Research Findings, May 8 2012

Here are some interesting papers I’ve come across recently.

-BREAKING NEWS: Humans are biased by silly, superfluous factors. For example, at one school, MBA admissions officers are relatively unlikely to “strongly recommend” four candidates in a given day, relative to what would be predicted if excellent candidates were randomly distributed – i.e. this implies that they have an implicit ‘quota’ of three candidates for each day, and don’t like to go above that. In English: No matter how good a candidate you are, you’re less likely to get in if other outstanding candidates also happen to be interviewing on the same day. Which might strike such people as unfair.

-Financial deregulation in the U.S. led to financial development, which helped drive technological progress. In those states that deregulated finance earlier than others during the 70s and 80s, those firms that relied on bank financing undertook, and consequently enjoyed the benefits of, more R&D, as compared to those that deregulated later.

-There’s a cool financial innovation called the “Call Option Enhanced Reversed Convertible.” The idea is that it starts out as a bond – i.e., you loan to the bank at a set interest rate. But if that bank’s capital falls below a predetermined trigger level – i.e., it appears to be struggling or nearing bankruptcy – then the bond automatically converts to equity (shares). If I understand this right, that recapitalizes the bank, which prevents a downward ‘death spiral,’ of other banks refusing to lend to it because they fear it will go bankrupt, causing a self-fulfilling prophecy. This innovation could dampen financial panics.

-Jared Diamond’s narrative about the collapse of the Easter Island civilization due to overexploitation of the island’s resources is questionable.

-Is geography political destiny? Stephen Haber finds that “there is a systematic, non-linear relationship between rainfall levels, human capital, property rights institutions and regime types such that stable democracies overwhelmingly cluster in a band of moderate rainfall (540 to 1200 mm of precipitation per year)”—think Europe and America.

-In a controlled experiment, loan officers who were paid commission—as opposed to a fixed salary—accepted 20% more loan applications, and their loans were on average 28% more likely to default. This is very unsurprising—an easy prediction from simple theory. But it’s a good statistical demonstration of one contributor to the explosion of bad mortgage lending in the run-up to the crisis. As per the abstract, “the deterioration of underwriting standards can be partly attributed to the incentives of loan officers.”

-Very interestingly, the more that a bank’s shares were owned by its senior level managers and directors, the less risky its investments were in the run-up to the financial crisis, and the less likely it was to fail. Meanwhile, the more than its shares were owned by mid-level managers (who made day-to-day decisions) the riskier its investments were, and the more likely it was to default.

-Some Federal Reserve Board economists argue that the single biggest determinant of why one firm goes out of business rather than another—even bigger than, say, the characteristics of their managers—is their sustained access to credit. That access to credit is a Good Thing is not a super surprising or novel claim. But the study is good reminder of just how important keeping the financial system on stable and sound footing is for the real economy.

-When firms pay dividends, it is much more costly for them to do “earnings management”—i.e., playing make believe that they made more money last quarter/year than they actually did. So, as that would lead you to predict, dividend-paying firms do, in fact, do less earnings management than others. (One interesting little effect/proof of this is that, in the wake of the post-Enron Sarbanes-Oxley act, which improved the stringency of financial reporting standards in the U.S., non-dividend paying firms made more subsequent changes in their earnings-reporting behaviors, suggesting that they had been doing more shady stuff, on average, than dividend-paying firms.)

-Capital controls (which emerging economies often use to moderate the speed and volatility of the inflow and outflow of capital from exuberant and panicking foreign investors) don’t actually seem to achieve their intended effect. But the volatile flows of the developed world’s capital into and out of emerging markets — flows which are largely driven by the developed world’s sentiments, rather than the emerging markets’ fundamentals — are undoubtedly a big and unfair problem.

Political uncertainty reduces cross-border investment, in both directions, for both rich and poor countries. U.S. firms invest less abroad both around the times of national elections in the U.S., and around the times of elections in the counter-country. The more likely it is that the outcome of the election could significantly effect the country’s policy environment, the greater the reduction in Foreign Direct Investment (FDI). Political stability and predictability matters for investment and, hence, growth.

-The U.S.’s Clinton-era welfare reforms appear to have caused a 10-21% decline of illicit drug use among the population normally “at risk” of relying on welfare. Nudging people into actual employment had the extra benefit of reducing drug abuse.

-This is an incredibly cool review of the question, mystery, and theory of “health inequalities” in developed Europe—i.e., why is that, even though the welfare state has done much to mitigate desperate want and material inequalities among classes, different social classes in Europe still have radically different health outcomes? The authors are willing to entertain some provocative hypotheses.

-As gasoline prices rise, people become more active, both due to a “substitution effect”—people choose to ride bikes more and drive less to save money—and due to an “income effect”—higher gas prices cut into your disposable income, making you more inclined to mow your own lawn, etc. (This is true for most, but not all, segments of society.)

-Most of the research I’ve seen concludes that, contrary to the political conservative/libertarian narrative of the financial crisis, Fannie and Freddie’s “Affordable Housing Goals,” ushered through Congress in 1992, made at most a very small contribution — and arguably none at all — to the rise in the extension of credit to very-high risk borrowers.

-In the press and popular imagination, the terms “financial deregulation” and “financial instability” are linked together. In fact, however, there are a lot of ways in which, financial deregulation, broadly defined, contributes to greater financial stability. For example, if banks can more easily invest across state boundaries and national borders, they can better diversify their risks — reducing their rate of failure. This theoretical prediction is borne out from evidence from U.S. states’ staggered process of deregulation during the 70s and 80s — states that deregulated earlier saw fewer bank failures later on.

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