Category: Research

Stimulus or austerity: an economist’s search for answers

New finance faculty member Jonathan Parker examines the effects of 2008 stimulus payments

Professor Jonathan Parker

In February 2008, Congress passed a $100 billion stimulus bill aimed at shoring up an an economy on the edge of freefall.

The stimulus awarded a tax rebate of up to $600 per person or $1,200 per couple in hopes that recipients would spend the money and prop up the sagging economy.

Jonathan Parker, one of MIT Sloan’s newest professors, said he believes the 2008 Economic Stimulus Act offers a promising opportunity to study a vexing question: Is household stimulus effective and good public policy?

“My research suggests that the stimulus payments did increase spending, and the extent to which they did informs us about the effects of similar policies on the economy.” Parker said. “We now have a reasonable idea about the spending responses to hitting the Fiscal Cliff or to a proposed tax change.”

“Whether the stimulus bill was good public policy, some will say ’yes,’ others will say ’no,’” he said. “That’s one of the things I’m studying.”

Parker joins MIT Sloan from Northwestern’s Kellogg School of Management, where he wrote several papers examining the impact of stimulus spending. He says at MIT he expects to continue to study stimulus spending versus austerity.

“My view is there is not a great case for either,” Parker said. “A convincing quantitative picture is still murky. A requisite for clarifying that picture is a better understanding of how firms and households behave. That’s what I’m continuously chasing.”

Parker’s path

This fall, Parker returns to MIT, where he received his doctorate in 1996. He joins an impressive roster of finance faculty at MIT Sloan, which is home to Nobel laureate Robert Merton and 2012 Time 100 honoree Andrew Lo.

“It’s a great institution with fantastic colleagues, from the grad students to the most senior faculty member,” Parker said. “It’s an exciting place to be.”

It is also a personal homecoming for Parker, who was born in Portland, Ore., but raised in the Boston suburb of Newton.

As a child, Parker couldn’t avoid being influenced by the academic life. Both parents worked at Boston University—his mother was an administrator, his father a professor of ancient Near Eastern languages and religion specializing in the ancient language Ugaritic.

While he didn’t choose economics until college, Parker’s studies began at the kitchen table.

“My mother was continuously coming up with mechanisms to make sure things were reasonably fairly divided between me and my brother,” he said. For instance, one brother sliced a piece of cake and the other brother got to pick which slice he got. “There’s something about that in economics, determining allocations in reasonable ways, understanding incentives, and thinking about how to make mechanisms that efficiently allocate resources,” said Parker.

His parents sent him to the rigorous Roxbury Latin School in the West Roxbury neighborhood of Boston. Parker went on to earn a bachelor’s in economics and mathematics from Yale University in 1988, and later a PhD in economics from MIT. The longtime headmaster at Roxbury Latin, F. Washington “Tony” Jarvis, an Episcopal priest who oversaw the school from 1974 to 2004, left a lasting impression.

“He was an inspirational figure for thinking about living for more than a house in the suburbs and the 2.5 kids and a minivan,” Parker said. “It was about doing something bigger, better, and beneficial to other people rather than measuring success in life by income.”

Work and public service

Parker studies household economics and asset pricing—the big economic questions that touch on people’s everyday lives.

After posts at the University of Michigan and the University of Wisconsin, Parker taught at Princeton University.

In 2009, while at Northwestern, Parker was tapped to join a team of economists charged with devising a way to attach values to the assets in the government’s Troubled Asset Relief Program (TARP) portfolio. It was critical to find ways to help the government pin values to assets to protect taxpayers. There were many challenges, Parker said.

“How do we value claims the government holds against AIG, Citigroup, and most of the smaller banks in the U.S.?” Parker asked. “Many of the claims on these institutions held by the U.S. government—and so taxpayers—were not traded in the marketplace, so how do you figure out their worth? Given that some may not pay the government back, and the government controls policies that influence whether they will be able to, how do you price the risk in these banks?”

Parker’s work studying the efficacy of stimulus spending started at Princeton with the tax rebates of 2001, and continued at Northwestern. There he set out in several studies to measure exactly what households did with their stimulus checks, and why, with an eye toward influencing future policy.

In 2012, Parker wrote “The Economic Stimulus Payments of 2008 and the Aggregate Demand for Consumption,” with Christian Broda of Duquesne Capital Management. The pair used consumer purchase scans to see how the tax rebates were spent.

What they learned was that after rebates arrived, households raised spending 10 percent in the first week and 4 percent in the following seven weeks, then the spending trailed away. Almost all consumer spending was by households with incomes of $35,000 or less and with two months or less of liquid assets.

Parker said it is tough to sell stimulus programs if households believe they don’t work and are costly because they add to the nation’s long-term debt.

“The $64,000 question is, ’What do we do now—with the US debt to GDP as high as it is and a perceived need to increase spending for demand?’” Parker said. “There’s a tough trade-off because household spending reflects not just cash flow, but also future concerns about who’s going to pay, and will there be a default crisis?”

His research so far doesn’t give a clear answer—stimulus or austerity. But then again, no one has the answer yet.

“Economists who get on TV and say ’I’m sure we should do more stimulus’ or claim that the only way forward is austerity, they are not getting there from the academic evidence they’ve read,” Parker said. “They’re getting there from somewhere else.”

“I’m always humbled by how little we know,” Parker said. “The world is infinitely more complex than our economic models. So we’re continuously learning. Some of the biggest questions in economics are still up for grabs.”

 

Can Financial Engineering Cure Cancer?

Professor Andrew Lo

There is growing consensus that the bench-to-bedside process of translating biomedical research into effective therapeutics is broken. In a paper published in the October 2012 issue of Nature Biotechnology, my coauthors, Jose-Maria Fernandez and Roger M. Stein, and I suggest that this is caused in large part by the trend of increasing risk and complexity in the biopharma industry. This trend implies that the traditional financing vehicles of private and public equity are becoming less effective for funding biopharma because the needs and expectations of limited partners and shareholders are becoming less aligned with the new realities of biomedical innovation. The traditional quarterly earnings cycle, real-time pricing, and dispersed ownership of public equities imply constant scrutiny of corporate performance from many different types of shareholders, all pushing senior management toward projects and strategies with clearer and more immediate payoffs, and away from more speculative but potentially more transformative science and translational research.

We propose a new framework for simultaneously investing in multiple biomedical projects to increase the chances that a few will succeed, thus generating enough profit to more than make up for all the failures. Given the outsized cost of drug development, such a “megafund” will require billions of dollars in capital; but with so many projects in a single portfolio, our simulations suggest that risk can be reduced enough to attract deep-pocketed institutional investors, such as pension funds, insurance companies, and sovereign wealth funds.

A key innovation of this proposal is to tap into public capital markets directly through securitization, using structured debt securities as well as traditional equity to finance the cost of basic biomedical research and clinical trials. Securitization is a common financing method in which investment capital is obtained from a diverse investor population by issuing debt and equity that are claims on a portfolio of assets—in this case biomedical research. Debt financing is an important feature because the bond market is much larger than the equity market, and this larger pool of capital is needed to support the size of the portfolios required to diversify the risk of the drug development process. In addition, this vast pool of capital tends to be more patient than the longest-horizon venture capital fund.

Our findings suggest that bonds of different credit quality can be created, which could appeal to a broad set of short-term and long-term investors. The results from the simulations we ran indicate that a megafund of $5 billion to $15 billion may be capable of yielding average investment returns in the range of 9 percent to 11 percent for equity holders, and 5 percent to 8 percent for bondholders. These returns may be lower than traditional venture capital hurdle rates, but are more attractive to large institutional investors.

To calibrate and test our simulation of the investment performance of a hypothetical cancer drug megafund, we accessed the databases of hundreds of anti-cancer compounds assembled by Deloitte Recap LLC and the Center for the Study of Drug Development at Tufts University School of Medicine. These simulations not only yielded attractive investment returns on average, but also implied that many more drugs would be successfully developed and brought to market. Such an outcome would be particularly welcome given the current scarcity of investment capital in the life sciences industry despite the growing burden of disease. One in two men and one in three women in the United States will develop cancer at some point in their lifetimes, making this one of the major priorities facing society.

We acknowledge that our analysis is only the first of many steps needed to create a private-sector solution to the funding gap in the life sciences industry. The practical challenges of creating a megafund would require unprecedented collaboration among medical researchers, financial engineers, and biopharma practitioners. Support from charitable organizations and the government also could play a critical role in expediting this initiative. In an extension of this simulation, we show that the impact of such support can be greatly magnified in the form of guarantees rather than direct subsidies. The MIT Laboratory for Financial Engineering will be hosting a conference at MIT in June where representatives from all the major stakeholder communities will be invited to explore these ideas together.

Finally, our proposal is clearly motivated by financial innovations that played a role in the recent financial crisis, so it is natural to question the wisdom of this approach. Despite Wall Street’s mixed reputation in recent years, we are convinced that securitization can be used responsibly to address a host of pressing social challenges. With lessons learned from the crisis and proper regulatory oversight, financial engineering can generate significant new sources of funding for the biopharma industry, even in this difficult economic climate. Raising billions of private-sector dollars for biomedical research may seem ill timed and naive—but given the urgency of cancer, diabetes, heart disease, and other medical challenges, the question is not whether we can afford to invest billions more at this time, but rather whether we can afford to wait.

Finance, policy, and global warming; A Q&A with Dr. Robert Litterman

Dr. Robert Litterman, an expert in risk management and quantitative investment strategies, returns to MIT Sloan Feb. 28 to deliver the second of three lectures he will give as the inaugural recipient of the S. Donald Sussman Award.

Robert Litterman

In advance of his talk, Litterman discussed the need for appropriate emissions pricing, the asset allocation model that bears his name, and the role of academia in the development of financial policy.

The first of your three lectures at MIT Sloan was a strong argument that pricing of carbon emissions worldwide must incorporate the cost of the risk emissions pose to society. Have you seen any indication that governments are moving toward appropriate pricing of emissions?

The most important recent development has been the announcement just last week by the Chinese Ministry of Finance that local tax authorities in China will soon berequired to institute a carbon tax. We don’t have much information yet about the level of the tax, or how robust it will be, but this positive development, coupled with the announcement of a carbon tax to take effect in South Africa in 2015, means that carbon taxes will not exist in Europe, Australia, California, China, South Africa, and South Korea.

However, the most important current front on which to focus in carbon pricing is the negotiation to institute a uniform global tax on carbon emissions in aviation. These negotiations are taking place in the International Civil Aviation Organization, the global body that governs civil aviation. Such a tax would be a strong signal that there is a global recognition that appropriate incentives are required to avoid wasting the remaining capacity of the earth’s atmosphere to safely absorb emissions.

The United States position in these negotiations remains unclear. Despite the current administration’s rhetoric about supporting market-based solutions in climate policy and the strong environmental record of Secretary of State John Kerry, there has been no clear signal from the U.S. government that it will support the creation of a market-based-mechanism to institute an appropriate price for emissions in commercial aviation, a policy that the aviation sector committed to more than a decade ago. Without appropriate incentives both airlines and the public will be led to continue their current inappropriate behavior, which creates excessive emissions. Sadly, if this waste of the atmosphere’s capacity to safely absorb emissions leads to much higher than necessary emissions prices in the future both the aviation sector and those who wish to fly will pay the price. In fact, even though aviation is currently a small part of the climate problem, because of its steep demand curve for future emissions capacity, it is in aviation’s best interest to lead the effort to immediately price emissions globally at an appropriate level in all sectors in order to efficiently allocate this remaining scarce resource across time.

Your second lecture at MIT Sloan will discuss the Black-Litterman model for asset allocation, which you developed at Goldman Sachs in 1990 with former MIT Sloan professor Fischer Black. Two decades later, what is your assessment of the model?

The Black-Litterman model has proven to be a very useful tool for building portfolios. As I will discuss in my second lecture, the incorporation of a prior that centers asset expected returns on equilibrium values provides a framework that allows investors to more flexibly express their views.

The model has been usefully employed in asset allocation contexts as well as portfolio construction of actively managed portfolios. The performance of Black-Litterman optimized portfolios, however, depends not so much on the Black-Litterman framework as the accuracy of the views that are supplied by the investor.

Thus, the benefit of Black-Litterman is to allow investors to efficiently allocate risk to take advantage of their forecasts. This is particularly valuable in contexts where there are constraints, transactions costs, or other trade-offs, for example, the use of leverage or balance sheet constraints.

In recent years many other academics and practitioners have extended Black-Litterman in ways not imagined early on. See, for example, Attilio Meucci’s paper, “The Black-Litterman Approach: Original Model and Extensions.”

As the inaugural recipient of the S. Donald Sussman Award, what has been the highlight of your experience visiting MIT Sloan and meeting with finance faculty and students?

Even though I was an assistant professor at MIT over 30 years ago, coming back to give a public lecture was a unique opportunity for me to participate in this incredible center of intellectual excellence. Obviously, coming back in the context of the Sussman Award, and having the opportunity to invite my family and friends to listen to a talk on a topic that I feel very passionate about was a personal highlight. Beyond that, the substantive discussions that took place with both students and faculty over lunch and during the afternoon of the day of the first lecture were very useful. And finally, I remember the dinner in the MIT Museum was lots of fun in an incredibly nice venue.

MIT Sloan this year is debuting the MIT Center for Finance and Policy, which will connect academics and policymakers in the public and private sectors to develop better, more informed financial policy and decision-making. Considering the recent financial crisis, what role do you see for the academic world in the development and support of financial policy?

Academia provides an incredibly important opportunity for impartial and informed debate about many of the most important issues in finance. This academic debate provides the backdrop for the development of financial policy and practice. I have had a rather unique opportunity in my career to participate in all three venues: in academia for two years at MIT, in government policy development for five years within the Federal Reserve system, and then for a 25 year career on Wall Street in the private sector.

All three venues—academia, the public sector, and the private sector—are important, but the incentives in each are different, and those incentives matter. Only in academia are participants rewarded for developing knowledge for its own sake. This independence and high ideal is a precious aspect of the academic environment, although for those who choose this venue it is unfortunately necessarily coupled with a frustrating amount of subjectivity in the recognition of valuable contributions.

Nonetheless, both public policy and private practice are eventually constrained, as they should be, by the knowledge that flows from the free and open academic debate. The better these sectors are connected to and communicate with academia, the better off will be the functioning of financial markets. Bringing academic insights to the public and private sectors is a key aspect of both my role as a board member of the Heller-Hurwicz Economics Institute at the University of Minnesota, and as the Executive Editor of theFinancial Analysts Journal. Facilitating this cross-sector communication of knowledge is incredibly important and I look forward to the contribution of the MIT Center for Finance and Policy.

Visit MIT Sloan Finance on TechTV here to view the S. Donald Sussman Lecture videos.