A market-based solution to price externalities
Robert Townsend, Weerachart Kilenthong 09 November 2014
In the aftermath of the Global Crisis, models with pecuniary externalities have gained popularity. This column presents a new framework that encompasses many of these externalities. The authors also show how to design financial contracts and markets in such a way that ex ante competition can achieve a constrained-efficient allocation.
In the aftermath of the recent Global Crisis, models with pecuniary externalities have regained the interest of researchers as they seek policy interventions and regulations to remedy externality-induced distortions. There is a growing literature on fire sales and amplifiers where private agents undervalue net worth in a period of financial distress because they fail to internalise that net worth has positive spillovers on other agents.
financial markets, pecuniary externalities, Contracts, trading
The ‘fear factor’: Personal experience and risk aversion in times of crisis
Peter Koudijs, Hans-Joachim Voth 12 April 2014
Human behaviour in times of financial crises is difficult to understand, but critical to policymaking. This column discusses new evidence showing that personal experience in financial markets can dramatically change risk tolerance. A cleanly identified historical episode demonstrates that even without losses, negative shocks not only modify risk appetite, but can also create ‘leverage cycles’. These, in turn, have the potential to make markets extremely fragile. Remarkably, those who witnessed this episode but were not directly threatened by it, did not change their own behaviour. Thus, personal experience can be a powerful determinant of investors’ actions and can eventually affect aggregate instability.
To paraphrase Larry Summers, some people are scared – just look around. The crisis of 2007–08 took a toll on a lot of people, investors included. What seemed to be a new age of steady, moderately high growth and stable equity returns suddenly turned into the biggest economic crisis since the 1930s:
Economic history Financial markets
financial markets, crisis, behaviour, risk aversion, lending
The price of political uncertainty
Bryan T. Kelly, Lubos Pastor, Pietro Veronesi 31 March 2014
Despite obvious ties between political uncertainty and financial markets, the nature of this connection has not been studied in detail. This column describes a theoretical framework for evaluating the influence of political uncertainty on financial markets. Political uncertainty commands a risk premium, especially when the economy is weak. By raising firms’ cost of capital, it depresses investment and real activity. Furthermore, by raising risk premia, political uncertainty destroys market value.
Amid the 2008 financial crisis, political uncertainty around the world reached record levels and has remained elevated ever since (Baker et al. 2013). While uncertainty is a natural feature of even the healthiest political processes, its recent surges have been in large part self-inflicted, for example, by the stubbornly dysfunctional discourse in the US Congress. What is the price we pay for cultivating an uncertain political climate?
Politics and economics
financial markets, political uncertainty
Asset pricing in the frequency domain: Theory and empirics
Ian Dew-Becker, Stefano Giglio 20 October 2013
Stabilisation policy should focus on the frequencies consumers care most about. This column presents evidence from stock-market returns suggesting that consumers are willing to pay the most to avoid – and are therefore most concerned about – fluctuations that last tens or hundreds of years. Modern macroeconomic theory tends to view the role of monetary policy as smoothing out inflation and unemployment over the business cycle. The authors’ findings suggest that resources would be better spent on policies that smooth out longer-run fluctuations.
Economic fluctuations act at frequencies that range from the hourly or even minute-by-minute level – such as shifts in electricity demand due to temperature fluctuations – to shocks that last for decades or longer – such as large-scale technological changes. While economic policy can do little to change factors like the temperature at a particular time of day, it can affect the behaviour of the economy at a certain range of frequencies – for example by trying to stabilise the business cycle or encourage innovation that affects long-run growth rates.
Financial markets Macroeconomic policy Monetary policy
financial markets, business cycles, asset pricing, Stabilisation policy, fluctuations, habit formation
The Fractal Market Hypothesis and its implications for the stability of financial markets
Nicola Anderson, Joseph Noss 03 September 2013
Financial prices display ‘fractal’ properties. This column conjectures that this is caused by interactions among agents with different horizons and interpretations of information. This structure appears to be associated with a special sort of stability that can be disrupted – leading to price crashes – if these interaction breaks down. While embryonic, this thinking may have important implications for the regulation of financial markets.
Financial prices appear to exhibit ‘fractal’ properties over time. A defining property of fractals is the tendency of an object to be similar to parts of itself.1 To fix ideas before turning to financial markets, consider a well-known natural example – an oak tree (Figure 1).
Figure 1. A fractal tree
financial markets, Fractal market hypothesis, self-similarity
Stock market turnover and corporate governance
Alex Edmans, Vivian W Fang, Emanuel Zur 16 February 2013
The stock market is a powerful tool for controlling corporations’ behaviour. But which is better, a highly liquid market or a number of large blockholders? This column argues in favour of liquidity. Evidence suggests that policymakers should not reduce stock liquidity through greater regulation. While the idea that liquidity encourages short-term trading – rather than long-term governance – sounds intuitive, deeper analysis shows that liquidity is beneficial because it encourages large shareholders to form in the first place, and allows shareholders to punish underperforming firms through selling their stake.
The stock market is a powerful tool for controlling corporation’s behaviour. But what is best:
financial markets, liquidity, corporate governance, firms, stocks
Limits to currency momentum trading
Lukas Menkhoff, Lucio Sarno, Maik Schmeling, Andreas Schrimpf 31 March 2012
Momentum trading – buying past winners and selling past losers – is a popular trading strategy in many assets. In foreign exchange high returns to momentum trading have fuelled concerns that it is little more than destabilising speculation. This column argues that, for better or worse, such strategies are likely to continue.
Momentum trading, ie buying past winners and selling past losers, is a very popular trading strategy in many assets. In foreign exchange high returns to momentum trading have been documented since the 1970s and have fuelled concerns about destabilising speculation. However, such concerns may be a bit one-sided because it is not really obvious whether there is too much momentum trading or possibly even not enough.
International finance International trade
financial markets, currency trading, speculation, momentum trading
Innovations in the real economy thrive on modern financial markets
Thomas Meyer 19 August 2011
Against the backdrop of noise about the damage financial markets can cause, this column focuses on the positives. It presents an analysis of innovation at 1,200 firms worldwide and finds that financial markets usually award a premium to innovative firms, though this premium differs across countries. Economies with more active financial markets have higher innovation – which may be a driver of faster productivity growth.
There is by now a fairly large literature arguing that modern financial markets are very important drivers of innovations in the real economy. Efficient financial markets should allocate capital towards up-and-coming sectors, promising companies, and exciting business ideas but away from declining industries. This role is easy to see when it comes for instance to venture capital, which supports innovative start-ups, but should also hold when looking at established companies.
Financial markets Productivity and Innovation
financial markets, innovation
Contingent capital and risk taking: Evidence from Britain’ banks 1878-1912
Richard S. Grossman, Masami Imai 07 September 2010
One of the striking features in the buildup to the global crisis was the extent of risk taken on by highly leveraged financial institutions. This column blames such behaviour on the limited liability status of these institutions. Using data on British banks from 1878 to 1912, it finds that the banks with greater liability for their debts took on less risk.
From the enactment of the first commercial banking codes in the nineteenth century through the adoption of the Basel and Basel II accords in recent years to the anticipated adoption of Basel III, policymakers have argued that holding increased amounts of capital promotes bank “soundness and stability” (Basel Committee on Banking Supervision 1988, 2004).
Economic history Financial markets Global crisis
financial markets, financial regulation, global crisis
The US financial reform bill: Hit or flop?
Thorsten Beck 16 June 2010
Will the upcoming Financial Reform Bill in the US help prevent the next crisis or at least reduce its probability? This column argues that the answer is a firm “no”. It says this is not because the reform steps are damaging or wrong, but simply because they only provide the framework and do little to change incentives for banks and regulators.
A few weeks ago, the US Senate passed its version of the Financial Reform Bill. While it still has to be reconciled with the House version, the outline of the regulatory reform in the US is slowly becoming clear. A thorough assessment of the Bill, however, is made difficult by the sheer size of the Bill with over 1,000 pages, compared to 53 pages of the Glass-Steagall Act.
Financial markets Global crisis Microeconomic regulation
financial markets, global crisis, microeconomic regulation