Most tax systems create a tax bias toward debt finance. Such debt bias increases leverage and may negatively affect financial stability. This paper models and estimates debt bias in the financial sector, and present novel estimates for investment banks and non-bank financial intermediaries such as finance and insurance companies. We find debt bias to be pervasive, explaining as much as 10 percent of total leverage for regular banks and 20 percent for investment banks, with the effects most pronounced before the global financial crisis. Going forward, debt bias is likely to once again gain prominence as a key driver of leverage decisions, underscoring the importance of policy reform at this juncture.
The recent plunge in oil prices has brought into question the generally accepted view that lower
oil prices are good for the United States and the global economy. In this paper, using a quarterly
multi-country econometric model, we first show that a fall in oil prices tends relatively quickly to
lower interest rates and inflation in most countries, and increase global real equity prices. The
effects on real output are positive, although they take longer to materialize (around four quarters
after the shock). We then re-examine the effects of low oil prices on the U.S. economy over
different sub-periods using monthly observations on real oil prices, real equity prices and real
dividends. We confirm the perverse positive relationship between oil and equity prices over the
period since the 2008 financial crisis highlighted in the recent literature, but show that this
relationship has been unstable when considered over the longer time period of 1946–2016. In
contrast, we find a stable negative relationship between oil prices and real dividends which we
argue is a better proxy for economic activity (as compared to equity prices). On the supply side,
the effects of lower oil prices differ widely across the different oil producers, and could be
perverse initially, as some of the major oil producers try to compensate their loss of revenues by
raising production. Taking demand and supply adjustments to oil price changes as a whole, we
conclude that oil markets equilibrate but rather slowly, with large episodic swings between low
and high oil prices.
This paper proposes a measure of the welfare cost of volatitliy derived from an endogenous growth model (AK) under uncertainty extended to the case of a recursive utility function which disentangles risk aversion from intertemporal elasticity of substitution. It encompasses a direct welfare cost of fluctuations and a welfare cost due to the endogeneity of the consumption. The total welfare cost of volatility increases with both the risk aversion and the intertemporal elasticity of substitution. For plausible values of the agent's preference parameters, the cost of volatility may be greater than measures bases on an exogenous process for consumption.
Economic theory suggests that vulnerable financial conditions of the corporate sector can trigger or worsen an economy-wide recession. This paper proposes a measure of corporate vulnerability, the Corporate Vulnerability Index (CVI) and analyses whether it can explain the probability and severity of recessions. The CVI is constructed as the default probability for the entire corporate sector, using the model of corporate debt by Anderson, Sundaresan, and Tychon (1996). The CVI is shown to be a significant predictor of the probability of a recession 4 to 6 quarters ahead, even controlling for other leading indicators. An increase in the CVI is also associated with an increase in the probability of a more severe and lengthy recession 3 to 6 quarters ahead.
Mr. John C Bluedorn, Mr. Jörg Decressin, and Mr. Marco Terrones
This paper examines the usefulness of asset prices in predicting recessions in the G-7 countries. It finds that asset price drops are significantly associated with the beginning of a recession in these countries. In particular, the marginal effect of an equity/house price drop on the likelihood of a new recession can be substantial. Equity price drops are, however, larger and are more frequent than house price drops, making them on average more helpful as recession predictors. These findings are robust to the inclusion of the term-spread, uncertainty, and oil prices. Lastly, there is no evidence of significant bias resulting from the rarity of recession starts.
This paper studies private investment in India against the backdrop of a significant investment
decline over the past decade. We analyze the potential causes of weaker investment at the firm
level, using both firm-level financial statements and a novel dataset on firms’ investment project
decisions, and find that financial frictions have played a role in the slowdown. Firms with higher
financial leverage invest less, as do firms with lower earnings relative to their interest expenses.
Consistent with the notion of credit constraints leading to pro-cyclical investment, we also find
that firms with higher leverage are (i) less likely to undertake new investment projects, (ii) less
likely to complete investment projects once begun, and (iii) undertake shorter-term investment
Mr. Francisco d Nadal De Simone and Mr. Luc Everaert
Data on the weekly operating time of capital improve the measurement of effective capital input in production. The production function of the French business sector is found to be consistent with a Cobb-Douglas technology under constant returns to scale. Total factor productivity growth, estimated as an unobservable variable, has declined steadily since the late 1970s, but more slowly since 1994. During the 1990s, a secular increase in shift work raised the operating time of capital and began to contribute positively to growth, albeit only slightly.
The recent boom-bust cycle in the euro area's equity valuations has left nonfinancial corporations saddled with a legacy of high debt or leverage. Models of corporate investment behavior based on imperfect capital markets predict that highly leveraged balance sheets can act as a brake on investment spending. The paper's empirical analysis suggests that leverage effects on corporate investment can be substantial and persistent, particularly if leverage exceeds threshold values.
Mr. Marco Terrones, Mr. Ayhan Kose, and Mr. Stijn Claessens
This paper provides a comprehensive analysis of financial cycles using a large database covering 21 advanced countries over the period 1960:1-2007:4. Specifically, we analyze cycles in credit, house prices, and equity prices. We report three main results. First, financial cycles tend to be long and severe, especially those in housing and equity markets. Second, they are highly synchronized within countries, particularly credit and house price cycles. The extent of synchronization of financial cycles across countries is high as well, mainly for credit and equity cycles, and has been increasing over time. Third financial cycles accentuate each other and become magnified, especially during coincident downturns in credit and housing markets. Moreover, globally synchronized downturns tend to be associated with more prolonged and costly episodes, especially for credit and equity cycles. We discuss how these findings can guide future research on various aspects of financial market developments.
Mr. Alessandro Rebucci, Mr. Akito Matsumoto, Pietro Cova, and Massimiliano Pisani
We study equity price volatility in general equilibrium with news shocks about future productivity and monetary policy. As West (1988) shows, in a partial equilibrium present discounted value model, news about the future cash flow reduces asset price volatility. We show that introducing news shocks in a canonical dynamic stochastic general equilibrium model may not reduce asset price volatility under plausible parameter assumptions. This is because, in general equilibrium, the asset cash flow itself may be affected by the introduction of news shocks. In addition, we show that neglecting to account for policy news shocks (e.g., policy announcements) can potentially bias empirical estimates of the impact of monetary policy shocks on asset prices.