners with several faculty members. During his visit he also worked with Guerrieri to explore new ideas related to the co-movement of emerging market bonds.

Michael Greenstone’s research focuses on regulation of market-based behavior and the costs of environmental change and regulation. Greenstone is one of the world’s foremost experts on the economics of the environment and global climate change. Since Greenstone’s visit, he was named chief economist of the President’s Council of Economic Advisors.

During his time at Chicago, Greenstone presented his recent work entitled “Climate Change, Consumption Smoothing, and Mortality in India” to a group of more than 30 faculty.

He also attended and participated in a number of research workshops around campus and met extensively with both junior and senior faculty at Chicago Booth, the Department of Economics, and the Harris School of Public Policy.

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Peter Kondor came to Chicago Booth for two weeks during the spring quarter. During his visit, Kondor interacted with various Chicago Booth faculty members in the finance and macro-and-international groups. He also attended various seminars, lunches, and dinners with several faculty members. During his visit, he mostly worked with Chicago Booth’s Veronica Guerrieri on a project entitled “Fund Managers, Career Concerns, and Asset Price Volatility,” which was submitted to the American Economic Review at the end of his visit.

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Christian Laux Chair of Corporate Finance and Risk Management Goethe Universität October 6–17, 2008

Christian Laux’s research interests are in the areas of financial contracting, risk management, and corporate governance. His current work focuses on the design of instruments and institutions to share risks between households, firms, and markets, and on issues in organizational design such as separating functions within the supervisory board.

During his visit, Laux interacted extensively with faculty from the accounting and finance groups. He organized an informal workshop on “Financial Markets Regulation, Securitization, and Incentives” with six presentations and more than 30 participants from the accounting, economics, and finance groups to discuss the causes and consequences of the subprime crisis. Laux worked closely with Chicago Booth’s Christian Leuz to explore new research ideas, in particular topics related to the role of fair value accounting during the financial crisis. He also attended various workshops and met with junior faculty to discuss his and their work.

Nancy Qian is a development economist at Brown University.

Qian’s research mainly focuses on China. In particular, she has investigated the economic determinants of sex imbalance (missing women) in the country and the role of infrastructure development in China’s economic growth.

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Nancy Qian Assistant Professor of Economics Brown University March 30–April 17, 2009

During her visit, Qian met frequently with faculty from the micro- and macroeconomics groups. She also presented some of her research in the spring 2009 Applied Economics Workshop.

Robert Stambaugh’s research interests are mostly in the area of empirical asset pricing. His current focus is on the measurement of stock volatility and analyzing active fund management.

Robert Stambaugh Miller Anderson and Sherrerd Professor of Finance Wharton June 1–12, 2009

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During his visit, Stambaugh interacted extensively with the finance faculty, and he gave two research presentations.

First he presented his recent research on volatility in a finance workshop, and then he presented his work in progress on active fund management during a lunch workshop. On a daily basis, he collaborated with Chicago Booth’s Lubos Pastor on joint work. He also held discussions

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with several other finance faculty as well as faculty members from statistics and econometrics. Finally, he participated in multiple lunches as well as two research-oriented dinners with different groups of finance faculty.

David Strömberg Associate Professor at the Institute for International Economic Studies Stockholm University May 15–28, 2009

David Strömberg’s research focuses on political economy and the media. His recent work addresses the way scrutiny by the press affects policy outcomes and the behavior of congresspeople, the relationship between press coverage and the provision of U.S. foreign aid in response to natural disasters, and competition between private and public media outlets.

While at Chicago Booth, Strömberg met often with faculty from the economics and finance groups as well as faculty from the wider university community. He presented “Press Coverage and Political Accountability” at the Applications of Economics Workshop and a work in progress on climate change and infant mortality at the Microeconomics Lunch.

He also attended various lunches and workshops and met with junior faculty to discuss their work.

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Adam Szeidl Assistant Professor University of California, Berkeley April 20–May 1, 2009

Adam Szeidl has two primary research interests: household finance and social networks. Szeidl has analyzed the role of habit formation and committed consumption in affecting asset allocation and preferences for risk. He also has analyzed strategic interactions within a social network and has applied his theoretical analysis to data on trust and social collateral in developing countries.

Szeidl came to Chicago for two weeks during the spring quarter. During his visit, Szeidl interacted with many faculty members at Chicago Booth, including Canice Prendergast and Emir Kamenica, and Roger Myerson from the Department of Economics. He participated in several workshops, among them Applications of Economics, Applied Economics, and the Macro/International.

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Marianne Bertrand Chris P. Dialynas Professor of Economics Neubauer Family Faculty Fellow

Adair Morse Assistant Professor of Finance

“What Do High-interest Borrowers Do With Their Tax Rebate?�

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Building on prior literature that constrained individuals consume the most out of a tax rebate, we study the trade-offs high-interest borrowers faced when they received their 2008 tax stimulus checks. We find a persistent decline in payday borrowing in the pay cycles that follow the receipt of the tax rebate. The reduction in borrowing is a significant fraction of the mean outstanding loan (12%) and appears fairly persistent over the time, but is moderate in dollar magnitude (about $35) relative to the size of the rebate check ($600 per person). In trying to reconcile this finding with the cost of not retiring expensive payday debt, we find substantial heterogeneity across borrowers. Among individuals that we classify as temptation spenders (e.g. those that use 400% APR loans to buy electronic goods or go on vacation), we find no reduction in payday borrowing after the tax rebate is issued, but this group represents only a small fraction of payday borrowers. A second group, for which we find no debt retirement postcheck, is the set of borrowers that appear to use what should be short-term payday loans as a long-term financing solution.

We infer that the marginal use of the tax rebate for this group was to deal with regular monthly obligations, such as paying down late utility bills or making rent payments.

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Hoyt Bleakley Associate Professor of Economics

Other IGM working papers: • “ Maturity Mismatch and Financial Crises: Evidence from Emerging Market Corporations”

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“Mishmash on Mismatch? Balance-Sheet Effects and Emerging-Markets Crises”

We critically assess the recent empirical literature on the importance of dollar debt and balance-sheet effects in the emerging-market financial crises of the 1990s. Using a simple model, we discuss which specifications are theoretically appropriate, and provide additional insights as to the proper interpretation of the reduced-form evidence in the literature.

We show that the variety of results found in the existing literature are related to the heterogeneity of regression specifications. Using harmonized micro data on corporates across a dozen countries in Latin America and Asia, we replicate common specifications for the effect of dollar debt on investment and output at the firm level. In this light, we suggest that the literature on corporate-level currency mismatch is hardly a mishmash, but in fact quite concordant.

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Jean-Pierre Dubé Sigmund E. Edelstone Professor of Marketing Robert King Steel Faculty Fellow

“Tipping and Concentration in Markets with Indirect Network”

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This paper develops a framework to measure “tipping”—the increase in a firm’s market share dominance caused by indirect network effects. Our measure compares the expected concentration in a market to the hypothetical expected concentration that would arise in the absence of indirect network effects. In practice, this measure requires a model that can predict the counter-factual market concentration under different parameter values capturing the strength of indirect network effects. We build such a model for the case of dynamic standards competition in a market characterized by the classic hardware/software paradigm. To demonstrate its applicability, we calibrate it using demand estimates and other data from the 32/64-bit generation of video game consoles, a canonical example of standards competition with indirect network effects. In our example, we find that indirect network effects can lead to a strong, economically significant increase in market concentration. We also find important roles for beliefs on both the demand side, as consumers tend to pick the product they expect to win the standards war, and on the supply side, as firms engage in penetration pricing to invest in growing their networks.

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Chang-Tai Hsieh Professor of Economics

“The Price of Political Opposition: Evidence from Venezuela’s Maisanta�

From 2002 to 2004, the identities of millions of Venezuelan voters who had signed petitions to recall President Hugo Chavez or opposing politicians in office were made public by the government. We match these petition signers to manufacturing firm owners and household survey respondents to measure the economic effects of political expression. Put simply, do individuals who join the political opposition pay an economic price? We find that pro-opposition individuals see a fall in their income and disproportionately leave public sector employment, while pro-government individuals leave private sector employment.

Pro-opposition firms show rising tax burdens, falling profits, and less access to foreign exchange, while the marginal products of capital and labor in pro-government firms decrease. The misallocation of resources associated with political polarization after 2002 contributed to a six percent decline in total factor productivity in our sample of firms.

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Christian Leuz Joseph Sondheimer Professor of international economics, finance, and accounting Neubauer Family Faculty Fellow

“Global Accounting Convergence and the Potential Adoption of IFRS by the United States: An Analysis of Economic and Policy Factors”

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Drawing on the academic literature in accounting, finance, and economics, we analyze economic and policy factors related to the potential adoption of International Financial Reporting Standards (IFRS) in the United States. We highlight the unique institutional features of U.S. markets to assess the potential impact of IFRS adoption on the quality and comparability of U.S. reporting practices, the ensuing capital market effects, and the potential costs of switching from U.S. GAAP to IFRS. We discuss the compatibility of IFRS with the current U.S. regulatory and legal environment as well as the possible effects of IFRS adoption on the U.S. economy as a whole. We also consider how a switch to IFRS may affect worldwide competition among accounting standards and standard setters, and discuss the political ramifications of such a decision on the standard-setting process and on the governance structure of the International Accounting Standards Board. Our analysis shows that the decision to adopt IFRS mainly involves a cost-benefit trade-off between (1) recurring, albeit modest, comparability benefits for investors, (2) recurring future cost savings that will largely accrue to multinational companies, and (3) one-time transition costs borne by all firms and the U.S. economy as a whole, including those from adjustments to U.S. institutions. We conclude by outlining several possible scenarios for the future of U.S. accounting standards, ranging from maintaining U.S. GAAP, letting firms decide whether and when to adopt IFRS, to the creation of a competing U.S. GA AP–based set of global accounting standards that could serve as an alternative to IFRS.

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“The Crisis of Fair Value Accounting: Making Sense of the Recent Debate”

The recent financial crisis has led to a vigorous debate about the pros and cons of fair-value accounting (FVA). This debate presents a major challenge for FVA going forward and for standard setters’ push to extend FVA into other areas. In this article, we highlight four important issues as an attempt to make sense of the debate. First, much of the controversy results from confusion about what is new and different about FVA. Second, while there are legitimate concerns about marking to market (or pure FVA) in times of financial crisis, it is less clear that these problems apply to FVA as stipulated by the accounting standards, be it IFRS or U.S. GA AP. Third, historical cost accounting (HCA) is unlikely to be the remedy. There are a number of concerns about HCA as well and these problems could be larger than those with FVA. Fourth, although it is difficult to fault the FVA standards per se, implementation issues are a potential concern, especially with respect to litigation. Finally, we identify several avenues for future research.

“Disclosure and the Cost of Capital: Evidence from Firms’

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Response to the Enron Shock”

This paper examines the link between disclosure and the cost of capital. We exploit an exogenous cost of capital shock created by the Enron scandal in fall 2001 and analyze firms’ disclosure responses to this shock. These tests are opposite to the typical research design that analyzes cost of capital responses to disclosure changes. In reversing the tests and using an exogenous shock, we mitigate concerns about omitted variables in traditional cross-sectional disclosure studies. We estimate shocks to firms’ betas around the Enron events and the ensuing transparency crisis. Our analysis shows that these beta shocks are associated with increased disclosure. Firms expand the number of pages of their annual 10-K filings, notably the sections containing the financial statements and footnotes. The increase in disclosure is particularly pronounced for firms that have positive cost of capital shocks and larger financing needs. We also find that firms respond with additional interim disclosures (e.g., 8-K filings) and that these disclosures are complementary to the 10-K disclosures. Finally, we show that firms’ disclosure responses reduce firms’ costs of capital and hence the impact of the transparency crisis.

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Atif Mian Associate Professor of Finance

Amir Sufi Associate Professor of Finance

“House Prices, Home Equity–Based Borrowing, and the U.S. Household Leverage Crises”

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Using individual-level data on homeowner debt and defaults from 1997 to 2008, we show that borrowing against the increase in home equity by existing homeowners is responsible for a significant fraction of both the sharp rise in U.S. household leverage from 2002 to 2006 and the increase in defaults from 2006 to 2008. Employing land topology–based housing supply elasticity as an instrument for house price growth, we estimate that the average homeowner extracts 25 to 30 cents for every dollar increase in home equity. Money extracted from increased home equity is not used to purchase new real estate or pay down high credit card debt, which suggests that consumption is a likely use of borrowed funds. Home equity–based borrowing is stronger for younger households, households with low credit scores, and households with high initial credit card utilization rates. Homeowners in high house-price appreciation areas experience a relative decline in default rates from 2002 to 2006 as they borrow heavily against their home equity, but they then experience very high default rates from 2006 to 2008. Our estimates suggest that home equity–based borrowing is equal to 2.3 percent of GDP every year from 2002 to 2006, and accounts for over 20 percent of new defaults in the last two years.

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Research by: •A tif Mian, Associate Professor of Finance • A mir Sufi, Associate Professor of Finance • Francesco Trebbi, Assistant Professor of Economics

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“The Political Economy of the U.S. Mortgage Default Crisis”

We examine the effects of constituent interests, special interests, and politician ideology on congressional voting behavior on two of the most significant pieces of legislation in U.S. economic history: the American Housing Rescue and Foreclosure Prevention Act of 2008 and the Emergency Economic Stabilization Act of 2008. Representatives from districts experiencing an increase in mortgage default rates are more likely to vote in favor of the AHRFPA, and the response is stronger in more competitive districts.

Representatives only respond to mortgage related defaults (not non-mortgage defaults), and are more sensitive to defaults of their own-party constituents. Higher campaign contributions from the financial services industry are associated with an increased likelihood of voting in favor of the EESA, a bill which transfers wealth from tax payers to the financial services industry. Examining the trade-off between ideology and economic incentives, we find that conservative politicians are less responsive to both constituent and special interests. This latter finding suggests that politicians, through ideology, can commit themselves against intervention even during severe crises.

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Robert Novy-Marx Assistant Professor of Finance

Joshua Rauh Associate Professor of Finance Northwestern University Kellogg School of Management

“The Intergenerational Transfer of Public Pension Promises�

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The value of pension promises already made by U.S. state governments will grow to approximately $7.9 trillion in 15 years. We study investment strategies of state pension plans and estimate the distribution of future funding outcomes.

We conservatively predict a 50 percent chance of aggregate underfunding greater than $750 billion and a 25 percent chance of at least $1.75 trillion (in 2005 dollars). Adjusting for risk, the true intergenerational transfer is substantially larger. Insuring both taxpayers against funding deficits and plan participants against benefit reductions would cost almost $2 trillion today, even though governments portray state pensions as almost fully funded.

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Raghuram Rajan Eric J. Gleacher Distinguished Service Professor of Finance

“Landed Interests and Financial Underdevelopment in the United States�

Landed elites in the United States in the early decades of the 21st century played a significant role in restricting the development of finance. States that had higher land concentration passed more restrictive banking legislation. At the county level, counties with very concentrated land holdings tended to have disproportionately fewer banks per capita.

45 Banks were especially scarce both when landed elites’ incentive to suppress finance, as well as their ability to exercise local influence, was higher. Finally, the resulting financial underdevelopment was negatively correlated with subsequent manufacturing growth. We draw lessons from this episode for understanding economic development.

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Jeffrey Russell Professor of Econometrics and Statistics

“Measuring and Modeling Execution Cost and Risk�

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Financial markets are considered to be liquid if a large quantity can be traded quickly and with minimal price impact. Although the idea of a liquid market involves both a cost as well as a time component, most measures of execution costs tend to focus on only a single number reflecting average costs and do not explicitly account for the temporal dimension of liquidity. In reality, trading takes time since larger orders are often broken up into smaller transactions, or when limit orders are used. Recent work shows that the time taken to transact introduces a risk component in execution costs. In this setting, the decision can be viewed as a risk/reward trade-off faced by the investor who can solve for a mean variance utility-maximizing trading strategy. We introduce an econometric method to jointly model the expected cost and the risk of the trade, thereby characterizing the mean variance trade-offs associated with different trading approaches given market and order characteristics. We apply our methodology to a novel data set and show that the risk component is a non-trivial part of the transaction decision.

The conditional distribution of transaction costs is also used to construct a new measure of liquidation risk that we refer to as liquidation value at risk (LVaR).

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Amit Seru Assistant Professor of Finance

“The Failure of Models that Predict Failure: Distance, Incentives, and Defaults�

Using data on securitized subprime loans issued in the period from 1997 to 2006, we demonstrate that as the degree of securitization increases, interest rates on new loans rely increasingly on hard information about borrowers. As a result, a statistical default model fitted in a low securitization period breaks down in the high securitization period in a systematic manner: it underpredicts defaults for borrowers for whom soft information is more valuable (i.e., borrowers with low documentation, low FICO scores, and high loan-to-value ratios). We rationalize these findings in a theoretical model that highlights a reduction in lenders’ incentives to collect soft information as securitization becomes common, resulting in worse loans being issued to borrowers with similar hard information characteristics. Our results partly explain why statistical default models severely underestimated defaults during the subprime mortgage crisis, and imply that these models are subject to a Lucas critique. Regulations that rely on such models may therefore be undermined by the actions of market participants.

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Francesco Trebbi Assistant Professor of Economics

“Competition and Political Organization: Together or Alone in Lobbying for Trade Policy?�

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This paper employs a novel data set on lobbying expenditures to measure the degree of within-sector political organization and to explore the determinants of the mode of lobbying and political organization across U.S. industries. The data show that sectors characterized by a higher degree of competition (more substitutable products and a lower concentration of production) tend to lobby more together (through a sector-wide trade association), while sectors with higher concentration and more differentiated products lobby more individually. The paper proposes a theoretical model to interpret the empirical evidence. In an oligopolistic market, firms can benefit from an increase in their product-specific protection measure if they can raise prices and profits. They find it less profitable to do so in a competitive market where attempts to raise prices are more likely to reduce profits. In competitive markets, firms are therefore more likely to lobby together, thereby simultaneously raising tariffs on all products in the sector.

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Other IGM working papers: • “ The Political Economy of the U.S. Mortgage Default Crisis” see page 43.

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“Votes or Money? Theory and Evidence from the U.S. Congress”

This paper investigates the relationship between the size of interest groups in terms of voter representation and the interest group’s campaign contributions to politicians. We uncover a robust hump-shaped relationship between the voting share of an interest group and its contributions to a legislator.

This pattern is rationalized in a simultaneous bilateral bargaining model where the larger size of an interest group affects the amount of surplus to be split with the politician (thereby increasing contributions), but is also correlated with the strength of direct voter support the group can offer instead of monetary funds (thereby decreasing contributions). The model yields simple structural equations that we estimate at the district level, employing data on individual and PAC donations and local employment by sector. This procedure yields estimates of electoral uncertainty and politicians effectiveness as perceived by the interest groups. Our approach also implicitly delivers a novel method for estimating the impact of campaign spending on election outcomes: we find that an additional vote costs a politician between $100 and $400 depending on the district.

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Luigi Zingales Robert C. McCormack Professor of Entrepreneurship and Finance David G. Booth faculty fellow

“The Housing Crisis and Bankruptcy Reform: The Prepackaged Chapter 13 Approach”

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The housing crisis threatens to destroy hundreds of billions of dollars of value by causing homeowners with negative equity to walk away from their houses. A house in foreclosure is worth 30 to 50 percent less than a house that a homeowner either retains or sells on the market, and a foreclosed house damages neighboring property values as well. We advocate a reform of Chapter 13 that would allow homeowners to strip down the value of their mortgages in a prepackaged bankruptcy. Such a plan would give homeowners an incentive to keep or resell their homes, thus reducing the market value loss of homes while protecting the effective value of creditors’ interests. Two further key elements of the plan are that it uses prices based on the average house price in a particular ZIP code, which reduces moral hazard; and it is automated, requiring only a rubber stamp by a bankruptcy judge or other official, thus preserving judicial resources. Other plans, including that of the Obama administration, are compared.

11/30/09 12:29:37 AM

“Innovation and Institutional Ownership�

We find that institutional ownership in publicly traded companies is associated with more innovation (measured by cite-weighted patents). To explore the mechanism through which this link arises, we build a model that nests the lazy-manager hypothesis with career concerns, where institutional owners increase managerial incentives to innovate by reducing the career risk of risky projects. The data supports the career-concerns model. First, whereas the lazy-manager hypothesis predicts a substitution effect between institutional ownership and product market competition (and managerial entrenchment generally), the career-concerns model allows for complementarity. Empirically, we reject substitution effects. Second, CEOs are less likely to be fired in the face of profit downturns when institutional ownership is higher. Finally, using instrumental variables, policy changes, and disaggregating by type of owner, we find that the effect of institutions on innovation does not appear to be due to endogenous selection.

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11/30/09 12:29:37 AM

“The Future of Securities Regulation”

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The U.S. system of securities law was designed more than 70 years ago to regain investors’ trust after a major financial crisis. Today we face a similar problem. But while in the 1930s the prevailing perception was that investors were defrauded by offerings of dubious quality securities, in the new millennium, investors’ perception is that they have been defrauded by managers who are not accountable to anyone.

For this reason, I propose a series of reforms that center on corporate governance, while shifting the focus from the protection of unsophisticated investors in the purchasing of new securities issues to the investment in mutual funds, pension funds, and other forms of asset management.

“Media Versus Special Interests”

We argue that profit-maximizing media help overcome the problem of rational ignorance highlighted by [Anthony] Downs (1957) and in so doing make elected representatives more sensitive to the interests of general voters. By collecting news and combining it with entertainment, media are able to inform passive voters on politically relevant issues. To show the impact this information has on legislative outcomes, we document the effect muckraking magazines had on the voting patterns of U.S. representatives and senators in the early part of the 20th century. We also show under what conditions profit-maximizing media will cater to general (less affluent) voters in their coverage, providing a counterbalance to special interests.

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12/12/09 1:02:38 AM

“Long-Term Persistence”

Is social capital long lasting? Does it affect long-term economic performance? To answer these questions we test [Robert] Putnam’s conjecture that today’s marked differences in social capital between the North and South of Italy are due to the culture of independence fostered by the free city-states experience in the North of Italy at the turn of the first millennium. We show that the medieval experience of independence had an impact on social capital within the North, even when we instrument for the probability of becoming a city-state with historical factors (such as the Etruscan origin of the city and the presence of a bishop in year 1000).

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More importantly, we show that the difference in social capital among towns that in the Middle Ages had the characteristics to become independent, and towns that did not, existed in the North (where most of these towns later became independent) but not in the South (where the power of the Norman kingdom prevented them from doing so). Our difference-in-difference estimates suggest that at least 50 percent of the North-South gap in social capital is due to the lack of a free city-state experience in the South.

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12/6/09 10:42:05 PM

A Selection of Events and Visitors Planned for the 2009–10 Academic Year Myron Scholes Global Market Forum In Fed We Trust: Ben Bernanke’s War on the Great Panic David Wessel, September 15, 2009 David Wessel is economics editor of the Wall Street Journal and writes “Capital,” a weekly column that looks at the economy and forces shaping living standards around the world. He has shared two Pulitzer Prizes, one for Boston Globe stories in 1983 on the persistence of racism in Boston, and the other for stories in 2002 in the Wall Street Journal on corporate wrongdoing.

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The Unrealized Opportunity in Health Care David Cutler, September 21, 2009 David Cutler is the Otto Eckstein Professor of Applied Economics in the Department of Economics and Kennedy School of Government at Harvard University.

He served on the Council of Economic Advisors and the National Economic Council during the Clinton administration and was senior health care advisor to Barack Obama’s presidential campaign.

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Inflation or Deflation?

John Cochrane, October 28, 2009 John Cochrane is the AQR Capital Management Professor of Finance at the University of Chicago Booth School of Business. His recent finance publications include the book Asset Pricing as well as articles on dynamics in stock and bond markets, the volatility of exchange rates, the term structure of interest rates, the returns to venture capital, liquidity premiums in stock prices, the relation between stock prices and business cycles, and option pricing when investors cannot perfectly hedge.

Should Executive Pay Be Regulated?

Steven Kaplan, December 2, 2009 Steven Kaplan is the Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business. He conducts research on issues in private equity and entrepreneurial finance, corporate governance, mergers and acquisitions, and corporate finance

12/6/09 10:42:05 PM

Conferences

2009–10 Visiting Faculty Fellows

Saving the Financial System December 2009 The IGM will host a conference in Miami, Florida, on December 4 and 5 to discuss solutions to the financial crisis. The conference consists of an off-the-record discussion among central bank officials, senior financial services executives, and academic economists.

Effi Benmelech, PhD ’05, fall 2009 Associate Professor Department of Economics Harvard University

U.S. Monetary Policy Forum February 2010 The USMPF is an annual conference that brings academics, market economists, and policy makers together. A standing group of academic and private sector economists has rotating responsibility for producing a report on a critical medium-term issue confronting the Federal Open Market Committee. The fourth annual USMPF will be held in New York City.

The China Summer Institute: Creating a Global Network of China Scholars Summer 2010 Asia is one of the fastest growing regions of the world. The long-run goal of this project is to create a network of high-quality scholars working on economic issues in Asia. We have met twice: in Dailian at the end of June 2008 and in Beijing in June 2009. These meetings have been cosponsored by business schools in China and Europe. We plan to hold the third annual meeting in China at the end of June 2010.

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Barry Eichengreen, spring 2010 George C. Pardee and Helen N. Pardee Professor of Economics and Political Science University of California, Berkeley Justine Hastings, fall 2009 Associate Professor of Economics Yale University Sergio Rebelo, winter 2010 Tokai Bank Professor of International Finance Northwestern University

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Antoinette Schoar, fall 2009 Michael Koemer, ’49, Professor of Entrepreneurial Finance MIT Sloan School of Management

12/12/09 1:04:05 AM

The Initiative on Global Markets was launched with a founding grant from the Chicago Mercantile Exchange (CME) Group Foundation. The CME Group Foundation funds academic research on various aspects of financial markets.

The Initiative on Global Markets Corporate Partners Program is designed to build a deeper relationship between the private sector and faculty from the University of Chicago Booth School of Business. Our corporate partners support the research efforts of the world’s best faculty in accounting, economics, and finance on topics of great importance to financial and economic decision making around the globe.

AQR Capital Management is an investment

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management firm that specializes in using a “disciplined multi-asset, global research process” to achieve long-term success in both investment and risk management. They apply research-driven models as well as good common sense to a broad spectrum of products. aqrcapital.com

John Deere and Company is a 170-year-old Illinois-based company that produces cutting-edge equipment across three key areas: agriculture, commercial and consumer products, and construction and forestry. The company also includes a finance division that operates in more than 110 countries. John Deere and Company’s goal is to boost productivity and the quality of life for people throughout the world. deere.com

Barclays is a major global financial services provider engaged in retail and commercial banking, credit cards, investment banking, wealth management and investment management services, with an extensive international presence in Europe, the United States, Africa, and Asia. With over 300 years of history and expertise in banking, Barclays operates in over 50 countries and employs over 155,000 people. Barclays moves, lends, invests, and protects money for over 48 million customers and clients worldwide.

Northern Trust is a global leader in delivering innovative investment management, asset and fund administration, fiduciary and banking solutions to corporations, institutions, and affluent individuals. For nearly 120 years, we have evolved with the changing needs of our clients and our world. northerntrust.com

barclays.com

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12/12/09 1:05:32 AM

Executive Director

Brian Barry Clinical Professor of Economics Faculty Directors

Anil Kashyap, Co-director Edward Eagle Brown Professor of Economics and Finance Richard N. Rosett Faculty Fellow Christian Leuz, Co-director Joseph Sondheimer Professor of International Economics, Finance, and Accounting Neubauer Family Faculty Fellow Matthew Gentzkow Professor of Economics Neubauer Family Faculty Fellow Tobias Moskowitz Fama Family Professor of Finance Luigi Zingales Robert C. McCormack Professor of Entrepreneurship and Finance David G. Booth Faculty Fellow Administration

Jennifer Williams, Assistant Director Janice Luce, Assistant Director Peggy Eppink, Research Professional

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12/12/09 12:56:07 AM

2008–09 Annual Report

IGM Initiative on Global Markets 2008–09 Annual Report

IGM Initiative on Global Markets

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