selected publications
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wealth, price levels, and product quality
International Economics, March 2022 Why are price levels in Germany lower than in Switzerland despite comparable productivity levels and the possibility of goods arbitrage in this region? Standard theories in macroeconomics have severe difficulties in explaining this theoretically important outlier. We construct a dataset of 73 developed and developing countries to highlight the tight connection between price levels, product quality and household wealth. We find that wealth per capita has a 20 percentage points higher explanatory power than income per capita — the key variable implied by standard theories. Analyzing more than 4000 product import categories, we find that Swiss unit values are more than twice as high as German unit values in the median product category. We then provide a theory linking these three forces. Wealth induces consumption shifts toward more expensive goods. As official price statistics tend to underestimate quality improvements, they may overstate prices. In turn, higher product quality that comes with higher wealth inflates prices and thus contributes toward explaining price level differences across countries.
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antinoise in u.s. equity markets
Quantitative Finance, June 2021 There are many well documented behavioral biases in financial markets. Yet, analyzing U.S. equities reveals that less than 1% of returns are predictable in recent years. Given the high number of biases, why are returns not more predictable? We provide new evidence in support of one possible explanation. In the long-run, low correlations across signals that trigger biases may create sufficient antinoise which mutes more sizable patterns in returns. However, in the short-run, correlation spikes coincide with market volatility indicating that behavioral biases may become more visible during crises.
habit persistence and the long-run labor supply
Economics Letters, Volume 124, Issue 2, August 2014, Pages 243–247 Standard macroeconomic models possess the undesirable feature that people stop working in the long run. Assuming standard parameters, the neoclassical model predicts that 2% of annual productivity growth leads to a 99% decline in the labor supply after 624 years. Yet, this contradicts the fact that labor hours per capita are relatively stable, even over a long period of time. This paper shows how internal and external habit persistence each work to stabilize the long run labor supply, independent of key parameter choices.
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labor market frictions, investment, and capital flows Economics Letters, Volume 163, February 2018, Pages 27–31
The standard neoclassical model predicts that countries with higher productivity growth rates experience sharp increases in investment that are followed by rapid declines. This monotonic investment response contrasts with the empirical evidence that suggests a rather hump-shaped investment behavior. In this paper, we present a two-country general equilibrium model that generates hump-shaped investment responses from labor market frictions. In the model, we decompose investment into tradable and non-tradable components and show that an increase in the growth rate of a country results in scarcities of the non-tradable components which raise the relative price of investment goods. These scarcities occur because labor is unable to reallocate quickly between sectors within economies. This mechanism has two main implications. First, the induced movement in relative prices equates cross-country returns to capital and thus greatly reduces initial investment. Second, domestic saving now plays a more important role in financing investment, inducing a co-movement between these variables.
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the cross-section of commodity returns: a non-parametric approach
The Journal of Financial Data Science, Summer 2020, jfds.2020.1.034 To what extent are financial market returns predictable? Standard approaches to asset pricing make strong parametric assumptions that undermine their return-predicting ability. The authors employ tree-based methods to overcome these limitations and attempt to approximate an upper bound for the predictability of returns in commodities futures markets. Out of sample, they find that up to 3.74% of 1-month returns are predictable—more than a 10-fold increase from standard approaches. The findings hint at the importance multiway interactions and nonlinearities acquire in the data; they imply that new factors should be tested on their ability to add explanatory power to an ensemble of existing factors.
time-series momentum: a monte-carlo approach
The Journal of Financial Data Science, Fall 2019, jfds.2019.1.012 This paper develops a Monte-Carlo backtesting procedure for risk premia strategies and employs it to study Time-Series Momentum (TSM). Relying on time-series models, empirical residual distributions and copulas we overcome two key drawbacks of conventional backtesting procedures. We create 10,000 paths of different TSM strategies based on the S&P 500 and a cross-asset class futures portfolio. The simulations reveal a probability distribution which shows that strategies that outperform Buy-and-Hold in-sample using historical backtests may out-of-sample i) exhibit sizable tail risks ii) underperform or outperform. Our results are robust to using different time-series models, time periods, asset classes, and risk measures
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" In economics and finance, there are often many different rationalizations for each fact.
My approach is simple. I look at different ensembles of facts.
I ask which combination of explanations can explain the ensembles.
Thereby, I can exclude candidates.
My approach is simple. I look at different ensembles of facts.
I ask which combination of explanations can explain the ensembles.
Thereby, I can exclude candidates.
working papers
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currency implied copulas
PDF soon Fahri & Gabaix (2016) provide weak evidence from currency options that may explain why i) carry trades appear to be occasionally profitable in historical data ii) nominal exchange rate volatility is difficult to reconcile with a variety of models calibrated using historical data and iii) short-term exchange rates are disconnected from fundamentals. We provide a second piece of evidence supporting the same conjectured causality by studying cross-asset class OTC basket options. More specifically, we calculate implied copulas which reveal that expected correlations between extremely negative currency returns, negative domestic stock market returns, and negative domestic short-term interest rate changes are more skewed towards unity in currencies that appreciate faster.
solving identification problems in macro-economics with ensemble methods
PDF soon Experiments in economics have failed to provide key insights into long-standing questions because of two main reasons: first, they abstract from rich interactions between different economic forces that characterize real-world data. Second, there is a very limited and often quite exotic number of real world economic situations that can serve as quasi-experiments. It is often difficult to learn anything general from such situations. In this paper we present a different strategy to causal identification. Employing Monte-Carlo Tree Methods, we systemize the approach of Obstfeld and Rogoff (2001). We construct a dark pool that contains a large number of robust empirical facts from international macro, trade, growth and finance. It also contains a large set of tools from these fields including a variety of utility functions, market frictions and production setups. We draw 1m random subsets of facts from this pool and attempt to match them with randomly drawn tools. We stop the search procedure after obtaining matches in each subset. In over 95% of the draws, we converge to a setup that features habit persistence, non-nomothetic preferences, labor market frictions, and Melitz-style production. By contrast, in less than 5% of the draws we converge to a frictionless setup with standard utility.
price levels, non-homothetic preferences, and economies of scale with Adnan Velic PDF soon
A theory that aims at explaining the behavior of the real exchange rate needs to assign a central role to cross-country differences in product quality and variety. We present a model in which the heterogeneity in goods quality implies that the price level increases in development. In the model, higher quality goods are more difficult to produce and therefore command higher prices. As a result of fixed costs in production, only countries with sufficiently high levels of development can produce these goods in notable quantities. This scale effect in conjunction with non-homothetic preferences creates gains from trade: less advanced economies produce and export lower quality goods, while more advanced economies produce and export higher quality goods. Finally, we show that if official price indexes understate quality and variety growth annually by 1 percentage point, we can explain 60% of the differences in prices levels between developed and developing countries.
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bias or risk? PDF soon
Many empirical anomalies have been described in the finance literature. Yet, it is unclear whether they reflect behavioral biases, risk factors, or just noise. Employing Monte Carlo methods, we argue that it is impossible to identify the deeper cause. We show that for each trading rule derived from an anomaly a lethal market event exists. Thus, even if an anomaly results from a behavioral bias, attempting to exploit it exposes trading to the potential of a full loss. In turn, it cannot be distinguished if a premium earned from a strategy compensates for the risk or the bias.
competing gains from trade with Adnan Velic
Trinity Economics Paper 1116 Differences in growth rates across countries imply a strong relation between factor proportions based trade and key aggregate economic outcomes. We construct two macro-trade datasets and illustrate that this relation is rather weak in the data. We propose a simple explanation: in the presence of intra-industry trade, pronounced trade specialization patterns culminate in a loss of varieties. In a dynamic two-country model, we illustrate that the introduction of intra-industry trade overwhelmingly subdues the inter-industry trade dynamics and realigns the behavior of standard models with the empirical evidence along various dimensions.
antinoise with Enoch Cheng
SSRN Working Paper Equity returns are not very predictable despite the presence of many well-documented behavioral biases and risk factors. Why? We collect a comprehensive global dataset covering over 24,000 tradable equities and representing more than 99.9% of the market cap on developed exchanges. Analyzing three decades of data, we present two pieces of new evidence for one possible explanation: i) low correlations across signals that trigger trading may create sufficient antinoise to suppress higher overall predictability ii) subsamples with higher predictability are associated with higher cross-signal correlations. Yet, we also find that signal correlation spikes coincide with market volatility, indicating that trading styles may become more correlated during crises and, thus, that predictability may rise.
the emergence of a global middle class and the rise of U.S. income inequality PDF soon
In a model of heterogeneous consumers, non-homothetic preferences and industry directed technical change, I show that the emergence of a sizable global middle class that consumes homogeneous goods has fueled income inequality in the U.S.. In the model, a large market arises as a result of the advent of a global middle class. The dominant size of this market creates massive profit opportunities for firms. To gain from these opportunities, firms redirect activities. As a consequence, quality and variety growth predominantly occurs in this market. There are two main effects: first, the profits allow firm owners to pull away in terms of nominal income and, therefore, increase income inequality. Second, higher income leads richer consumers to consume more luxurious goods outside the main market where relative prices increase. Employing different price indexes for upper and middle class, I show that the price index of the middle class annually grows 1.5 percentage points slower than the price index of the rich. This relative price movement offsets the growing gap in nominal incomes between the bottom 90% vs. the top 5% or top 1% of U.S. consumers. Finally, I theoretically illustrate that a redistribution policy from rich to poor lowers the incentives for innovation and makes everybody worse off.
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factor stress tests PDF soon
Value, Momentum, Growth, Carry, Volatility, Size, Yield, and Quality have been found using narrow calibrations on historical data with very few tail events. We question the out-of-sample validity of such factors by showing that they are based on results that are highly sensitive to tail events. To illustrate this point, we develop Monte-Carlo simulations with an emphasis on tail event heterogeneity. Our simulations reveal that strategies based on those factors are likely to collapse in tail events that differ in timing and duration from those observed historically.
Following standard macroeconomic theory, recent evidence of a non-increasing labor share in income and of complementarity between capital and labor imply that productivity growth must be labor-augmenting. Analyzing post-war U.S. data, we however find that technical progress is rather evenly distributed across capital and labor intensive industries. To reconcile standard theory with the evidence, we stress inflation measurement errors in post-war U.S. data. If aggregate inflation is annually overstated by as little as a third of a percentage point, technical progress is already over 50 percent higher in the labor-intensive industries than in the capital-intensive industries.
solving leontief’s paradox with endogenous growth theory with George Sorg-Langhans and Adnan Velic
UCD Centre for Economic Research WP 18/19 Theories of international trade have severe difficulties in explaining why, despite i) substantial differences in factor-proportions across industries and ii) considerable cross-country differences in capital-labor ratios, the iii) the evidence for factor-proportions trade is rather weak. We propose a simple explanation of this well known finding: standard trade theories treat important forces such as the distribution of productivity within the economy as exogenous. We argue instead that the productivity allocation is endogenous and counter-balances factor-proportion differentials between countries. Consequently, comparative advantage across countries of different development levels is negligible and this is why the incentives for trade are low.
a model of mean-reversion
PDF soon Wealth mean reversion over generations is an empirically robust phenomenon. What explains it? I argue that incentives are a key driver. In my model output is generated by organizations. The incentives within these organizations favor those who comply with the institutional goal of increasing profits. There are two types of employees. Those who are wealthy enough to opt out and those who are too poor to opt out. Complying ist costly in utility terms and not complying means one forgoes income. In equilibrium the latter type therefore complies while the former opts out. The latter type advances income-wise while the former regresses. As a result, the wealthier type ends up with less income while the former ends up with more income and hence there is mean reversion in terms of wealth.
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recessions, leverage, and volatility insurance PDF soon
Tail-hedging can be beneficial for individuals. What if the entire economy tail-hedges? This paper argues that central-bank-issued mandatory volatility insurance for firms creates two desirable equilibrium effects that stabilize the economy during recessions: by paying during volatile times, it directly (1) strengthens firms’ balance sheets; by preventing margin calls and fire sales, it indirectly (2) lowers peak volatility. The latter effect reduces insurance costs.
automation, new technology and non-nomothetic preferences with Adnan Velic
UCD Centre for Eocnomic Research WP 19/12 This paper provides a microfoundation of the neoclassical growth theory. Motivated by recent evidence indicating that goods with higher income elasticities are more labor intensive, we present a simple model with non-homothetic preferences and industry heterogeneity in production technologies to rationalize a substantial share of labor in income despite ongoing automation of tasks. In the model, a hierarchal demand structure induces continuous reallocations of capital and labor toward more sophisticated goods that become increasingly difficult to produce but provide higher quality. Initially, labor has a comparative advantage over capital in the production of these complex goods. Subsequently, however, as technology progresses, capital replaces labor in these tasks and labor moves on to produce even more sophisticated goods. Importantly, automation of more advanced goods requires increasingly sophisticated capital. Such advanced capital remains scarce and that is why labor takes up a substantial fraction in income independent of core parameter assumptions. While our model features an entirely different mechanism and has a very different interpretation, we show that its aggregate representation is the one of a neoclassical model with labor-augmenting technical change.
on the two prerequisites of balanced growth
AEA 2016 conference This paper argues that the two theoretical prerequisites of balanced growth - purely labor augmenting technical progress and a unitary capital-labor elasticity - are inconsistent with long-run evidence from a simple decomposition of the post-war U.S. economy into heterogeneous industries. My decomposition is motivated by empirical evidence that the degree of substitution between capital and labor varies across industries and so does the capital-output ratio. Embedded into an otherwise standard macroeconomic framework, we show that the assumption of a single representative consumer with homogeneous preferences over industry value added implies that capital and labor have an elasticity of less than unity on aggregate. Thus, balanced growth relies on technical progress to be purely labor augmenting which further implies that technical progress is higher in industries that have a lower capital-labor elasticity and a lower capital-output ratio. In long-run U.S. data, however, I find no evidence that supports such a relation. Yet, I show that the network structure of the post-war U.S. economy induces balanced growth through the industries' intermediate input-output linkages. I show that this result emerges under a variety of parameter assumptions.
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I use machine learning in OTC derivatives arbitrage
highly recommended reads
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The Scientific Illusion in Empirical Macroeconomics
by Larry H. Summers The Scandinavian Journal of Economics, Vol 93 It is argued that formal econometric work, where elaborate technique is used to apply theory to data or isolate the direction of causal relationships when they are not obvious a priori, virtually always fails. The only empirical research that has contributed to thinking about substantive issues and the development of economics is pragmatic empirical work based on methodological principles directly opposed to those that have become fashionable in recent years.
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This paper discusses empirical approaches macro-economists use to answer questions like: What does monetary policy do? How large are the effects of fiscal stimulus? What caused the Great Recession?Why do some countries grow faster than others? Identification of causal effects plays two roles in this process. In certain cases, progress can be made using the direct approach of identifying plausibly exogenous variation in a policy and using this variation to assess the effect of the policy. However, external validity concerns limit what can be learned in this way. Carefully identified causal effects estimates can also be used as moments in a structural moment matching exercise. We use the term “identified moments” as a short-hand for “estimates of responses to identified structural shocks,” or what applied microeconomists would call “causal effects”. We argue that such identified moments are often powerful diagnostic tools for distinguishing between important classes of models (and thereby learning about the effects of policy). To illustrate these notions we discuss the growing use of cross-sectional evidence in macroeconomics and consider what the best existing evidence is on the effects of monetary policy.
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Government statistics paint an excessively grim picture of what is happening to real wages and the growth of real national income. Although most households’ take-home cash has been rising very slowly for decades, their standard of living is increasing more rapidly because those wages can now buy new and better products at little or no extra cost. The government’s measure of real incomes gives too little weight to this increase in what take-home pay can buy.
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Rare Disasters and Exchange Rates
by Emmanuel Farhi and Xavier Gabaix Quarterly Journal of Economics 131 (1): 1-52. We propose a new model of exchange rates, based on the hypothesis that the possibility of rare but extreme disasters is an important determinant of risk premia in asset markets. The probability of world disasters as well as each country’s exposure to these events is time-varying. This creates joint fluctuations in exchange rates, interest rates, options, and stock markets. The model accounts for a series of major puzzles in exchange rates: excess volatility and exchange rate disconnect, forward premium puzzle and large excess returns of the carry trade, and comovements between stocks and exchange rates. It also makes empirically successful signature predictions regarding the link between exchange rates and telltale signs of disaster risk in currency options.
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