The Ongoing Financial Upheaval: Understanding the Sources and Way Out

The present period of financial instability is also likely to become known as the end of an era; an era of economic calm and policy consensus on ways to maintain market stability. After World War II, the federal government operated on the Keynesian principles that the right mix of spending, regulation, and interest rates could tame economic cycles and eliminate surges of unemployment. In this period, now known as the Great Moderation, we assumed that we knew how to prevent economic crises, such as the recurrence of the Great Depression. However, it is clear that those principles were erroneous as the economy has entered a lesser, but still severe downturn; the Great Recession. This paper looks at the sources of the ongoing economic crisis and points to the unique role in its origins of real estate asset bubbles and mispriced credit, not only in the origin of this crisis, but of many financial crises. An analysis of the data points to the role of mispriced mortgage backed securities (MBS) in the spread of aggressive mortgage products and the unwarranted price speculation that resulted in massive foreclosures. In turn, the paper addresses the source of mispriced risk in MBS as incomplete markets in real estate and non-tradability of MBS and related securities, which ultimately led to the collapse of financial system, threatening global economic health. The paper also suggests corrective measures that can and should be taken to assist the short and long term recovery.

Trade Booms, Trade Busts, and Trade Costs

Evolutionary Stability of Prospect Theory Preferences

We demonstrate that in simple 2×2 games (cumulative) prospect theory preferences can be (semi-)evolutionarily stable, in particular, a population of players with prospect theory preferences is stable against more rational players, i.e. players with a smaller degree of probability weighting. We also show that in a typical game with infinitely many strategies, the “war of attrition”, probability weighting is (semi-)evolutionarily stable. Finally, we generalize to other notions of stability. Our results may help to explain why probability weighting is generally observed in humans, although it is not optimal in usual decision problems.

Children of War: The Long-Run Effects of Large-Scale Physical Destruction and Warfare on Children

During World War II, more than one-half million tons of bombs were dropped in aerial raids on German cities, destroying about one-third of the total housing stock nationwide. This paper provides causal evidence on long-term consequences of large-scale physical destruction on the educational attainment, health status and labor market outcomes of German children. I combine a unique dataset on city-level destruction in Germany caused by Allied Air Forces bombing during WWII with individual survey data from the German Socio-Economic Panel (GSOEP). My identification strategy exploits the plausibly exogenous city-by-cohort variation in the intensity of WWII destruction as a unique quasi-experiment. My findings suggest significant, long-lasting detrimental effects on the human capital formation, health and labor market outcomes of Germans who were at school-age during WWII. First, these children had 0.4 fewer years of schooling on average in adulthood, with those in the most hard-hit cities completing 1.2 fewer years. Second, these children were about half inches (one centimeter) shorter and had lower self-reported health satisfaction in adulthood. Third, their future labor market earnings decreased by 6% on average due to exposure to wartime physical destruction. These results survive using alternative samples and specifications, including controlling for migration. Moreover, a control experiment using older cohorts who were not school-aged during WWII reveals no significant city-specific cohort trends. An important channel for the effect of destruction on educational attainment appears to be the destruction of schools and the absence of teachers, whereas malnutrition and destruction of health facilities during WWII seem to be important for the estimated impact on health.

The Conscientious Legislator and Public Opinion on Taxes

This essay examines some of the difficulties of understanding public opinion on taxes, and offers some suggestions as to how the conscientious legislator might proceed in light of those difficulties. The essay begins by describing two contexts in which public opinion appears to contradict itself, and suggests how the apparent contradictions might be resolved. It then offers three suggestions for the conscientious legislator whose goal is to discern (rather than to manipulate) public opinion on taxes - to be neither unduly optimistic nor despairing about the potential for educating the public on tax policy issues, to understand and guard against the manipulation of public opinion by those with particular tax policy agendas, and to be guided by opinion surveys which give the public a range of policy options rather than forcing a choice between two polar positions.

The Federal Retail Sales Tax that Wasn’t: An Actual History and an Alternate History

The federal income tax did not become a mass tax until World War II. Although some form of mass federal taxation was imperative for the financing of the war, a mass income tax was not inevitable. But for the determined opposition of the Roosevelt administration, Congress would almost certainly have enacted a federal retail sales tax during the war - perhaps in addition to the conversion of the income tax to a mass tax, but perhaps as the only form of mass taxation aimed at paying for the war. This article describes the wartime debates among proponents of different methods of federal mass taxation - conversion of the income tax to a mass tax, enactment of a federal retail sales tax, or both. Following that description, the article considers the continuing impact of the wartime choice of the income tax as the only instrument of mass taxation. The article concludes that the use of the mass income tax - rather than the combination of an elite income tax and a mass retail sales tax (or value-added tax) - has made a significant difference in several areas, including: the distribution of the benefits of postwar tax cuts and the burdens of postwar tax increases; public perceptions of the nature of the relationship between taxpayers and the federal government; the proliferation of tax subsidies targeted at particular categories of nonbusiness expenditures, ranging from long-term care to hybrid cars; income support for low-wage workers with dependent children; and federal policy toward homeownership.

Children of War: The Long-Run Effects of Large-Scale Physical Destruction and Warfare on Children

Exchange Rate Regimes and Reserve Policy on the Periphery: The Italian Lira 1883-1911

The three exchange rate regimes adopted by Italy from 1883 up to the eve of World War I — the gold standard (1883-1893), floating rates (1894-1902), and “gold shadowing” (1903-1911) — produced a puzzling result: formal adherence to the gold standard ended in failure while shadowing the gold standard proved very successful. This paper discusses the main policies underlying Italy’s performance particularly focusing on the strategy of reserve accumulation. It presents a cointegration analysis identifying a distinct co-movement between exchange rate, reserves, and banknotes that holds over the three sub-periods of the sample. Given this long-run relationship, the different performance in each regime is explained by the diversity of policy measures, reflected in the different variables adjusting the system in the various regimes. Italy’s variegated experience during the gold standard provides a valuable lesson about current developments in the international scenario, showing the central role of fundamenals and consistent policies.

Price Wars in Two-Sided Markets: The Case of the UK Quality Newspapers

This paper investigates the price war in the UK quality newspaper industry in the 1990s. We build a model of the newspaper market which encompasses demand for differentiated products on both, the readers and advertisers side of the market, and profit maximization by four competing oligopolistic editors who recognize the existence of an indirect network effect of circulation on advertising demand. Editors choose first the political position, then simultaneously cover prices and advertising tariffs. We contribute to the literature on two-sided markets by endogenizing the political differentiation of newspapers in a model with more than two firms. We simulate changes to market structure in order to explore which of the candidate explanations is most likely to lie behind the observed price war.

Military Empowerment and Civilian Targeting in Civil War

Civilians constitute a large share of casualties in civil wars across the world. They are targeted to create fear and punish allegiance with the enemy. This maximizes collaboration with the perpetrator and strength- ens the support network necessary to consolidate control over contested regions. I develop a model of the magnitude and structure of civilian killings in civil wars involving two armed groups who …ght over territorial control. Armies secure compliance through a combination of carrots and sticks. In turn, civilians dier from each other in their intrinsic preference towards one group. I explore the eect of an exogenous empowerment of one of the groups in the civilian death toll. There are two eects that go in opposite directions. While a direct eect makes the powerful group more lethal, a fear eect increases the number of civilians who align with that group, leaving less enemy supporters to kill. I study the conditions under which there is one dominant eect and illustrate the predictions using sub-national longitudinal data for Colombia's civil war.