SEPTEMBER 9 2011

Joshua Aizenman, Michael M Hutchison, Yothin Jinjarak, VoxEU: What is the risk of European sovereign debt defaults? Fiscal space, CDS spreads and market pricing of risk. We found strong evidence that high market-default-risk assessments in the five Eurozone-periphery countries are partly attributable to deteriorating fundamentals but that a large component is unpredicted. Actual CDS spreads in the five Eurozone-periphery countries are much higher than what the model predicts given actual fundamentals. In terms of our model, these spreads may be mispriced. One possibility is excessive pessimism on the part of market participants about the Eurozone-periphery countries or expectations of the further deterioration of fundamentals. This point is well illustrated by a comparison of five Eurozone-periphery countries with middle-income countries with similar fiscal conditions. In every case, risk pricing of the five Eurozone-periphery countries is comparatively high given current economic conditions.

Atif R. Mian, Amir Sufi: NBER Reporter. Research Summary. Finance and Macroeconomics: The Role of Household Leverage. The increase in household leverage prior to the most recent recession was stunning by any historical comparison. From 2001 to 2007, household debt doubled, from $7 trillion to $14 trillion. The household debt-to-income ratio increased by more during these six years than it had in the prior 45 years. In fact, the household debt-to-income ratio in 2007 was higher than at any point since 1929. Our research agenda explores the causes and consequences of this tremendous rise in household debt. Why did U.S. households borrow so much and in such a short span of time? What factors triggered the slowdown and collapse of the real economy? Did household leverage amplify macroeconomic shocks and make a quick recovery less likely? How do politics constrain policy responses to an economic crisis? While the focus of our research is on the recent U.S. economic downturn, we believe the implications of our work are wider. For example, both the Great Depression and Japan's Great Recession were preceded by sharp increases in leverage.1 We believe that understanding the impact of household debt on the economy is crucial to developing a better understanding of the linkages between finance and macroeconomics.

Roger E. A. Farmer , Dmitry Plotnikov, VoxEU: Does fiscal policy matter? Is there a better way to reduce unemployment? Can government spending help the economy recover from a recession by boosting job creation and lowering unemployment? Or is it a waste of money? This column addresses this question and others using a unique framework. It explains why fiscal policy was effective at ending the Great Depression but it argues that a big fiscal expansion may not be the best solution this time round.

Ryan Avent, NYT: One Path to Better Jobs - More Density in Cities. When it comes to economic growth and the creation of jobs, the denser the city the better. How great are the benefits of density? Economists studying cities routinely find that after controlling for other variables, workers in denser places earn higher wages and are more productive. Some studies suggest that doubling density raises productivity by around 6 percent while others peg the impact at up to 28 percent. Some economists have concluded that more than half the variation in output per worker across the United States can be explained by density alone; density explains more of the productivity gap across states than education levels or industry concentrations or tax policies.

Peter Diamond, Emmanuel Saez: The Case for a Progressive Tax: From Basic Research to Policy Recommendations. This paper presents the case for tax progressivity based on recent results in optimal tax theory. We consider the optimal progressivity of earnings taxation and whether capital income should be taxed. We critically discuss the academic research on these topics and when and how the results can be used for policy recommendations. We argue that a result from basic research is relevant for policy only if (a) it is based on economic mechanisms that are empirically relevant and first order to the problem, (b) it is reasonably robust to changes in the modelling assumptions, (c) the policy prescription is implementable (i.e., is socially acceptable and is not too complex). We obtain three policy recommendations from basic research that satisfy these criteria reasonably well. First, very high earners should be subject to high and rising marginal tax rates on earnings. Second, low income families should be encouraged to work with earnings subsidies, which should then be phased-out with high implicit marginal tax rates. Third, capital income should be taxed. We explain why the famous zero marginal tax rate result for the top earner in the Mirrlees model and the zero capital income tax rate results of Chamley-Judd and Atkinson-Stiglitz are not policy relevant in our view.

Yi Wen, St. Louise Fed: Making Sense of China’s Astronomical Foreign Reserves. The current global-imbalance literature (which explains why capital flows from poor to rich countries) cannot explain China’s foreign asset positions because capital cannot flow out of China under capital controls. A related but deeper puzzle that this literature fails to address is China’s high saving rate despite an astonishingly rapid income growth rate. This paper argues that understanding China’s massive foreign reserves must start with a basic trade model (e.g., Melitz, 2003) in which a growing trade volume is driven by an elastic labor supply and rapid productivity growth. Imbalanced trade will then emerge if there exist uninsured risks (which remain constant as the economy grows) and exporters are borrowing constrained. In this case, fast growth can lead to excessively high saving rates and trade surpluses. Thus, a modified Melitz model featuring rapid productivity growth, elastic labor supply, and incomplete markets can qualitatively and quantitatively explain China’s massive (and "passive") accumulation of low-yield foreign reserves. The simple infinite-horizon model is hence consistent with the stylized fact that high saving is the consequence of high growth instead of the opposite (Modigliani and Cao, 2004), which the permanent income theory and global-imbalance literature fail to predict."

Daron Acemoglu el al MIT: A Political Theory of Populism. When voters fear that politicians may have a right-wing bias or that they may be influenced or corrupted by the rich elite, signals of true left-wing conviction are valuable. As a consequence, even a moderate politician seeking reelection choose policies to the left of the median voter as a way of signalling that he is not from the right (while truly right-wing politicians also signal by choosing moderate or even left-of-center policies). This leftist bias of policy is greater when the value of remaining in office is higher for the politician; when there is greater polarization between the policy preferences of the median voter and right-wing politicians; and when politicians are indeed likely to have a hidden right-wing agenda. We show that similar results apply when some politicians can be corrupted or influenced through other non-electoral means by the rich elite.