SAFE working paper
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194
I present a new business cycle model in which decision making follows a simple mental process motivated by neuroeconomics. Decision makers first compute the value of two different options and then choose the option that offers the highest value, but with errors. The resulting model is highly tractable and intuitive. A demand function in level replaces the traditional Euler equation. As a result, even liquid consumers can have a large marginal propensity to consume. The interest rate affects consumption through the cost of borrowing and not through intertemporal substitution. I discuss the implications for stimulus policies.
234
A tale of one exchange and two order books : effects of fragmentation in the absence of competition
(2018)
Exchanges nowadays routinely operate multiple, almost identically structured limit order markets for the same security. We study the effects of such fragmentation on market performance using a dynamic model where agents trade strategically across two identically-organized limit order books. We show that fragmented markets, in equilibrium, offer higher welfare to intermediaries at the expense of investors with intrinsic trading motives, and lower liquidity than consolidated markets. Consistent with our theory, we document improvements in liquidity and lower profits for liquidity providers when Euronext, in 2009, consolidated its order ow for stocks traded across two country-specific and identically-organized order books into a single order book. Our results suggest that competition in market design, not fragmentation, drives previously documented improvements in market quality when new trading venues emerge; in the absence of such competition, market fragmentation is harmful.
214
In this study we investigate which economic ideas were prevalent in the macroprudential discourse post-crises in order to understand the availability of ideas for reform minded agents. We base our analysis on new findings in the field of ideational shifts and regulatory science, which posit that change-agents engage with new ideas pragmatically and strategically in their effort to have their economic ideas institutionalized. We argue that in these epistemic battles over new regulation, scientific backing by academia is the key resource determining the outcome. We show that the present reforms implemented internationally follow this pattern. In our analysis we contrast the entire discourse on systemic risk and macroprudential regulation with Borio’s initial 2003 proposal for a macroprudential framework. We find that mostly cross-sectional measures targeted towards increasing the resilience of the financial system rather than inter-temporal measures dampening the financial cycle have been implemented. We provide evidence for the lacking support of new macroprudential thinking within academia and argue that this is partially responsible for the lack of anti-cyclical macroprudential regulation. Most worryingly, the financial cycle is largely absent in the academic discourse and is only tacitly assumed instead of fully fledged out in technocratic discourses, pointing to the possibility that no anti-cyclical measures will be forthcoming.
229
This paper analyzes how the combination of borrowing constraints and idiosyncratic risk affects the equity premium in an overlapping generations economy. I find that introducing a zero-borrowing constraint in an economy without idiosyncratic risk increases the equity premium by 70 percent, which means that the mechanism described in Constantinides, Donaldson, and Mehra (2002) is dampened because of the large number of generations and production. With social security the effect of the zero-borrowing constraint is a lot weaker. More surprisingly, when I introduce idiosyncratic labor income risk in an economy without a zero-borrowing constraint, the equity premium increases by 50 percent, even though the income shocks are independent of aggregate risk and are not permanent. The reason is that idiosyncratic risk makes the endogenous natural borrowing limits much tighter, so that they have a similar effect to an exogenously imposed zero-borrowing constraint. This intuition is confirmed when I add idiosyncratic risk in an economy with a zero-borrowing constraint: neither the equity premium nor the Sharpe ratio change, because the zero-borrowing constraint is already tighter than the natural borrowing limits that result when idiosyncratic risk is added.
211
Bargaining with a bank
(2018)
This paper examines bargaining as a mechanism to resolve information problems. To guide the analysis, I develop a parsimonious model of a credit negotiation between a bank and firms with varying levels of impatience. In equilibrium, impatient firms accept the bank’s offer immediately, while patient firms wait and negotiate price adjustments. I test the empirical predictions using a hand-collected dataset on credit line negotiations. Firms signing the bank’s offer right away draw down their line of credit after origination and default more than late signers. Late signers negotiate price adjustments more frequently, and, consistent with the model, these adjustments predict better ex post performance.
233
This paper presents new evidence on the expectation formation process from a Dutch household survey. Households become too optimistic about their future income after their income has improved, consistent with the over-extrapolation of their experience. We show that this effect of experience is persistent and that households over-extrapolate income losses more than income gains. Furthermore, older households over-extrapolate more, suggesting that they did not learn over time to form more accurate expectations. Finally, we study the relationship between expectation errors and consumption. We find that more over-optimistic households intend to consume more and subsequently report higher consumption, even though they do not consume as much as they intended to. These results suggests that overextrapolation hurts consumers and amplify business cycles.
226
We show that bond purchases undertaken in the context of quantitative easing efforts by the European Central Bank created a large mispricing between the market for German and Italian government bonds and their respective futures contracts. On top of the direct effect the buying pressure exerted on bond prices, we show three indirect effects through which the scarcity of bonds, resulting from the asset purchases, drove a wedge between the futures contracts and the underlying bonds: the deterioration of bond market liquidity, the increased bond specialness on the repurchase agreement market, and the greater uncertainty about bond availability as collateral.
219
We use minutes from 17,000 financial advisory sessions and corresponding client portfolio data to study how active client involvement affects advisor recommendations and portfolio outcomes. We find that advisors confronted with acquiescent clients stick to their standards and recommend expensive but well diversified mutual fund portfolios. However, if clients take an active role in the meetings, advisors deviate markedly from their standards, resulting in poorer portfolio diversification and lower Sharpe ratios. Our findings that advisors cater to client requests parallel the phenomenon of doctors prescribing antibiotics to insistent patients even if inappropriate, and imply that pandering diminishes the quality of advice.
200
This paper investigates the roles psychological biases play in empirically estimated deviations between subjective survival beliefs (SSBs) and objective survival probabilities (OSPs). We model deviations between SSBs and OSPs through age-dependent inverse S-shaped probability weighting functions (PWFs), as documented in experimental prospect theory. Our estimates suggest that the implied measures for cognitive weakness, likelihood insensitivity, and those for motivational biases, relative pessimism, increase with age. We document that direct measures of cognitive weakness and motivational attitudes share these trends. Our regression analyses confirm that these factors play strong quantitative roles in the formation of subjective survival beliefs. In particular, cognitive weakness is an increasingly important contributor to the overestimation of survival chances in old age.