Knowledge that Transforms

This article provides guidance on how to evaluate and improve the forecasting ability of models in the presence of instabilities, which are widespread in economic time series. Empirically relevant examples include predicting the financial crisis of 2007–08, as well as, more broadly, fluctuations in asset prices, exchange rates, output growth, and inflation. In the context of unstable environments, I discuss how to assess models’ forecasting ability; how to robustify models’ estimation; and how to correctly report measures of forecast uncertainty. Importantly, and perhaps surprisingly, breaks in models’ parameters are neither necessary nor sufficient to generate time variation in models’ forecasting performance: thus, one should not test for breaks in models’ parameters, but rather evaluate their forecasting ability in a robust way. In addition, local measures of models’ forecasting performance are more appropriate than traditional, average measures. (JEL C51, C53, E31, E32, E37, F37)

This article synthesizes the large literature regarding the role of various players in residential mortgage-backed securities (RMBS) securitization at the center of the 2008–09 US housing and financial crisis. Underwriting banks facilitated wide-scale mortgage fraud by knowingly misreporting key loan characteristics underlying mortgage-backed securities (MBS). Under the cover of complexity, credit rating agencies catered to investment banks by issuing increasingly inflated ratings on both RMBS and collateralized debt obligations (CDOs). Originators who engaged in mortgage fraud gained market share, as did CDO managers who catered to underwriters by accepting the lowest-quality MBS collateral. Appraisal targeting and inflated appraisals were the norm. RMBS and CDO prices indicate that the marginal AAA investor was unaware of pervasive mortgage fraud and ratings inflation, but these factors were strongly related to future deal performance. The supply of fraudulent credit was not uniform, but clustered in certain geographic regions and zip codes. As these dubious originators extended credit to those who could not afford the loans, the credit expansion led to house price booms and subsequent crashes in these zip codes. Overall, a consistent narrative based on substantial research indicates that conflicts of interest, misreporting, and fraud were focal features of the financial crisis. (JEL G01, G21, G28, K42, R30)

This paper synthesizes recent advances in the theoretical and empirical literature on capital controls. We start by observing that international capital flows have both benefits and costs, but some of these are not internalized by individual actors and thus constitute externalities. The theoretical literature has identified pecuniary externalities and aggregate demand externalities that respectively contribute to financial instability and recessions. These externalities provide a natural rationale for countercyclical capital controls that lean against boom and bust cycles in international capital flows. The empirical literature has developed several measures of capital controls to capture different aspects of capital account openness. We evaluate the strengths and weaknesses of different measures and provide an overview of the empirical findings on the effectiveness of capital controls in addressing the externalities identified by the theory literature, that is, in reducing financial fragility and enhancing macroeconomic stability. We also discuss strategies to deal with the endogeneity of capital controls in such statistical exercises. We conclude by providing an overview of the historical and current debates on the role of capital controls in macroeconomic management and their relationship to the academic literature. (JEL D62, F32, F33, F38, F44)

After China’s recent great success in eliminating absolute poverty, addressing relative income inequality becomes a more important issue. This survey finds that income inequality rapidly increased in the first three decades since 1978 but stabilized and slightly declined in the past decade, consistent with the well-known Kuznets hypothesis. In addition to documenting the trend and patterns over time and across groups and regions, seven sources of income inequality are systematically discussed with an effort to reconcile and extend the existing literature. Furthermore, a negative correlation is documented between income inequality and intergenerational mobility, consistent with the Great Gatsby curve observed in developed countries. (JEL D31, D63, O15, P36)

This essay surveys the literature on directed search and competitive search equilibrium, covering theory and a variety of applications. These models share features with traditional search theory, but also differ in important ways. They share features with general equilibrium theory, but with explicit frictions. Equilibria are often efficient, mainly because markets price goods plus the time required to get them. The approach is tractable and arguably realistic. Results are presented for finite and continuum economies. Private information and sorting with heterogeneity are analyzed. While emphasizing issues and applications, we also provide several hard-to-find technical results. (JEL D50, D83)

Recent literature has reconstructed estimates of wealth and income inequality for a range of preindustrial, mostly European, societies covering medieval and early modern times, occasionally reaching back to antiquity and even prehistory. These estimates have radically improved our knowledge of distributive dynamics in the past. It now seems clear that in the period circa 1300–1800, inequality of both income and wealth grew almost monotonically almost everywhere in Europe, with the exception of the century-long phase of inequality decline triggered by the Black Death of 1347–52. Regarding the causes of inequality growth, recent literature ruled out economic growth as the main one. Other possible factors include population growth (also as mediated by inheritance systems) and especially regressive fiscal institutions (also as connected to the unequal distribution of political power). The recently proposed theoretical framework of the inequality possibility frontier (IPF) lends a better understanding of the implications of the reconstructed trends. This article concludes by showing how connecting preindustrial trends to modern ones changes our perception of long-term inequality altogether. (JEL D31, D63, N33)

The role of real estate during the global financial and economic crisis has prompted efforts to better incorporate housing and financial channels into macro models, improve housing models, develop macroprudential tools, and reform the financial system. This article provides an overview of major, recent contributions to the literature in relation to earlier research on what drives housing prices and how they affect economic activity. Particularly emphasized are studies, both theoretical and more strongly evidence-based, that connect housing markets with credit markets, house price expectations, financial stability, and the wider economy. The literature reveals much diversity in the international and regional behavior of house prices and the need to improve data tracking key housing supply and demand influences. Also reviewed are studies examining how monetary, macroprudential, and other policies affect house prices and access to housing. This survey is designed to help readers navigate the plethora of recent studies and understand the unsettled issues and avenues for further research. The findings should be of interest to policy makers concerned with financial stability as well as those dealing with the role of housing in the wider economy (JEL E32, E44, E63, G01, G21, R31).

This survey investigates the increasing importance of global public goods (GPGs) in today’s interdependent world, driven by ever-growing, cross-border externalities and public good spillovers. Novel technologies, enhanced globalization, and population increases are among the main drivers of the rise of GPGs. Key GPGs include curbing climate change, instituting universal regulatory practices, eradicating infectious diseases, preserving world peace, discovering scientific breakthroughs, and limiting financial crises. The survey presents a compact theoretical foundation for GPGs, grounded in the provision of public goods. Because countries may be contributors or noncontributors to a particular GPG, coalition formation and behavior play a role, as do strategic interactions between a contributor coalition and other countries. In the survey, recurrent themes include strategic considerations, alternative institutional arrangements, GPGs’ defining properties, new actors’ roles, and collective action concerns. The four properties of GPGs—benefit non-rivalry, benefit non-excludability, aggregator technology, and spillover range—influence the GPGs’ supply prognoses and the need for and form of provision intervention, which may affect the requisite institutional changes. Three representative case studies illustrate how theoretical insights inform policy and empirical tests. Regional public goods are shown to involve a question of subsidiarity and different actors compared to GPGs. (JEL C71, C72, D62, D70, H41, Q54)

This survey discusses behavioral and experimental macroeconomics, emphasizing a complex systems perspective. The economy consists of boundedly rational heterogeneous agents who do not fully understand their complex environment and use simple decision heuristics. Central to our survey is the question of under which conditions a complex macro-system of interacting agents may or may not coordinate on the rational equilibrium outcome. A general finding is that under positive expectations feedback (strategic complementarity)—where optimistic (pessimistic) expectations can cause a boom (bust)—coordination failures are quite common. The economy is then rather unstable, and persistent aggregate fluctuations arise strongly amplified by coordination on trend-following behavior leading to (almost-)self-fulfilling equilibria. Heterogeneous expectations and heuristics switching models match this observed micro and macro behavior surprisingly well. We also discuss policy implications of this coordination failure on the perfectly rational aggregate outcome and how policy can help to manage the self-organization process of a complex economic system. (JEL C63, C90, D91, E12, E71, G12)

The recent digitization of complete count census data is an extraordinary opportunity for social scientists to create large longitudinal datasets by linking individuals from one census to another or from other sources to the census. We evaluate different automated methods for record linkage, performing a series of comparisons across methods and against hand linking. We have three main findings that lead us to conclude that automated methods perform well. First, a number of automated methods generate very low (less than 5 percent) false positive rates. The automated methods trace out a frontier illustrating the trade-off between the false positive rate and the (true) match rate. Relative to more conservative automated algorithms, humans tend to link more observations but at a cost of higher rates of false positives. Second, when human linkers and algorithms use the same linking variables, there is relatively little disagreement between them. Third, across a number of plausible analyses, coefficient estimates and parameters of interest are very similar when using linked samples based on each of the different automated methods. We provide code and Stata commands to implement the various automated methods. (JEL C81, C83, N01, N31, N32)