How much is human capital worth? This is an important question when one this about the amount of resources that goes into education, both from public and private funds, as well as the substantial opportunity cost of attending school instead of working. The traditional approach is to compare the labor income of people with different levels of education and then come up with a return on investment or more often a return of one additional year of schooling.
Mark Huggett and Greg Kaplan take a different approach. They consider human capital to be an asset and decompose it into a bond (with fixed return), a stock (with variable return) and a residual. This becomes then a standard asset pricing problem. Then taking the labor income flow as a representation of the dividends from this portfolio, they can infer its composition, and how it changes over time. Using data for US males, it turns out the value of human capital is much lower than previously estimated. This is because the stochastic discount factor covaries negatively with earnings (they take into account capital income as well). Also, the bond component dominates the portfolio, especially for the college educated, which is not surprising given the large variance of income and employment among the less educated. What is more surprising, I think, is that stock market and human capital returns are not correlated. I would have thought that the business cycle would have had a strong impact there.
Showing posts with label financial markets. Show all posts
Showing posts with label financial markets. Show all posts
Do remittances create credit?
Remittances from foreign workers to their families at home are an important source of income in some countries. Whether this is a good solution for the long term is debatable, though, as it may create a dependency. Thus it is important to understand whether these remittances end up not just fueling consumption but build the basis for investment in various forms of capital and future domestic income.
Christian Ambrosius looks at Mexico and finds that receiving remittances is strongly associated with the ownership of a savings account, especially in rural areas. So at least all of the remittances are going into consumption. More interesting is that there is also evidence that it also builds up some borrowing capacity, especially in microfinance banks. Once more, it is not the big financial institutions that seem to be the key to the development of the poorest, but the small institutions that rely on the local social network. And remittances are perfect to finance that.
Christian Ambrosius looks at Mexico and finds that receiving remittances is strongly associated with the ownership of a savings account, especially in rural areas. So at least all of the remittances are going into consumption. More interesting is that there is also evidence that it also builds up some borrowing capacity, especially in microfinance banks. Once more, it is not the big financial institutions that seem to be the key to the development of the poorest, but the small institutions that rely on the local social network. And remittances are perfect to finance that.
Why does Angola invest in Portugal?
Standard theory tells us that a country with a low capital endowment, relative to its labor endowment, should have high capital returns and thus should be attracting foreign capital until capital returns are equal at home and abroad. While there is foreign direct investment from the North to the South, it is by far as high as it should be, and capital returns are far from being equalized. There are proposed answers to this puzzle, from mismeasurement to country-specific risk, but that does not explain why there would be foreign direct investment from the South to the North.
Carlos Pestana Barros, Bruno Damásio and João Ricardo Faria look at the case of Angola investing substantially in its former colonial master, Portugal. They build a model of a open economy subject to corruption practices. It is not quite clear to me how this model maps into the linear equation that is estimated (partly because not all equations display in the paper). But at this points, the interesting results is that this FDI is driven by exports and mostly by corruption. One has to understand that corruption in Angola is among the world's highest. For example, there is an unexplained residual in the country's fiscal account that corresponds to about a quarter of its GDP, which is absolutely mind boggling. This corruption is so big that not only does it dry out the FDI flow from Portugal, it reverses it.
Carlos Pestana Barros, Bruno Damásio and João Ricardo Faria look at the case of Angola investing substantially in its former colonial master, Portugal. They build a model of a open economy subject to corruption practices. It is not quite clear to me how this model maps into the linear equation that is estimated (partly because not all equations display in the paper). But at this points, the interesting results is that this FDI is driven by exports and mostly by corruption. One has to understand that corruption in Angola is among the world's highest. For example, there is an unexplained residual in the country's fiscal account that corresponds to about a quarter of its GDP, which is absolutely mind boggling. This corruption is so big that not only does it dry out the FDI flow from Portugal, it reverses it.
What to do when people expect the government to default on its debt
The situation in Greece is rapidly getting worse, with clear signs that a bank run is in the works, mainly because there is no party majority that would avoid a default on the public debt. In such a situation, what should the fiscal policy be? Clearly, the budgets have to be reduced dramatically as no one would be willing to lend to the government and the government can only pay with cash (which is not the new drachma, as no one will trust that either and we would have immediate hyperinflation and the complete collapse of public services). This is why the government has no choice but to honor its debts if it wants to continue offering public goods, and this is what the Greeks want, I think.
So then, what should happen if the government is committed to pay the debt, but the public does not believe it? For advice, we can turn to the recent paper by Francesco Caprioli, Pietro Rizza and Pietro Tommasino. Suppose economic agents eventually and gradually learn about the good dispositions of the government. They also believe there is a positive correlation between the level of debt and the probability of default. The consequence of these very reasonable assumptions is that government expenses need absolutely to be reduced after a negative tax revenue shock. The first reason is that the interest rate goes up and worsens the situation, the second is that the government needs to keep the debt low to avoid fueling more default expectations, not just today but also in the future due to inertia of beliefs. This is in stark contrast from a situation where the government can credibly commit to repaying the debt: then, debt can effectively be used to smooth out fluctuations in tax revenue.
Greece is so screwed.
So then, what should happen if the government is committed to pay the debt, but the public does not believe it? For advice, we can turn to the recent paper by Francesco Caprioli, Pietro Rizza and Pietro Tommasino. Suppose economic agents eventually and gradually learn about the good dispositions of the government. They also believe there is a positive correlation between the level of debt and the probability of default. The consequence of these very reasonable assumptions is that government expenses need absolutely to be reduced after a negative tax revenue shock. The first reason is that the interest rate goes up and worsens the situation, the second is that the government needs to keep the debt low to avoid fueling more default expectations, not just today but also in the future due to inertia of beliefs. This is in stark contrast from a situation where the government can credibly commit to repaying the debt: then, debt can effectively be used to smooth out fluctuations in tax revenue.
Greece is so screwed.
Wealth exemptions do not matter in bankruptcy
The major aspect in bankruptcy law variation across states in the US is the wealth exemption. Some states protect substantial wealth from the creditors, the prime example being Texas where housing is exempted without limits, plus $30,000 per spouse. Maryland, however, exempts only $11,000 total personal property plus about $20,000 in owner-occupied housing. This considerable source of variation ought to lead to cross-state variation in bankruptcy rates, as several models would predict, yet the data does not show it.
Jochen Mankart explains why. He uses a life-cycle model where households borrow and save, and they are subject to a variety of shocks, the most relevant being health expense shocks, the most common trigger of bankruptcy in the United States. Varying bankruptcy exemptions, he finds no significant change in bankruptcy rates. The reason is quite simple: those who file for bankruptcy are so poor they have nothing left anyway, thus exemptions do not matter to them. Where it matters though is in the savings rate. Higher exemptions encourages especially the poor to save more. To boot, the model solves the credit card puzzle (see posts 1 and 2).
Jochen Mankart explains why. He uses a life-cycle model where households borrow and save, and they are subject to a variety of shocks, the most relevant being health expense shocks, the most common trigger of bankruptcy in the United States. Varying bankruptcy exemptions, he finds no significant change in bankruptcy rates. The reason is quite simple: those who file for bankruptcy are so poor they have nothing left anyway, thus exemptions do not matter to them. Where it matters though is in the savings rate. Higher exemptions encourages especially the poor to save more. To boot, the model solves the credit card puzzle (see posts 1 and 2).
Are rickshaw pullers myopic?
It is sometimes difficult to imagine why some people take decisions that make no economic sense. Take those that accept to receive payday loans at interest rates that defy any reason. Yet it can make economic sense, under some circumstances. In a similar vein is the observation that some people pay rent that seems to be far too high compared to the intrinsic value of the good.
Magnus Hatlebakk reports about one such example, rickshaw pullers in Nepal. They typically rent their rickshaws, and the rent cumulated over a year corresponds to the price of the rickshaw. It is particularly puzzling as microcredit is available, although at a different payment schedule: rent is 40 rupees a day, while servicing a loan would be 240 rupees a week. From a survey, Hatlebakk concludes that rickshaw pullers are not myopic, excessively impatient or financial completely illiterate: their income is simply so close to subsistence consumption that they cannot save up the 240 rupees for the loan service. At least this is what Hatlebakk argues, which I do not understand. If they do not pay rent, they could have save 40 rupees a day and be able to pay the weekly 240 rupees after six days. I suspect what is at play is more something like what makes ROSCAs so popular in many developing economies: people unable to keep significant amounts of cash, either because of the risk theft, misuse or, yes, myopia.
It would have helped the paper if it mentioned what the average lifespan of a rickshaw is, and whether rental provided some form of insurance, for example by providing a replacement in the event a rented rickshaw breaks. Indeed, the insurance aspect could also be important if there is substantial risk, or if the owner provides for repairs.
Magnus Hatlebakk reports about one such example, rickshaw pullers in Nepal. They typically rent their rickshaws, and the rent cumulated over a year corresponds to the price of the rickshaw. It is particularly puzzling as microcredit is available, although at a different payment schedule: rent is 40 rupees a day, while servicing a loan would be 240 rupees a week. From a survey, Hatlebakk concludes that rickshaw pullers are not myopic, excessively impatient or financial completely illiterate: their income is simply so close to subsistence consumption that they cannot save up the 240 rupees for the loan service. At least this is what Hatlebakk argues, which I do not understand. If they do not pay rent, they could have save 40 rupees a day and be able to pay the weekly 240 rupees after six days. I suspect what is at play is more something like what makes ROSCAs so popular in many developing economies: people unable to keep significant amounts of cash, either because of the risk theft, misuse or, yes, myopia.
It would have helped the paper if it mentioned what the average lifespan of a rickshaw is, and whether rental provided some form of insurance, for example by providing a replacement in the event a rented rickshaw breaks. Indeed, the insurance aspect could also be important if there is substantial risk, or if the owner provides for repairs.
Why the rich save more
It surprises no one that the rich save more. But they save even more than what could be accounted for the lower propensity to consume that one would get from any reasonably parametrized model. What could account for the difference?
Annamaria Lusardi, Pierre-Carl Michaud and Olivia Mitchell that survey evidence tends to indicate that the rich are financially more literate, whereby the direction of the causality is not clear. They build a life-cycle model where financial literacy is endogenous. The mechanism generating higher savings is interesting. As the rich get retirement benefits that are relatively small compared to their permanent income, they need to have more precautionary savings. To manage these savings, they get more financially literate. This allows them to get higher returns and get even richer, while those that are content with their public retirement package see no need to save more and learn how to get better returns. One more reason to improve economic literacy in the public.
Annamaria Lusardi, Pierre-Carl Michaud and Olivia Mitchell that survey evidence tends to indicate that the rich are financially more literate, whereby the direction of the causality is not clear. They build a life-cycle model where financial literacy is endogenous. The mechanism generating higher savings is interesting. As the rich get retirement benefits that are relatively small compared to their permanent income, they need to have more precautionary savings. To manage these savings, they get more financially literate. This allows them to get higher returns and get even richer, while those that are content with their public retirement package see no need to save more and learn how to get better returns. One more reason to improve economic literacy in the public.
Increasing public debt is a consequence of financial liberalization and inequality
The current debt crisis is the culmination of a long process of public debt accumulation over the last three decades in developed economies. Why this trend? I do not think it has suddenly become fashionable for governments to go deeper in debt, or that suddenly we came up with policy prescription leading that way more than before.
Marina Azzimonti, Eva de Francisco and Vincenzo Quadrini think it has to do with financial liberalization and globalization. The fact that more financial instruments and opportunities are now available certainly must contribute. There is already considerable evidence that the emergence of new borrowing instruments has increased household borrowing in the US, in particular for unsecured debt (credit cards). What these authors show is that a key component in the endogenous increase in public debt is a concurrent increase in income inequality in a political equilibrium. Public debt is beneficial because allows intertemporal smoothing. But at some point, higher debt leads to interest rates too high for the good of a majority. Interestingly, the model shows that it is not necessary for inequality to increase in all countries for this to happen. Globalization leads to a world-wide market, and local interest rates are largely determined on that market.
Marina Azzimonti, Eva de Francisco and Vincenzo Quadrini think it has to do with financial liberalization and globalization. The fact that more financial instruments and opportunities are now available certainly must contribute. There is already considerable evidence that the emergence of new borrowing instruments has increased household borrowing in the US, in particular for unsecured debt (credit cards). What these authors show is that a key component in the endogenous increase in public debt is a concurrent increase in income inequality in a political equilibrium. Public debt is beneficial because allows intertemporal smoothing. But at some point, higher debt leads to interest rates too high for the good of a majority. Interestingly, the model shows that it is not necessary for inequality to increase in all countries for this to happen. Globalization leads to a world-wide market, and local interest rates are largely determined on that market.
Why do people let life insurance policies lapse?
Life insurance is complex matters, and some say this is why you need the visit of an insurance salesman to understand the policy option (and other say this is to trick you into paying too much). But it is true that people sometimes make pretty stupid choices with their life insurance. One of them is to lapse their policy: stop paying their premium. The reason this is stupid is that policies are front-loaded: as risk of death increases with age but premiums are constant, a policy holder pays more than an actuarially fair rate during the first years and is rewarded in the later years. A lapsing policy is thus pure profit for the insurance industry, and it is factored in in premium calculations.
Hanming Fang and Edward Kung report that all this is now subject to upheaval due to the emergence of the life settlement industry, which takes policies about to lapse over, pay cash to the holder and continue paying premiums to the end of the policy. Because of the lack of lapsing profits, life insurance companies thus do have to increase premiums or leave the market. The latter would probably mean a loss of welfare for households. But the cash payment may be a welfare improvement, depending on the circumstances of lapsing. If it is because a policy holder lost interest in leaving a bequest, welfare is lower because he does not really need the cash plus faces insurance reclassification risk. If it is because of an income shock, then a cash payout is of course welfare improving.
Fang and Kung study how the life settlement industry should be regulated to maximize household welfare, under the constraint that one cannot observe why a policy holder is lapsing the life insurance policy. They try to find whether one or the other shock dominates and thus which way welfare would go. For the old policy holders, who are the huge majority, it appears the no shocks emerges as more important, thus they do not really have an answer.
Hanming Fang and Edward Kung report that all this is now subject to upheaval due to the emergence of the life settlement industry, which takes policies about to lapse over, pay cash to the holder and continue paying premiums to the end of the policy. Because of the lack of lapsing profits, life insurance companies thus do have to increase premiums or leave the market. The latter would probably mean a loss of welfare for households. But the cash payment may be a welfare improvement, depending on the circumstances of lapsing. If it is because a policy holder lost interest in leaving a bequest, welfare is lower because he does not really need the cash plus faces insurance reclassification risk. If it is because of an income shock, then a cash payout is of course welfare improving.
Fang and Kung study how the life settlement industry should be regulated to maximize household welfare, under the constraint that one cannot observe why a policy holder is lapsing the life insurance policy. They try to find whether one or the other shock dominates and thus which way welfare would go. For the old policy holders, who are the huge majority, it appears the no shocks emerges as more important, thus they do not really have an answer.
Stock market trader inattention and major sports events
Whenever some important sports event looms, the popular press inevitably comes up with articles about the loss of productivity during said event. The quoted numbers have always been a mystery to me, as I have yet to see any serious study about this. Well, now there is one, sort of.
Michael Ehrmann and David-Jan Jansen analyze stock market activity during the 2010 FIFA World Cup in South Africa. Using minute by minute activity from 15 stock markets, they find that there are markedly fewer trades when games are on, especially when the home side plays, roughly half of normal trades. That may be because traders are less attentive to markets, but also because domestic investor are less on the ball, so to say. The effect is amplified by goals.
There are other times when attention is decreasing, such as lunchtime. The decrease in trades may have some welfare implications, as some arbitrage opportunities are not taken. However, it appears to be more serious that there is a change in patterns for prices during those football matches, unlike lunch time. Indeed, the cross-section of returns across firms is lower, and the correlation of domestic prices with world prices drops by 20% when a game is on. I cannot quite quantify how much of a welfare consequence this is, I would need a model for that, but I guess this is not negligible. NB: these effects are also present on US stock markets, despite the marginal interest in soccer.
Michael Ehrmann and David-Jan Jansen analyze stock market activity during the 2010 FIFA World Cup in South Africa. Using minute by minute activity from 15 stock markets, they find that there are markedly fewer trades when games are on, especially when the home side plays, roughly half of normal trades. That may be because traders are less attentive to markets, but also because domestic investor are less on the ball, so to say. The effect is amplified by goals.
There are other times when attention is decreasing, such as lunchtime. The decrease in trades may have some welfare implications, as some arbitrage opportunities are not taken. However, it appears to be more serious that there is a change in patterns for prices during those football matches, unlike lunch time. Indeed, the cross-section of returns across firms is lower, and the correlation of domestic prices with world prices drops by 20% when a game is on. I cannot quite quantify how much of a welfare consequence this is, I would need a model for that, but I guess this is not negligible. NB: these effects are also present on US stock markets, despite the marginal interest in soccer.
Divorce risk is good for the savings rate
Savings rates have declined over the last decades in developed economies. Many explanations have been offered for this, including the availability of better insurance that allows to smooth out better potential risks. One other that was suggested was that the higher divorce rates and the larger number of out-of-wedlock children would lead to lower savings because economies of scale in consumption do not kick in. An old paper by Luis Cubeddu and José-Víctor Ríos-Rull dispelled this idea, showing in a model economy that the higher risk of divorce actually increases the savings rate, as people foresee the risk and accumulate precautionary savings.
You may dismiss this theoretical result on the grounds that there is no way that freshly married people foresee increased divorce risk and react by saving more. And that may be why this paper was never published. But they there is now evidence from Italy that there is some truth to this result.
Filippo Pericoli and Luigi Ventura, who do not quote the above study, find that this precautionary saving is actually quite substantial at 11% of overall savings. So there, Italians are more rational than we thought.
You may dismiss this theoretical result on the grounds that there is no way that freshly married people foresee increased divorce risk and react by saving more. And that may be why this paper was never published. But they there is now evidence from Italy that there is some truth to this result.
Filippo Pericoli and Luigi Ventura, who do not quote the above study, find that this precautionary saving is actually quite substantial at 11% of overall savings. So there, Italians are more rational than we thought.
Risk preferences are heterogeneous across countries
In any international economic model I can think of, or any study comparing countries using economic models with utility maximizing utility, it is never considered that the preferences of households may differ. In closed economy models, some heterogeneity in preferences may be considered, but it is generally avoided because it is difficult to measure and in most cases would not make much a different anyway. But if we are thinking about some international imbalances, why not think about differences in aggregate preferences?
Marc Oliver Rieger, Mei Wang and Thorsten Hens look at the results of a survey administered across 45 countries that tries to elicit measurements about risk aversion, loss aversion and subjective probabilities. Too bad they did not consider discounting and the intertemporal elasticity of substitution. Anyway, they find that there are actually large differences across countries, differences that they attribute partially to economic conditions and "culture." For the former, the authors looks a GDP per capita and the human development index. I would also have looked at a measure of financial development. It seems to me that people become financially more sophisticated and thus willing to take risks if they are more exposed to financial markets. But I can be proven wrong.
Marc Oliver Rieger, Mei Wang and Thorsten Hens look at the results of a survey administered across 45 countries that tries to elicit measurements about risk aversion, loss aversion and subjective probabilities. Too bad they did not consider discounting and the intertemporal elasticity of substitution. Anyway, they find that there are actually large differences across countries, differences that they attribute partially to economic conditions and "culture." For the former, the authors looks a GDP per capita and the human development index. I would also have looked at a measure of financial development. It seems to me that people become financially more sophisticated and thus willing to take risks if they are more exposed to financial markets. But I can be proven wrong.
Understanding Chinese household savings
It is not a secret that the Chinese are saving like crazy. The big question is why their savings rate is the highest in the world and it was addressed before on this blog (more below). The explanation that this would have to do with life-cycle considerations as the population ages (with few children) has by now been largely dismissed. So can explain it?
Riccardo Cristadoro and Daniela Marconi make the point that we really need to look at households, as firms or the government have not increased their savings rate sufficiently. Using panel data, they notice that the savings behavior differs markedly across provinces. And one aspect that does as well vary across provinces is the provision of social services and the access to credit. Thus they tie the high savings rate with the need to build up precautionary savings. This corroborates my previous posts about increased idiosyncratic risk and the reform of the public pension system.
Riccardo Cristadoro and Daniela Marconi make the point that we really need to look at households, as firms or the government have not increased their savings rate sufficiently. Using panel data, they notice that the savings behavior differs markedly across provinces. And one aspect that does as well vary across provinces is the provision of social services and the access to credit. Thus they tie the high savings rate with the need to build up precautionary savings. This corroborates my previous posts about increased idiosyncratic risk and the reform of the public pension system.
Exchange rate modelling: is the random walk beatable?
Forecasting price movements on asset markets is very difficult, especially at high frequencies. This is also true for exchange rates, where economists have been hard-pressed to come up with a theoretical or statistical model that can beat a random walk. And when they did, it did not hold up to the test of time. So what is the latest in this quest?
Mario Cerrato, John Crosby and Muhammad Kaleem point out the the statistical tests used to evaluate the forecasting performance and not relevant. Indeed, one does not care whether the mean square errors are low out of sample, or what the Sharpe ratio is. What really matters is how a portfolio managed using the forecasting model performs. And there, the news is good, one can beat the random walk. And this not even with a purely statistical model, but rather with a model that has some theoretical foundations. Very few of those are needed: money and GDP growth in both countries, and a time trend, the latter not being essential to beat the random walk. One can imagine that a more elaborate model could do even better.
But note that nobody here has claimed you can beat the market.
Mario Cerrato, John Crosby and Muhammad Kaleem point out the the statistical tests used to evaluate the forecasting performance and not relevant. Indeed, one does not care whether the mean square errors are low out of sample, or what the Sharpe ratio is. What really matters is how a portfolio managed using the forecasting model performs. And there, the news is good, one can beat the random walk. And this not even with a purely statistical model, but rather with a model that has some theoretical foundations. Very few of those are needed: money and GDP growth in both countries, and a time trend, the latter not being essential to beat the random walk. One can imagine that a more elaborate model could do even better.
But note that nobody here has claimed you can beat the market.
Reclassification risk in health insurance
The American health care system has his fair share of problems, a prominent one being health insurance. One particularly frustrating one is when premiums are significantly raised after a health event, so-called health insurance reclassification. Economically, this can be explained by the fact that the insured has revealed being of higher risk. But it seems self-evident that there a large room for improvement in insurance outcome if such reclassification would not occur, that is, if premiums would be almost invariant to health outcomes.
Not so, say Svetlana Pashchenko and Ponpoje Porapakkarm. Their points are that 1) with most people insured under group coverage of their employer, relatively few people are subjects to reclassification; 2) for the latter, means-tested government transfers cushion well the shock of reclassification (or loss of insurance). To come to this conclusion, they use a stochastic overlapping generation general equilibrium model, trying to match the major institutional features of US health care (including Medicaid, uninsureds, private and employer-sponsored insurance) and calibrated using Medical Expenditure Panel Survey.
Pashchenko and Porapakkarm find that introducing guaranteed renewable insurance contracts with constant premiums lowers the proportion on uninsured from 25% to 19%, the difference taking such contracts. Thus it appears that, not surprisingly, eliminating premium fluctuations is welfare-improving. But the welfare gain is very small. For one, These new insurance contracts tends to be more expensive, especially in the first years when standard insurance premiums are low for healthy (and young) people, who tend also to be more liquidity constrained. If there is no guaranteed renewable insurance contract, the government provides a similar insurance: Medicaid, which has essentially the same conditions but is free and asset-tested. The fact that it is a last resort insurance provides the right smoothing benefits for extreme cases, much like insuring premium fluctuations does. The latter is just a little broader, because there is no asset test, and hence the welfare improvement is small if it is priced actuarilly.
Not so, say Svetlana Pashchenko and Ponpoje Porapakkarm. Their points are that 1) with most people insured under group coverage of their employer, relatively few people are subjects to reclassification; 2) for the latter, means-tested government transfers cushion well the shock of reclassification (or loss of insurance). To come to this conclusion, they use a stochastic overlapping generation general equilibrium model, trying to match the major institutional features of US health care (including Medicaid, uninsureds, private and employer-sponsored insurance) and calibrated using Medical Expenditure Panel Survey.
Pashchenko and Porapakkarm find that introducing guaranteed renewable insurance contracts with constant premiums lowers the proportion on uninsured from 25% to 19%, the difference taking such contracts. Thus it appears that, not surprisingly, eliminating premium fluctuations is welfare-improving. But the welfare gain is very small. For one, These new insurance contracts tends to be more expensive, especially in the first years when standard insurance premiums are low for healthy (and young) people, who tend also to be more liquidity constrained. If there is no guaranteed renewable insurance contract, the government provides a similar insurance: Medicaid, which has essentially the same conditions but is free and asset-tested. The fact that it is a last resort insurance provides the right smoothing benefits for extreme cases, much like insuring premium fluctuations does. The latter is just a little broader, because there is no asset test, and hence the welfare improvement is small if it is priced actuarilly.
How public debt has been liquidated
Many are now claiming that public debt is much too high and that serious austerity measures are absolutely necessary to keep them in check and even reduce them. Beyond the question on whether public debt matters at all and what consequences of this austerity regime may be, another important question is whether austerity is the right way to reduce public debt. It is not like this would be the first time economies grapple with such high and even higher debt/GDP ratios. The war effort in WWII lead most economies to be in much direr situations than today, yet they managed to get out of it without too much trouble. How did they do that?
Carmen Reinhart and Belen Sbrancia pour over the data and notice a common trend: keeping interest rates low with a little bit of inflation works miracles. The negative real interest rate keep debt servicing at a minimum, while a moderate but high than usual inflation eats little by little the principal. And inflation was not even a surprise at the time, and investors accepted low returns on government bonds. This may have to do with a somewhat limited range of investment options, both because investment markets were not as well developed as today and because investors were coaxed or openly forced to buy government bonds at reduced yields. But the situation is not that different today, as everybody is frightened by stock markets and finds refuge in public bonds, money markets and simple savings accounts. And interest rates are really low, too! Now we just need a little bit of inflation.
Carmen Reinhart and Belen Sbrancia pour over the data and notice a common trend: keeping interest rates low with a little bit of inflation works miracles. The negative real interest rate keep debt servicing at a minimum, while a moderate but high than usual inflation eats little by little the principal. And inflation was not even a surprise at the time, and investors accepted low returns on government bonds. This may have to do with a somewhat limited range of investment options, both because investment markets were not as well developed as today and because investors were coaxed or openly forced to buy government bonds at reduced yields. But the situation is not that different today, as everybody is frightened by stock markets and finds refuge in public bonds, money markets and simple savings accounts. And interest rates are really low, too! Now we just need a little bit of inflation.
European credit ratings: a case of self-fulfilling expectations
Europe is a mess, and one has to wonder why. First, there is no reason that the credit difficulties of Greece should have any consequences on the Euro. I doubt the US Federal Reserve would feel compelled to do anything if a state were to default on its debt, and nobody would claim it should. Why should it be different in Europe? Because politics want it.
To make things worse, the credit rating agencies generate self-fulfilling expectations. These are of a different kind of those that make that Greece will have to default. Witness yesterday's announcement by Moody's while threatening a downgrade of French debt: "Elevated borrowing costs persisting for an extended period would amplify the fiscal challenges the French government faces amid a deteriorating growth outlook, with negative credit implications." In other words, high credit costs would lead to a downgrade and this would lead to even higher credit costs, etc. The rating is not about the intrinsic risk of default (what rating agencies are supposed to measure) but about the expectation of where the rating should, as signaled by the cost of credit. And this after Standard and Poor's downgraded the same debt "by error." The rating agencies are clearly not helping at this point.
To make things worse, the credit rating agencies generate self-fulfilling expectations. These are of a different kind of those that make that Greece will have to default. Witness yesterday's announcement by Moody's while threatening a downgrade of French debt: "Elevated borrowing costs persisting for an extended period would amplify the fiscal challenges the French government faces amid a deteriorating growth outlook, with negative credit implications." In other words, high credit costs would lead to a downgrade and this would lead to even higher credit costs, etc. The rating is not about the intrinsic risk of default (what rating agencies are supposed to measure) but about the expectation of where the rating should, as signaled by the cost of credit. And this after Standard and Poor's downgraded the same debt "by error." The rating agencies are clearly not helping at this point.
Miss sharing with future generations? You are not missing much
Markets are not complete. Two major ways in whuch they are not complete is that we have borrowing constraints and that we cannot exchange with future generations. The latter can be a big deal when we think about the valuation of future amenities (like the environment) or long term risks. In particular, future generations could make us behave in certain ways if they could influence some of today's markets. This is precisely why the overlapping generation literature emerged, and a principal conclusion of it is that the government needs to intervene, in particular by providing an security that lives beyond generations: the government bond. While there is obviously a welfare cost to the lack of future generations on current markets, how large is it? The literature tells us the welfare benefit of the government bond is large.
Roel Mehlkopf just defended a dissertation on this topic, focusing on risk. In a nutshell, the cost is not that large, and it all has to do with distortions on the labor market. For one, those you ex-post need to transfer to another generation face a commitment problem in the sense that they want to reduce their labor supply, for example by retiring early. Once you take this into account, there is little to redistribute, and it can even be welfare-decreasing to transfer. This rationalizes why pension funds needs to be solvent at all times, even if they are solvent in the long run. One important implication is that when cuts are necessary in pensions, they should be larger for the young workers, as this reduces the labor market distortions.
Also, the dissertation points out that comparing to a situation with fictitious markets between non-overlapping generations can be misleading. Indeed, this implies that they all have the same weight in a social welfare sense. But there can be good reason for a social planner to deviate from this, and the analysis above, fr example, implies that future generations benefit more from risk sharing than current ones (who are at least partially locked in by past decisions). This should entice the social planner to give more weight to current generations, even beyond normal discounting of the future. And as only current generations for for the current government, we are not far from that optimum.
Roel Mehlkopf just defended a dissertation on this topic, focusing on risk. In a nutshell, the cost is not that large, and it all has to do with distortions on the labor market. For one, those you ex-post need to transfer to another generation face a commitment problem in the sense that they want to reduce their labor supply, for example by retiring early. Once you take this into account, there is little to redistribute, and it can even be welfare-decreasing to transfer. This rationalizes why pension funds needs to be solvent at all times, even if they are solvent in the long run. One important implication is that when cuts are necessary in pensions, they should be larger for the young workers, as this reduces the labor market distortions.
Also, the dissertation points out that comparing to a situation with fictitious markets between non-overlapping generations can be misleading. Indeed, this implies that they all have the same weight in a social welfare sense. But there can be good reason for a social planner to deviate from this, and the analysis above, fr example, implies that future generations benefit more from risk sharing than current ones (who are at least partially locked in by past decisions). This should entice the social planner to give more weight to current generations, even beyond normal discounting of the future. And as only current generations for for the current government, we are not far from that optimum.
Is index-based weather insurance useful?
Whenever you are facing a risk, you want to be able to hedge against it (at least if you are risk averse). For this, there are all sorts of insurance policies. There are also markets in all sorts of instruments that allow you to find the right contingent claim for your situation. This includes farmers (and others) who want to hedge against meteorological risks. If you crop yields depend on weather patterns, you are looking for securities that pay out depending on some weather statistic. And they are available and have been heavily pushed by aid agencies in developing countries.
Chiratan Banerjee and Ernst Berg say they may not be such a great idea. They take the examples of rice farmers in the Philippines who bought wind-speed based indexes on the hypothesis that rice yields are lower when there are typhoons. But rice is remarkably resistant to typhoons and wind in general, the reason why it is so popular in the region in the first place. This means that rice farmers are heavily over-insured. That is especially bad and farmers are now confused about the concept of insurance as it looks like they face more risk than before.
Chiratan Banerjee and Ernst Berg say they may not be such a great idea. They take the examples of rice farmers in the Philippines who bought wind-speed based indexes on the hypothesis that rice yields are lower when there are typhoons. But rice is remarkably resistant to typhoons and wind in general, the reason why it is so popular in the region in the first place. This means that rice farmers are heavily over-insured. That is especially bad and farmers are now confused about the concept of insurance as it looks like they face more risk than before.
The imperfect market for re-insurance
The insurance market is thought to be rather competitive, at least for the most common risks. That is in part because insurance companies are willing to take risks thanks to re-insurance, where they can insure large event risks and to some degree over-exposure. But there are rather few actors on the re-insurance market. Is this bad, and does it have an impact on the insurance market?
Sabine Lemoyne de Forges, Ruben Bibas and Stéphane Hallegatte play with a model of re-insurance and find that there is a trade-off. The lack of competition leads to sub-optimal re-insurance provision, obviously. But is also allows the few players to take on larger risks, some of which may not have been insured otherwise. And, the larger the re-insurers, the more resilient the market can be. As a regulator, this means that means that you may to let the re-insurance companies grow larger than want is optimal in terms of competition.
Sabine Lemoyne de Forges, Ruben Bibas and Stéphane Hallegatte play with a model of re-insurance and find that there is a trade-off. The lack of competition leads to sub-optimal re-insurance provision, obviously. But is also allows the few players to take on larger risks, some of which may not have been insured otherwise. And, the larger the re-insurers, the more resilient the market can be. As a regulator, this means that means that you may to let the re-insurance companies grow larger than want is optimal in terms of competition.
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