Using survey forecasts, we find that systematic errors in expectations of long-term inflation and short-term nominal earnings growth are the main driver of prices and return puzzles for bonds and stocks. We demonstrate this by deriving and testing a single necessary and sufficient condition based on accounting identities. Errors in expectations of short-term inflation and long-term nominal earnings growth do not play a role in either asset market. Because of these systematic errors, real cash flow expectations closely match aggregate bond and stock prices, leaving little room for time-varying discount rates. These expectations also accurately match key return puzzles for bonds and stocks: the rejection of the expectations hypothesis and stock return predictability. These results are consistent with a simple model in which agents believe the persistences of inflation and nominal earnings growth are magnified versions of the objective persistences.
Subjective Cash Flow and Discount Rate Expectations Journal of Finance March 2021 with Ricardo De la O (Download Expectations)
Why do stock prices vary? Using survey forecasts, we find that cash flow growth expectations explain most movements in the S&P 500 price-dividend and price-earnings ratios, accounting for at least 93% and 63% of their variation. These expectations comove strongly with price ratios, even when price ratios do not predict future cash flow growth. In comparison, return expectations have low volatility and small comovement with price ratios. Short-term, rather than long-term, expectations account for most price ratio variation. We propose an asset pricing model with beliefs about earnings growth reversal that accurately replicates these cash flow growth expectations and dynamics.
Survey expectations of dividend growth (blue) vary substantially over time and strongly comove with the S&P 500 price-dividend ratio (red). Survey expectations of returns (green) are relatively flat over time and have low comovement with the price-dividend ratio.
This paper studies how municipal governments jointly manage spending, credit market borrowing, and a public employee pension system. I model governments as levered investors who must meet non-defaultable pension obligations and may value government spending more than citizens. I quantify the model using data on California cities, including a new record of fiscal emergencies, tax increases required to maintain essential city services. After the financial crisis depleted pension funds, cities engaged in excessive risk-taking: the fiscal emergency option encouraged gambling for resurrection that kept cities vulnerable to shocks well into the recovery. To correct this problem, a spending cap works better than a restriction on risk-taking.
California city governments are highly levered. They issue safe liabilities (bonds and pensions) and invest in risky equity-based pension funds. The cities with the lowest Assets - Total Liabilities are also the most exposed to risky pension funds.
This paper studies the effect of public pension obligations on a sovereign government's commitment to repaying debt. In the model, the government can renege on its pension promises but suffers a cost from losing the trust of households about future pensions. Large pension promises act as a commitment device for debt because they require the government to have regular access to credit markets. The government's decision to default is driven by its total obligations, not just its debt. Thus, there is a range of pension obligations large enough to act as a commitment device without raising total obligations to the point of default. This otherwise deterministic economy has an endogenous cycle in which periods of high spending and increasing debt are followed by periods of pension reform and debt reduction. The model successfully produces high debt in excess of 100% GDP without default and back-loaded pension cuts that match salient features of recent reforms in six EU nations.