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Tuesday, May 7, 2013

Spring 2013 Journal of Economic Perspectives

The Spring 2013 issue of my own Journal of Economic Perspectives has two main symposia: one on "The Growth of the Financial Sector," and one on "Early and Late Interventions." It also has several individual articles on topics like the the political reasons why good economics can make for bad policy outcomes, Latin America's social policy challenge, and the investment strategies of sovereign wealth funds. The back of the issue has my own "Recommendations for Further Reading" column, and some correspondence about neuroscience and economics.

I'll probably do some blogging about specific articles in the next week or so, but for now, here's a list of the articles, with abstracts and links. Like all issues of JEP back to the first issue in 1987, this issue is freely available on-line compliments of the American Economic Association. It's also possible to go to the JEP website and download the journal in a format that works on an e-reader.

Symposium: The Growth of the Financial Sector

 "The Growth of Finance," by Robin Greenwood and David Scharfstein

The US financial services industry grew from 4.9 percent of GDP in 1980 to 7.9 percent of GDP in 2007. A sizeable portion of the growth can be explained by rising asset management fees, which in turn were driven by increases in the valuation of tradable assets, particularly equity. Another important factor was growth in fees associated with an expansion in household credit, particularly fees associated with residential mortgages. This expansion was fueled by the development of nonbank credit intermediation (or "shadow banking"). We offer a preliminary assessment of whether the growth of active asset management, household credit, and shadow banking -- the main areas of growth in the financial sector -- has been socially beneficial.
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"Finance: Function Matters, Not Size," by John H. Cochrane

It's fun to pass judgment on waste, size, usefulness, complexity, and excessive compensation. But as economists, we have an analytical structure for thinking about these questions. "I don’t understand it" doesn't mean "it's bad," or "regulation will improve it." That attitude pervades policy analysis in general and financial regulation in particular, and economists do the world a disservice if we echo it. I will not offer a competing black box [to explain the size of the finance industry]. I don’t claim to estimate the socially optimal "size of finance" at, say, 8.267 percent of GDP. It's just the wrong question. Hayek and the failure of planning should teach us a little modesty: Pronouncing on socially optimal industry size is a waste of time. Is the finance industry functioning well? Are there identifiable market or government distortions? Will proposed regulations help or make matters worse? These are useful questions.
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"Moore's Law versus Murphy's Law: Algorithmic Trading and Its Discontents," by Andrei A. Kirilenko and Andrew W. Lo

Financial markets have undergone a remarkable transformation over the past two decades due to advances in technology. These advances include faster and cheaper computers, greater connectivity among market participants, and perhaps most important of all, more sophisticated trading algorithms. The benefits of such financial technology are evident: lower transactions costs, faster executions, and greater volume of trades. However, like any technology, trading technology has unintended consequences. In this paper, we review key innovations in trading technology starting with portfolio optimization in the 1950s and ending with high-frequency trading in the late 2000s, as well as opportunities, challenges, and economic incentives that accompanied these developments. We also discuss potential threats to financial stability created or facilitated by algorithmic trading and propose "Financial Regulation 2.0," a set of design principles for bringing the current financial regulatory framework into the Digital Age.
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"An International Look at the Growth of Modern Finance," by Thomas Philippon and Ariell Reshef

We study the rise of finance across a set of now-industrial economies. The long-run pattern of the growth of the income share of finance from the nineteenth century to current times in the United States is similar to some economies, but not all economies reach the same size and instead reach a plateau. The relationship between financial output and income is nonhomothetic and changes three times in this sample. Most of the increase in real GDP per capita from 1870 occurred while financial output and the income share of finance were smaller than their size in 1980. After 1980 the elasticity of income with respect to financial output falls significantly. We find considerable heterogeneity in the size of finance in recent times. There is no evidence for an increase in the unit cost of financial intermediation. We find that information technology and financial deregulation can help explain the increase in relative skill intensity and in relative wages in finance, while common trends, which may be related to financial globalization, also play a role.
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"Asset Management Fees and the Growth of Finance," by Burton G. Malkiel

From 1980 to 2006, the financial services sector of the US economy grew from 4.9 percent to 8.3 percent of GDP. A substantial share of that increase was comprised of increases in the fees paid for asset management. This paper examines the significant increase in asset management fees charged to both individual and institutional investors. One could argue that the increase in fees charged by actively managed funds could prove to be socially useful if it reflected increasing returns for investors from active management or if it was necessary to improve the efficiency of the market for investors who availed themselves of low-cost passive (index) funds. But neither of these arguments can be supported by the data. Actively managed funds of publicly traded securities have consistently underperformed index funds, and the amount of the underperformance is well approximated by the difference in the fees charged by the two types of funds. Moreover, it appears that there was no change in the efficiency of the market from 1980 to 2011. Thus, the increase in fees is likely to represent a deadweight loss for investors. Indeed, perhaps the greatest inefficiency in the stock market is in "the market" for investment advice.
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Symposium on Early and Later Interventions

"Investing in Preschool Programs," by Greg J. Duncan and Katherine Magnuson

We summarize the available evidence on the extent to which expenditures on early childhood education programs constitute worthy social investments in the human capital of children. We provide an overview of existing early childhood education programs, and then summarize results from a substantial body of methodologically sound evaluations of the impacts of early childhood education. The evidence supports few unqualified conclusions. Many early childhood education programs appear to boost cognitive ability and early school achievement in the short run. However, most of them show smaller impacts than those generated by the best-known programs, and their cognitive impacts largely disappear within a few years. Despite this fade-out, long-­run follow-ups from a handful of well-­‐known programs show lasting positive effects on such outcomes as greater educational attainment, higher earnings, and lower rates of crime. It is uncertain what skills, behaviors, or developmental processes are particularly important in producing these longer-­‐run impacts. Our review also describes different models of human development used by social scientists, examines heterogeneous results across groups, and tries to identify the ingredients of early childhood education programs that are most likely to improve the performance of these programs.
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"What Can Be Done to Improve Struggling High Schools?," Julie Berry Cullen, Steven D. Levitt, Erin Robertson and Sally Sadoff 

In spite of decades of well-intentioned efforts targeted at struggling high schools, outcomes today are little improved. A handful of innovative programs have achieved great success on a small scale, but more generally, the economic futures of the students at the bottom of the human capital distribution remain dismal. In our view, expanding access to educational options that focus on life skills and work experience, as opposed to a focus on traditional definitions of academic success, represents the most cost-effective, broadly implementable source of improvements for this group.
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"Beyond BA Blinders: Lessons from Occupational Colleges and Certificate Programs for Nontraditional Students," by James E. Rosenbaum and Janet Rosenbaum

Postsecondary education mostly focuses on the four-year BA degree. Community colleges are often promoted as the first step toward the ultimate goal of a four-year degree. However, community colleges have extremely poor degree completion rates. There is evidence suggesting better results for their private, two-year counterparts -- particularly for certificate completion. We will focus on occupational colleges -- private accredited colleges that offer career preparation in occupational fields like health care, business, information technology, and others. These institutions challenge many of our preconceptions about college. They are less wedded to college traditions, which raises some interesting questions: Do private colleges offering certificates or AA degrees use different procedures? Should community colleges consider some of these procedures to reduce student difficulties and improve their completion rates? For many community college students, earning a more likely, quick sub-BA credential -- perhaps followed by a four-year degree in the future -- will be preferable to the relatively unlikely pathway from a community college program directly to a four-year BA. In sum, this paper suggests that nontraditional colleges and nontraditional credentials (certificates and AA degrees) deserve much closer attention from researchers, policymakers, and students.
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Individual Articles

"Economics versus Politics: Pitfalls of Policy Advice," Daron Acemoglu and James A. Robinson

The standard approach to policy making and advice in economics implicitly or explicitly ignores politics and political economy and maintains that if possible, any market failure should be rapidly removed. This essay explains why this conclusion may be incorrect; because it ignores politics, this approach is oblivious to the impact of the removal of market failures on future political equilibria and economic efficiency, which can be deleterious. We first outline a simple framework for the study of the impact of current economic policies on future political equilibria -- and indirectly on future economic outcomes. We then illustrate the mechanisms through which such impacts might operate using a series of examples. The main message is that sound economic policy should be based on a careful analysis of political economy and should factor in its influence on future political equilibria.
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"Latin America's Social Policy Challenge: Education, Social Insurance, Redistribution," by Santiago Levy and Norbert Schady

Long regarded as a region beset by macroeconomic instability, high inflation, and excessive poverty and inequality, Latin America has undergone a major transformation over the last 20 years. The region has seen improved macroeconomic management and substantial and sustained reductions in poverty and inequality. In this paper, we argue that social policy, including human capital and education, social insurance, and redistribution, need special attention if achievements of the last two decades are to be sustained and amplified. Starting in the mid 1990s, many governments in the region introduced a variety of programs, including noncontributory pensions and health insurance, and cash transfers targeted to the poor. Social spending in Latin America increased sharply. These policies have been widely praised, and we believe they have resulted in substantial improvements in the lives of the poor in the region. However, a more nuanced view shows some worrisome trends. Moving forward, we believe it is necessary to pay much closer attention to the quality of services, particularly in education; to the incentives generated by the interplay of some programs, particularly in the labor market; to a more balanced intertemporal distribution of benefits, particularly between young and old; and to sustainable sources of finance, particularly to the link between contributions and benefits.
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"The Investment Strategies of Sovereign Wealth Funds," Shai Bernstein, Josh Lerner and Antoinette Schoar

Sovereign wealth funds have emerged as major investors in corporate and real resources worldwide. After an overview of their magnitude, we consider the institutional arrangements under which many of the sovereign wealth funds operate. We focus on a specific set of agency problems that is of first-order importance for these funds: that is, the direct involvement of political leaders in the management process. We show that sovereign wealth funds with greater involvement of political leaders in fund management are associated with investment strategies that seem to favor short-term economic policy goals in their respective countries at the expense of longer-term maximization of returns. Sovereign wealth funds face several other issues, like how best to cope with demands for transparency, which can allow others to copy their investment strategies, and how to address the problems that arise with sheer size, like the difficulties of scaling up investment strategies that only work with a smaller value of assets under investment. In the conclusion, we discuss how various approaches cultivated by effective institutional investors worldwide -- from investing in the best people to pioneering new asset classes to compartmentalizing investment activities -- may provide clues as to how sovereign wealth funds might address these issues.
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"Recommendations for Further Reading," by Timothy Taylor 

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Correspondence: Are Cognitive Functions Localizable? Colin Camerer et al. versus Marieke van Rooij and John G. Holden

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