Tag Archives: MIT Sloan

Evidence of the Financial Accelerator using Corn Fields

The role of financial frictions in amplifying and propagating economic shocks has received significant attention in explaining fluctuations over the business cycle. Financial frictions introduce a wedge between the cost of external finance and the opportunity cost of internal funds. This implies that the strength of firms’ balance sheets will affect the manner in which their investment activity reacts to economic shocks. Current firm investment affects future balance sheet strength, creating a dynamic feedback loop that propagates economic shocks over time. Theoretical models of this so-called “financial accelerator” have played an important role in the literature (e.g. Bernanke and Gertler (1989); Kiyotaki and Moore (1997); Shleifer and Vishny (1992), Bernanke (2007)).

In spite of their importance, empirically testing financial accelerator models has proven to be difficult. While a vast literature exists examining the presence of financial frictions, these frictions serve only as a necessary ingredient for financial accelerator models. See, for example, Lamont (1997), Rauh (2006), Hennessy and Whited (2007) and Kaplan and Zingales (1997), Hubbard and Kashyap (1992), and Rajan and Ramcharan (2012). The essence of financial accelerator models—namely, the role that financial frictions play in propagating economic shocks—remains understudied empirically. There are at least three reasons why this is the case. First, it is difficult to measure exogenous shocks that affect firm productivity. Second, measuring firm productivity, in and of itself, is quite challenging. Indeed, standard productivity measures, such as TFP, are often residuals of regressions relating (mismeasured) outputs and inputs. Finally, it is difficult to obtain clean measures of collateral values, which often play an important role in financial accelerator models.

In a recent project we test the central predictions of financial accelerator models by focusing on a novel setting – the agricultural sector in Iowa. This sector provides a natural environment, rich in data, to examine how shocks to productivity are propagated, both during normal times as well as during crises. As a source of identification, we use exogenous shocks to productivity arising from variation in weather. To analyze productivity, and relate it to productivity shocks as well as measures of financial constraints, we exploit the rich data available on farm crop yields. Finally, focusing on the agricultural sector provides us with a measure of collateral values: land is a main source of collateral for farms and data on land prices are readily available.

We find that the effect of weather shocks is indeed persistent: past weather-driven shocks to productivity affect both current farm yields as well as current land values, up to two years following the shock. We also find these effects are weaker for counties with higher per-capita income. Consistent with the importance of financial frictions in accelerator models, our results show that the sensitivity of farm yields and land values to past weather shocks increases during the 1980s farm debt crisis. The effect is economically substantial, with the sensitivity of yields to past shocks increasing during the debt crisis by a factor of more than three. The result highlight how temporary shocks to productivity can have long lasting effects.

Rajkamal Iyer is an Associate Professor of Finance at MIT Sloan School of Management.

Contributors to this post include Nittai Bergman,  Associate Professor of  Finance at MIT Sloan and Richard Thakor, a doctoral student at MIT Sloan.

Unfunded State and Local Healthcare Benefits, the Elephant in the Room?

Last week Bob Pozen, a Visiting Senior Lecturer here at MIT Sloan with a distinguished background in government, business and education gave an eye-opening lunch talk. The topic was “Other Post-Employment Benefits” or OPEBs—which is accounting jargon for the liabilities governments incur for retiree healthcare.

Here’s what he found:

“The 30 largest American cities had over $100 BILLION in retiree healthcare deficits in 2013, as estimated by the Pew Charitable Trust. In that year, New York City showed the most serious retiree healthcare deficits at $22,857 per household. The retiree healthcare deficits of the States were even larger in 2013 — a total of $528 BILLION according to the credit rating agency Standard & Poor’s.”

How have such enormous liabilities gone largely under the radar? One reason appears to be lack of transparency in how they are reported. Governments are not required to fund those liabilities, and in most places they don’t appear on balance sheets. (That omission will be corrected if GASB, the government accounting standards setter, prevails.) OPEBs also lack the constitutional protections of pension promises. That means cities like Detroit that run into financial trouble may find a way out of those obligations. In most places though, taxpayers will foot the bill unless benefits are renegotiated.

You can read more about OPEBs and Bob’s suggestions for how to address them at:

Real Clear Markets – “Unfunded Retired Healthcare Benefits are the Elephant in the Room

Boston Globe – “Boston Must Rein Retiree Health Plans

Tackling the challenges of governments as financial institutions

From the MIT Sloan Newsroom:

Governments not only regulate the private financial marketplace, they also own and operate some of the world’s largest financial institutions. Government agencies make trillions of dollars of loans, insure large and complex risks, and design new financial products. Yet their leaders often lack the analytical support and rigorous financial training of their peers in the private sector, and transparency is often lacking.


The MIT Center for Finance and Policy officially launched this month to address those gaps, along with other challenges facing financial policy makers.

“This is a big unmet need,” said Professor Deborah Lucas, director of the center. “To have an academic center devoted to the broad swath of government financial policies that have such an enormous effect on the allocation of capital and risk in the world economy.”

“What we want to do is to promote research that policymakers, practitioners, and informed citizens can turn to as an objective source of information when they’re thinking about these policy issues. That information often isn’t available now,” she said.

Research endeavors so far include, among others: the production of a world atlas of government financial institutions, an effort helmed by Lucas to catalog, compare, and evaluate governments’ financial involvement worldwide; a project led by Professor Andrew Lo to develop a dashboard that measures systemic financial risk; a study of the effects of algorithmic and high frequency trading, led by Professor Andrei Kirilenko; and a study of policies on retirement finance led by MIT Sloan professor and Nobel laureate Robert Merton.

Lo, Kirilenko, and Merton are all co-directors of the center.

Along with the research work, Lucas said there is also an educational mission for the center. In many cases, the center’s leaders say, financial problems could have been avoided, mitigated, or at least predicted had public sector workers had an education on par with that received by many private sector finance professionals.

“The idea is to provide the people who are working on finance within a government context with the same skillset as their peers in private industry,” Lucas said. “One reason you see a lack of finance education is because it’s tended to be a rather expensive education. And people going into the public sector may not even realize that finance is what they will need to know.”

At MIT Sloan, work at the center has already led to the creation of Kirilenko’s new course—Core Values, Regulation, and Compliance—as well as a student club on financial markets and policy.

The center began sponsoring events in October 2013, but officially launched Sept. 12-13 with the inaugural MIT Center for Finance and Policy Conference in Cambridge, Mass. More than 120 people attended the invite-only event, which featured discussions on the cost of government credit support, the costs of single-family mortgage insurance, and contagion in financial markets. Peter Fisher, senior director at BlackRock Investment Institute and a former undersecretary at the U.S. Department of the Treasury, gave a keynote talk.

The conference also included a panel discussion on improving government financial institutions, which addressed the need for government agencies to improve how they manage credit portfolios and monitor program risk levels over time. Panel members also discussed ways to raise red flags when there are problems in government credit programs.

The outlook was not entirely dire. “The move toward embracing risk management concepts across the federal government has been impressive in recent years,” said Doug Criscitello, a managing director at Chicago-based audit, tax, and advisory firm Grant Thornton and the former CFO of the U.S. Department of Housing and Urban Development. “We’ve seen the rise of independent risk management offices … that are housed outside the credit extension department.”

Lucas said she believes MIT’s depth in finance, economics, policy, and systems thinking make it the ideal place to study governments as the world’s largest and most complex financial institutions.

“I think an important reason that more academics haven’t taken on these issues—despite their importance—is that they are extremely complex,” she said. “Making progress takes a big investment in understanding institutions and laws and motivations. The problems are inherently interdisciplinary. And MIT is this great institution in terms of having the horsepower and energy to go after it and say ‘We can hit this question from a lot of different dimensions.’”