34 research outputs found
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Causes of the Financial Crisis: Many Responsible Parties
This analysis argues that blame for the financial crisis falls specifically and heavily on a broad range of the private players and public regulators in our financial sector. Wall Street and the government joined hands in a situation of contributory negligence. Even recognizing the triggering event of the collapse of the subprime market, a key question arises: How did a relatively small loss – 20 trillion? By contrast, the NASDAQ swoon of 2001-02, though entailing equal direct losses, had virtually no reverberating consequences. The novel aspect of this crisis was the tremendous inter-penetration of the various affected sectors, notably due to financial engineering. Assets were put in place that were both unfamiliar and opaque. This enabled Firm B’s shortfalls to become A’s losses, and similarly for Firm C’s impositions on B and hence A. This was a cascade of risk that A had not perceived. Such engineering, like nuclear weapons will be with us forever. Unfortunately, they are very difficult to regulate, since critical elements of secrecy provide some of their value, and creative new products are always around the corner. In the critical race between effective regulation and innovation, innovation will win at least some of the time. A modest proposal is made for a mechanism that will provide better information about the security of financial institutions and the financial system as a whole. It is also recommended that we have a financial intelligence agency, and that that agency bear no regulatory responsibilities lest it be subject to political pressures to shield its eyes or use rose-colored glasses
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The Methodology of Normative Policy Analysis
Policy analyses frequently clash. Their disagreements stem from many sources, including models, empirical estimates, and values such as who should have standing and how different criteria should be weighted. We provide a simple taxonomy of disagreement, identifying distinct categories within both the positive and values domains of normative policy analysis. Using disagreements in climate policy to illustrate, we demonstrate how illuminating the structure of disagreement helps to clarify the way forward. We conclude by suggesting a structure for policy analysis that can facilitate assessment, comparison, and debate by laying bare the most likely sources of disagreement
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Rank as an Incentive
Money is the prime incentive in economic models. Recent evidence makes it clear that people are also greatly concerned about how their incomes compare with those of others, suggesting that rank may be a strong motivator as well. Three experiments in Vietnam assessed whether students in real-world learning environments were concerned with their performance rankings. The results showed that concern with rank, even when rankings were not publicly revealed, strongly motivated performance on academic tests. Moreover, rank was able to outweigh money as a motivator
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The Trouble with Cases
For several decades now a debate has raged about policy-making by litigation. Spurred by the way in which tobacco, environmental, and other litigation has functioned as an alternative form of regulation, the debate asks whether policy-making or regulation by litigation is more or less socially desirable than more traditional policy-making by ex ante rule-making by legislatures or administrative agencies. In this paper we step into this debate, but not to come down on one side or another, all things considered. Rather, we seek to show that any form of regulation that is dominated by high-salience particular cases is highly likely to make necessarily general policy on the basis of unwarranted assumptions about the typicality of one or a few high-salience cases or events. Two cornerstone concepts of behavioral decision – the availability heuristic and related problems of representativeness – explain this bias. This problem is virtually inevitable in regulation by litigation, yet it is commonly found as well in ex ante rule-making, because such rule-making increasingly takes place in the wake of, and dominated by, particularly notorious and often unrepresentative outlier events. In weighing the net advantages of regulation by ex ante rule-making against those of regulation by litigation, society must recognize that any regulatory form is less effective insofar as it is unable to transcend the distorting effect of high-salience unrepresentative examples
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Overreaction to Fearsome Risks
Fearsome risks are those that stimulate strong emotional responses. Such risks, which usually involve high consequences, tend to have low probabilities, since life today is no longer nasty, brutish and short. In the face of a low-probability fearsome risk, people often exaggerate the benefits of preventive, risk-reducing, or ameliorative measures. In both personal life and politics, the result is damaging overreactions to risks. We offer evidence for the phenomenon of probability neglect, failing to distinguish between high and low-probability risks. Action bias is a likely result
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The Methodology of Positive Policy Analysis
Policy analyses frequently clash. Their disagreements stem from many sources, such as models, empirical estimates, values, who should have standing, and weighting of different criteria. We provide a simple taxonomy of disagreement, identifying distinct categories within both the positive and value domains. Using disagreements in climate policy to illustrate, we demonstrate how illuminating the structure of disagreement can help to clarify the way forward. We conclude by suggesting a structure for new policy analysis that can facilitate assessment, comparison, and debate by making clear the likely sources of disagreement
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The Behavior of Savings and Asset Prices When Preferences and Beliefs are Heterogeneous
Movements in asset prices are a major risk confronting individuals. This paper establishes new asset pricing results when agents differ in risk preference, time preference and/or expectations. It shows that risk tolerance is a critical concept driving savings decisions, consumption allocations, prices and return volatilities. Surprisingly, due to the equilibrium risk sharing, the precautionary savings motive in the aggregate can vastly exceed that of even the most prudent actual agent in the economy. Consequently, a low real interest rate, resulting from large aggregate savings, can prevail with reasonable risk aversions for all agents. One downside of a large aggregate savings motive is that savings rates become extremely sensitive to output fluctuation. Thus, the same mechanism that produces realistically low interest rates tends to make them unrealistically volatile. A powerful isomorphism allows differences in time preference and expectations to be swept away in the analysis, yielding an equivalent economy whose agents differ merely in risk aversion. These results hold great potential to simplify the analysis of heterogeneous-agent economies, as we demonstrate in quantifying how asset prices move and bounding their volatilities. All results are obtained in closed form for any number of agents possessing additively separable preferences in an endowment economy
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The CAPS Prediction System and Stock Market Returns
We analyze the informational content of more than 1.2 million stock picks provided by more than 60,000 individuals from November 1, 2006 to October 31, 2007 on the CAPS open access website created by the Motley Fool company (www.caps.fool.com). On average, an individual pick in CAPS outperformed the S&P 500 index by 4 percentage points in the twelve months after the pick. We use a four-factor regression framework to estimate the excess returns associated with portfolios that aggregate these picks; a portfolio of the most popular CAPS stocks yielded excess returns of more than 18 percentage points annually relative to the portfolio of the least popular stocks
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Shunning Uncertainty: The Neglect of Learning Opportunities
Financial, managerial, and medical decisions often involve alternatives whose possible outcomes have uncertain probabilities. In contrast to alternatives whose probabilities are known, these uncertain alternatives offer the benefits of learning. In repeat-choice situations, such learning brings value. If probabilities appear favorable (unfavorable), a choice can be repeated (avoided). In a series of experiments involving bets on the colors of poker chips drawn from bags, decision makers often prove to be blind to the learning opportunities offered by uncertain probabilities. Such decision makers violate rational decision making and forgo significant expected payoffs when they shun uncertain alternatives in favor of risky ones. Worse, when information is revealed, many make choices contrary to learning. A range of factors explain these violations. The results indicate that priming with optimal strategies offers little improvement
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Deterring and Compensating Oil Spill Catastrophes: The Need for Strict and Two-Tier Liablility
The BP Deepwater Horizon oil spill highlighted the glaring weakness in the current liability and regulatory regime for oil spills and for environmental catastrophes more broadly. This article proposes a new liability structure for deep sea oil drilling and for catastrophic risks generally. It delineates a two-tier system of liability. The first tier would impose strict liability up to the firm’s financial resources plus insurance coverage. The second tier would be an annual tax equal to the expected costs in the coming year beyond this damages amount. A single firm will be identified as responsible for generating the risk. It would be required to demonstrate substantial ability to pay in the first tier before being permitted to engage in the risky activity. This structure provides for efficient deterrence for environmental catastrophes, since the responsible party is bearing in expectation the risks it is imposing. It also addresses the challenges posed by the fat-tailed distributions of catastrophic environmental risks and provides for more assured and adequate compensation of potential losses than current liability and regulatory arrangements