Nowhere to run: designing a run-free financial system

Many economic crises start on Wall Street and it is often not clear whether fundamental problems caused the financial markets to crumble or whether it was the bankers that brought down the whole economy. The latest crisis made the proponents of the latter view more vocal but there are still moments in history that suggest that the mistakes of the financial markets can be easily contained; just think of the dot-com bubble. When the bubble burst in 2001, stock markets plunged but the real economy only quivered. Learning from that, regulators want to prevent any distress on the financial markets or at least limit the damage to the real economy.

Probably the most vulnerable link between the financial sector and the rest are banks. When banks suffer, the rest of the economy gets into trouble as well. Consequently, the regulators want to protect banks from any sort of trouble as they want to isolate the real economy from shocks caused by the financial markets. However, with all the capital regulation, risk-weighted assets, and so on, they focus predominantly on the asset side of banks’ balance sheets. What if there is another way?

Banks are not vulnerable because of their assets but because of their liability structure. Dependence on deposits makes them prone to runs, although they can be structurally healthy and only in need of liquidity. John Cochrane suggests a solution. What if all banks were financed only by equity? What if you did not deposit your salary in a bank, but you instead immediately bought shares of the bank? The idea sounds outrageous at first, but Cochrane argues that not much would actually change. We would be still able to withdraw money at ATMs or pay for a sandwich with a credit card. The only difference would be that we would not reduce the amount of money deposited on our account but we would sell a portion of our bank shares – just a technical change from the consumer’s perspective. And luckily, today’s technology would allow that.

When depositors actually own shares, they have no reason to run. Even if they are concerned with the bank’s actions, they would not sell out indefinitely as the bank’s assets remain safe and stable. Thus the banks are safe from runs and they, along with their shareholders, have to only endure mild swings in value of their assets. The discussion is still at the beginning and there are many potential pitfalls along the way, but thinking about our structural problem in this way can help us to rethink the status quo and stop kicking the can down the road.

Reference: Cochrane, J. H. (2014). Toward a run-free financial system. Available at SSRN 2425883. Retrieved from Available here.

Link to FED symposium discussing the topic. 

Laissez-faire vs. regulation – which colonial legacy is better?

Since the very beginnings of market economies, there have been two general views of how things should be done; how the governments should behave. Laissez-faire vs. regulation, right vs. left, liberalism vs. social state, republicans vs. democrats, keep-your-money-and-use-it-however-you-want vs. give-us-your-money-and-we-will-redistribute-it. One might think that by now, we should have known for a long time which system works better. We can just compare two nations that each use one of the systems, right? However, comparing two nations with different systems shows to be a very difficult task due to great heterogeneity in virtually all other characteristics that affect the outcome. In the words of the theory of treatment econometrics, constructing a counterfactual is incredibly difficult. In the words of a normal person, we don’t know what economies would look like had they adopted a different system.

Alexander Lee and Kenneth A. Schultz of Stanford have used a unique natural experimental setting in Cameroon in their 2011 paper to shed more light on this agelong discussion. Cameroon was first colonized by the German empire in 1884. After the defeat of Germany in World War I, it became a League of Nations mandate territory and was artificially divided between the French and British colonial powers until Cameroon gained independence in the beginning of the 1960’s. During the more than 40 years of colonial regime, the French and the British took a very different approach as to which institutions to put in place to ensure effective economic development of their part of Cameroon. While the French flooded their part (East) of Cameroon with investment into infrastructure and made the public sector in general very powerful, the British (West Cameroon) preferred letting the economy work largely on its own.

This situation made for a very promising experimental setting, but large regional differences remained an issue. That is why the authors focused on pairs of rural towns that are close to each other geographically, but divided by the French-British border. This method is called local average treatment effect and it is an integral part of regression discontinuity design. To see its fundamental idea on a simpler example, suppose you want to estimate the effect of studying at the best law school on post-university wage as compared to studying at a worse (less challenging) law school. Taking a simple difference in wage between the two groups leads to a huge selection bias, as more skilled people usually get to the best school, because they score better on the entrance exam. Using the local average treatment effect in this example means to compare people who scored close to the cut-off level but below, and those who scored close but above. These two groups are roughly the same (since entrance exams are only rough approximations of your true skills), but one of them got the treatment (i.e. the best law school) and the other did not (i.e. they went to a worse law school). Similarly, in Cameroon, two villages that are close to  the French-British border are roughly the same (in geographical and other characteristics), but they received different treatment (i.e. the French vs. the British colonial legacy).

And the result? As shown in the figure below, the British part appears to have higher levels of economic dynamism, evidenced by greater household wealth, and better functioning local government institutions, evidenced by its higher level of public goods provision. These findings are consistent with the hypothesis that the mix of institutions and practices associated with British colonial rule generated superior outcomes. This does not imply, of course, that British-colonized areas always perform better or that West Cameroon is an elysia of wealth and strong institutions. But for the rural areas in this particular case, it seems that the British way was the better one to go with.


Reference: Lee, A., & Schultz, K. A. (2012). Comparing British and French Colonial Legacies: A Discontinuity Analysis of Cameroon. Quarterly Journal of Political Science, 7(4), 365-410. Available here.

Do we work less than we did a century ago?

Valerie Ramey and Neville Francis developed comprehensive measures of time spent doing different activities – working, doing housework (cooking, cleaning etc.), being at school and enjoying leisure time – in the U.S. since the beginning of the 20th century. The research question was initially motivated by economic theory which suggests that as the society is getting richer, we should be able to afford more leisure time and work less. This is called the income effect.

Interestingly, at the aggregate level, hours devoted to work have changed only mildly. In particular, our generation works, on average, 23 hours per capita per week, which is 4 hours less than in 1900. The overall home production does not change at all – we still work at home around 22 hours per week. Not surprisingly, there has been a huge increase in hours devoted to formal schooling by those aged between 10 and 17 years old. When it comes to leisure, the effect is of a similar magnitude as the change in work hours, but the direction is opposite. We now enjoy four hours more of leisure every week than people who lived a century ago.

Even though the results may seem boring as we observe slight or no changes at all, there are underlying stories which are indeed interesting. During the last century, we have witnessed significant gender convergence. While men tend to work less in market production and more at home, the opposite is true for women. As a result, the gap between male and female hours spent working in work and at home seems to disappear.


Reference: Ramey, V. A., & Francis, N. (2009). A Century of Work and Leisure. American Economic Journal: Macroeconomics, 189-224. Available here.

Migration: Another side, another story

The debate about the effects of migration on economy and society in Central, Eastern, and Southeastern Europe (CESEE) is uninformed and emotional, but it also misses a phenomenon that has economically influenced the CESEE region more than both the civil war in Syria and dire socioeconomic conditions in Maghreb. A recent IMF study shows that the post-communist countries have been affected by emigration more than it was previously thought and that the associated brain drain had significant negative effects on their economies.

The data clearly shows that the emigrants are more educated than the average population, and thus may be taking the economic potential of their home countries with them. The researchers estimate that an increase of 1 percentage point of immigrants’ share on indigenous population can be associated with 2 percent of GDP per capita growth. On the other hand, the adverse effect of skilled labor migration in the original countries translates itself to lower labor productivity. That in turn results in the convergence gap between Western Europe and CESEE region being 7 percentage points higher than it would have been without the massive emigration.

The standard economic theory suggests that such migration pushes wages of skilled labor in CESEE up and thus motivates the unskilled labor to move up in the labor hierarchy which results in higher GDP per capita. Although the wages had been pushed up by the migration, the output per capita had not grown due to that. The authors turn to endogenous growth models putting more emphasis on agglomeration effects of skilled labor: its abundance only increases its returns. Clearly, as educated people leave the economic hubs of the post-communist countries, they hardly make them more performing.

It would be foolish though to consider only the economic effects. Exodus of educated people surely influences also the domestic institutions and the quality of public life in general. Although it is difficult to quantify this effect, it should be taken into account in the analysis and in the plans of how to counter this issue. The authors suggest to improve the rule of law and other institutions in order to cut the vicious circle. Moreover, they cite Ireland’s success of engaging with diasporas all over the world and bringing back workforce that obtained its qualification elsewhere.

Such paper is a refreshing read in the world where only the issues of unskilled immigration are considered. True, the effects seem negative for the CESEE region, which can hardly improve the case for free movement of labor. However, since both the respective migrants and Europe as a whole are better off thanks to the migration, the report ends on a cheerful note after all.

Reference: Atoyan, M. R., Christiansen, L. E., Dizioli, A., Ebeke, M. C., Ilahi, M. N., Ilyina, M. A., … Raei, M. F. (2016). Emigration and Its Economic Impact on Eastern Europe. International Monetary Fund. Available here.

Letting others do the work will not get you a Nobel

You have probably done this at some point in your life, be it school, work, or organizing a party – you are part of a group assigned to a task, and while working on it, you realize you might as well just let others do the hard part. In the end, you all get the same credit for the final outcome anyway, right? Congratulations, you have just become the so-called free-rider of the group.

The seminal work of one of the two men woken up this morning by a call from the Nobel committee, Bengt Holmstrom, shed more light on this phenomenon. One of his most famous papers, published in 1982, shows that the free-rider problem described above can largely be resolved if ownership and labor are partly separated, which gives capitalistic firms an advantage over partnerships. In other words, if you are in a partnership, it is more likely that there will be a free-rider among your co-workers (partners) than when you own the company yourself and hire workers with assigned jobs. The rather technical paper also discusses some other issues arising due to such moral hazard questions. For example, it assesses the consequences of relative performance evaluation of workers and suggests ways to improve risk-sharing in entrepreneurship in general.

This is is one of the founding works in contracts theory, for which The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was awarded this year to Bengt Holmstrom and Oliver Hart.

Reference: Holmstrom, B. (1982). Moral hazard in teams. The Bell Journal of Economics,13(2), 324-340. Available here.

Bitcoin mining: Should I do it?

Is it worth it to mine bitcoins? Should I do it on my computer? The short answers would be: it depends and definitely no, respectively. To shed more light on the issue of bitcoin mining, Karl O’Dwyer and David Malone published a short study which analyses the costs of electricity used to mine bitcoins. It is commonly known that bitcoin mining is more and more difficult as there is more of the virtual currency already in circulation. Therefore, computers have to solve more complicated mathematical problems and use more electricity. As a result, mining has become more expensive.

The authors calculated that it has never been profitable to mine bitcoins even with Core i7 950 processors or with a Sony Playstation 3. Moreover, they argued that the only way to mine bitcoins profitably, taking into account only electricity usage as a cost, is to employ special hardware – Monarch BPU 600 C (ASIC) – which was constructed specifically for bitcoin mining. Note, however, the profit gap is closing even for such advanced hardware. Equally interestingly, the authors estimated how much electricity is used to mine and administrate the bitcoin currency and found out that it is comparable with the electricity usage of Ireland. The picture below depicts the development of the cost of bitcoin mining and the value of bitcoins in US dollars.


Reference: O’Dwyer, K. J., & Malone, D. (2013). Bitcoin mining and its energy footprint. In Irish Signals & Systems Conference 2014 and 2014 China-Ireland International Conference on Information and Communications Technologies (ISSC 2014/CIICT 2014). 25th IET (pp. 280-285). IET. Available here.

Statisticians as the new government watchdogs

After Benford’s law, which describes frequency distribution of leading digits in datasets and is often used for accounting fraud detection, data scientists developed a new method which helps to uncover fraud using data analysis.  In a paper from 2016, Dmitry Kobak, Sergey Shpilkin and Maxim S. Pshenichnikov show that the results of Russian elections have some very disturbing artefacts indicating fraudulent behavior at polling stations.

The authors started with a simple assumption that people, when making up numbers, tend to go with round integers. So if polling stations do not report the real results but made-up numbers instead, there would be a disproportionate count of polling stations reporting round and neat percentages. This natural inclination to round numbers can be only intensified by thresholds that the central authority considers as “success”.

To test that some polling stations really do make up the reported numbers, the authors used a Monte Carlo simulation to estimate likelihoods of the whole spectrum of percentage results. This way, they were able to find 99.99% confidence intervals for the number of polling stations reporting round results. Their careful analysis shows that there are indeed improbable spikes in the empirical distributions which can be hardly explained in any other way than by fraud.

Interestingly, this phenomenon can be observed since the presidential elections in 2004 when Vladimir Putin was seeking his first reelection. The analysis works with the data from Russian elections in years 2000 till 2012, and it is only the early elections of 2000 and 2003 that do not suggest manipulation in the vote count. The paper does not attempt to answer the question of what the driver of this turning point is, but it is symptomatic that the regions showing persistent anomalies are largely located in the North Caucasian Federal District (e.g. Chechnya).

As a control, the same method is employed using data from German, Polish and Spanish elections. None of these countries show suspicious spikes in the data. Could a group of statisticians serve as a watchdog for national elections? It certainly seems so! Although fraudulent governments can randomize in their vote count manipulation or simply use other dishonest methods to influence democratic elections, let us hope that the honest data scientist will be always step ahead uncovering dirty practices.

Reference: Kobak, D., Shpilkin, S., Pshenichnikov, M.S., others, 2016. Integer percentages as electoral falsification fingerprints. The Annals of Applied Statistics 10, 54–73. Available here.

Do minimum wage increases influence worker health?

It is commonly accepted that a minimum wage increase has two direct effects on health. These effects result from the Grossman model, which is heavily used in economics of health. On the one hand, minimum wage increases allow individuals with low income to purchase more market goods that improve their health, for example better medical care and better food. On the other hand, it increases the opportunity cost of not working and thus makes non-market goods consumption (sport, relax) more expensive. Not surprisingly, the overall effect seems heterogeneous and differs for cohorts.

To shed more light on minimum wage effects on health, B. Horn, J. Catherine Maclean, and M. Strain analyzed data about lesser-skilled workers. As they concluded, the results fail to suggest any indisputable general improvements of the people’s health. The effect depends upon the particular group of people. While workers tend to report better health conditions after minimum wage increases, the unemployed are more likely to be negatively affected. Overall, the contribution of this study lies in providing a more comprehensive view on minimum wage policy and its consequences. Notably, the authors focused on more than just the potential decline in employment of marginal workers and recognized also additional social and medical issues.

Reference: Horn, B. P., Maclean, J. C., & Strain, M. R. (2016). Do minimum wage increases influence worker health? AEI Economics Working Paper 2016-01. Available here.

Does it pay off to motivate consumers to leave feedback?

The importance of online customer-to-customer (C2C) marketplaces has been growing and nowadays Taobao, the biggest platform in China, has 500 millions of registered users. Such platforms have a common inherent issue – the presence of asymmetric information and adverse selection problems, which obstruct trade. Fortunately, the online world allows buyers to leave feedback assessing how much they were satisfied with the bought items. However, it is not that easy. It turns out that feedback has one of the most characteristic aspects of public goods – everybody would appreciate it, but only a minority of consumers are willing to provide it.

Nevertheless, as Lingfang Li, Steven Tadelis, and Xiaolan Zhoushowed showed, if consumers are motivated to leave a feedback, they do so. As a result, information asymmetry is reduced. In particular, the authors studied roughly 7 million transactions made on Taobao between September 2012 and February 2013. As a measure to sweeten online shopping, Taobao introduced a “rebate-for-feedback” reward system. This mechanism allows sellers to offer part of the paid amount to be returned back to buyer if he or she met certain conditions and left a fine feedback (not necessarily a positive one). The authors’ main results suggest that high quality sellers are more likely to ask for a review and also the reviews tend to be of higher quality (measured as the length of the rating).

Reference: Li, L. I., Tadelis, S., & Zhou, X. (2016). Buying Reputation as a Signal of Quality: Evidence from an Online Marketplace. NBER Working Paper, (w22584). Available here.

Does legalization of marijuana increase the consumption of tobacco?

It has been a tricky question for such a long period of time: are marijuana and tobacco substitutes or complements? Leaving the economic terminology aside: do people tend to use tobacco and marijuana at the same time or do they rather alternate between the two? Since several states in the US have recently agreed to legalize (medical) marijuana use, economists were finally given the opportunity to collect and study US data about consumption habits of both.

Having gathered the data, Anna Choi, Dhaval Dave, and Joseph J. Sabia ran a difference-in-differences regression with the aim to estimate whether and to what extent the legalization of marijuana affects the consumption of cigarettes. The empirical results suggest that after the legalization of marijuana the consumption of cigarettes tends to decrease. In other words, tobacco and marijuana seem to be substitutes. If the results prove to be right, it may have important implications for policy-makers. For example, an increase in tax burden levied on tobacco might increase the demand for marijuana. Or, on the contrary, legal usage of marijuana might decrease the sales of tobacco products and thus decrease the amount of taxes collected from tobacco.

Reference: Choi, A., Dave, D., & Sabia, J. J. (2016). Smoke Gets in Your Eyes: Medical Marijuana Laws and Tobacco Use (No. w22554). National Bureau of Economic Research. Available here.