Greenwood, Robin, Andrei Shleifer, and Yang You. Forthcoming. “Bubbles for Fama.” Journal of Financial Economics.Abstract
We evaluate Eugene Fama’s claim that stock prices do not exhibit price bubbles. Based on US industry returns 1926-2014 and international sector returns 1985-2014, we present four findings: (1) Fama is correct in that a sharp price increase of an industry portfolio does not, on average, predict unusually low returns going forward; (2) such sharp price increases predict a substantially heightened probability of a crash; (3) attributes of the price run-up, including volatility, turnover, issuance, and the price path of the run-up can all help forecast an eventual crash and future returns; and (4) some of these characteristics can help investors earn superior returns by timing the bubble. Results hold similarly in US and international samples.
We present a model of credit cycles arising from diagnostic expectations – a belief formation mechanism based on Kahneman and Tversky’s (1972) representativeness heuristic. In this formulation, when forming their beliefs agents overweight future outcomes that have become more likely in light of incoming data. The model reconciles extrapolation and neglect of risk in a unified framework. Diagnostic expectations are forward looking, and as such are immune to the Lucas critique and nest rational expectations as a special case. In our model of credit cycles, credit spreads are excessively volatile, over-react to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility
We present a model of investment hangover motivated by the Great Recession. Overbuilding of durable capital such as housing requires a reallocation of productive resources to other sectors, which is facilitated by a reduction in the interest rate. When monetary policy is constrained, overbuilding induces a demand-driven recession with limited reallocation and low output. Investment in other capital initially declines due to low demand, but it later booms and induces an asymmetric recovery in which the overbuilt sector is left behind. Welfare can be improved by expost policies that stimulate investment (including in overbuilt capital), and ex-ante policies that restrict investment.
Chinese housing prices rose by over 10 percent per year in real terms between 2003 and 2014, and are now between two and ten times higher than the construction cost of apartments. At the same time, Chinese developers built 100 billion square feet of residential real estate. This boom has been accompanied by a large increase in the number of vacant homes, held by both developers and households. This boom may turn out to be a housing bubble followed by a crash, yet that future is far from certain. The demand for real estate in China is so strong that current prices might be sustainable, especially given the sparse alternative investments for Chinese households, so long as the level of new supply is radically curtailed. Whether that happens depends on the policies of the Chinese government, which must weigh the benefits of price stability against the costs of restricting urban growth.
We present a model of stereotypes based on Kahneman and Tversky’s representativeness heuristic. A decision maker assesses a target group by overweighting its representative types, defined as the types that occur more frequently in that group than in a baseline reference group. Stereotypes formed this way contain a ‘‘kernel of truth’’: they are rooted in true differences between groups. Because stereotypes focus on differences, they cause belief distortions, particularly when groups are similar. Stereotypes are also context dependent: beliefs about a group depend on the characteristics of the reference group. In line with our predictions, beliefs in the lab about abstract groups and beliefs in the field about political groups are context dependent and distorted in the direction of representative types. JEL Codes: D03, D83, D84, C91.
We present a model of market competition in which consumers' attention is drawn to the products' most salient attributes. Firms compete for consumer attention via their choices of quality and price. Strategic positioning of a product affects how all other products are perceived. With this attention externality, depending on the cost of producing quality some markets exhibit “commoditized” price salient equilibria, while others exhibit “de-commoditized” quality salient equilibria. When the costs of quality change, innovation can lead to radical shifts in markets, as in the case of decommoditization of the coffee market by Starbucks. In the context of financial innovation, the model generates the phenomenon of “reaching for yield”.
Using micro data from Duke University quarterly survey of Chief Financial Officers, we show that corporate investment plans as well as actual investment are well explained by CFOs’ expectations of earnings growth. The information in expectations data is not subsumed by traditional variables, such as Tobin’s Q or discount rates. We also show that errors in CFO expectations of earnings growth are predictable from past earnings and other data, pointing to extrapolative structure of expectations and suggesting that expectations may not be rational. This evidence, like earlier findings in finance, points to the usefulness of data on actual expectations for understanding economic behavior.
We examine the business model of traditional commercial banks when they compete with shadow banks. While both types of intermediaries create safe “money-like” claims, they go about this in different ways. Traditional banks create money-like claims by holding illiquid fixed-income assets to maturity, and they rely on deposit insurance and costly equity capital to support this strategy. This strategy allows bank depositors to remain “sleepy”: they do not have to pay attention to transient fluctuations in the market value of bank assets. In contrast, shadow banks create money-like claims by giving their investors an early exit option requiring the rapid liquidation of assets. Thus, traditional banks have a stable source of funding, while shadow banks are subject to runs and fire-sale losses. In equilibrium, traditional banks have a comparative advantage at holding fixed-income assets that have only modest fundamental risk but are illiquid and have substantial transitory price volatility, whereas shadow banks tend to hold relatively liquid assets.
We present a new model of investors delegating portfolio management to professionals based on trust. Trust in the manager reduces an investor’s perception of the riskiness of a given investment, and allows managers to charge fees. Money managers compete for investor funds by setting fees, but because of trust, fees do not fall to costs. In equilibrium, fees are higher for assets with higher expected return, managers on average under perform the market net of fees, but investors nevertheless prefer to hire managers to investing on their own. When investors hold biased expectations, trust causes managers to pander to investor beliefs.
The 2014 John Bates Clark Medal of the American Economic Association was awarded to Matthew Gentzkow of the University of Chicago Booth School of Business. The citation recognized Matt’s “fundamental contributions to our understanding of the economic forces driving the creation of media products, the changing nature and role of media in the digital environment, and the effect of media on education and civic engagement.” In addition to his work on the media, Matt has made a number of significant contributions to empirical industrial organization more broadly, as well as to applied economic theory. In this essay, I highlight some of these contributions, which are listed on Table 1. I will be referring to these papers by their number on this list.
Matt earned both his AB in 1997, and, after a brief career in the theatre, his PhD in 2004 from Harvard, where he began to work on the media. At Harvard he also met Jesse Shapiro, his close friend and collaborator. I was one of Matt’s (as well as Jesse’s) thesis advisors. From Harvard, both Matt and Jesse moved to Chicago Booth School, where their research truly thrived and they contributed to a fantastic group of applied economists.
We present a model of judicial decision making in which the judge overweights the salient facts of the case. The context of the judicial decision, which is comparative by nature, shapes which aspects of the case stand out and draw the judge's attention. By focusing judicial attention on such salient aspects of the case, legally irrelevant information can aect judicial decisions. Our model accounts for a range of recent experimental evidence bearing on the psychology of judicial decisions, including anchoring eects in the setting of damages, decoy eects in choice of legal remedies, and framing eects in the decision to litigate. The model also oers a new approach to positive analysis of damage awards in torts.
Survey evidence suggests that many investors form beliefs about future stock market returns by extrapolating past returns. Such beliefs are hard to reconcile with existing models of the aggregate stock market. We study a consumption-based asset pricing model in which some investors form beliefs about future price changes in the stock market by extrapolating past price changes, while other investors hold fully rational beliefs. We find that the model captures many features of actual prices and returns; importantly, however, it is also consistent with the survey evidence on investor expectations.
Gary Becker, who died on 3 May 2014 at the age of 83, redefined economics both in its methodology and scope. He radically expanded the sphere of economic analysis. As the range of issues and especially data in economics increased over the last half century, Becker's approach became more and more relevant and modern. He was awarded the 1992 Nobel Prize in Economics for “having extended the domain of microeconomic analysis to a wide range of human behavior and interaction, including nonmarket behavior.”
We establish five facts about the informal economy in developing countries. First, it is huge, reaching about half of the total in the poorest countries. Second, it has extremely low productivity compared to the formal economy: informal firms are typically small, inefficient, and run by poorly educated entrepreneurs. Third, although avoidance of taxes and regulations is an important reason for informality, the productivity of informal firms is too low for them to thrive in the formal sector. Lowering registration costs neither brings many informal firms into the formal sector, nor unleashes economic growth. Fourth, the informal economy is largely disconnected from the formal economy. Informal firms rarely transition to formality, and continue their existence, often for years or even decades, without much growth or improvement. Fifth, as countries grow and develop, the informal economy eventually shrinks, and the formal economy comes to dominate economic life. These five facts are most consistent with dual models of informality and economic development.
We analyze time series of investor expectations of future stock market returns from six data sources between 1963 and 2011. The six measures of expectations are highly positively correlated with each other, as well as with past stock returns and with the level of the stock market. However, investor expectations are strongly negatively correlated with model-based expected returns. The evidence is not consistent with rational expectations representative investor models of returns.
We introduce the model of asset management developed in Gennaioli, Shleifer, and Vishny (GSV, 2014) into a Solow-style neoclassical growth model with diminishing returns to capital. Savers rely on trusted intermediaries to manage their wealth (claims on capital stock), who can charge fees above costs to trusting investors. In this model, the ratio of financial income to GDP increases with the ratio of aggregate wealth to GDP. Both rise along the convergence path to steady state growth. We examine several further implications of the model for management fees, unit costs of finance, and the consequences of shocks to trust and to the capital stock.
We use a newly assembled sample of 1,528 regions from 83 countries to compare the speed of per capita income convergence within and across countries. Regional growth is shaped by similar factors as national growth, such as geography and human capital. Regional convergence rate is about 2% per year, comparable to that between countries. Regional convergence is faster in richer countries, and countries with better capital markets. A calibration of a neoclassical growth model suggests that significant barriers to factor mobility within countries are needed to account for the evidence.