First Look

February 10, 2009

An ounce of prevention is worth a pound a cure, as the saying goes. The same applies to government and the U.S. financial system, according to HBS professor David Moss in his working paper available for download, "An Ounce of Prevention: The Power of Public Risk Management in Stabilizing the Financial System." Moss looks at bank failures and financial panics past and present, and argues that prudent oversight is needed on an ongoing basis.

"Almost everyone now recognizes that the government has a critical role to play—as the lender, insurer, and spender of last resort—in times of crisis. But effective public risk management is also needed in normal times to protect consumers and investors and to help prevent financial crises from starting in the first place," he writes.

"Today, the biggest threat to our financial system is posed not by volatile commercial banks (as in 1933), but rather by systematically significant institutions that have the power to trigger financial avalanches. And the threat posed by these institutions is only compounded by the unprecedented federal guarantees introduced in response to the current crisis and the pervasive moral hazard they spawn," he continues.

Also new this week: a Harvard Business Review article, "Just Because I'm Nice, Don't Assume I'm Dumb," and cases on, respectively, GLOBALGAP food safety standards and transforming the economy of the United Arab Emirates.

— Martha Lagace

Working Papers

Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds


The covariance between U.S. Treasury bond returns and stock returns has moved considerably over time. While it was slightly positive on average in the period 1953-2005, it was particularly high in the early 1980s and negative in the early 2000s. This paper specifies and estimates a model in which the nominal term structure of interest rates is driven by five state variables: the real interest rate, risk aversion, temporary and permanent components of expected inflation, and the covariance between nominal variables and the real economy. The last of these state variables enables the model to fit the changing covariance of bond and stock returns. Log nominal bond yields and term premia are quadratic in these state variables, with term premia determined mainly by the product of risk aversion and the nominal-real covariance. The concavity of the yield curve—the level of intermediate-term bond yields, relative to the average of short- and long-term bond yields—is a good proxy for the level of term premia. The nominal-real covariance has declined since the early 1980s, driving down term premia.

Download the paper:

Global Currency Hedging


(Forthcoming in the Journal of Finance.) Over the period 1975 to 2005, the U.S. dollar (particularly in relation to the Canadian dollar) and the euro and Swiss franc (particularly in the second half of the period) have moved against world equity markets. Thus these currencies should be attractive to risk-minimizing global equity investors despite their low average returns. The risk-minimizing currency strategy for a global bond investor is close to a full currency hedge, with a modest long position in the U.S. dollar. There is little evidence that risk-minimizing investors should adjust their currency positions in response to movements in interest differentials.

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The Bloody Millennium: Internal Conflict in South Asia


This paper documents the short-term and long-term trends in internal conflict in South Asian countries, using multiple data sources. I find that incidents of terrorism have been rising across South Asia over the past decade, and this increase has been concentrated in economically lagging regions in the post-2001 period. This is in contrast to both the historical patterns of conflict and the evolution of other types of violence. Analyzing the role of economic, geographic, and demographic factors, I find that poorer areas have significantly higher levels of conflict intensity. The paper reviews the various approaches taken by governments to deal with conflict, contrasting security-based approaches with political accommodation and economic approaches. Finally, the paper reviews the potential role of regional cooperation in mitigating conflict.

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An Ounce of Prevention: The Power of Public Risk Management in Stabilizing the Financial System


The magnitude of the current financial crisis reflects the failure of an economic and regulatory philosophy that had proved increasingly influential in policy circles over the past three decades. This paper suggests (1) that contrary to the prevailing wisdom, New Deal policies (including federal deposit insurance and bank supervision) worked to stabilize the financial system; (2) that the financial catastrophe of 2007-2009 was not an accident, but rather a mistake, driven by a deregulatory mindset that took 50 years of post-New Deal financial stability for granted; and (3) that the dramatic federal response to the current financial crisis has created a new reality, in which virtually all systemically significant financial institutions now enjoy an implicit guarantee from the federal government that will continue to exist (and continue to generate moral hazard) long after the immediate crisis passes. Based on this analysis, one major step that is necessary now to help ensure financial stability in the future is to identify and regulate "systemically significant" institutions on an ongoing basis, rather than simply in the heat of a crisis. To guard against moral hazard (in the face of large implicit guarantees) and to ensure the safety of the broader financial system, these institutions must face significant prudential regulation, they should be required to pay premiums for the federal insurance they already enjoy, and they should be subject to an FDIC-style receivership process in the event of failure.

Download the paper:


Cases & Course Materials

Altoona State Investment Board: December 2008

Harvard Business School Case 809-095

Rod Calhoun, the head of the Altoona State Investment Board's private equity investment program, considered the communication he had just received. It was from Permira, the leading European buyout fund, and concerned its fourth fund, to which Altoona had made a $100 million commitment. The memorandum offered investors a chance to reduce their commitment to Permira IV. This potential offer was an attractive one, as it would allow the state pension to address its "over-commitment problem," one that plagued many institutional investors. But the terms of the arrangement gave Calhoun pause.

Purchase the case: b01/en/common/item_detail.jhtml?id=809095

GLOBALGAP: Food Safety and Private Standards

Harvard Business School Case 509-004

In response to new laws governing liability and several food safety scares in the 1990s, European retailers drove the creation of a universal production standard based on Good Agricultural Practices (GAP) for fresh fruit and vegetables and a third-party certification system to monitor compliance. By 2008, the GLOBALGAP standard had expanded to cover coffee, tea, livestock, and aquaculture. Over 90,000 producers in 87 countries had been certified. Looking ahead, GLOBALGAP's board and management were discussing a number of questions, including the following: should GAP include environmental and social aspects beyond food safety; what was GLOBALGAP's role outside of Europe; and how GLOBALGAP is a 'hidden asset' compared to ethical labels such as Fair Trade.

Purchase the case: b01/en/common/item_detail.jhtml?id=509004

The Great Moderation

Harvard Business School Note 709-023

The Great Moderation is a significant decline in the volatility of fluctuations in most macroeconomic variables that the United States and other developed and developing economies have experienced at least since the mid-1980s. This case describes the basic facts, presents contending explanations, and explores the consequences of the Great Moderation for the likely amplitude of future business cycles.

Purchase the note: b01/en/common/item_detail.jhtml?id=709023

Marks and Spencer: Plan A

Harvard Business School Case 509-029

Marks & Spencer initiated a comprehensive approach to sustainability (reduction of waste, carbon emissions, fair trade) called Plan A. Does it offer a competitive advantage?

Purchase the case: b01/en/common/item_detail.jhtml?id=509029

Mubadala: Forging Development in Abu Dhabi

Harvard Business School Case 708-033

In 2007, Khaldoon Khalifa Al Mubarak, the CEO of Mubadala Development Company (Mubadala), had every reason to be optimistic about the future of his home, Abu Dhabi, one of the emirates comprising the United Arab Emirates (UAE). The tiny, sandy, and dry emirate with a population of 1.5 million, only 420,000 of whom were citizens, was nestled upon nearly 10% of the world's known reserves of oil and the 4th largest proven reserve of natural gas. With the price of oil doubling every 10 years between 1970 and the 2000s, the state-owned Abu Dhabi National Oil Company (ADNOC) had enjoyed an era of increasing profitability. Another state-owned firm, Abu Dhabi Investment Authority (ADIA), had been investing extra oil revenues outside of the county for more than 30 years, and the intensely secretive organization had amassed assets worth an astonishing—and still rapidly growing—$500 billion to $900 billion. A common refrain held that Abu Dhabi nationals could live off of the returns generated by ADIA forever. Some accordingly referred to the emirate as "the richest city in the world." Yet Al Mubarak, trusted advisor to the crown prince Mohamed bin Zayed Al Nahayan, and Mubadala were charged with transforming the economy of the emirate. Many were concerned that Abu Dhabi was in danger of suffering from the so-called "resource curse," as its economy focused on fossil fuels and little else. Not only would Abu Dhabi's economy continue to be subjected to the vagaries of world energy prices, there would be little for its citizens to do. Not everyone could work for ADNOC or ADIA. Not everyone was from one of Abu Dhabi's handful of incredibly wealthy families. To be a developed country, Abu Dhabi needed change. Fortune had already played perhaps too large a role.

Purchase the case: b01/en/common/item_detail.jhtml?id=708033



Just Because I'm Nice, Don't Assume I'm Dumb


We often judge colleagues on the basis of their perceived warmth and competence, finding clues to these qualities in stereotypes rooted in race, gender, or nationality. Many of our decisions about fellow workers are thus premised on faulty data—harming judged and judgers alike.

When Dreaming Is Believing: The (Motivated) Interpretation of Dreams


This research investigated laypeople's interpretation of their dreams. Participants from both Eastern and Western cultures believed that dreams contain hidden truths (Study 1) and considered dreams to provide more meaningful information about the world than similar waking thoughts (Studies 2 and 3). The meaningfulness attributed to specific dreams, however, was moderated by the extent to which the content of those dreams accorded with participants' preexisting beliefs—from the theories they endorsed to attitudes toward acquaintances, relationships with friends, and faith in God (Studies 3—6). Finally, dream content influenced judgment: Participants reported greater affection for a friend after considering a dream in which a friend protected rather than betrayed them (Study 5) and were equally reluctant to fly after dreaming or learning of a plane crash (Studies 2 and 3). Together, these results suggest that people engage in motivated interpretation of their dreams and that these interpretations impact their everyday lives.