Knowledge that Transforms

A half century of empirical work attempting to predict the factor content of trade in goods has failed to bring theory and data into congruence. Our study shows how the Heckscher-Ohlin-Vanek theory, when modified to permit technical differences, a breakdown in factor price equalization, the existence of nontraded goods, and costs of trade, is consistent with data from ten OECD countries and a rest-of-world aggregate.

Four main messages emerge from the study of subjective survey data. First, a large experimental literature by and large supports economists' skepticism of subjective questions. Second, put in an econometric framework, these findings cast serious doubts on attempts to use subjective data as dependent variables, because the measurement error appears to correlate with a large set of characteristics in behaviors. Third, these data may be useful as explanatory variables. Finally, the empirical work suggests that subjective variables are useful in practice for explaining differences in behavior across individuals. Changes in answers to these questions, however, do not appear useful in explaining changes in behavior.

An evolutionary game model shows how an equilibrium distribution of competence may evolve when members of a population prey on one another, but when predatory competence is costly to acquire. Under one interpretation, the competence distribution is an endogenously determined distribution of bounded rationality. An example shows how “tricksters” and “suckers” might coexist in the long run. The analysis leads to a curious result about a mixed equilibrium for a symmetric, zero-sum game. An increase in the costs of one or more competence levels has exactly zero effect on the fraction of the population at those levels.

Monetary policy; Interest rates; Inflation (Finance)

The returns earned by U.S. equities since 1926 exceed estimates derived from theory, from other periods and markets, and from surveys of institutional investors. Rather than examine historic experience, we estimate the equity premium from the discount rate that equates market valuations with prevailing expectations of future flows. The accounting flows we project are isomorphic to projected dividends but use more available information and narrow the range of reasonable growth rates. For each year between 1985 and 1998, we find that the equity premium is around three percent (or less) in the United States and five other markets.

This paper documents that investors are more likely to hold, buy, and sell the stocks of Finnish firms that are located close to the investor, that communicate in the investor's native tongue, and that have chief executives of the same cultural background. The influence of distance, language, and culture is less prominent among the most investment‐savvy institutions than among both households and less savvy institutions. Regression analysis indicates that the marginal effect of distance is less for firms that are more nationally known, for distances that exceed 100 kilometers, and for investors with more diversified portfolios.

We examine whether stock prices fully value firms' intangible assets, specifically research and development (R&D). Under current U.S. accounting standards, financial statements do not report intangible assets and R&D spending is expensed. Nonetheless, the average historical stock returns of firms doing R&D matches the returns of firms without R&D. However, the market is apparently too pessimistic about beaten‐down R&D‐intensive technology stocks' prospects. Companies with high R&D to equity market value (which tend to have poor past returns) earn large excess returns. A similar relation exists between advertising and stock returns. R&D intensity is positively associated with return volatility.

Using dealer's quotes and transactions prices on straight industrial bonds, we investigate the determinants of credit spread changes. Variables that should in theory determine credit spread changes have rather limited explanatory power. Further, the residuals from this regression are highly cross‐correlated, and principal components analysis implies they are mostly driven by a single common factor. Although we consider several macroeconomic and financial variables as candidate proxies, we cannot explain this common systematic component. Our results suggest that monthly credit spread changes are principally driven by local supply/demand shocks that are independent of both credit‐risk factors and standard proxies for liquidity.

This paper studies the role of fluctuations in the aggregate consumption–wealth ratio for predicting stock returns. Using U.S. quarterly stock market data, we find that these fluctuations in the consumption–wealth ratio are strong predictors of both real stock returns and excess returns over a Treasury bill rate. We also find that this variable is a better forecaster of future returns at short and intermediate horizons than is the dividend yield, the dividend payout ratio, and several other popular forecasting variables. Why should the consumption–wealth ratio forecast asset returns? We show that a wide class of optimal models of consumer behavior imply that the log consumption–aggregate wealth (human capital plus asset holdings) ratio summarizes expected returns on aggregate wealth, or the market portfolio. Although this ratio is not observable, we provide assumptions under which its important predictive components for future asset returns may be expressed in terms of observable variables, namely in terms of consumption, asset holdings and labor income. The framework implies that these variables are cointegrated, and that deviations from this shared trend summarize agents' expectations of future returns on the market portfolio.

This study uses a new data set to assess whether capital structure theory is portable across countries with different institutional structures. We analyze capital structure choices of firms in 10 developing countries, and provide evidence that these decisions are affected by the same variables as in developed countries. However, there are persistent differences across countries, indicating that specific country factors are at work. Our findings suggest that although some of the insights from modern finance theory are portable across countries, much remains to be done to understand the impact of different institutional features on capital structure choices.