February 6, 2018
The Riddle of Latin American Economies
Scholars Join Forces to Create a Monetary and Fiscal History of Latin America
Macroeconomists have long been interested in how best to design monetary and fiscal policies that address the societal needs provided by governments and nurture the overall performance of economies. They confront this challenge by building formal models that are designed to capture the policy inputs and macroeconomic outcomes and have empirical credibility.
While there is a tendency in public discourse to focus on monetary and fiscal policies as distinct, in fact there are important interactions between the two. Neither operate in a vacuum, and collectively they can have a major impact on the overall performance of an economy. On April 1, 2016, the Becker Friedman Institute held a conference assessing some of the overall conceptual and empirical challenges posed by interactions of monetary and fiscal policy. The aim of the project featured at this conference was to draw on Latin American economic history to further our understanding of which policies best nurture economic success and which result in bad outcomes. This complements George Hall and Thomas Sargent’s research described in Sargent’s Fiscal Insights piece called, “Honoring Public Debts.”
This is no small task, acknowledges Juan Pablo Nicolini, one of the organizers of the collaborative research effort titled “The Monetary and Fiscal History of Latin America.” However, he says, the time is right for economists to turn their attention to the vexing questions left in the wake of Latin America’s post-World War II economic performance. “We have the tools today,” Nicolini says, “and we are gathering important new data sets to shed light on Latin America’s turbulent economic performance in recent decades. We not only hope to help explain the past, but also to provide insights for better policies going forward.”
The Becker Friedman Institute, under the leadership of the University of Chicago’s Lars Peter Hansen, initiated sponsorship of this project starting in 2014. Nicolini, senior economist at the Federal Reserve Bank of Minneapolis, is joined by Tim Kehoe of the University of Minnesota, and BFI Distinguished Fellow Tom Sargent in leading this project, which has engaged more than 30 economists to provide supporting research and analytical insights on 11 Latin American countries. The Becker Friedman Institute sponsored two conferences in Chicago, the most recent in December 2017, and six country-specific conferences and workshops dating back to 2014, where economists presented and refined their work. Among University of Chicago faculty, Fernando Alvarez has been actively engaged in this project. The next step is to publish the completed papers, along with a comparative analysis that will describe common themes and suggest how to better structure macroeconomic policies going forward.
According to Hansen, these Latin American countries provide important sources of evidence to enrich existing models that connect monetary and fiscal policy. “My whole interest in this project from the outset has been to introduce some systematic evidence that can be used for proving grounds for alternative economic models and theories,” Hansen says.
To achieve that aim, the researchers are not only employing a common conceptual framework, but they are also building a comparable data set, according to Alvarez. The data, he says, will serve as an important contribution for future work. “As economists, we propose hypotheses, write models, and test them with data,” Alvarez says. “Some of these experiments are so extreme that they lend to speculative answers. However, we still need to test them, and that’s why a good database is so important.”
For some countries, data can be elusive. Abrupt regime changes—sometimes violent—along with corrupt institutions, means that data gaps exist over key timeframes. In those cases, economists have engaged with local officials, in person and long-distance, to comb through records and piece together reliable data. “This is the first effort of its kind,” Alvarez says. “And we’re doing everything possible to get this right.”
Many of the 11 countries have similar experiences, which will allow for common lessons, but Kehoe stresses that all Latin American economies cannot be lumped together. For example, while some have famously experienced hyperinflation measured in the hundreds and even thousands, others, like Colombia, never experienced hyperinflation.
The varied experience with inflation is just one of many perplexing questions facing the researchers. As an example, Nicolini and his co-author, Francisco Buera, ask in their paper, “The Fiscal and Monetary History of Argentina, 1960-2013″:
- Was a particular crisis driven by primary deficits, by increases in the world interest rate, or by changes in the countries risks?
- Was the “too big to fail” doctrine used during the period to justify bail-outs to the banking sector?
- Is there any evidence of moral hazard problems in periods previous to the crisis?
- Is there any evidence that central bank independence legislation changed the way monetary and fiscal policies interacted?
A central mystery for many Latin American economies, according to Kehoe, is that they were poised after World War II for economic success, much like the United States and other developed economies. At that time, Kehoe says, nobody would have predicted East Asia’s rise over that of Latin America, and yet that is exactly what happened. But why did it happen? “I’m not going to tell you that we’re going to provide all of the answers,” Kehoe says. “But we are going to arrange the stories.”
That was the advice of Francois Velde, senior economist at the Federal Reserve Bank of Chicago, and a discussant at the recent conference. An economic historian, Velde encouraged his colleagues to “find a narrative” among their many narrow points of research. In his closing remarks, Sargent repeated Velde’s advice, reminding the gathered economists of the scientist’s job to spot patterns and to organize them in meaningful ways.
One of the scholarly inspirations for this research effort is the 1981 paper by Sargent and Neil Wallace, “Some Unpleasant Monetarist Arithmetic,” which warned policymakers against overconfidence in monetary policy for controlling inflation without simultaneously considering the underlying fiscal challenges. While Sargent and Wallace wrote about unintended consequences of US deficits, the issues that they raised—along with those embedded in research on the so-called “fiscal theory of price level’’ by Michael Woodford, Christopher Sims, John Cochrane and others—carry over more generally to Latin America and other economies around the world.
While some may be concerned that studies of Latin America are too unique to be of a broader economic interest, Alvarez challenged this viewpoint and encouraged the economists to revisit another 1981 paper by Sargent, “The Ends of Four Big Inflations.” In that paper, Sargent stressed that contemporary countries—like the United States—had much to learn from the past struggles of other countries, a lesson that applies today: “… I have encountered the view that the events described here are so extreme and bizarre that they do not bear on the subject of inflation in the contemporary United States. On the contrary, it is precisely because the events were so extreme that they are relevant. … I believe that these incidents are full of lessons about our own, less drastic predicament with inflation, if only we interpret them correctly.”
As scholars have probed into the details of different countries’ experiences, they have exposed important contributing factors to how macro policies operated in the past. While the economic models necessarily pose monetary and fiscal policy in formal ways, there are important institutional details that undermine the actual conduct of these policies. This becomes an important part of the narrative of the experiences in these economies. The value of stable institutions immune from corruption, and longer-term commitments to credible policies not vulnerable to short-sided political motives, emerge as common themes from this exploration across various Latin American economies. The cross-country comparisons will open the door to further strengthening our understanding of the circumstances when monetary and fiscal policy and their interplay can either enhance or weaken economic performance and development.
he following three videos, with economists attending the December conference, provide unique insights into questions surrounding the economic history of Latin America:
Spotlight on Chile with Jose De Gregorio, Former Governor of the Central Bank of Chile and Professor of Economics, Universidad de Chile
Spotlight on Mexico with Felipe Meza, Centro de Investigacion Economica, Instituto Tecnologico Autonomo de Mexico
Spotlight on Argentina with Ricardo Lopez Murphy, Former Minister of Economy and Defense for Argentina, Academica Advisor, FIEL
Read the full news feature article on the Becker Friedman Institute website.
February 6, 2018
The Becker Friedman Institute initiated sponsorship of a major project starting in 2014, “The Monetary and Fiscal History of Latin America,” to investigate the complicated economic histories of 11 Latin American countries. Since then, BFI has engaged more than 30 economists to provide supporting research and analytical insights for the project and sponsored six conferences, in which economists received feedback and refined their work. A unique aspect of this project is that researchers are employing a common framework and building comparable data sets. While each country is different, many share similar experiences that will allow for some common lessons to emerge. A December 2017 conference sponsored by the Becker Friedman Institute’s Macro Financial Research Initiative (MFRI), under the leadership of Lars Peter Hansen, was the final gathering of researchers prior to the release of their papers. The next step is to publish the completed papers, along with a comparative analysis that will describe common themes and suggest how to better structure macroeconomic policies going forward.
The following three videos, with economists attending the December conference, provide unique insights into questions surrounding the economic history of Latin America:
Spotlight on Chile with Jose De Gregorio, Former Governor of the Central Bank of Chile and Professor of Economics, Universidad de Chile
January 11, 2018
The 2018 Macro Financial Modeling (MFM) Winter meeting will be held on January 25-26, 2018 in New York City.
The Winter Macro FInancial Modeling Meeting is a research project supported by a generous grant from the Alfred P. Sloan Foundation, CME Group Foundation, and Fidelity Management & Research Company. The main organizers of the conference are Lars Peter Hansen, University of Chicago, and Andrew W. Lo of Massachusetts Institute of Technology.
Learn more about the MFM project here.
Find information about previous MFM meetings here.
January 10, 2018
Chicago Research Fellow Piotr Dworczak Awarded Amundi Smith Breeden First Prize
Piotr Dworczak, a Chicago Research Fellow with the Becker Friedman Institute for Economics (BFI), has been awarded the annual Amundi Smith Breeden First Prize for his research article, “Benchmark in Search Markets.” The article was published in the October 2017 issue of the Journal of Finance.
Many important financial trades are made through more informal over the counter markets rather than exchanges. Especially since the financial crisis there has been considerable interest in obtaining a deeper understanding of how such markets function and how successful they are in supporting efficient trades among interested parties. This article, co-authored with Darrell Duffie of Stanford University’s Graduate School of Business and Haoxiang Zhu of MIT’s Sloan School of Management, provides new insights by showing that reliable benchmarks reduce informational asymmetries between customers and dealers, thereby increasing the volume of socially beneficial trades. The increase in trading volume may offset the reduction in profit margins, giving dealers who can coordinate an incentive to introduce benchmarks. The authors argue that benchmarks deserve strong and well-coordinated support by regulators around the world.
The journals’ associate editors selected the top three papers published in the first five issues of the 2017 and in the December issue of 2016 for the Amundi Smith Breeden Prizes in any area other than corporate finance.
View the original feature story as it appears on the Becker Friedman Institute website.
December 7, 2017
2017 Latin American Fiscal Studies Conference
This conference will discuss a series of papers that–by using a common conceptual framework and building a comparable date set–will narrate the history of the 11 largest Latin-American countries since 1960. That period was plagued by macroeconomic crises of a different nature: defaults, devaluations, balance of payment crises, banking crises or sudden stops, to name the most common ones. The events of the last five years made clear that developed economies are in no way immune to these events. While bad macroeconomic fundamentals like chronic deficits and high public debt appear many times as potential causes for the crises, this does not seem to always be the case. Indeed, as a large literature review has shown, expectations and multiplicity may play a key role in these events. The case studies discussed in the conference will serve as laboratories to test alternative theories and strengthen our understanding of economic crises. This conference is part of a long-run project, funded by the Becker Friedman Institute at the University of Chicago.
View full conference schedule here.
November 21, 2017
I just returned from an insightful trip to visit Tsinghua University in Beijing, China.
It was a busy few days as I gave four talks in total, three of them at Tsinghua University – the Chen Daisun Memorial Lecture in Economics at the Tsinghua School of Economics and Management, a Tsinghua Top Talk for the Graduate Student Union, and a more academically oriented lecture at the Tsinghua Forum & Tsinghua PBCSF Global Academic Leader Forum at the Tsinghua School of Finance.
While I appreciated the opportunity of participating in all three forums, the most fun talk of the three was the Top Talk, in which I was able to share insights with close to 200 energetic graduate students from a variety of fields. Their thoughtful questions led to some interesting exchanges. In my third talk, I shared my perspective on an academic literature on valuation and uncertainty. This allowed me to place some of my recent research into a broader context. In addition, I met with several scholars over a two-day period and found the environment to be intellectually vibrant.
I had the opportunity to talk to some of the administrative leaders, including the university president, Qiu Yong, about potential collaboration between Tsinghua University scholars and the Macro Financial Research Initiative (MFRI) that I oversee at the University of Chicago. Zhiguo He of University of Chicago had set the stage for these conversations. He is a graduate of Tsinghua and continues to spend time there and collaborates with some of the researchers. He, along with Hui Chen of MIT and others, are keenly interested in furthering the study of credit opportunities, financial restrictions, and investment in China. Tsinghua University was kind enough to make me an Honorary Professor. I was a bit mischievous and asked if the title came with tenure.
China has much to be proud of given its pace of economic development. It has a truly remarkable history. The cultural revolution was very harmful to intellectual endeavors and the nurturing of scholarship. Luckily, it did not fully deplete the stock of human capital so that more open markets including the market for ideas have contributed to China’s economic success. While this transition has been remarkable, there is some cause for concern going forward. The state-owned banks continue to play a prominent role in financing businesses. On the other hand, the shadow-banking sector has arguably been better suited to support new ventures and to nurture creative entrepreneurial activity. There is potential for the government to limit this outside activity to ensure financial stability, but this could inhibit productive investments and retard economic growth.
On Saturday, I was pleased to speak at an event hosted by the National Economics Foundation that honored Gregory Chow and Xiaohong Chen as the new winners of the “2017 China Economics Prize.” Both researchers have made important contributions to econometrics over the last several decades. Interestingly, Xiaohong was born 36 years after Gregory. As many people noted, in addition to his intellectual contributions, Gregory contributed to Chinese scholarship in economics by helping to open the door for many promising scholars in China to attend graduate schools in the United States. Xiaohong Chen was actually one of the initial scholars to benefit from Gregory’s efforts and received her PhD degree at the University of California, San Diego.
Gregory was very kind to me early in my career. Just out of graduate school, I participated in an Economic Dynamics and Control Society conference in Cambridge, England. Gregory was the President of the Society at the time. He was very kind for welcoming me to the event and for allowing me to present joint work with Tom Sargent.
I first got to know Xiaohong Chen when she was recruited as a new Assistant Professor at the University of Chicago. I have followed her career with great interest ever since, and I have written a couple of papers with her. I have learned much from her over the years. As I anticipated, many speakers at the award ceremony discussed specific aspects of Gregory and Xiaohong’s contributions. I chose instead to put their work into a broader perspective and discuss why their characterizations of statistical complexity and the associated econometric challenges contribute to an understanding of a variety of market phenomena and should help us in obtaining and framing a more sanguine approach to economic policy. I ended my talk with a reference to Confucius:
When you know a thing, hold that you know it; and when you do not know a thing, allow that you do not know it – this is knowledge.
October 20, 2017
Reflection from recent trip to Chile
I recently returned from my first trip to Chile. There is a long-standing, well-known connection between the University of Chicago and Chile. The Pinochet regime in Chile is renowned for two reasons – political repression and economic reforms. The former was brutal and indefensible, while the latter had a long-lasting positive impact on the Chilean economy. Indeed, in terms of economics, Chile has become one of the best success stories in Latin America. The so-called “Chicago boys,” trained at the University of Chicago, played a central role in designing and implementing liberal reforms following the economically flawed policies of the previous socialist government of Allende. The long-term impact of some of these reforms has been an interesting and valuable test case for economists and governments.
Against this backdrop, I was pleased to visit Chile in person, to share ideas and learn from local expert economists and policy-makers. During my two and half-day visit, I gave three talks in total. One of the lectures was an academic talk at the Pontifical Catholic University of Chile, and another was an open lecture to about 600 people at an event in downtown Chile hosted by University of Desarrollo (University for Development) in Santiago. My third talk was during a dinner to a group of about 130 interested alumni.
In addition, I had two very productive lunches, one at the Pontifical Catholic University and another at the Central Bank of Chile, along with a small dinner with faculty from Catholic University. My talks focused on uncertainty conceived broadly and its implications for markets and policy. The lunches and private dinner were fascinating to me, as they allowed to me engage in wide-ranging policy discussions pertinent for both the Chilean and the U.S. economies.
As part of the economic reforms of the past, Chile designed a pension system to help people save for their own retirement and to avoid burdening current taxpayers to support the pensions of existing retirees. While I like the aims and basic design, the current pension system is under attack because many retirees expected to be in better shape financially. They did not save sufficiently to provide the retirement income they hoped they would receive. There are some calls to have the government scrap the basic approach, but this would be a mistake. In my view, it would be better to structure incentives and encourage more savings from some during their working lives. Transient subsidies might be required in the short run, but these should be phased out. Thus, it would be best to make some repairs to the pension system without scrapping the basic approach.
There is a move afoot to provide free education including college or undergraduate education. I am sympathetic to some educational subsidies, but one has to ensure that these investments are done wisely. As my colleague Jim Heckman likes to emphasize, early childhood education can be a valuable social investment. In contrast, government guarantees for free college education are apparently being tied to more governmental control on how the higher education is to be provided and valued. This can be truly counterproductive. I would rather continue to see multiple colleges and universities flourish, nurtured in part by competition. I was also pleased to learn more about the successes and limitations of the voucher system in Chile, aimed at providing school choice and nurturing productive competition.
For these and other reasons, my visit to Chile expanded my understanding of economic policy in practice. The trip served as a reminder that there is more to policy design than abstract constructs that look appealing. The details of implementation are significant and sometimes require a form of “learning by doing.”
At the Central Bank of Chile, I had the opportunity to discuss some of the Macro Financial Research Initiative (MFRI) projects that are currently being undertaken. The Central Bank if Chile will be co-hosting a MFRI/BFI event next summer which will take a systematic inventory of what we have learned from the observed and documented monetary and fiscal histories of Latin America.
I very much look forward to my opportunity to return the Chile, and I even hope to have the opportunity to ski there during the summer months in the northern hemisphere.
A number of Chilean media entities interviewed me during my stay, including La Tercera and CNN Chile. Some of the original interviews can be found here and here.
October 19, 2017
Latin American and Caribbean Economic Association (LACEA) and the Latin American Econometric Society (LAMES) annual meeting – November 9-11, 2017
The Latin American and Caribbean Economic Association (LACEA) and the Latin American Econometric Society (LAMES) 2017 annual meeting will be held in Buenos Aires, Argentina between November 9th and 11th, 2017. This conference will serve as a precursor for the upcoming MFRI Latin American Fiscal Studies conference hosted by the Becker Friedman Institute at the University on Chicago on December 11-13, 2017.
Learn more about the LACEA LAMES 2017 annual meeting here.
October 13, 2017
Pierre-André Chiappori, Columbia University, and Maxim Pinkovskiy, Federal Reserve Bank of New York, offer some important perspectives on the public financing of health
As posted on the Becker Friedman Institute for Research in Economics featured news section:
Creating a More Efficient Health Insurance Market in the United States: Goals and Challenges
With the latest legislative defeat of attempts to repeal all or parts of the Affordable Care Act (ACA), there is renewed interest in bi-partisan, evidence-based approaches to reforming health insurance markets in the United States.
Becker Friedman Institute (BFI) Distinguished Fellow Pierre-André Chiappori of Columbia University and Maxim Pinkovskiy of the Federal Reserve of New York explore the performance of the US health insurance system over recent decades, both prior to and after implementation of the Affordable Care Act (ACA). They find that relative to other OECD countries, Americans tend to pay more for less, making the health system a top priority for US policymakers. The authors highlight key misperceptions in discussions around health care reform and target factors for consideration in reforming the ACA, including the ban on using pre-existing conditions in the underwriting and pricing process. Chiappori and Pinkovskiy also explore the role of government in the regulation and provision of health insurance in the United States, raising the basic question of whether health insurance should be linked to employer contacts. Read the full piece here.
Articles in the Fiscal Insight Series are authored by BFI’s Distinguished Research Fellows and use research-based approaches to exploring policy questions around debt, wages, taxes and inflation. The views expressed in these articles are those of the author and not necessarily those of BFI.
Previous articles can be found here.
October 4, 2017
The Fiscal and Monetary History of Mexico 1960-2016: From Fiscal Dominance to Debt Crisis to Low Inflation
The event took place on October 4th 2017 at ITAM’s main campus in Mexico City. The local organizers were Professors Felipe Meza and Diego Dominguez, ITAM faculty, and Dr. Enrique Cárdenas, former director of the research center CEEY in Mexico City, and Mexico’s most well-known contemporary economic historian. The audience included current policy makers from the central bank, the Banco de México, and from the treasury, the Secretaría de Hacienda y Crédito Público, as well as ITAM faculty and researchers from other institutions.
After a description of the Latin America project by Juan Pablo Nicolini, Felipe Meza presented an analysis of the modern fiscal and monetary history of Mexico using as framework the model of Sargent and Wallace. In a first panel his work was analyzed dividing 1960-2016 into periods:
· Enrique Cárdenas analyzed the part of the paper that studies 1960-1982.
· Dr. Ignacio Trigueros, head of the CAIE research center on applied macroeconomics, analyzed 1983-2000.
· Dr. Germán Rojas, Director of Undergraduate Studies at ITAM, analyzed 2001-2016.
In a second panel a group of former and current policy makers analyzed the work presented by Felipe Meza. This panel was moderated by Dr. Alejandro Hernández-Delgado, Provost of ITAM. The group of economists included:
· Dr. Jesús Marcos-Yacamán, former Deputy Governor of the Banco de México
· Dr. Jaime Serra-Puche, former Secretary of Trade and Industrial Development, and former Secretary of the Treasury
· Dr. Francisco Gil-Díaz, former Secretary of the Treasury, and former Deputy Governor of the Banco de México
· Dr. Manuel Ramos-Francia, Deputy Governor of the Banco de México.
Additionally, Dr. Manuel Sánchez-Gónzalez, former Deputy Governor of the Banco de México sent comments by email, as he could not attend the event.
The former and current policy makers provided their thoughts on the implementation of economic reforms, and on policy responses to large events in the economic history of Mexico. There was a lot of interaction between the presenter, the panelists and the audience, and a frank and profound discussion of events that shaped Mexico’s economic history. Two events that generated many comments were the 1982 Debt Crisis, and the 1994 Crisis. The audience and the panelists provided a large amount of feedback that after processing will be added to the paper on Mexico’s fiscal and monetary history.
— Juanpa Nicolini
July 21, 2017
MFM Summer Session for Young Scholars
The 2017 MFM Summer Session for Young Scholars was held at Bretton Woods, NH. Below are Lars Peter Hansen’s reflections from the conference:
It was my great privilege to participate in the 2017 Macro Financial Modeling Summer Session for Young Scholars held at the Omni Hotel at Mt. Washington in Bretton Woods, NH. This was my first visit to Bretton Woods.
The location has much history attached to it. In 1944, 730 delegates from 44 countries participated in a forum to reshape the commercial and financial interactions around the world. Prominent economists such as John Maynard Keynes were actively involved in the conversations. Coming out of Bretton Woods were a set of rules and institutions to oversee the international monetary system. The International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD) were created, the gold standard was embraced, and it set the stage for fixed exchange rate regimes. The gathering was at the same hotel, the Mt. Washington Hotel, as this year’s summer camp.
It was my pleasure to participate. The lectures covered a wide variety of topics including liquidity, financial network modeling, histories of financial crises and exchange rate regimes, housing finance, along with methods for estimation, inference and model comparison. Many elite scholars gave informative lectures. A lot (perhaps too much) was packed into the first two days of the camp. Two of the speakers, Maryam Farboodi and Luigi Bocola were 2013 MFM fellowship awardees.
Like last year, my co-director Andy Lo and I found value in having private sector and public sector panels with research support leaders adding their perspectives on the important policy challenges and open research questions. Leo Melamed, CME Group Chairman Emeritus’ talk was a real highlight, as he provided a personalized discussion of the breakdown of the fixed exchange rate regime and the resulting emergence of derivative claims markets.
I was particularly impressed with the student engagement, both formal and informal. There were some terrific poster sessions and some nice short talks given by MFM scholars. The MFM project has provided research support for 61 graduate students, and the camp provided an opportunity for some of this research to be presented. Dinners were fun for me because they were engaging. I enjoyed talking to many of the students. I even joined them at the Mt. Washington Hotel bar, The Cave, but embarrassed myself in my attempts to table shuffleboard. It is truly terrific to see such young and energetic talent enter the macrofinance field, and I look forward to watching them develop in the future.
— by Lars Peter Hansen
June 20, 2017
CME Group Chairman Emeritus Leo Melamed Speaks at 2017 MFM Summer Session
Leo Melamed, Chairman Emeritus of the CME Group, was invited to the 2017 MFM Summer Session for Young Scholars at Bretton Woods, NH.
Below is his full speech from the conference, as posted on his website.
Allow me to begin by applauding the Becker Friedman Institute for initiating this Macro Financial Modeling Project and to congratulate its two Project Directors, Lars Peter Hansen, of the U of C and Andrew W. Lo of MIT.
While I congratulate them and agree that identifying the root causes of the 2008 crisis and similar calamities—in a quest to discover a canary for the financial mineshaft—is a noble mission, I feel compelled to tell them that their task is daunting. They are attempting to defy what Georg Wilhelm Hegel sadly told us two hundred year ago: “Experience and History,” he stated, “teach us that people and governments never have learned anything from history, or acted on principles deduced from it.”
Hegel’s admonition stands nearly unblemished.
That said, I feel honored to support this innovative initiative by offering some brief thoughts. I assume that one reason for my invite here is that much of my life is intertwined with Bretton Woods. As everyone knows, it was here in Bretton Woods, at the Mount Washington Hotel, in 1944, that there was an assembly of 730 delegates from 44 Allied Nations in order to re-establish financial order in a war-torn world after the Second World War. No, I was not present. I was just a child at that time and had just arrived to this country.
The squeaky wheel at Bretton Woods
The Conference lasted three weeks, from July 1 to July 22. The agreement established a system of fixed exchange rates in which world currencies became pegged to the dollar, with the dollar itself convertible into gold. Its two principal architects were John Maynard Keynes, representing the British Treasury, and Harry Dexter White, representing the U.S. Treasury. The Articles of Agreement were hailed as a seminal achievement and ratified on December 27, 1944. It ambitiously prescribed open markets but with fixed exchange rates.
There was but one squeaky wheel. A single voice defying the near-unanimous applause for this achievement. The voice belonged to Milton Friedman. He argued that Bretton Woods was doomed to failure. It tried to achieve incompatible objectives: freedom for countries to pursue an independent internal monetary policy; fixed exchange rates; and relatively free international movement of goods and capital.
Allow me to digress. The world eventually learned that Milton Friedman’s opinions were not to be ignored. That truism was adroitly described by Milton’s very good friend, Nobel Laureate, George Stigler, on the occasion of 1976 Nobel Prize celebration for Milton Friedman. Professor Stigler introduced Friedman in the following fashion:
Milton, he said, will begin a debate by asking you to grant him three simple assumptions. For instance: That $2 is better than $1; That the law of diminishing returns is valid; And, that individuals do not have complete knowledge of the future.
Simple, undeniable assumptions, right? My fundamental advice,” said Professor Stigler, “Do not grant him these assumptions. For if you do, you will find yourself led, by inexorable logic, to conclusions such as these:” That the Federal Reserve System should be abolished; that the Board of Governors of the Federal Reserve should be put on Social security; and that Social Security should be abolished.
During the first decade of Bretton Woods, the system worked fine and it looked as if Friedman was wrong. Trouble was the 44 nations grew up. Some of them on a fast track who became competitive to each other and to the U.S. In practice, maintaining announced parities became a matter of prestige and political controversy. Foreign exchange became a competitive tool. Countries held on to parity as long as they could, in the process letting minor problems grow into major crises and then making large changes. Friedman’s prediction was coming true.
The information era and its implications for the fixed exchange rate system
Then, beginning in the late 1950s, the curtain opened on the “Information Era.” Technology created the transistor—perhaps the greatest invention of the 20th Century. With the transistor communication was revolutionized and information began to flow globally in minutes rather than in days or weeks. The technological revolution which is still very much alive, enabled markets to learn facts before finance ministers could gather to react. It became impossible for a fixed exchange rate system to cope with continual changes in currency values resulting from the daily flows of political and economic information. By the late 1960s, the Bretton Woods fixed exchange rate system had become a joke.
As it happened, I was then the chairman of an insignificant, back-water, pork-belly futures market, the Chicago Mercantile Exchange. My good friend, Adlai Stevenson, the former US Illinois Senator, likes to tell the story this way. One day in August of 1971, as Chairman of the Senate Subcommittee on International Finance, he received a note that the President, Richard Nixon, had closed the gold window. Stevenson says he had no idea what this meant. In fact, in his view nobody in Congress knew what it meant. And maybe, he goes on to say, no one in the US— except this one guy at the Chicago Mercantile Exchange.
That is a bit of an overstatement but several things are certain. It wasn’t easy. What the modern world needed, I thought, was a system that would allow currency values to adjust in an ongoing fashion. In other words—at a futures market in financial instruments —where prices reflected continuous changes as demanded by the constant flow of new information. Such a system would allow risks to be hedged and opportunities to be captured in real time.
Futures in finance? “Fuhgeddaboudit!”
In early 1971, my suggestion for a futures market in foreign exchange was met by derision and contempt, not only by my board of directors, but by practically the whole financial world. The idea prompted a prominent New York banker to laughingly say, that “foreign exchange couldn’t be entrusted to a bunch of pork belly crapshooters in Chicago.”
As some in Chicago were apt to say, “Futures in Finance, fuhgeddaboudit.”
Besides, I was a lawyer, not an economist. To achieve a measure of credibility I went directly to Milton Friedman. Not only did he like the idea, at my request, he authored a feasibility paper embracing the concept. That paper proved magical. His fee was $5,000. The International Monetary Market, IMM, was launched by the CME on May 16, 1972 and merged with the CME in 1976. Some will tell you that today the CME has a street value of perhaps $100 billion. Now that’s what I call a pretty good trade.
Actually Friedman also tried to defy Hegel’s law by urging President Nixon to abandon fixed exchange rates directly after his election in 1968. Nice try! By the time Nixon acted on August 15, 1971, world currency values were so screwed up, they were nearly beyond repair, and the US was about to go broke selling gold to the whole world at $35 an ounce.
I must admit our timing was lucky. If one could ordain the perfect backdrop for the creation of a new futures exchange designed to manage the risk in instruments of finance, one could not have bettered what actually happened. The decade that followed can be described as a “Perfect Financial Storm,” — turmoil that tested the very foundations of western civilization.
The U.S. dollar plunged precipitously; U.S. unemployment reached in excess of 10%; oil prices skyrocketed from about $7 a barrel to $39; the Dow fell to 570; gold, from its $35 base, reached $800 an ounce; U.S. inflation climbed to an unprecedented peacetime rate of 20%; interest rates went even higher.
The IMM went from currency futures to interest rates to stock indexes and to derivatives across the entire financial spectrum. We were copied by every industrial nation in the world. Not to brag, but in 1986, Nobel Laureate, Merton Miller called financial futures the most important financial invention of the past twenty years.
So, what did history teach us over the past five or so decades? Well, yes, that necessity is the mother of invention. And yes, that timing is everything. But we also learned that when it comes to innovation, the US is the place to be. Could the Internet, Google, Apple, Microsoft, Facebook, or Amazon, to name but a few, have been created somewhere else? I have grave doubts. Could the IMM have been initiated in another country? Same answer.
The U.S. as the world’s crucible for innovation
Thomas Friedman said it best: America, he wrote, allows “extreme freedom of thought, an emphasis on independent thinking, a steady immigration of new minds, and a risk-taking culture with no stigma attached to failure.” Yes, those are the precise attributes that make our nation exceptional. We are the world’s crucible for innovation.
This Becker Friedman undertaking is another example. It is an initiative within the academic sciences which to my knowledge has not been undertaken anywhere else. An innovative effort to jointly advance our understanding of the links between financial markets and the macro-economy. To construct more comprehensive models for assessing systemic risk. To foster discussion and research. To collect resources for analysis and study. And, to the extent possible, to create and share a data-bank of economic information.
In short: To learn from history and act on principles deduced from it, and finally prove Georg Wilhelm Hegel wrong. I wish you luck.
— by Leo Melamed
June 16, 2017
Macro Financial Modelers Make Good
Former MFM Fellows launch successful careers probing sources of financial instability that impact the economy
Two 2013 MFM dissertation fellowship awardees are well on their way to establishing themselves as top scholars. For Maryam Farboodi and Luigi Bocola, their research potential was affirmed their job market success and by their participation in the 2014 Review of Economic Studies Tour. This prestigious opportunity selects top candidates on the job market to visit and present their work to multiple schools in Europe.
Both economists are now engaged in a variety of interesting research projects, so we took the opportunity to interview them and gain a better appreciation of their successes.
Maryam Farboodi initially embarked on a PhD program in computer science with a focus on theoretical work, after earning undergraduate and master’s degress in that area from Sharif University of Technology in Tehran, Iran and the University of Maryland. While she found the work interesting and mentally stimulating, she came to view that angle as a bit too narrow and detached from problems found in the world around her.
“I wanted to do something a bit more significant that allowed me to think about relatively abstract problems with real-world implications,” Farboodi explained.
She decided that pursuing economics would entail broad, interdisciplinary work across various fields she found particularly appealing, so she switched her doctoral studies from computer science to economics, pursuing her degree at the University of Chicago. After graduating in 2014 with interests in banking, financial macroeconomics, and mechanism design, Farboodi accepted an opportunity as an assistant professor at Princeton University.
At Princeton, Farboodi has further focused her research agenda more specifically on financial intermediation.
Bringing the tools of micro and finance to macroeconomics
“Intermediation is a broad field, and many different aspects of it can be studied to provide insights pertaining to the financial sector and the various setbacks that can potentially occur,” she explained. “I am particularly interested in inter-financial institution market structure, information consequences of interactions in the financial sector, market power, and spill over to the real economy.”
One strand of her research focuses on technological choices of financial institutions and their welfare implications with a focus on interbank intermediation. In another sequence of papers, she uses information economics to study the long-run impact of advances in financial technology on economic growth and various types of misallocation that can arise from the interaction of financial and real sector. In another project, she explores the strategic incentives of banks, which is a central concern for enhancing our understanding of systemic risk in the financial sector.
“I believe that the strategic nature of the interaction between financial institutions is actually really important,” she said. “In one of my recent projects, I focus on how these strategic incentives change a lot of factors, such as opacity of the portfolio in order for banks to make themselves gain market power.”
Newer themes in her work bring in microeconomic and corporate finance tools to study questions which traditionally have had a macroeconomics focus, such as sovereign debt.
Receiving an MFM fellowship allowed Farboodi to concentrate only on her job market paper without having to teach. The financial support and the extra time it freed up is one benefit the MFM provided. “The most unique quality of the MFM program is its commitment to promoting young researchers and to expose them to high-quality talks by elite, senior researchers who actively participate and help young scholars evolve their research,” Farboodi concluded.
“I was incredibly lucky to have the opportunity to present at the October 2013 Young Scholars meeting just before I went out on the job market,” she explained. “The exposure that I got from that particular meeting contributed to all of the interviews that I was offered, and this exposure remains invaluable to me.”
This opportunity allowed her to present her work among elite scholars and young researchers and to gain valuable feedback from them.
Probing the sources of instability
Luigi Bocola, another 2013 MFM dissertation fellowship recipient who is now an assistant professor of economics at Northwestern University, derived similar benefits from his MFM support. In addition to the financial stipend, the fellowship gave him the opportunity to present his work in various early stages in front of distinguished researchers. This was instrumental in the completion of his dissertation, according to Bocola.
“What I found most unique about the MFM program is that it was essentially understood that everything presented at the conference was simply a work in progress. That understanding enabled feedback about which components of the work were genuinely worth pursuing and which weren’t,” he explained.
Bocola’s dissertation studied a key aspect of the debt crisis in Europe, namely the negative spillovers that sovereign default risk had on financial intermediation and the real economy. He developed a macroeconomic model in which banks are exposed to risky sovereign debt, and applied the model to Italian data. His work also made progress on the empirical analysis of this class of models, which are inherently nonlinear.
His dissertation was the recipient of the William Polk Carey Prize in Economics, which is awarded annually to the best doctoral dissertation in the Economics Department at the University of Pennsylvania.
Much of Bocola’s research focus since has remained the same, with a continuing emphasis on the exploration of linkages between macroeconomics and finance in an international framework. His recent work has two objectives in mind: identifying sources of financial crises in modern economics and understanding what government policies can do to make the financial sector more stable.
In a recent joint work with Guido Lorenzoni of Northwestern University, Bocola studies the sources of financial instability for emerging markets and the constraints that an open capital account imposes on the lender of last resort.
“We believe our research can shed light on the motivations behind the large accumulation of foreign currency reserves by emerging market over the past 20 years,” Bocola concluded.
Given the successful launch of their professional careers, both Maryam Farboodi and Luigi Bocola were recruited to present their perspectives on important lines of research at the 2017 Macro Financial Modeling Summer Session for Young Scholars in Bretton Woods, New Hampshire, June 18-22, 2017.
— by Diana Petrova
May 23, 2017
Lenel to Pursue Macro Finance Studies as a Chicago Research Fellow
May 2, 2017
Fourteen Scholars Awarded Fellowships to Study Macrofinance
The Becker Friedman Institute’s Macro Financial Modeling Initiative has announced the recipients of this year’s dissertation fellowships. Thirteen promising new scholars from universities across the United States and Europe were chosen from a highly competitive pool of applicants to receive funding for their MFM research. The project, supported by the Alfred P. Sloan Foundation , CME Group Foundation and Fidelity Management & Research Company, provides dissertation support for doctoral students who are working to advance macroeconomic models with financial sector linkages.
The 2017 awardees are studying an impressive range of research questions, with dissertation subjects including bank consolidation and credit expansion, household finance, institutional risk management, and corporate debt and transmission of unemployment risk.
“Supporting early career scholars is one of the key goals of the Macro Financial Modeling Program,” says Lars Peter Hansen, the David Rockefeller Distinguished Service Professor in Economics, Statistics, and the College and Research Director of the Becker Friedman Institute for Research in Economics. “These awards recognize the contributions that graduate students are making in the field of macroeconomics and finance, and the fellowship process serves as a vehicle to preview some of the cutting-edge work in the field. We look forward to learning more about their progress and potential breakthroughs in their dissertations.”
Sasha Indarte, a PhD candidate at Northwestern University and one of this year’s grantees, says the funding will ease her teaching burdens and allow her to focus on her research studying the effect of bank consolidation on lending standards.
As high school student in Minnesota during the 2008 financial crisis, Indarte saw people she knew losing their jobs and heard disturbing discussions of another Great Depression. That experience inspired her to pursue a career investigating elements of financial crises.
Her current research, which she hopes will be the cornerstone of her dissertation, evaluates large declines in the number of U.S. banks – down more than 50 percent since the 1980s – despite a growing population. Alongside this banking trend, researchers have observed interesting changes in household credit; lower income borrowers are seeking more credit for different types of activities. “My aim is to understand if consolidation is one of the reasons credit has expanded to riskier populations by looking at how borrower and loan characteristics change after bank mergers,” she explains.
Daniel Green, a PhD student in finance at the Sloan School of Management at MIT, was similarly troubled by the 2008 financial crisis and fascinated by the slew of policies that injected billions of dollars into the financial sector, affecting not only financial markets, but the broader economy as well.
Green’s MFM project examines how the type of information available to credit institutions affects lending decisions. For instance, does information about the broader economy versus individual contracts affect the types of industry or the riskiness of projects that a lender will finance, and do those decisions have aggregate implications for the overall economy?
Quentin Vandeweyer is taking a slightly different, more computational approach to his research, illustrating the breadth and diversity of activities supported by the MFM fellowship initiative. As part of his PhD work at Sciences Po in Paris, he is working on an innovative methodology to account for heterogeneous incentives and behaviors that the financial sector may have as both a creator of liquidity and a manager of risk.
Vandeweyer’s research interests position him at the intersection of macro, finance, and monetary economics. As an MFM Summer Camp alumnus (2016), he is setting his roots firmly within the MFM community. “I am, of course, delighted to win the fellowship. A big part of growth in research is the interaction you have with different people along the way. The MFM initiative provides a forum for discussion and exchange of ideas between very smart people with similar concerns and interests.”
In addition to Indarte, Green, and Vandeweyer, 2017-18 awardees include:
Carlos Avenancio-Leon, University of California, Berkeley
Sarita Bunsupha, Harvard University
Cristian Fuenzalida, New York University
Paul Ho, Princeton University
Adam Jorring, University of Chicago
Yann Koby, Princeton University
Anton Petukhov, Massachusetts Institute of Technology Sloan School of Business
Julian Richers, Boston University
Samuel Rosen, University of North Carolina at Chapel Hill
Tianyue Ruan, NYU Stern School of Business
Ishita Sen, London Business School
—by Tina A. Cormier
Macro Financial Modeling dissertation support is provided annually to doctoral students who are working toward improved and more comprehensive models of systemic risk in the financial sector that can impact the broader economy. The application deadline for the next round of funding is February 10, 2018.
February 1, 2016
Students Trace the Causes, Impact of Systemic Financial Crisis
Turbulent times make for compelling research questions
Young scholars funded through the Macro Financial Modeling initiative are adding to our understanding of the macroeconomic effects rippling out from each of these areas. They shared their research in progress at the January 2016 meeting.
N. Aaron Pancost, a doctoral student at the University of Chicago, used data from India to explore the question of whether and to what extent financial development increases economic growth. Aggregate labor productivity in India growing at about six percent a year, and the financial sector is also growing. Is access to capital driving investment that boosts firms’ productivity?
No, Pancost showed. “What I find is that it’s a common shock to productivity across the board, not financial development, that explains cross-sectional productivity. His results show that firms that are unproductive don’t borrow, while productive firms choose a higher leverage and grow faster on average.
Credit Markets and Liquidity
Two students focused on problems in the financial sector during the recent crisis, presenting work addressing issues of liquidity and credit provision.
Credit market disruptions in the recent crisis were devastating to economy, so Alexander Rodnyansky of Princeton University, in joint work with Olivier Darmouni, looked at how unconventional monetary policy affected bank lending. They found that in the US, the first and third rounds of quantitative easing had a large effect on lending, particularly in real estate, commercial, and industrial lending. QE2 had no significant effect on banks.
The results show that the type of asset used in QE—not just the quantity—makes a difference, Rodnyansky said.
While debt-laden banks stopped lending in the crisis, many also faced insolvency when depositors and investors reclaimed their funds. New Basel rules tried to stabilize the financial system by requiring banks to hold enough assets to withstand a one-month run.
University of Chicago student Fabrice Tourre studied the influence of portfolio liquidity composition on run behavior of banks’ creditors. Taking his model to data, he found that cash can play a novel role in corporate finance, as a run deterrent. Currently liquidity regulations are too conservative for certain firms, and not conservative enough for others, he showed. And it’s not always the case that issuing more long-term debt makes the firm less run-prone.
“The takeaway is that regulators, as opposed to focusing on capital on one side and liquidity on other, should think about them together; the two regulatory regimes talk to each other,” Tourre said.
The Housing Boom Before the Bust
Jack Liebersohn, a Massachusetts Institute of Technology student, shared work that tried to explain the nationwide variation in the severity of the housing bust that precipitated the financial crisis. The standard model holds that local differences in housing supply shocks, mediated by differences in elasticity of the supply response explained the variation. Liberson added a demand shock to the model.
He hypothesized that areas with a large manufacturing sector would have lower payrolls in general and therefore lower demand for housing that would keep prices lower. He comparing areas with high and low manufacturing concentration but also high and low supply elasticity. He found that housing prices rose and fell dramatically in low-manufacturing cities, and less so in cities with greater manufacturing employment. High elasticity dampened the housing price effect, he found.
To see whether higher housing prices led to more consumption, he looked at auto sales, as measured by employment in the auto industry. He found that wages had a much stronger effect on auto sales than housing prices did.
Turning to more methodological issues, Elisabeth Pröhl of the University of Geneva demonstrated a promising approach to using numerical algorithms to solve a labor income risk model with aggregate risk.
Work from Former Grantees
Zachary Stangebye, an assistant professor of economics at the University of Notre Dame, presented theoretical work on sovereign debt motivated by the recent European debt crises. He presented a model in which such a crisis arises, driven by the sovereign’s inability to commit to future debt issuance.
The intuition behind the model is that when investors anticipate high borrowing in the future, they demand a dilution premium on long-term bonds. That forces the sovereign to borrow more today because they can’t borrow as much tomorrow. As a result, high current borrowing causes need for high rollover, which indeed leads the sovereign to borrowing more in the future, fulfilling expectations.
Stangebye’s model imposes a commitment on borrowing, and finds that multiple financing trajectories arise as result of coordination failures with long-term debt
When the model is calibrated to Ireland’s results, it accounts for about 85 percent of the increase in debt-to-GDP ratio seen in the crisis.
Marco Machiavelli of the Federal Reserve Board presented work on the role of dispersed information in pricing default. Studying modern bank runs with data from the recent crisis, he showed that if forecasts about a bank’s viability are bad, lower dispersion of beliefs about a bank’s prospects greatly increases default risk, and amplifies the reaction to changes in market expectations. In other words, more precise and consistent shared information coordinates bank runs, as all investors respond to the information in the same way.
Her work focused on the process of intermediation that provides access to assets and turns risky illiquid assets into safe and liquid ones. In a model with households, banks, and shadow banks, she found that increasing capital requirements on regulated banks caused an increase in shadow bank activity. It also led to higher prices of intermediated assets but reduced default risk for both types of banks.
—by Toni Shears