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Distribution Risk and Equity Returns, with J.B. Donaldson and P. Siconolfi,

Chapter 10 in The Equity Risk Premium, R. Mehra, ed., North Holland Handbook of Finance Series, North Holland, Amsterdam, 2007.

Abstract

In this paper we entertain the hypothesis that observed variations in income shares are the result of changes in the balance of power between workers and capital owners in labor relations. We show that this view implies that income share variations represent a risk factor of first-order importance for the owners of capital and,
consequently, are a crucial determinant of the return to equity. When both risks are calibrated to observations, this distribution risk dominates in importance the usual systematic risk for the pricing of assets. We also show that distribution risks may originate in non-traded idiosyncratic income shocks.

Background to section 7

The Macroeconomic Consequences of Reciprocity in Labor Relations, with André Kurmann

Scandinavian Journal of Economics, 109, (4), 857-881, 2007

Abstract

We develop and analyze a structural model of efficiency wages founded on reciprocity. Workers are assumed to face an explicit trade-off between the disutility of providing effort and the psychological benefit of reciprocating the gift of a wage offer above some reference level. The model provides a rationale for rent sharing -- a feature that is very much present in the data but absent from previous formulations of the efficiency wage hypothesis. This firm-internal perspective on efficiency wages has important macroeconomic consequences: rent-sharing considerations promote wage rigidity, internal amplification and differential responses to technology and demand shocks.

Appendix to "The Macroeconomic Consequences .."

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Intangible Capital, Firm Valuation and Asset Pricing, with Xiangrong Jin

Economic Theory, 2007, 32: 157-177

Abstract

Recent studies have found unmeasured intangible capital to be large and important. In this paper we observe that by nature intangible capital is also very different from physical capital. We find it plausible to argue that the accumulation process for intangible capital differs significantly from the process by which physical capital accumulates. We study the implications of this hypothesis for rational firm valuation and asset pricing using a two-sector general equilibrium model. Our main finding is that the properties of firm valuation and stock prices are very dependent on the assumed accumulation process for intangible capital. If one entertains the possibility that intangible investments translates into capital stochastically, we find that plausible levels of macroeconomic volatility are compatible with highly variable corporate valuations, P/E ratios and stock returns.

Efficiency Wages Revisited: The Internal Reference Perspective , with André Kurmann

Economics Letters , 2006, 90: 278-284

Abstract

The missing wage rigidity in general equilibrium models of efficiency wages is an artifact of the external wage reference
perspective conventionally adopted by the literature. Efficiency wage models based on an internal perspective, in which the wage reference is made dependent on the firm's ability to pay, are capable of generating strong wage rigidity. This paper makes the point in the context of the gift-exchange framework originally proposed by Akerlof [1982].

Zip file containing a mathematical appendix and the matlab codes for Efficiency Wages Revisited

Equity Returns and Integration: Is Europe Changing?, with Kpate Adjaouté, Oxford Review of Economic Policy, 2004 20(4):555-570

Abstract

This paper analyses the consequences of the process of financial and economic integration on European equity markets. It documents significant changes in ‘fundamentals’, notably an increased synchronization of macroeconomic activities, and a non-negligible evolution in pricing, with a decrease in the cost of capital and converging equity premiums. As to equity returns themselves, in the face of what could turn out to be long-run upward trends in the correlations among both country and sector returns and a narrowing of the superiority of country factors, the benefits to be gained from finding diversification opportunities at a more disaggregated level appear to be higher than ever.

http://oxrep.oupjournals.org/cgi/content/abstract/20/4/555?ijkey=679yLm2oeJY6Y&keytype=ref

Portfolio Diversification in Europe, with Kpate Adjaouté and Dušan Isakov, chapter 5 in The Internationalisation of Asset Ownership in Europe, H. Huizinga and L. Jonung, eds, Cambridge U. Press, pp. 140-172, 2005

April 2003

Abstract

Have the euro and accompanying measures of financial integration had a discernable impacton the degree of diversification of European investors? This is an empirical question that this paper tries to answer by exploring four alternative avenues. First we focus on the final outcome: If European investors are indeed better diversified, their consumption should be increasingly correlated. Second we check more directly what is known about the composition of Europeans’ portfolios. A third perspective focuses on the evolution of returns and prices. If indeed European investors are attempting to exploit new arbitrage opportunities opened up by the euro and European financial integration, then it is likely that these behavioral changes will be matched by significant changes in returns or in the nature of the return generating process. Finally, we explore the possibility that the answer to our question may be better revealed by examining the changes that have taken place in the investment process itself.

On the Consequences of State Dependent Preferences for the Pricing of Financial Assets, with John. B. Donaldson, Christos Giannikos and Hany Guirguis, Finance Research Letters , vol.1, 3, September 2004, pp.143-153

Abstract

This paper introduces state dependent utility into the standard Mehra and Prescott (1985) economy by allowing the representative agent's coefficient of relative risk aversion to vary with the underlying economy's growth rate. Existence of equilibrium is proved and its asymptotic properties analyzed. This generalization leads to level dependent marginal rates of substitution, a property that sharply distinguishes this model from the standard construct. For very low coefficients of relative risk aversion, the equilibrium risk free and risky security returns are demonstrated to have volatilities and an associated equity premium that substantially exceed what is found in the data. This provides a contrasting perspective on the classic "equity premium puzzle."

Portfolio Diversification: Alive and Well in Euroland, with Kpate Adjaouté, Applied Financial Economics, vol. 14, 1225-1231, November 2004

Abstract.

Diversification opportunities in Euroland appear to have improved significantly since the advent of the euro, thus invalidating the prospects identified in the last years of the convergence-to-EMU period. We identify low frequency movements in the time series of return dispersions suggestive of cycles and long swings in return correlations. The most recent post-euro period is clearly associated with an important upswing with return dispersions exceeding for the first time their peaks of the early nineties.

Fair Wages in a New Keynesian Model of the Business Cycle, with André Kurmann, Review of Economic Dynamics, 7, pp. 107-142, 2004.

Abstract

We build a New Keynesian model of the business cycle with sticky prices and real wage rigidities motivated by e.ciency wages of the gift exchange variety. Compared to a standard sticky price model, our Fair Wage model provides an explanation for structural employment and generates more plausible labor market dynamics — notably accounting for the low correlation between wages and employment. The fair wage induced real wage rigidity also significantly reduces the elasticity of marginal cost with respect to output. The smoother dynamics of real marginal cost increase both amplification and persistence of output responses to monetary shocks, thus remedying the well-known lack of internal propagation of standard sticky price models. We take these improvements as a strong endorsement of the addition of real wage rigidities to nominal price rigidities and conclude that the fair wage extension of this paper constitutes a promising platform for an enriched New Keynesian synthesis.

European Financial Integration and Equity Returns: A Theory-Based Assessment, with Kpate Adjaouté, in V. Gaspar, P. Hartmann and O. Sleijpen (Eds.), The Transformation of the European Financial System, Chapter 5, pp. 185-245, 2003.

Abstract

This paper reassesses, at the light of economic and financial theory, the well documented recent evolution of the euro area public debt and equity markets. Doing so leads to associating the EMU and the single market with the changes in fundamentals and financial integration with convergence in pricing. For the public debt market, we stress the observation, conform with predictions, that risk free interest rates are now less volatile in the euro area. But also the fact that the establishment of a single public debt market is still not completed. The current fragmentation is costly to Treasuries and tax payers and understanding its cause is important to evaluate the prospects of currently considered measures of financial integration.

Theory predicted that the single currency would have a minor impact on equity markets since the currency component in euro area equity returns has historically been small. That the asset management industry has undergone a paradigmatic change, moving from a top-down country-based allocation to a top-down global sector-based allocation, is a puzzle in this light. A careful examination of the changing relative importance of country and industry factors for equity returns provides some weak rationale for the change in paradigm. A more complete assessment of the evolving nature of equity returns in terms of portfolio efficiency strengthens this evidence.

A Note on NNS Models: Introducing Physical Capital; Avoiding Rationing, with John B. Donaldson, Economic Letters, 77, pp. 433-437, 2002.

Abstract

This note makes two comments on recent NNS models. First, it disputes the way physical capital has been introduced into these models arguing that this leads to the dubious postulate that the cost of adjusting physical capital stock is an order of magnitude lower than the cost of changing prices. Second it warns against a possible logical inconsistency whereby calibrated NNS models are implicitly assuming that some (price-constrained) firms are willing and able to sell their output below cost.

Labor Relations and Asset Pricing, with John B. Donaldson, Review of Economic Studies, 69, pp. 41-64, 2002.

Abstract

This paper studies a dynamic GE model with risk sharing labor contracts. Workers with restricted access to financial markets are insured by firms. While these contracts are optimal given the bargaining power of firm owners and workers, we interpret fluctuations in income shares as reflective of variations in the relative bargaining power of both parties. These variations constitute a persistent, idiosyncratic source of risk which cannot be insured against in our incomplete market framework. In this economy, only the consumption of firm owners determines the pricing kernel. These features lead to a significant increase in the equity premium and in the volatility of asset returns even in the case where firms adopt a dividend smoothing payout policy.

The Effect of EMU on Financial Markets : A First Assessment, with F. Giavazzi and E.-L. von Thadden, to appear in C. Wyplosz, ed. EMU: Its Impact on Europe and the World, Oxford University Press, 2001

Abstract

This paper reviews the first evidence on the impact of European Monetary Union on European capital markets, one year after the launch of the single currency. Our assessment of this evidence is very favourable. On almost all counts EMU has either changed the European financial landscape already drastically or has the potential to do so in the future. We argue that this is less due to the well-known direct effects of EMU, such as the elimination of intra-European currency risk, than to a number of indirect consequences through feedback mechanisms that seem to have been triggered by EMU.

Banking : Is Bigger Really Better, in Z. Mikdashi ed., Financial Intermediation in the 21st Century, Palgrave, 2001.

Abstract

On both sides of the Atlantic, the banking industry has been undergoing two decades of spectacular transformations and the consolidation process does not seem to slow down, in Europe in particular, as we enter the 21st century. For academics, sceptical by profession, the trend towards ever bigger banking institutions is puzzling as they do not find in their studies confirmation of the rhetoric adopted by practitioners and consultants to justify their actions or rationalise their strategies. In this note we review arguments and counter-arguments.

Macroeconomic Frictions : What have we learned from the Real Business Cycle research programme ? with John B. Donaldson, in J. Drèze, ed. Advances in Macroeconomic Theory, Palgrave, 2001.

Abstract

One interpretation of the RBC research program is that it was meant to identify and incorporate into dynamic general equilibrium models those market imperfections which are most relevant for macroeconomic theory and policy. This paper reviews the methodological basis for this interpretation. It then discusses the empirical foundations for some of the many frictions that have found their way into RBC models including efficiency wages, labour contracts, nominal price rigidities, limited market participation, imperfect competition and expectational errors. We find that the ‘necessity’ of these frictions is better established in some cases than in others. While one is lead to the prediction that the ‘next neo-classical synthesis’ will be a dynamic stochastic general equilibrium with frictions, it is premature to decide which specific friction will necessarily be taken on board.

The Future of European Banking, Euro, N° 49, IV, pp3-6, 1999

The Future of European Banking, with F. Giavazzi, X. Vives and E.L. von Thadden, Monitoring European Integration 9, CEPR, London, 1999

Executive Summary

A la poursuite du Graal : le successeur d'IS-LM est-il identifié ? L'Actualité économique, Revue d'analyse économique, 74, 4, pp.607-620, décembre 1998

Résumé

On commence à deviner les contours du successeur de IS-LM; la démarche à suivre comme la nature de l'objectif à atteindre sont aujourd'hui relativement claires. A l'aide de trois expériences spécifiques, on déduit quelques-uns des ingrédients susceptibles de faire partie de la nouvelle synthèse néo-classique. Au bout du compte, il apparaît que seule notre connaissance imparfaite de quelques faits stylisés essentiels nous tient éloigné d'un nouveau consensus.

Abstract

The profile of the successor to the IS-LM model starts to emerge; the identifying process and the nature of the objective one is groping for are now relatively clear. With the help of three specific experiments, a few of the likely ingredients of the new neo-classical synthesis are derived. In the end, it appears that only our imperfect knowledge of some key empirical facts keeps us away from a new consensus.

Comment on "Business Cycle: Theory, Evidence and Policy Implications", Scandinavian Journal of Economics, 100, 1, 239-242, 1998, reprinted in Public Policy and Economic Theory, T.M. Andersen and K.O Moene editors, Blackwell Publishers 1998

Front-running by Mutual Fund Managers: A Mixed Bag, with Serge Moresi, European Finance Review, vol. 2, pp. 29-56, 1998

Abstract

This paper evaluates the welfare implications of front-running by mutual fund managers. It extends the model of Kyle (1985) to a situation in which the insider with fundamentals-information competes against an insider with trade-information and in which noise trading is endogenized. Noise traders are small investors trading through mutual funds to hedge non-tradable or illiquid assets. The insider with trade-information is one of the fund managers. We find that her front-running activity reduces the liquidity costs of her customers, but it also reduces their hedging benefits. As a result, the customers of the front-running manager may be worse off and place smaller orders. The opposite is true, however, for those investors who are not subject to front-running. In aggregate, front-running has either no or positive consequences for welfare.

Productivity Growth, Consumer Confidence and the Business Cycle, with John B. Donaldson and Thore Johnsen, European Economic Review, 42, 1113-1140, 1998

Executive Summary

Abstract

The objective of this paper is to provide, in the context of a dynamic general equilibrium model, an answer to the following five questions:

1. To what extent does an economy subject to regular variations in labor productivity growth differ from one where labor productivity is constant?

2.What is the impact on major macro indicators of a one-time change in labor productivity growth?

3. What are the business cycle implications of autonomous (non-falsifiable) changes in growth expectations?

4. What is the potential of such expectation changes for explaining the volatility of consumption to output ratio?

5. Can autonomous changes in growth expectations help us understand recent business cycle episodes?

Non Falsified Expectations and Asset Pricing: the Power of the Peso, with John B. Donaldson, mimeo, October 1997, forthcoming in The Economic Journal

Executive Summary

Abstract

To what extent can the expectation of a rare event, which happens not to materialise over the sample period but which is not rationally excludable - the peso problem -, affect the behaviour of rational agents and the characteristics of market equilibrium? We analyse a standard equilibrium business cycle model modified to allow for a very small probability of a depression state. We produce a reasonable model specification for which both business cycle characteristics and mean financial returns are in accord with United States observations. The 6.2% premium is obtained in an economy where agents are only moderately risk averse and where there are no frictions.

In Search of a Successor to IS-LM, Oxford Review of Economic Policy, 13, 3, 135-144, 1997

Abstract

After discussing the general characteristics that the successor to IS-LM should possess, this article argues that the business cycle research programme initiated by Kydland and Prescott (1992) is beginning to show a promising capacity to incorporate a broad range of modelling features into a logically consistent and theoretically satisfactory framework. This ability and the systematic process of model enrichment it permits make it possible to predict that the dynamic general equilibrium models developed around the neoclassical stochastic growth model-but possibly evolving towards friction-prone non-Walrasian models-will become the platform for a new neoclassical synthesis.

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