Meetings: Fall, 2003

Economics Fluctuations and Growth

The NBER's Program on Economic Fluctuations and Growth met in Cambridge on July 19. Organizers Andrew Abel, NBER and University of Pennsylvania, and Valerie Ramey, NBER and University of California, San Diego, chose these papers for discussion:

• Laura L. Veldkamp, INSEAD, "Media Frenzies in Markets for Financial Information"
• Discussant: John V. Leahy, NBER and New York University
• Markus K. Brunnermeier, Princeton University, and Jonathan A. Parker, NBER and Princeton University, "Optimal Expectations"
• Discussant: David Laibson, NBER and Harvard University
• Fatih Guvenen, University of Rochester, "A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation or Cross-Sectional Heterogeneity?"
• Discussant: John Y. Campbell, NBER and Harvard University
• Change-Tai Hsieh, NBER and Princeton University, and Peter J. Klenow, Federal Reserve Bank of Minneapolis, "Relative Prices and Relative Prosperity," (NBER Working Paper No. 9701)
• Discussant: Samuel S. Kortum, NBER and University of Minnesota
• Robert E. Hall, NBER and Stanford University, "Wage Determination and Employment Fluctuations"
• Discussant: Garey Ramey, University of California, San Diego
• Olivier J. Blanchard, NBER and MIT, and Thomas Philippon, MIT, "The Decline of Rents, and the Rise and Fall of European Unemployment"
• Discussant: Jordi Gali, NBER and CREI

Promising emerging equity markets often witness investment herds and frenzies, accompanied by an abundance of media coverage. Complementarity in information acquisition can explain these anomalies. Because information has a high fixed cost of production, its equilibrium price is low when its quantity is high. Investors all buy the most popular information because it has the lowest price. Given two identical asset markets, investors herd: asset demand is higher in the market with abundant information because information reduces risk. By lowering risk, information raises the asset's price. Transitions between low-information/low-asset-price and high-information/high-asset-price equilibriums raise price volatility and create price paths resembling periodic frenzies. Using equity data and a new panel data set of news counts for 23 emerging markets, Veldkamp shows that when asset market volatility increases, news coverage intensifies, and that more news is correlated with higher asset prices.

Brunnermeier and Parker introduce a tractable structural model of subjective beliefs. Forward-looking agents care about expected future utility flows, and hence are happier now if they believe that better outcomes are more likely. On the other hand, expectations that are biased towards optimism worsen decisionmaking, leading to poorer realized outcomes on average. Optimal expectations balance these forces by maximizing the lifetime well-being of an agent. The authors apply their optimal expectations framework to three different economic settings. In a portfolio choice problem, agents overestimate the return on their investment and may invest in an asset with negative expected excess return if sufficiently positively skewed. In general equilibrium, agents’ prior beliefs are endogenously heterogeneous, leading to gambling. Finally, in a consumption-saving problem with stochastic income, agents are both overconfident and overoptimistic, and consume more than implied by rational beliefs early in life.

Guvenen studies the asset pricing implications of a parsimonious two-agent macroeconomic model with two key features: limited participation in the stock market and heterogeneity in the elasticity of intertemporal substitution. The parameter values for the model are taken from the business cycle literature and are not calibrated to match any financial statistic. Yet, with a risk aversion of two, the model is able to explain a large number of asset pricing phenomena, including: a high equity premium and a low risk-free rate; a counter-cyclical risk premium, volatility, and Sharpe ratio; predictable stock returns with coefficients and R2 values of long-horizon regressions matching their empirical counterparts, among others. In addition the model generates a risk-free rate with low volatility (5.7 percent annually) and with high persistence. Guvenen also shows that the similarity of her results to those from an external habit model is not a coincidence: the model has a reduced form representation which is remarkably similar to Campbell and Cochrane's framework for asset pricing. However, the macroeconomic implications of the two models are quite different, favoring the limited participation model. Moreover, she shows that policy analysis yields dramatically different conclusions in each framework.

The positive correlation between purchasing power parity (PPP) investment rates and PPP income levels across countries is one of the most robust findings of the empirical growth literature. Hsieh and Klenow show that this relationship is driven almost entirely by differences in the price of investment relative to output across countries. When measured at domestic prices rather than at international prices, investment rates are barely correlated with PPP incomes. The authors find that the high relative price of investment in poor countries is attributable solely to the low price of consumption goods in poor countries. Investment prices are no higher in poor countries than in rich countries. These facts suggest that the low PPP investment rates in poor countries are not caused by low savings rates or by high tax or tariff rates on investment. Instead, poor countries appear to be plagued by low efficiency in producing investment goods and in producing exportables to trade for machinery and equipment.

After a recession, the aggregate labor market is slack: employment remains below normal and recruiting efforts of employers, as measured by vacancies, are low. A model of matching frictions explains the qualitative responses of the labor market to adverse shocks, but requires implausibly large shocks to account for the magnitude of observed fluctuations. The incorporation of wage-setting frictions vastly increases the sensitivity of the model to driving forces. Hall develops a new model of wage friction. The friction arises in an economic equilibrium and satisfies the condition that no market participant has an unexploited opportunity for unilateral improvement. The wage friction neither interferes with the efficient formation of employment matches nor causes inefficient job loss. Thus it provides an answer to the fundamental criticism previously directed at sticky-wage models of fluctuations.

Blanchard and Philippon develop three propositions: 1) Higher product and capital market competition and integration since the 1970s have led to a steady decline in rents and to smaller and briefer quasi-rents. 2) These changes are likely to increase efficiency and output in the long run, but it may take time for economic actors to fully understand them and to adapt. In the presence of collective bargaining and slow learning by unions, these changes can generate first a rise and then a decline in unemployment. This fits the general evolution of unemployment in Europe since the 1970s. 3) The speed of learning by unions is likely to depend on the degree of trust between labor and capital. The empirical evidence suggests that differences in trust can explain much of the difference in the evolution of unemployment across countries. Countries with lower trust have had more of an increase, and a later turnaround, in unemployment.

The Chinese Economy

The NBER's Working Group on the Chinese Economy, organized by Shang-Jin Wei, NBER and International Monetary Fund, met in Cambridge on October 3. The participants in this first meeting of the working group included NBER Research Associates and Faculty Research Fellows who had participated in a joint NBER-CCER (China Center for Economic Research) meeting in Beijing, plus a number of experts on the Chinese economy who teach at American universities. The formal meeting was preceded by a dinner at which Professor Dwight Perkins of Harvard spoke about current issues facing the Chinese economy. The meeting program was:

• Robert C. Feenstra, NBER and University of California, Davis, and Gordon H. Hanson, NBER and University of California, San Diego, "Ownership and Control in International Outsourcing: Estimating the Property-Rights Theory of the Firm"
• Discussant: Chenggang Xu, London School of Economics
• Chun-Chung Au, Brown University, and J. Vernon Henderson, NBER and Brown University, "Estimating Net Urban Agglomeration Economies with an Application to China"
• Discussant: Mary Amiti, International Monetary Fund
• Genevieve Boyreau-Debray, World Bank, and Shang-Jin Wei, “Can China Grow Faster? A Diagnosis on the Fragmentation of the Domestic Capital Market”
• Discussant: Chun Chang, University of Minnesota
• Hehui Jin and Barry R. Weingast, Stanford University, and Yingyi Qian, University of California, Berkeley, "Federalism, Chinese Style I: Fiscal Incentives and Regional Development" and "Federalism and Chinese Style II: Economic Decentralization and Political Centralization"
• Discussant: Barry Naughton, University of California, San Diego
• Wei Li, University of Virginia, "Measuring Corruption under China's Dual-Track System"
• Discussant: Loren Brandt, University of Toronto

Feenstra and Hanson develop a simple model of international outsourcing and apply it to processing trade in China. They observe China's processing exports, broken down by who owns the plant and by who controls the inputs that the plant uses. Multinational firms engaged in export processing in China tend to split factory ownership and input control with managers in China: the most common outcome is to have foreign factory ownership but Chinese control over the inputs. To account for this organizational arrangement, the authors appeal to a property-rights model of the firm. Multinational firms and the Chinese factory managers with whom they contract divide the surplus associated with export processing by Nash bargaining. Threat-point payoffs are subject to a loss in human capital. In their benchmark estimates, this loss in human capital is estimated at 33-40 percent in all provinces except the southern coast, but only about 22 percent in Fujian, Guangdong, and Hainan. The probability of legal enforcement of contracts has a similar pattern and is lowest in the southern coastal provinces and highest in Beijing.

Au and Henderson model and estimate net urban agglomeration economies for cities. Economic models of cities postulate an inverted-U shape of real income per worker against city employment, where the inverted-U shifts with industrial composition across the urban hierarchy of cities. This relationship has never been estimated, in part because of data requirements. China has the necessary data and context. The authors find that the benefits of urban agglomeration are high: real incomes per worker rise sharply with increases in city size from a low level. They level out nearer the peak, but then decline very slowly past the peak. Au and Henderson find that a large fraction of cities in China are undersized, because of strong migration restrictions, and they find large income losses from these restrictions.

Boyreau-Debray and Wei look at the financial side of Chinese economic development. One serious drawback of the Chinese financial system (beyond the bad-loans problem in its banking sector) may be the segmentation of the internal capital market, but it has not received much research attention. This paper fills the void, using two standard tools from international finance to analyze internal financial integration across 28 Chinese provinces from 1978-2000. The first test, proposed by Feldstein and Horioka (1980) and modified in the subsequent literature, examines the correlation between local investment and local saving. The second test, drawn from the risk-sharing literature, uses consumption data to evaluate financial integration. Both tests confirm a similar (and somewhat surprising) picture: capital mobility within China is low! More precisely, it is much lower than within financially integrated countries, such as Japan or the United States. In fact, the degree of inter-provincial capital mobility within China is similar to the level observed across national borders among the OECD countries. Furthermore, the degree of internal financial integration appears to have decreased significantly, rather than increased, in the 1990s relative to the earlier period. Finally, the authors document that the government (as opposed to the private sector) tends to systematically re-allocate capital from more productive regions to less productive ones. In this sense, a smaller role for the government in the financial sector might increase the growth rate of the economy.

The theory of market-preserving federalism stresses the importance of fiscal decentralization and the incentives of government on market development. Using a panel dataset from China, Jin, Quian, and Weingast investigate the changing fiscal relationship between the central and provincial governments before and after reform. They first find a much higher correlation, about four times, between the provincial government’s budgetary revenue collection and its budgetary expenditure after the reform than before the reform. This is evidence of much stronger ex post fiscal incentives for provincial governments. The authors also find that stronger ex ante fiscal incentives, measured by the contractual marginal retention rate of the provincial government in its budgetary revenue collection, imply faster development of the provincial economy. This is evidence of the impact of fiscal incentives on regional development. Finally, the authors compare federalism, Chinese style, to federalism, Russian style.

In a second and related paper, these authors use a panel dataset to investigate the central-provincial relationship during China’s reform. Here the two major empirical findings are: first, greater fiscal decentralization and stronger fiscal incentives — the latter measured in terms of higher (ex ante) provincial marginal revenue retention rate — imply faster development of non-state enterprises and more reform in state-owned enterprises in the province. Second, the political control of the central government, through the Communist Party, over provincial officials’ appointment has the opposite effect, but does restrict the provincial government’s excess investment. It is not as effective in curbing excess credit expansion, also a concern of the central government at the time.

Li presents statistical evidence of the pervasiveness of official diversion in China’s industrial planning bureaucracy under the dual-track system. The underpricing of in-plan goods and their ensuing shortage has led to gains from trade between officials who controlled the allocation of in-plan goods and customers willing to pay more than the plan prices. By diverting goods from the plan and reselling them at higher market prices, this corruption creates leaks in the plan. Using data from a survey of state-owned manufacturers supplemented by aggregate input-output data, Li finds that the leakage in the plan, which measures the size of official diversion, became statistically detectable after the introduction of the dual-track system in 1985 and increased sharply in the late 1980s. Estimates show that approximately one-third of all in-plan industrial output was diverted between 1987 and 1989.