Miller, Marcus, 1941- and Zhang, Lei, Dr. (2005) World finance and the US 'new economy': risk sharing and risk exposure. Discussion Paper. Centre for Economic Policy Research (Great Britain), London.

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Abstract

The promising prospect of a ‘New Economy’ in the US attracted substantial equity inflows in the late 1990s, helping to finance the country’s burgeoning current account deficit. After peaking in 2000, however, US stocks fell by some 8 trillion dollars in value. To assess the welfare effects of international financial markets in this context, we use an analytically tractable (two-country, two-period, two-state) model of the global economy which allows the country experiencing the favourable supply side ‘shock’ to consume more against expected future output and to spread risk by selling shares. Since irrational exuberance and distorted corporate incentives can cause serious asset overvaluation, however, an asset price ‘bubble’ is also included, where market participants assign unwarranted likelihood to high pay offs. Relative to autarky, internationalizing financial markets does offer welfare gains. But these are small relative to the international wealth transfer that can arise from selling shares globally at inflated prices. Parameter variations suggest that this conclusion is quite robust. A calibrated exercise shows how capital inflows to finance the ‘New Economy’ can be twice the consumption-smoothing deficit on current account; and how market losses – due to ‘misfortune’ or ‘excess upside probability’ – can have global effects on consumption when the bubble bursts. The analysis complements recent econometric studies of the transmission mechanism which find that financial factors are needed to explain why the European economy was so strongly affected by the US downturn starting in 2002.

Item Type:	Working or Discussion Paper (Discussion Paper)
Subjects:	H Social Sciences > HG Finance E History America > E151 United States (General)
Divisions:	Faculty of Social Sciences > Economics
Library of Congress Subject Headings (LCSH):	Financial crises -- United States, Capital movements -- United States, Moral hazard -- United States, Risk management -- United States, United States -- Economic conditions -- 1981-2001
Series Name:	Discussion paper (Centre for Economic Policy Research (Great Britain))
Publisher:	Centre for Economic Policy Research (Great Britain)
Place of Publication:	London
Date:	January 2005
Number:	No.485
Number of Pages:	36
Status:	Not Peer Reviewed
Access rights to Published version:	Open Access
Funder:	Economic and Social Research Council (Great Britain) (ESRC)
Grant number:	R000239216 (ESRC)
URI:	http://wrap.warwick.ac.uk/id/eprint/1694

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