Highlights 2016

WP 16/15

Recent literature on wealth inequality has emphasized that the heterogeneity and the persistence of individual returns on financial and physical assets can potentially explain both the observed skewness of wealth distribution and the rapid increases in wealth inequality. Yet the evidence on the empirical properties of individual returns to wealth is still very scant mainly due to data limitations. In “Heterogeneity and Persistence in Returns to Wealth” Luigi Guiso, with Andreas Fagereng, Davide Malacrino and Luigi Pistaferri, provide a systematic analysis of individual returns to wealth using twenty years of population data from Norway’s administrative tax records. Their study presents a number of novel and interesting results. Firstly, in a given cross-section, individuals earn markedly different returns on their assets. Secondly, heterogeneity in returns does not arise merely from differences in the allocation of wealth between safe and risky assets: returns are heterogeneous even within asset classes. Thirdly, returns are positively correlated with wealth. Fourthly, returns have an individual permanent component that accounts for almost 60% of the explained variation. Fifthly, for wealth below the 95th percentile, the correlation between average returns and wealth rank is largely due to the individual permanent component; for wealth above the 95th, the correlation is largely driven by compensation for higher risk exposure among the wealthy, with a small role played by the individual permanent component. Finally, the latter is also (mildly) correlated across generations. The authors discuss how and to what extent their findings are relevant for several strands of the wealth inequality debate.

WP 16/14

In “ESBies: Safety in the tranches“, Marco Pagano and other economists explain that the euro crisis was fueled by the diabolic loop between sovereign risk and bank risk, coupled with cross-border flight-to safety capital flows and claim that European Safe Bonds (ESBies), a union –wide safe asset without joint liabilities, would help to solve these problems. Their paper makes three contributions: firstly, by means of numerical simulations, it shows that ESBies would be at least as safe as German bunds and approximately double the supply of euro safe assets when protected by a 30%-thick junior tranche; secondly, it shows how, when and why the two features of ESBies – diversification and seniority – can weaken the diabolic loop and its diffusion across countries; finally, it proposes a step-by-step guide on how to create ESBies, starting with limited issuance by public or private-sector entities.

WP 16/13

In “Bank Exposures and Sovereign Stress Transmission“, Marco Pagano, with Carlo Altavilla and Saverio Simonelli, make use of novel monthly data for 226 euro-area banks from 2007 to 2015 to address three questions: (i) Did banks with different characteristics change their public debt holdings differently in response to sovereign stress? (ii) Were larger sovereign exposures associated with more forceful transmission of sovereign stress to bank risk and lending policies? (iii) Can this association be interpreted as causal? The empirical analysis highlights the following results. Firstly, in stressed euro-area countries, publicly owned and less capitalized banks reacted to sovereign stress by increasing their holdings of domestic governments bonds more than other banks, which suggests that portfolio choices were influenced both by government moral suasion and by the search for yield. Domestic sovereign debt purchases by public banks in stressed countries were also facilitated by the ECB’s 3-year refinancing operations of 2011-12. Secondly, banks’ domestic sovereign exposure in stressed countries was indeed associated with a sizeable and statistically significant amplification of sovereign risk transmission and of its impact on lending. Thirdly, this amplification effect cannot be ascribed to spurious correlation or reverse causality.

WP 16/12

In “Are They All Like Bill, Mark, and Steve? The Education Premium for Entrepreneurs“, Claudio Michelacci and Fabiano Schivardi make use of the Survey of Consumer Finances to collect evidence on the return to education of US entrepreneurs over the period 1989-2013. They calculate the yearly income that an entrepreneur expects to obtain during his entrepreneurial venture summing up labor income, dividend payments, and realized capital gains upon selling the business. They find that the premium of having a college degree compared to a high school degree has increased, but roughly as much as the analogous premium for workers. Instead, the premium for postgraduate education compared to college education has increased substantially more for entrepreneurs than for workers. Today an entrepreneur with a postgraduate degree earns on average 100,000 dollars more per year (at constant 2010 prices) than an entrepreneur with a college degree. In the late 80’s, the same difference was close to zero. All this suggests that the more advanced skills associated with higher education have become increasingly important for the more recent generations of US entrepreneurs and that the experience of “Mark, Bill and Steve” was the exception rather than the rule.

WP 16/11

In “Public Debt and Private Firm Funding: Evidence from Chinese Cities“, Marco Pagano, with Yi Huang and Ugo Panizza, claim that in China local public debt issuance between 2006 and 2013 crowded out investment by private manufacturing firms by tightening their funding constraints, while it did not affect state-owned and foreign firms. Using novel data for local public debt issuance, they show firstly that local public debt is inversely correlated with the city-level investment ratio of domestic private manufacturing firms. Instrumental variable regressions indicate that this link is causal. Secondly, they find that local public debt has a larger negative effect on investment by private firms in industries more dependent on external funding. Finally, in cities with high government debt, firm-level investment is more sensitive to internal funding, also when this sensitivity is estimated jointly with the firm’s likelihood of being credit-constrained. Altogether, these results suggest that the massive public debt issuance associated with the post-2008 fiscal stimulus curtailed private investment thus weakening China’s long-term growth prospects.

WP 16/10

In “Are State and Time dependent models really different?“, Francesco Lippi and Juan Passadore, with Fernando Alvarez, analyze to what extent “state dependent” models and “time dependent” models of sticky prices generate different real effects in response to monetary policy shocks. They show analytically that in a broad class of models the propagation of the monetary impulse is independent of the nature of the sticky price friction when shocks are small. Instead, the propagation of large shocks depends on the nature of the friction: in time dependent models the impulse response of inflation to monetary shocks is independent of the shock size, while in state dependent models it is non-linear. Using data on exchange rate devaluations and inflation for a panel of countries over 1974-2014 the authors present some evidence of a non-linear effect of exchange rate changes on prices in a sample of flexible-exchange rate countries with low inflation, thus giving support to the presence of state dependent price frictions.

WP 16/09

Transitory price changes, namely short lived deviations from a reference price level, are prominent in the data but do not fit neatly in standard sticky price models. In “Price plans and the real effects of monetary policy“, Francesco Lippi, with Fernando Alvarez, analyze a sticky price model where a firm chooses a price plan, namely a set of two prices. Changing the plan entails a “menu cost”, but either price in the plan can be changed at any point in time. The authors analytically solve for the optimal policy and for the output response to a monetary shock. The setup generates a persistent reference price level and short lived deviations from it, as well as a decreasing hazard function for price changes, consistent with some datasets. The paper shows that the temporary price changes substantially increase the flexibility of the aggregate price level.

WP 16/08

In “The real effects of monetary shocks in sticky price models: a sufficient statistic approach”, Francesco Lippi, with Fernando Alvarez and Hervé Le Bihan, develop an analytical model that is able to match the cross sectional patterns on the frequency, variance and kurtosis of price changes, for small values of the (menu) cost of price adjustment. The model nests several classic models of price setting (such as Taylor (1980), Calvo (1983) and Golosov and Lucas (2007)) and sheds new light on the propagation of monetary shocks. The main finding is that the real cumulative output effect of a small unexpected monetary shock is proportional to the kurtosis of the size-distribution of price changes. The sizeable differences of output responses produced by previous models can be largely explained in terms of their different predictions for the kurtosis of price changes.

WP 16/07

In: “Dynamic Factor Models with Infinite-Dimensional Factor Space: Asymptotic Analysis“, Marco Lippi, with Mario Forni, Marc Hallin and Paolo Zaffaroni, derive the asymptotic properties of a semiparametric estimator of the loadings and common shocks based on one-sided filters. Consistency and exact rates of convergence are obtained for this estimator, under a general class of Generalized Dynamic Factor Models which does not require a finite-dimensional factor space. A Monte Carlo experiment and an empirical exercise on US macroeconomic data corroborate those theoretical results and show the excellent performance of these estimators in out-of-sample forecasting.

WP 16/06

In “Memory and Markets” Sergei Kovbasyuk and Giancarlo Spagnolo notice that, though an increasing volume of past outcomes is being recorded and made publicly accessible, part of the information is erased from the public records after some time. They investigate to what extent deletion of public records affects long-term information and market outcomes in a dynamic market model with heterogeneous sellers whose quality can change over time and where buyers can leave positive or negative feedback on sellers. The authors find that when average seller quality is low, so that buyers would not be willing to trade with no information at all on sellers, a perfect, infinite memory of past records leads to a market breakdown. They also find that in the same market configuration with limited records, stationary equilibria with trade are sustainable in the long run if the memory of positive records is short and the memory of negative ones is long.

WP 16/05

In “Politics in the Family. Nepotism and the Hiring Decisions of Italian Firms” Stefano Gagliarducci, with Marco Manacorda, estimate the effects of family connections to public officials on individuals’ labor market outcomes in Italy. Although there is plenty of anecdotal evidence on practices of favoritism in hiring and promotion of public officials’ relatives, sound empirical evidence is still missing by and large. By exploiting the unique piece of information available in two Italian databases, the authors are able to match public officials and workers based on similar last names and place of birth and to identify relatively small groups of individuals, hence offering the possibility to identify, although imprecisely, family connections. They estimate that the monetary return to having a politician in the family is in the order of 3.5 per cent of private sector earnings per year and that each politician is able to extract rent for his family worth between one fourth and one full private sector job per year. Moreover, the effect of nepotism is long lasting, extending well beyond the period in office.

WP 16/04

In “Short-Selling Bans and Bank Stability” Marco Pagano, with Alessandro Beber and Daniela Fabbri, test the effectiveness of bans on short sales imposed by regulators in both the 2008-09 subprime crisis and in the 2011-12 euro debt crisis to avoid that a collapse in a bank’s stock price could lead to funding problems, triggering further price drops, hence undermining bank stability. To this aim, they estimate panel data regressions for 13,473 stocks in 2008 and 16,424 stocks in 2011 in 25 countries, taking the endogeneity of short-selling bans into account. The results show that, contrary to the regulators’ intentions, in neither crisis the bans were associated with increased bank stability. Instead, when financial institutions were subjected to a short-selling ban, they displayed larger share price drops, greater return volatility and higher probability of default. And the effects were more pronounced for the more vulnerable banks. Nor did the ban in 2011 do anything to mitigate the “diabolic loop” between bank and sovereign insolvency risk during the euro-area sovereign debt crisis.

WP 16/03

In “The Sovereign-Bank Diabolic Loop and ESBies” Marco Pagano and other economists present a simple model to analyze the feedback loop between sovereign and bank solvency risk and to explore whether and how this loop can be defused by restricting banks’ portfolio of sovereign holdings. Firstly, they show that what matters is the ratio of banks’ equity to their domestic sovereign exposure: the diabolic loop can equivalently be defused by raising banks’ equity requirements or by restricting their holdings of domestic sovereign debt. Secondly, restricting banks to hold only a senior tranche of domestic sovereign debt is more effective than requiring them to diversify their sovereign portfolios across countries. Thirdly, requiring banks to hold only the senior tranche of an internationally diversified sovereign portfolio (ESBies in the euro-area context ) turns out to be even more effective. The authors also show that ESBies generate a larger amount of risk-free assets relative to a situation where banks are restricted to hold senior domestic sovereign debt only. Finally, it is shown that, insofar as the diabolic loop is defused, in equilibrium even the junior tranche of ESBies is itself risk-free.

WP 16/02

In “Back to Background Risk?” Luigi Guiso, with Andreas Fagereng and Luigi Pistaferri, address the following question: how important is background labor income risk for individuals’ portfolio allocations? To answer this question they assemble a rich administrative data set from Norway that allows them to overcome the identification problems that plague most of the empirical work on this issue. Their results are quite striking. First, ignoring the endogeneity of wage variability but accounting for unobserved heterogeneity, they reproduce the small marginal effect of background labor income risk on portfolio allocation to risky assets that characterizes the empirical literature so far. However, when instrumenting earning variability with the firm-variation component of background risk, the authors find that the marginal effect is an order of magnitude larger. This suggests a large downward bias in the prevailing estimates of the effect of background risk and, in principle, a potentially more important role for human capital risk in explaining household portfolio decisions. However, while the sensitivity to backward wage risk is rather large, its overall effect on portfolio decisions is limited because its size is small. And the size of background risk is small because firms provide substantial wage insurance.

WP 16/01

In “Heterogeneity in Returns to Wealth and the Measurement of Wealth Inequality” Luigi Guiso, with Andreas Fagereng, Davide Malacrino and Luigi Pistaferri, analyze the effect of heterogeneity in asset returns and of their correlation with the level of wealth on the discrepancies between measures of inequality based on actual wealth and those based on imputed measures of wealth obtained from capitalized income (where income is obtained from tax records). Using administrative Norwegian data, which have the unique feature of reporting both income from capital and actual wealth holdings for the whole population, the authors show that measures of wealth based on the capitalization approach can lead to misleading conclusions about the level and the dynamics of wealth inequality if returns are heterogeneous across households and even moderately correlated with wealth.

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