Knowledge that Transforms

We collect 2,848 instrumental variable (IV) regressions from 391 papers published in top economics and finance journals and show that estimated IV coefficients are often much larger than their OLS counterparts, even when theory suggests they should be smaller. We derive meta-regression estimators that distinguish measurement error bias from omitted variable bias and simultaneity bias; applying our estimators to a set of 1,040 comparable regressions from 139 papers, we find that measurement error shrinks reported coefficients by about two to four times. Measurement error remains quantitatively important even after accounting for weak instruments, publication bias, instrument invalidity, and heterogeneous treatment effects. Our results suggest that measurement error is a severe, pervasive, and understated source of bias in economics and finance.

We study competition between two payment instruments: bank deposits and digital platform tokens. Using a Hotelling model that integrates the theory of two-sided markets and payment economics, we assess how this competition is affected by a public payment infrastructure that makes private payment instruments interoperable. We show that interoperability, whether implemented as a fast payment system (FPS) or a central bank digital currency (CBDC), may eliminate payment access exclusion and increase trade volumes and social welfare, but at the cost of some disintermediation. When new payment service providers (PSPs) enter and compete for consumers, they soften competition for merchants: incumbent intermediaries then charge merchants higher fees and earn higher profits. This contrasts with entry of PSPs on the merchant side, which disciplines incumbent fees instead.

What are the consequences of making central bank deposits accessible to actors beyond the banking sector? We collect novel micro data on deposit accounts historically held with the Bank of England by individuals and firms other than banks to study their role in the financial panic of 1866. We document that the use of deposit accounts at the central bank soared during the crisis, while commercial banks permanently lost funding. The expansion in the number of active accounts was fueled by individuals, but the intensive margin increase in balances came almost entirely from firms. Recourse to central bank deposits was heterogeneous and persisted well beyond the panic, reflecting easy access, low opportunity costs, and positive network externalities. At the same time, retail borrowers seeking liquidity support from the Bank during the crisis preferred receiving loan proceeds in the form of cash rather than deposits.

We study a large and unanticipated bank cleanup in India after prolonged zombie lending under regulatory forbearance. The cleanup forced widespread zombie exits through bankruptcy. In contrast to a frictionless world where entry automatically follows exit, we show that with financial frictions, local banking conditions shape creation after destruction. New firm entry occurs primarily in regions where banks are present, well-capitalized, competitive, and possess sectoral expertise. We further find a decline in the dispersion of total factor productivity in regions with stronger financial intermediation, consistent with a reduction in misallocation in such areas.

Using novel data from the GSE Credit Risk Transfer (CRT) market and the enactment of the 2020 CARES Act as a natural experiment, we study the ex-ante pricing of mortgage forbearance. We show that private investors demanded higher compensation for bearing mortgage credit risk following the introduction of federal mortgage forbearance. The increase in CRT spreads was larger for securities with greater exposure to judicial foreclosure regimes, lower expected house price growth, higher house price volatility, and riskier borrowers. These patterns suggest that investors priced heightened uncertainty regarding future collateral values and recovery outcomes. We find little evidence that the response was driven by broader financial market conditions, prepayment risk, servicer liquidity concerns, or strategic forbearance take-up. Our findings show how borrower-protection policies are transmitted to mortgage markets through the pricing of mortgage credit risk.

We construct a present-value model with a rational bubble identified using stock market data and survey expectations. The model captures the 1970s “nifty-fifty” bubble, the dot-com bubble, the bubble prior to the 2007–2009 recession, a COVID-19 bubble, and a recent bubble possibly linked to artificial intelligence. When bubble-adjusting the price–dividend ratio, we no longer find explosive dynamics and excess volatility in stock prices. To examine the macroeconomic implications of a bubble, we use the bubble innovation as an instrument in a structural vector autoregression. The results show that a positive bubble shock is expansionary and leads to a higher monetary policy rate.

The Fama–French factors are ubiquitous in empirical finance. We find that factor returns differ substantially depending on when the data were downloaded. A large portion of these retroactive changes appears to be driven by modifications to the factor construction methodology rather than by revisions to the underlying data. Changes to the factors have large effects in two widely studied contexts: mutual fund performance and cross-sectional equity pricing. Model evaluation tests suggest that more recent vintages do not perform better.

This article studies how cash holdings at the onset of the global financial crisis affected the investment behavior of small and medium-sized enterprises (SMEs) after the shock. Using balance sheet data for UK SMEs, we find that cash-rich SMEs maintained their capital stock during the global financial crisis, while cash-poor rivals reduced theirs. This gave cash-rich SMEs an advantage when the economy rebounded, resulting in a persistent investment gap that grew over the recovery period. Competition dynamics, borrowing constraints, and adjustments in cash balances contributed to this amplification effect. The amplification effect was more pronounced for younger and smaller firms and in industries for which credit conditions tightened more. We do not observe a persistent effect of cash in non-crisis periods or for publicly listed firms. Our findings show that when financial constraints tighten after crises, cash holdings are a key determinant of investment by SMEs in the long term.

Information-theoretic methods recover investors’ subjective beliefs by minimizing the statistical discrepancy between beliefs and the data-generating process, subject to assets’ Euler constraints. We show that the estimated beliefs converge in probability to their pseudo-true value. Comparing estimators in the Cressie–Read family, we show that the exponential tilting and empirical likelihood estimators produce qualitatively similar estimates of the risk aversion levels and beliefs. The quadratic divergence estimator leads to negative subjective probabilities, implausibly large risk aversion levels, and underestimation of left tail risk. Our results suggest that large institutional investors, like pension funds, have countercyclical beliefs about the market return, while extrapolative investors have procyclical beliefs. Our results offer an alternative explanation of the momentum effect in stock returns, help reconcile procyclical beliefs reported in individual investor surveys versus countercyclical beliefs implied by rational expectations representative agent models, and establish the information-theoretic approach as a powerful methodology for the recovery of beliefs.

The rise in passively managed corporate debt funds has resulted in an increasingly inelastic demand for corporate debt. In this study, we quantify how passive debt ownership affects firms’ financial policy. Using fund-specific flows to capture firm-level changes in passive debt ownership that are exogenous to firm fundamentals, we find that firms respond to higher levels of passive debt ownership by increasing leverage. The borrower-friendly terms provided by passive debtholders could also theoretically lead to several potential changes in investment or payout policy. We show that passive debt holding does not affect investment policy. Instead, higher passive ownership predicts increased dividend payouts—even for firms far from index thresholds—exacerbating shareholder-debtholder conflicts. Passive debtholders enable these effects by reducing aggregate ex-ante and ex-post monitoring. The presence of a bank monitor moderates the relationship between passive debt ownership and increased payout, reinforcing the importance of this monitoring channel.