Working Papers

We present a model of cash constrained entrepreneurs who raise money from banks and from dispersed uninformed creditors. There is a moral hazard problem, which can be partially overcome through bank monitoring. However, monitoring is only effective if the bank can commit ex ante to liquidate after a poor signal. We show that this is possible only if the continuation value of a poorly performing firm is reduced for the bank by anticipated violation of the Absolute Priority Rule (APR) in favour of junior creditors. Two classes of creditors with APR violation therefore constitutes an optimal capital structure.

Reference: 2004-FE-06

Authors: Teresa da Silva Lopes

Feb 2004

This paper considers aspects of the evolution of ownership and control in global industries from 1960. The existing literature usually uses the largest firms in industrialized countries, to provide generalizations about national systems of corporate governance. In practice, this characterization is far from being comprehensive. For example, global industries which are not dominant in countries’ economies – such as alcoholic beverages – are overlooked. Including such overlooked cases, this study suggests that there is a broader range of combinations of ownership and control of firms than is usually considered. Regardless of national systems of corporate governance, family ownership may remain very important in some industries. Industry-specific factors, such as brands and marketing knowledge in alcoholic beverages, help explain why the predominant ownership and control structures of global firms are distinct from those that characterize their countries of origin.

Reference: 053

Individual View

Authors: Valerie Lechene, Jerome Adda, University College London and IFS

Feb 2004

This paper considers the identification of the effect of tobacco on mortality. If individuals select into smoking according to some unobserved health characteristic, then estimates of the effect of tobacco on health that do not account for this are biased. We show that using information on mortality, morbidity and smoking, it is possible to control for this selection effect and obtain consistent estimates of the effect of smoking on mortality. We implement our method on Swedish data. We show that there is selection into smoking, and considerable dispersion around the average effect, so that health policies that aim at decreasing smoking prevalence and quantities smoked might have less effect in terms of average number of years of life gained than previously estimated. We also empirically show that selection into smoking has increased over the last fifty years with the availability of information on the dangers of smoking, so that future studies comparing smokers and nonsmokers will spuriously reveal a worsening effect of tobacco on health if they fail to control for selection.

JEL Codes: I12

Keywords: Health, Duration, Smoking, Selection, Mortality, Life Expectancy, Causality

Reference: 184

Individual View

Authors: Oren Sussman, Javier Suarez

Jan 2004

This paper explores the business cycle implications of financial distress and bankruptcy law. We find that due to the presence of financial imperfections the effect of liquidations on the price of capital goods can generate endogenous fluctuations. We show that a law reform that ‘softens’ bankruptcy law may increase the amplitude of the cycle in the long run. In contrast, a policy of bailing out businesses during the bust, or actively managing the interest rate across the cycle, could stabilize the economy in the long run. A comprehensive welfare analysis of the policy is provided as well.

JEL Codes: E32, E44, G33

Keywords: bankruptcy law, business cycles, financial distress

Reference: 2004-FE-07

Authors: Richard Mash

Jan 2004

Much recent monetary policy literature has searched for structural models suitable for policy analysis that are both based on optimising microfoundations and consistent with the data, especially observed persistence in inflation and output. Few models do well on both criteria. We derive an optimising model of the Phillips curve based on a generalised time dependent pricing rule, calibrate it using microeconomic evidence on price changing behaviour and simulate it with a standard discretionary policy maker. The model predicts inflation and output persistence comparable to that observed without reliance on rule of thumb behaviour or serially correlated shock processes.

JEL Codes: E52, E58, E22

Keywords: Monetary Policy, Phillips Curve, Inflation Persistence, Microfoundations

Reference: 183

Individual View

Authors: Jorg Scheibe

Dec 2003

We estimate potential GDP for China comparing univariate and multivariate methods and derive a quarterly output gap series. For the multivariate, production function based estimates we employ aggregate data and data on five economic subsectors. We estimate production functions in levels as well as an EqCM specification, which we argue is better suited for identifying the long-run share of capital and labour in production. Our output gap estimates improve on earlier work which has so far been used in the emerging literature on macro-modelling of the Chinese economy. Drawing on the literature on Chinese economic growth, productivity measurement, and capital stock construction, we find that across a range of reasonable assumptions for capital and labour data specifications the output gap estimates remain correlated and robust. All our methods show that at the end of 2002 China is entering a period of economic upswing, but the current level of the output gap is much below the previous peaks in 1988/9 and 1994/5.

JEL Codes: E32, O47, O53

Keywords: output gap, growth regressions, EqCM specification of production function, Chinese capital stock data

Reference: 179

Individual View

Authors: Marcel Fafchamps, Klaus Desmet, Universidad Carlos III de Madrid and CEPR

Dec 2003

This paper examines the spatial distribution of jobs across US counties and investigates whether sectoral employment is becoming more or less concentrated. The existing literature has found deconcentration (convergence) of employment across urban areas. Cities only cover a small part of the US, though. Using county data, our results indicate that deconcentration is limited to the upper tail of the distribution. The overall picture is one of increasing concentration (divergence). While this seemingly contradicts the well documented deconcentration in manufacturing, we show that these aggregate employment dynamics are driven by services. Non-service sectors - such as manufacturing and farming - are indeed becoming more equally spread across space, but services are becoming increasingly concentrated.

JEL Codes: R11, R12, O51

Keywords: Spatial Distribution, Convergence, Sectoral Employment, US Counties

Reference: 180

Individual View

Authors: Sujit Kapadia

Dec 2003

By assuming Cobb-Douglas production technology, many well-known imperfectly competitive macroeconomic models of the labour market (e.g. Layard, Nickell and Jackman, 1991) imply that equilibrium unemployment is independent of the capital stock. This paper introduces a new notion of capacity into the standard framework. Specifically, we adapt the Cobb-Douglas production function so that when the capital-labour ratio drops below a certain threshold, the returns to labour fall while the returns to capital increase. Using this assumption, we show that equilibrium unemployment depends on the capital stock over a certain range. We also briefly discuss the generalisation for an endogenous capital stock.

JEL Codes: E22, E23, E24, E25, J64.

Keywords: Unemployment, Capital Stock, Investment, Capacity, Technology.

Reference: 181

Individual View

Authors: Valpy Fitzgerald, Pablo Astorga, Ame R. Bergés

Dec 2003

Analysis of new comparable series on output and employment between 1900 and 2000 for Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela indicates that productivity growth was significantly higher and less volatile during the middle decades of the century than in the opening and closing decades. The first estimate of total factor productivity (TFP) growth for Latin America during the twentieth century as a whole, derived from the residuals of a skill-augmented production function, indicates that unembodied technical progress was low and that the accumulation of fixed and human capital accounted for almost all recorded economic progress. Sectoral disaggregation suggests that this factor accumulation was associated with increased levels of capital per worker during industrialization on the one hand; and with both out-migration from agriculture and the lagged consequences of a demographic transition on the other. The relatively low rates of human and physical capital accumulation in Latin America remain to be explained, although these are more likely to be associated with inadequate public provision of infrastructure and education than with the cycle of protection and liberalization as such.

JEL Codes: O1, O4, N3, N5, N6

Keywords: Aggregate Productivity and Growth, Agriculture, Manufacturing, Total Factor Productivity, Human Capital

Reference: 052

Individual View

Authors: Daniel John Zizzo

Dec 2003

This paper employs neurobehavioral and psychological evidence to argue that anger is an emotion arising from significant cognitive processing, one that, in relation to economic decision-making, may be subtly mediated by many factors (including intentions). Anger is an emotion implying a higher likelihood of a behavioral response directed against the object of anger. The medial and possibly other prefrontal cortex regions play an important role in anger processing, whereas the amygdala does not. Any eventual difficulty for rational choice may come more from the difficulty of understanding the cognitive underpinnings of anger than from understanding the emotional process itself.

JEL Codes: C91, D11.

Keywords: Anger, Emotions, Neuroeconomics, Rationality.

Reference: 182

Individual View

Authors: Peter Stemp, Ric D. Herbert, The University of Newcastle Callaghan, Australia.

Nov 2003

This paper investigates the success of the well-known reverse-shooting and forward-shooting algorithms in finding stable solutions for linear macroeconomic models that both possess the particular property known as saddle-path instabiity and also have highly cyclic dynamic properties. It is anticipated that assessing how well these algorithms cope with solving highly cyclic models will also provide insights into how well they are likely to cope with solving non-linear models. In this paper, a perfect foresight version of the well-known Cagan (1956) model of the monetary dynamics of hyperinflation is augmented with a labour market. Additional eignevalues are then generated through sluggish adjustment mechanisms for wages and for the supply of labour. This process provides the simplest model with stable complex-valued eigenvalues and a saddlepath: a model with two stable complex-valued eigenvalues and one unstable real-valued eigenvalue. Using this model, it is possible to define an indexing parameter that, when varied, determines a range of values for the stable eignvalues: from (i) real-valued, to (ii) complex-valued with small absolute imaginary part, to (iii) complex-valued with large absolute imaginary part. This leads to corresponding stable time-paths for the model, which are (i) either humped or monotonic, (ii) cyclic but with infrequent cycles, and (iii) cyclic but with frequent cycles. This paper then compares the properties of solutions derived using the reverse-shooting and forward-shooting approaches as the magnitude of the indexing parameter (and hence of the cycles) is allowed to vary. In the highly oscillatory case, we show that the success of both approaches is crucially dependent on the choice of ODE solver and of parameters.

JEL Codes: C63, E17.

Keywords: Macroeconomics, Complex-valued eigenvalues, Real-valued eigenvalues, Cyclic convergence, Monotonic convergence, Saddle-path instability, Computational techniques.

Reference: 178

Individual View

Authors: Neil Shephard, Ole Barndorff-Nielsen

Nov 2003

In this paper we provide an asymptotic distribution theory for some non-parametric tests of the hypothesis that asset prices have continuous sample paths. We study the behaviour of the tests using simulated data and see that certain versions of the tests have good finite sample behaviour. We also apply the tests to exchange rate data and show that the null of a continuous sample path is frequently rejected. Most of the jumps the statistics identify are associated with governmental macroeconomic announcements.

Keywords: Bipower variation, Jump process, Quadratic variation, Realised variance, Semimartingales, Stochastic volatility

Reference: 2004-FE-01

Authors: David P. Myatt, Chris Wallace

Nov 2003

Team formation will often involve a coordination problem. If no-one else is contributing to a team, there is little point in an agent exerting any effort. Similarly, once a team is formed, an agent within the team will not leave, as to do so would result in team collapse; non-contributing agents would not join, as they currently receive the benefits of the team`s efforts whilst paying none of the costs. The methods of the stochastic adjustment dynamics literature can help select between these equilibria. Team and population size, and cost and benefit parameters all play a role in determining the chances of successful team formation. Increasing the pool of agents from which to choose team members seems at first glance to have a positive impact upon team formation. However, just one bad apple within the extended pool can have a disproportionate effect on the outcome. Although an agent with high participation costs would never contribute to a successful team, their mere presence alone can result in the failure of an otherwise successful team.

JEL Codes: C72, C73, H41

Keywords: collective action, evolution, teamwork, equilibrium selection

Reference: 177

Individual View

Authors: David R. Stead

Oct 2003

This article scrutinises the claim that the residual claimant in English agriculture was the fixed-rent tenant farmer rather than the landlord. Examination of methods of agricultural insurance and risk management indicates that the income risks of farming were sizeable, not straightforward to manage, and largely borne by the tenant. Thus the farmer’s profit appears to have fluctuated by more over time and space than did the rent paid to the landlord. Attempts are made to assess changes over time in the nature and size of the production and price risks that farmers were exposed to.

Reference: 051

Individual View

Authors: Dimitrios P Tsomocos, Charles A.E. Goodhart, Pojanart Sunirand

Oct 2003

Our purpose in this paper is to produce a tractable model which illuminates problems relating to individual bank behaviour and risk-taking, to possible contagious inter-relationships between banks, and to the appropriate design of prudential requirements and incentives to limit `excessive` risk-taking. Our model is rich enough to include heterogenous agents (commercial banks and investors), endogenous default, and multiple commodity, and credit and deposit markets. Yet, it is simple enough to be effectively computable. Financial fragility emerges naturally as an equilibrium phenomenon. In our model a version of the liquidity trap can occur. Moreover, the Modigliani-Miller proposition fails either through frictions in the (nominal) financial system or through incentives, arising from the imposed capital requirements, for differential investment behaviour because of capital requirements. In addition, a non-trivial quantity theory of money is derived, liquidity and default premia co-determine interest rates, and both regulatory and monetary policies have non-neutral effects. The model also indicates how monetary policy may affect financial fragility, thus highlighting the trade-off between financial stability.

Reference: 2003-FE-13

Authors: Richard Mash

Oct 2003

We analyse the derivation of optimal monetary policy under discretion and commitment when lagged expectations appear in the Phillips curve, making use of the comparatively simple MSV approach which does not require transformation of the model into state-space form.

JEL Codes: C61, E52, E58.

Keywords: Monetary Policy, Rational Expectations, Solution Methods, Minimal State Variable, Undetermined Coefficients.

Reference: 173

Individual View

Authors: Richard Mash

Oct 2003

We analyze the microfoundations of the Phillips curve and the close links between that relationship and results concerning optimal monetary policy, stabilisation bias and monetary policy delegation. Most recent literature has used a New Keynesian Phillips Curve based on Calvo pricing, often with an additional lagged inflation term motivated by rule-of-thumb behaviour. We develop a framework which encompasses this workhorse model while allowing for a richer time dependent pricing rule. This permits a more general analysis while showing that the standard model and policy conclusions derived from it are not robust to relatively minor changes in its microfoundations.

JEL Codes: E52, E58, E22, C61

Keywords: monetary policy, New Keynesian Phillips Curve, Calvo pricing, rule of thumb, stabilisation bias, Monetary Policy Delegation

Reference: 174

Individual View

Authors: Dieter Helm,Cameron Hepburn,Richard Mash

Oct 2003

Time consistency problems can arise when environmental taxes are employed to encourage firms to take irreversible abatement decisions. Setting a high carbon tax, for instance, would induce firms to invest in low-carbon technology, yet once investment has occurred the government can then reduce the carbon tax to better achieve other objectives; lower energy prices, redistribution, and electoral success. The resulting time inconsistency discourages firms from investing in the first place. We propose an institutional solution to this problem, adapted from the monetary policy literature; the commitment outcome can be achieved through delegation to an `environmental policymaker`, akin to a conservative central banker.

JEL Codes: E52, E61, Q43, Q48

Keywords: Time Inconsistency, Environmental Taxation, Monetary Policy, Delegation

Reference: 175

Authors: Daniel John Zizzo, Jonathan H.W. Tan, Institute of Microeconomics, European University Viadrina

Oct 2003

Game harmony is a generic game property describing how conflictual or non-conflictual the interests of players are. Simple and general game harmony measures can predict mean cooperation in 2 x 2 games such as the Prisoner`s Dilemma, the Chicken and trust games. Two measures can be simply computed from monetary payoffs; another, the similarity index, can also be justified by theories of similarity-based reasoning. When data from Oxford and Frankfurt-Oder are disaggregated across experiments, countries and learning history, and when the similarity index is a valid measure, parsimonious regressions can explain around half of the variance in mean cooperation rates.

JEL Codes: C72, C91, H41

Keywords: game harmony, cooperation, similarity, 2 x 2 games, Prisoner`s Dilemma

Reference: 176

Individual View

Sometimes shareholders are better off delegating to a CEO with different objectives than their own. A top manager motivated to share surpluses with workers can encourage union members to adopt efficient production methods. Bond covenants may constrain managers from acquiescing to union wage demands. Nevertheless, we argue that unions can win higher wages by altering the non-shirking constraint. Resistance to monitoring leads to deadweight losses that a â€

JEL Codes: G32, G34, J41, J50

Keywords: efficiency wages, unions, bonds, takeovers, and CEO compensation

Reference: 2003-FE-12

Authors: James Malcomson

Sep 2003

Incentive contracts for gatekeepers who control patient access to specialist medical services provide too weak incentives to investigate cost further when expected cost of treatment is greater than benefit. Making gatekeepers residual claimants with a fixed fee from which treatment costs must be met (as with full insurers who are themselves gatekeepers) provides too strong incentives when expected cost is less than benefit. Giving patients the choice between a gatekeeper with an incentive contract and one without is unstable. With one scenario, patients always prefer the latter. With another, patients have incentives to acquire information that makes incentive contracts ineffective.

JEL Codes: I11, I18.

Keywords: Gatekeepers, Patient refererrals, General practitioners, Fundholding, Medical insurance, Incentive contracts.

Reference: 169

Authors: Colin Mayer, Julian Franks, Stefano Rossi

Sep 2003

While we associate the U.K. with a high level of investor protection, this was not the case in the first half of the twentieth century - U.K. capital markets were marked by an absence of investor protection and few common law rights for minorities. Notwithstanding this, securities markets flourished. There were a large number of listed firms, companies issued substantial amounts of equity and inside ownership diminished rapidly. Much of the equity issuance arose from share exchanges in mergers and acquisitions and these in turn were the main cause of dilution of inside ownership. They relied on informal relations of trust between directors and shareholders. When formal regulation (both statutory and self-regulation) was introduced in the second half of the century, it had no effect on equity issuance or dispersion. Instead, it was associated with a much higher level of trading of shares as reflected in membership of controlling coalitions of shareholders and in the emergence of a market for corporate control. These results cast doubt on the law and finance explanation of the development of financial markets and suggest that growth of equity and dispersion of ownership in the U.K. relied more on informal relations of trust than on formal systems of regulation.

JEL Codes: G32, G34

Keywords: ownership, investor protection, stock markets and trust

Reference: 2003-FE-14

Authors: Andrew Glyn, Dean Baker, Centre for Economic and Policy Research, Washington,David Howell, New School University, New York,John Schmitt

Aug 2003

This paper provides a critical view of the cross country literature on the impact of labour market institutions and policies on the evolving pattern of unemployment in OECD countries. Such widely used indicators as the generosity of unemployment insurance or the strength of trade unions are neither strongly correlated individually with unemployment nor contribute robust and well defined impacts on unemployment within increasingly sophisticated multivariate literature. Our own tests, with a comprehensive data set covering 1960-99, show how dependent the estimated effects are to the particular indicators used and periods covered and overall suggest that a relatively minor role for the institutions and policies in accounting for unemployment patterns.

JEL Codes: E24, J68

Keywords: Unemployment, institutions, OECD

Reference: 168

Individual View

Authors: Colin Mayer, Julian Franks, Stefano Rossi

Aug 2003

Family ownership was rapidly diluted in the twentieth century in Britain. Issuance of equity in the process of acquisitions was the main cause. In the first half of the century, it occurred in the absence of minority investor protection and relied on directors of target firms protecting the interests of shareholders. Families were able to retain control by occupying a disproportionate number of seats on the boards of firms. However, in the absence of large stakes, the rise of hostile takeovers and institutional shareholders made it increasingly difficult for families to maintain control without challenge. Potential targets attempted to protect themselves through dual class shares and strategic share blocks but these were dismantled in response to opposition by institutional shareholders and the London Stock Exchange. The result was a regulated market in corporate control and a capital market that looked very different from its European counterparts. Thus, while acquisitions facilitated the growth of family controlled firms in the first half of the century, they also diluted their ownership and ultimately their control in the second half.

JEL Codes: G32

Keywords: family ownership, control, takeovers

Reference: 2003-FE-15

Authors: Daniel John Zizzo

Jul 2003

Sharing a common fate with some people but not others may affect how economic agents behave within firms and organizations. Recognizing that many bilateral transactions occur both within and between groups sharing some degree of common fate, we present an experimental test of the effect of common fate in bargaining settings. Virtually all subjects differentiating between insiders and outsiders discriminate against outsiders. Within-group cooperation was not increased, but between-group conflict was. We also test, and find support for, theories of similarity-based decision-making. We develop and use a generally applicable technique to understand framing effects, based on identifying similarity attractors.

JEL Codes: C72, C78, C81, C91

Keywords: bargaining, common fate, similarity, framing effects

Reference: 167

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