Where Credit Is Due
Debt Overhangs: Past and Present
Carmen Reinhart, Vincent Reinhart & Kenneth Rogoff
NBER Working Paper, April 2012
Abstract:
We identify the major public debt overhang episodes in the advanced economies since the early 1800s, characterized by public debt to GDP levels exceeding 90% for at least five years. Consistent with Reinhart and Rogoff (2010) and other more recent research, we find that public debt overhang episodes are associated with growth over one percent lower than during other periods. Perhaps the most striking new finding here is the duration of the average debt overhang episode. Among the 26 episodes we identify, 20 lasted more than a decade. Five of the six shorter episodes were immediately after World Wars I and II. Across all 26 cases, the average duration in years is about 23 years. The long duration belies the view that the correlation is caused mainly by debt buildups during business cycle recessions. The long duration also implies that cumulative shortfall in output from debt overhang is potentially massive. We find that growth effects are significant even in the many episodes where debtor countries were able to secure continual access to capital markets at relatively low real interest rates. That is, growth-reducing effects of high public debt are apparently not transmitted exclusively through high real interest rates.
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The Impact of Legislative Term Limits on State Debt: Increased Spending, Flat Revenue
Jonathan Day & Keith Boeckelman
Politics & Policy, April 2012, Pages 320-338
Abstract:
This article examines the effect of state legislative term limits on government debt levels. Past research has shown the influence of term limits on spending, but the effect of term limits on state debt is arguably more important in considering their desirability. We explain the relation between term limits and debt using the expected impact of changes in the composition, institutional dynamics, and behavior of state legislatures after term limits take effect. The hypothesis is that term limits will increase state government debt. Using regressions with panel corrected standard errors on data from the states between 1993 and 2008, the results empirically support the expectation that term-limited states have significantly higher debt than nonterm limited states. Term-limited states greatly increase spending while not increasing revenue levels and thus substantially increase debt. Since states with term limits have higher debt, we advise caution in adopting them.
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The politics of government investment
Ran Duchin & Denis Sosyura
Journal of Financial Economics, forthcoming
Abstract:
This paper investigates the relation between corporate political connections and government investment. We study various forms of political influence, ranging from passive connections between firms and politicians, such as those based on politicians' voting districts, to active forms, such as lobbying, campaign contributions, and employment of connected directors. Using hand-collected data on firm applications for capital under the Troubled Asset Relief Program (TARP), we find that politically connected firms are more likely to be funded, controlling for other characteristics. Yet investments in politically connected firms underperform those in unconnected firms. Overall, we show that connections between firms and regulators are associated with distortions in investment efficiency.
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A Theory of Optimal Capital Taxation
Thomas Piketty & Emmanuel Saez
NBER Working Paper, April 2012
Abstract:
This paper develops a realistic, tractable theoretical model that can be used to investigate socially-optimal capital taxation. We present a dynamic model of savings and bequests with heterogeneous random tastes for bequests to children and for wealth per se. We derive formulas for optimal tax rates on capitalized inheritance expressed in terms of estimable parameters and social preferences. Under our model assumptions, the long-run optimal tax rate increases with the aggregate steady-state flow of inheritances to output, decreases with the elasticity of bequests to the net-of-tax rate, and decreases with the strength of preferences for leaving bequests. For realistic parameters of our model, the optimal tax rate on capitalized inheritance would be as high as 50%-60% - or even higher for top wealth holders - if the social objective is meritocratic (i.e., the social planner puts higher welfare weights on those receiving little inheritance) and if capital is highly concentrated (as it is in the real world). In contrast to the Atkinson-Stiglitz result, the optimal tax on bequest remains positive in our model even with optimal labor taxation because inequality is two-dimensional: with inheritances, labor income is no longer the unique determinant of lifetime resources. In contrast to Chamley-Judd, the optimal tax on capital is positive in our model because we have finite long run elasticities of inheritance to tax rates. Finally, we discuss how adding capital market imperfections and uninsurable shocks to rates of return to our optimal tax model leads to shifting one-off inheritance taxation toward lifetime capital taxation, and can account for the actual structure and mix of inheritance and capital taxation.
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Fiscal Policy Cyclicality and Growth within the US States
Justin Svec & Ayako Kondo
B.E. Journal of Macroeconomics, March 2012
Abstract:
This paper exploits differences in the stringency of balanced budget rules across US states to estimate the effect of the cyclicality of fiscal policy on state GDP growth. While most states have passed laws restricting deficits, the nature and strictness of these laws vary greatly. States with more stringent balanced budget restrictions run more procyclical fiscal policy. We use the diversity in these laws as an instrument for the cyclicality of policy. We find evidence that a more counter-cyclical primary deficit increases a state's average growth rate per capita. This effect is robust to a number of alternative specifications. One concrete policy implication of this analysis is that a state could increase its annual growth rate by relaxing its balanced budget restrictions.
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Bank Bailouts and Moral Hazard: Evidence from Germany
Lammertjan Dam & Michael Koetter
Review of Financial Studies, forthcoming
Abstract:
We use a structural econometric model to provide empirical evidence that safety nets in the banking industry lead to additional risk taking. To identify the moral hazard effect of bailout expectations on bank risk, we exploit the fact that regional political factors explain bank bailouts but not bank risk. The sample includes all observed capital preservation measures and distressed exits in the German banking industry during 1995-2006. A change of bailout expectations by two standard deviations increases the probability of official distress from 6.6% to 9.4%, which is economically significant.
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Financialization and the rentier income share - Evidence from the USA and Germany
Petra Duenhaupt
International Review of Applied Economics, July/August 2012, Pages 465-487
Abstract:
During the past two decades, there has been a shift of significance from the real to the financial sector. In the course of (financial) globalization, measures of liberalization and deregulation have contributed to a strengthening of financial capital. The concept of shareholder value orientation has become more powerful, capital income has increased tremendously, while real wages have stagnated. Most industrial countries have experienced a decline in the share of labor income. Based on a review of empirics and literature, this paper seeks to determine who gained from the fall in the labor share of income in the USA and Germany, respectively. If financialization is indeed responsible for the decline, rentiers should be the beneficiaries. In order to identify the relevant effects, the profit share of the two countries under observation is split between the share of retained earnings and the share of net property income (= rentiers' income) using a modification of the approach chosen by Epstein and Jayadev (2005). The evidence presented shows that the development of the rentier income share indeed corresponds quite well with the stages of development of financialization in the two different countries: in the US, where the important shift towards financialization occurred in the early 1980s, the rentiers' share of income shows a corresponding leap upwards exactly at that time and remains on a higher level until the end of the observation period. In Germany, the process of financialization started much later - in the beginning of the 1990s - and followed a much more gradual transition, which is perfectly mirrored by the development of income shares: from the 1990s onwards, the rentiers' income share gradually increased over time.
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The Economic Consequences of Banks' Derivatives Use in Good Times and Bad Times
Ken Cyree, Pinghsun Huang & James Lindley
Journal of Financial Services Research, June 2012, Pages 121-144
Abstract:
In a sample of 335 commercial banks, we do not detect a systematic effect on bank values from derivatives use in either the high growth period of 2003-2005 or the low growth period of 2007-2009. These findings apply to all types of derivatives including credit default swaps. Our results suggest that banks take a more balanced approach and restrict their derivative activities to providing derivative services for customers and risk management. We also find that the market disciplined banks significantly for taking TARP funds, indicating that receiving TARP funds was a signal that the banks were financially distressed. Lastly, we cannot discern valuation effects resulting from derivatives use even in large and poorly capitalized banks that are more likely to take risk-shifting opportunities. Collectively, we find no compelling evidence supporting the widespread allegation that derivatives use increased banks' speculating behaviors and significantly contributed to the loss of value during the subprime mortgage crisis.
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Thomas Philippon
NBER Working Paper, May 2012
Abstract:
I provide a quantitative interpretation of financial intermediation in the U.S. over the past 130 years. Measuring separately the cost of intermediation and the production of financial services, I find that: (i) the quantity of intermediation varies a lot over time; (ii) intermediation is produced under constant returns to scale; (iii) the annual cost of intermediation is around 2% of outstanding assets; (iv) adjustments for borrowers' quality are quantitatively important; and (v) the unit cost of intermediation has increased over the past 30 years.
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Practical Monetary Policy: Examples from Sweden and the United States
Lars Svensson
Brookings Papers on Economic Activity, Fall 2011, Pages 289-352
Abstract:
In the summer of 2010, the Federal Reserve's and the Swedish Riksbank's inflation forecasts were below the former's mandate-consistent rate and the latter's target, respectively, and their unemployment forecasts were above sustainable rates. Conditions in both countries clearly called for policy easing. The Federal Reserve maintained a minimum policy rate, soon started to communicate possible future easing, and in the fall launched QE2. In contrast, the Riksbank started a period of rapid tightening. I find the arguments against the Federal Reserve's easing and the arguments for the Riksbank's tightening unconvincing. Although the Swedish economy subsequently performed better than expected, probably an important reason was that the market implemented much easier financial conditions than were consistent with the Riksbank's policy rate path. Without the policy tightening, performance would have been even better. The U.S. economy meanwhile performed worse than expected because of factors other than monetary policy. Without the policy easing, performance would have been even worse. In short, the Riksbank did the wrong thing but was lucky, whereas the Federal Reserve did the right thing but was unlucky.
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The Effect of TARP on Bank Risk-Taking
Lamont Black & Lieu Hazelwood
Journal of Financial Stability, forthcoming
Abstract:
One of the largest responses of the U.S. government to the recent financial crisis was the Troubled Asset Relief Program (TARP). TARP was originally intended to stabilize the financial sector through the increased capitalization of banks. However, recipients of TARP funds were then encouraged to make additional loans despite increased borrower risk. In this paper, we consider the effect of the TARP capital injections on bank risk-taking by analyzing the risk ratings of banks' commercial loan originations during the crisis. The results indicate that, relative to non-TARP banks, the risk of loan originations increased at large TARP banks but decreased at small TARP banks. Loan levels also moved in different directions for large and small banks and, in supporting evidence, these effects are evaluated based on loan size and TARP repayment. For large banks, the increase in risk-taking without an increase in lending is suggestive of moral hazard due to government support. These results may also be due to the conflicting goals of the TARP program for bank recapitalization and bank lending.
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Előd Takáts
Journal of Housing Economics, forthcoming
Abstract:
The paper investigates how aging will affect house prices. It uses for the first time a house price dataset covering 22 advanced economies. The analysis finds that demography did and will affect real house prices significantly. The results suggest that a major shift is taking place. In the past forty years, on average demography increased advanced economy real house prices by around 30 basis points per annum, while in the next forty years aging will decrease them on average by around 80 basis points per annum compared to neutral demographics. The shift from demographic tailwinds to headwinds might also be relevant when thinking about financial asset prices.
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Debt and Creative Destruction: Why Could Subsidizing Corporate Debt be Optimal?
Zhiguo He & Gregor Matvos
NBER Working Paper, March 2012
Abstract:
We illustrate the welfare benefit of tax subsidies to corporate debt financing. Two firms engage in a socially wasteful competition for survival in a declining industry. Firms differ on two dimensions: exogenous productivity and endogenously chosen amount of debt financing, resulting in a two dimensional war of attrition. Debt financing increases incentives to exit, which, while socially beneficial, is costly for the firm. Therefore the planner can increase welfare by subsidizing debt financing. The duration of industry distress determines the tradeoff between the welfare benefit illustrated in our model and the costs of subsidizing corporate debt from the existing literature. Our theory also sheds light on why the IRS considers "conflict of interest" as one of the key determinants in identifying securities that are qualified for tax-benefits.
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Will Households Change Their Saving Behaviour After the "Great Recession"? The Role of Human Capital
Michael Walden
Journal of Consumer Policy, June 2012, Pages 237-254
Abstract:
The "Great Recession" of 2007-2009 (Rampell 2009) had a devastating impact on personal finances, causing households to retrench by limiting spending and reducing indebtedness. One positive outcome - evaluated by some - has been a rise in the widely cited "personal saving rate" from historic lows set in the middle of the decade. This paper evaluates the reasons for the rebound in the saving rate by undertaking a new examination of the determinants of household saving. Extending previous work and making use of data inclusive of the turbulent 2000s decade, the analysis finds support for an inverse relationship between the personal saving rate and the return to home equity. New in the research is a similar finding of an inverse relationship between the personal saving rate and the return to household investment in human capital. The results are used to make alternative forecasts of the personal saving rate through 2020. The path of the household human capital return is found to be a key determinant of these forecasts.
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The Incidence of the Mortgage Interest Deduction: Evidence from the Market for Home Purchase Loans
Andrew Hanson
Public Finance Review, May 2012, Pages 339-359
Abstract:
This article examines the incidence of the largest housing-related subsidy in the federal budget, the home mortgage interest deduction (MID). The author uses the difference in interest rates for loans made around the MID limit to identify the incidence of the subsidy. Using data on individual mortgages originated in 2004, the author estimates that for every $1,000 borrowed without the MID, the interest rate on the entire loan decreases by between 3.3 and 4.4 percent. Results suggest that lenders capture between 9 and 17 percent of the subsidy created by the home MID through higher mortgage interest rates.
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The Prevalence and Impact of Misstated Incomes on Mortgage Loan Applications
McKinley Blackburn & Todd Vermilyea
Journal of Housing Economics, forthcoming
Abstract:
Misstatement of income on mortgage loan applications (the "liar-loan" problem) is thought to have been a contributor to the boom and bust of mortgage markets. We provide nationwide measurements that reflect the degree to which incomes on mid-2000 home-purchase mortgage loan applications were overstated relative to the actual incomes of mortgage applicants. Our results suggest a substantial degree of income overstatement in 2005 and 2006, one consistent with the average mortgage application overstating income 15 to 20 percent. We find the tendency to misstate income was associated with markets with large home-price increases during the boom. There is little support for the proposition that income overstatement played a substantial role in subsequent mortgage defaults.
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Banks, Free Banks, and U.S. Economic Growth
Matthew Jaremski & Peter Rousseau
NBER Working Paper, April 2012
Abstract:
The "Federalist financial revolution" may have jump-started the U.S. economy into modern growth, but the Free Banking System (1837-1862) did not play a direct role in sustaining it. Despite lowering entry barriers and extending banking into developing regions, we find in county-level data that free banks had little or no effect on growth. The result is not just a symptom of the era, as state-chartered banks seem to have strong and positive effects on manufacturing and urbanization.
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The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy
Arvind Krishnamurthy & Annette Vissing-Jorgensen
Brookings Papers on Economic Activity, Fall 2011, Pages 215-287
Abstract:
We evaluate the effect of the Federal Reserve's purchase of long-term Treasuries and other long-term bonds (QE1 in 2008-09 and QE2 in 2010-11) on interest rates. Using an event-study methodology, we reach two main conclusions. First, it is inappropriate to focus only on Treasury rates as a policy target, because quantitative easing works through several channels that affect particular assets differently. We find evidence for a signaling channel, a unique demand for long-term safe assets, and an inflation channel for both QE1 and QE2, and a mortgage-backed securities (MBS) prepayment channel and a corporate bond default risk channel for QE1 only. Second, effects on particular assets depend critically on which assets are purchased. The event study suggests that MBS purchases in QE1 were crucial for lowering MBS yields as well as corporate credit risk and thus corporate yields for QE1, and Treasuries-only purchases in QE2 had a disproportionate effect on Treasuries and agency bonds relative to MBSs and corporate bonds, with yields on the latter falling primarily through the market's anticipation of lower future federal funds rates.
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Laffer Strikes again: Dynamic scoring of capital taxes
Holger Strulik & Timo Trimborn
European Economic Review, forthcoming
Abstract:
We set up a neoclassical growth model extended by a corporate sector, an investment and finance decision of firms, and a set of taxes on capital income. We provide analytical dynamic scoring of taxes on corporate income, dividends, capital gains, other private capital income, and depreciation allowances and identify the intricate ways through which capital taxation affects tax revenue in general equilibrium. We then calibrate the model for the US and explore quantitatively the revenue effects from capital taxation. We take adjustment dynamics after a tax change explicitly into account and compare with steady-state effects. We find, among other results, a self-financing degree of corporate tax cuts of about 70-90 percent and a very flat Laffer curve for all capital taxes as well as for tax depreciation allowances. Results are strongest for the tax on capital gains. The model predicts for the US that total tax revenue increases by about 0.3 to 1.2 percent after abolishment of the tax.
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Budget deficits and interest rates: A fresh perspective
Ari Aisen & David Hauner
Applied Economics, Spring 2012, Pages 2501-2510
Abstract:
We extend the literature on budget deficits and interest rates in three ways: we examine both advanced and emerging economies and for the first time a large emerging market panel; explore interactions to explain some of the heterogeneity in the literature; and apply system Generalized Method of Moments (GMM). There is overall a highly significant positive effect of budget deficits on interest rates, but the effect depends on interaction terms and is only significant under one of the several conditions: deficits are high, mostly domestically financed, or interact with high domestic debt; financial openness is low; interest rates are liberalized; or financial depth is low.
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Raghuram Rajan & Rodney Ramcharan
NBER Working Paper, April 2012
Abstract:
Does credit availability exacerbate asset price inflation? What channels could it work through? What are the long run consequences? In this paper we address these questions by examining the farm land price boom (and bust) in the United States that preceded the Great Depression. We find that credit availability likely had a direct effect on inflating land prices. Credit availability may have also amplified the relationship between the perceived improvement in fundamentals and land prices. When the perceived fundamentals soured, however, areas with higher ex ante credit availability suffered a greater fall in land prices, and experienced higher bank failure rates. Land prices stayed low for a number of decades after the bust in areas that had higher credit availability, suggesting that the effects of booms and busts induced by credit availability might be persistent. We draw lessons for regulatory policy.
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Do IMF and World Bank Programs Induce Government Crises? An Empirical Analysis
Axel Dreher & Martin Gassebner
International Organization, April 2012, Pages 329-358
Abstract:
We examine whether and under what circumstances World Bank and International Monetary Fund (IMF) programs affect the likelihood of major government crises. We find that crises are, on average, more likely as a consequence of World Bank programs. We also find that governments face an increasing risk of entering a crisis when they remain under an IMF or World Bank arrangement once the economy's performance improves. The international financial institution's (IFI) scapegoat function thus seems to lose its value when the need for financial support is less urgent. While the probability of a crisis increases when a government turns to the IFIs, programs inherited by preceding governments do not affect the probability of a crisis. This is in line with two interpretations. First, the conclusion of IFI programs can signal the government's incompetence, and second, governments that inherit programs might be less likely to implement program conditions agreed to by their predecessors.
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Financial Literacy and the Financial Crisis
Leora Klapper, Annamaria Lusardi & Georgios Panos
NBER Working Paper, March 2012
Abstract:
The ability of consumers to make informed financial decisions improves their ability to develop sound personal finance. This paper uses a panel dataset from Russia, an economy in which consumer loans grew at an astounding rate - from about US$10 billion in 2003 to over US$170 billion in 2008 - to examine the importance of financial literacy and its effects on behavior. The survey contains questions on financial literacy, consumer borrowing (formal and informal), saving and spending behavior. The paper studies both the financial consequences and the real consequences of financial illiteracy. Even though consumer borrowing increased very rapidly in Russia, the authors find that only 41% of respondents demonstrate understanding of the workings of interest compounding and only 46% can answer a simple question about inflation. Financial literacy is positively related to participation in financial markets and negatively related to the use of informal sources of borrowing. Moreover, individuals with higher financial literacy are significantly more likely to report having greater availability of unspent income and higher spending capacity. The relationship between financial literacy and availability of unspent income is higher during the financial crisis, suggesting that financial literacy may better equip individuals to deal with macroeconomic shocks.
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Pick your poison: Economic crises, international monetary fund loans and leader survival
Laron Williams
International Political Science Review, March 2012, Pages 131-149
Abstract:
Loans from international organizations impose large costs on the receiving nation. The decisions to accept such loans and then whether or not to implement the prescribed reforms are made with high stakes in mind. Domestic leaders are most likely facing punishment for the current economic crisis, but what is their incentive to implement the arrangements if the costly reforms associated with the loans may reduce their ability to satisfy their supporters? To fully understand this relationship, I develop a theory that explains leader tenure in the post-reform period as a function of the rational decision to accept a loan. Leaders who expect to be secure in the adjustment period are more willing to accept the conditions that accompany loans rather than attempt to withstand the crisis on their own. With the use of a selection duration model, I examine the interplay between electoral incentives and institutional dynamics to show that leaders governing under different institutional arrangements are affected differently for involvement in IMF loans. Since leaders choose when to accept IMF loans based on their own expectations of post-reform tenure, democratic leaders are less likely to participate in loans. Authoritarian leaders, on the other hand, are more likely to participate in agreements because their hold on power in the post-reform period is stronger.
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Repossession and the Democratization of Credit
Juliano Assunção, Efraim Benmelech & Fernando Silva
NBER Working Paper, February 2012
Abstract:
We exploit a 2004 credit reform in Brazil that simplified the sale of repossessed cars used as collateral for auto loans. We show that the change has led to larger loans with lower spreads and longer maturities. The reform expanded credit to riskier, low-income borrowers for newer, more expensive cars. Although the credit reform improved riskier borrowers' access to credit, it also led to increased incidences of delinquency and default. Our results shed light on the consequences of a credit reform, highlighting the crucial role that collateral and repossession play in the liberalization and democratization of credit.