Annual Review of Financial Economics - Current Issue

The COVID-19 pandemic has arguably been one of the worst global catastrophes over the last several decades. A plethora of real-time research has been produced by the finance profession to try and understand the impact COVID-19 had on financial markets. In this issue, the Annual Review of Financial Economics provides five articles, all touching on different aspects of the COVID-19 crisis. This introductory article provides a brief review of these articles.

The world has been confronted in recent decades with several infectious disease outbreaks caused by novel pathogens, with the COVID-19 pandemic being the most severe of these. In this article, I review some of the main elements of epidemiological models used to forecast the trajectory of a new epidemic and to guide public health policy responses to a new infectious disease. I argue that economists have a lot to contribute to the discussion of public health policies, particularly in regard to assessing the costs and benefits of alternative policies and in improving the modeling of changes in human behavior in response to new infectious diseases. This survey is intended to serve economists interested in starting research in these areas.

The global financial system showed remarkable resilience during the COVID-19 pandemic, despite a sharp decline in economic activity and the initial financial market upheaval in March 2020. This article takes stock of the factors that contributed to this resilience, focusing on the role of monetary and financial policies. Drawing on the existing literature, it argues that the swift and decisive policy actions of major central banks in response to the pandemic-induced crisis played a key role in easing financial conditions and sustaining the flow of credit to the real economy. While the pandemic crisis has underscored the importance of policies in preventing calamitous financial outcomes, it has also brought to the fore some unintended consequences of policy actions—in particular, of providing prolonged monetary policy support and of applying regulation to specific segments of the financial system rather than taking a broader approach—that could undermine financial stability in the future.

This article provides a critical appraisal of the March 2020 crisis in fixed income markets. We synthesize the main events, characterize what appears to be an emerging consensus on what caused the market breakdowns, summarize how the Federal Reserve's actions contributed to its resolution, and discuss potential lasting effects of the crisis. This review makes clearer the fragilities and interconnectedness that characterize the current fixed income market structure and their effects on liquidity provision. We argue that the current market structure, combined with the continued growth of Treasury markets, corporate and municipal bond markets, and particularly, mutual funds, raises the specter that periodic instability may remain a feature of fixed income markets.

We review the literature on the impact of the COVID-19 pandemic on financial markets. We first document several key facts about equity and fixed-income markets during this period. We then discuss various literatures that analyze broad movements in prices, market dislocations, and the impact of fiscal and monetary policy interventions. We conclude by discussing potential directions for future research.

The 2020 COVID-19 pandemic led to a large number of studies in household finance, using new high-frequency data in close to real time. In this article, we survey household behavior during the pandemic, with a focus on consumption, government policies, credit, and investment. The pandemic induced a rapid decline in consumption, which was affected by but largely preceded stay-at-home orders and was followed by a rapid rebound. Government stimulus was less effective in 2020 relative to other recessions, which is consistent with both shutdowns and precautionary savings. Delinquency rates fell, unlike in other recessions, likely due to government debt relief policies. Household investment behavior was affected by pandemic-induced changes in beliefs. We conclude by discussing avenues for future research.

Governments allocate a large share of real and financial capital globally, and their choices of discount rates for project and policy evaluation have a first-order effect on social welfare. The importance of adopting a principles-based approach to selecting discount rates has new urgency in light of the very long horizons over which the benefits and costs of policies to address climate change are being evaluated. The four articles in this theme provide an interpretive overview of the literature on many of the theoretical, practical, legal, and philosophical considerations for discount rate selection by governments. This introduction summarizes the main points of each article and highlights some of the common threads that emerge. These include the importance of using risk-adjusted rates, the problems that arise when discount rates are chosen to be artificially low, and the large disconnect between common government practices and the principles of financial economics.

Discounting of deferred impacts of government policies is a long-established practice that has been the target of substantial litigation and continued philosophical debate. Legal challenges to the social rate of discount have resulted in general acceptance of the principle of discounting at a nonzero rate for both monetary and nonmonetary impacts. Courts have displayed a general familiarity with discounting and often require transparent justification for the selection of the discount rate based on established scientific principles. The philosophical issues are more wide-ranging and include whether nonmonetary impacts should be discounted, the use of the opportunity cost of capital or the social rate of time preference, the time frame that is pertinent for setting the discount rate, and determination of whose preferences should have standing. Intergenerational issues are particularly challenging, raising questions regarding which generation's preferences should be recognized, the potential for dynamic inconsistencies arising from preferential discount rates, and intertemporal inequities. Benefit-cost analyses that include appropriate recognition of benefits and costs for future generations serve a constructive function in providing a mechanism for recognizing future effects on social welfare.

Most Western countries use a single discount rate to evaluate public investments and policies. This ignores the differential cost of risk, in a world where most risk markets exhibit surprisingly large prices of risk. The current discounting guidelines generate a misallocation of capital that entails a large welfare cost. We claim that the well-established asset pricing literature provides a strong normative justification in favor of risk-adjusting discount rates. More specifically, project-specific discount rates should be increasing in the income elasticity of the project's net benefit. This will favor projects whose net benefit materializes preferentially in low-income states, thereby recognizing their insurance benefit ex ante. The intuition is simple, the welfare benefit of the reform is large, and the methodology only requires evaluators to estimate an income elasticity on top of what is required in the current approach. It is time to fix our public discounting systems.

Market interest rates reflect the preferences of market participants. When market participants are missing, the average discount rate in the population may therefore differ from the market rate. Missing current market participants, such as constrained borrowers, tends to imply an average discount rate that is above the market rate, whereas missing future market participants, such as future generations, tends to imply an average rate below the market rate. Nonetheless, a government with the ability to transfer wealth intratemporally across agents will generally wish to use the market interest rate as a guide to policy. One robust argument for the use of a lower social discount rate is intrapersonal: Future selves discount the past, whereas current selves discount the future. Legacy utility may also justify a low social discount rate.

The principles of financial economics provide equally important insights into the optimal choice of discount rates for both public and private sector decision-makers. However, most governments largely ignore those principles, taking their cost of capital for most purposes as their borrowing rate. This article reviews the arguments often made in support of status quo discounting practices, along with the counterarguments to them. Governments have a choice between several methodologies for risk adjustment, and the practical and conceptual reasons that favor a fair value approach are recapped. The limitations of a financial economics approach become apparent for decisions involving very long time horizons, such as for climate policies. For policies with long-term impacts, intergenerational concerns become paramount, projections of cash flows and discount rates become highly uncertain, and present value calculations are an intrinsically unreliable measure of value. No approach to discount rate selection can overcome those problems; alternative decision criteria need to be established. However, most government investments involve much shorter horizons, and the adoption of standard approaches to risk adjustment could significantly improve social welfare.

This review revisits the literature on fiscal capacity using modern tools from asset pricing. We find that properly accounting for aggregate risk substantially reduces fiscal capacity. In this environment, the gap between the risk-free rate and the expected growth rate is not a sufficient statistic for fiscal capacity. To borrow at the risk-free rate when aggregate growth is risky, governments need to ask taxpayers to insure bondholders against aggregate risk, but governments in advanced economies tend to insure taxpayers against aggregate risk. We use this asset pricing perspective to review alternative mechanisms to boost fiscal capacity that have been explored in the literature.

Unfunded public pension obligations represent the largest liability for state and local governments in the United States. As of fiscal year 2021, the total reported unfunded liabilities of these plans are $1.076 trillion. In contrast, the market value of the unfunded liability is approximately $6.501 trillion. As a result, the reported funding ratio of 82.5% falls to 43.8% under a market-based valuation. The market values reflect the fact that accrued pension promises are a form of government debt with strong statutory and contractual rights. The assumed discount rates are based on expected returns and remain elevated relative to risk-free rates, despite a decline since 2014. As a result, not only is the unfunded pension liability understated, but the yearly pension cost for newly accruing liabilities is also understated. In order to achieve high returns, pension funds have accumulated large exposure to risky assets, in particular alternative investments, which results in highly uncertain investment returns.

We review the state of the sovereign debt literature and point out that the canonical model of sovereign debt cannot be easily reconciled with several facts about sovereign debt pricing and servicing. We identify and classify more than 20 puzzles. Some are well-known and documented, others are less so and are sometimes based on anecdotal evidence. We classify these puzzles into three categories: puzzles about how sovereigns issue debt; puzzles about the pricing of sovereign debt; and puzzles about sovereign default and the working out of defaults. We conclude by suggesting possible avenues for new research aimed at reconciling theory with what we observe in the real world.

This article surveys the recent empirical literature on historical banking crises, defined as events taking place before 1980. Advances in data collection and identification have provided new insights into the causes and consequences of crises both immediately and over the long run. We highlight three overarching threads that emerge from the literature: First, leverage in the financial system is a systematic precursor to crises; second, crises have sizable negative effects on the real economy; and third, government interventions can ameliorate these effects. Contrasting historical episodes reveals that the process of crisis formation and evolution varies significantly across time and space. Thus, we also highlight specific institutions, regulations, and historical contexts that give rise to these divergent experiences. We conclude by identifying important gaps in the literature and discussing avenues for future research.

We explore the design of climate stress tests to assess and manage macroprudential risks from climate change in the financial sector. We review the climate stress scenarios currently employed by regulators, highlighting the need to (a) consider many transition risks as dynamic policy choices, (b) better understand and incorporate feedback loops between climate change and the economy, and (c) further explore compound risk scenarios in which climate risks co-occur with other risks. We discuss how the process of mapping climate stress scenarios into financial firm outcomes can incorporate existing evidence on the effects of various climate-related risks on credit and market outcomes. We argue that more research is required to (a) identify channels through which plausible scenarios can lead to meaningful short-run impact on credit risks given typical bank loan maturities, (b) incorporate bank-lending responses to climate risks, (c) assess the adequacy of climate risk pricing in financial markets, and (d) better understand how market participants form climate risk expectations and how that affects financial stability. Finally, we discuss the advantages and disadvantages of using market-based climate stress tests that can be conducted with publicly available data to complement existing stress-testing frameworks.

Is shareholder interest in corporate social responsibility driven by pecuniary motives (abnormal rates of return) or nonpecuniary ones (willingness to sacrifice returns to address various firm externalities)? To answer this question, we summarize the literature by focusing on seven tests: (a) costs of capital, (b) performance of portfolios, (c) ownership by types of institutions, (d) surveys and experiments, (e) managerial motives, (f) shareholder proposals, and (g) firm inclusion in responsibility indices. These tests predominantly indicate that shareholders are driven by nonpecuniary motives. To stimulate further research on welfare implications for global warming, we assess whether estimates of the foregone returns for shareholders willing to reduce carbon emissions (or “greeniums”), along with the wealth pledged to firms that become sustainable, are consistent with the growth of aggregate investments in the decarbonization sector.

Several recent trends have reshaped the nature of bargaining in Chapter 11. These include increasingly complex prebankruptcy capital structures, decreasing time in Chapter 11 due to prepacks and prenegotiated plans, growing use of restructuring support agreements (RSAs) and sales of substantially all assets, an increased number of defaulting private equity–owned firms, and an increase in activity of specialized distressed debt investors. These trends have changed the balance of power in favor of senior secured lenders, who further shape the course of out-of-court negotiations. We examine evidence of the impact of these changes on important stakeholders, including creditors and workers.

In this article, we review the literature on the recent growth of corporate debt in China and present stylized facts on the evolution of debt composition, nonperforming loans, defaults, and bankruptcy filings. We then describe the legal and political institutions that characterize the system for restructuring and liquidating financially distressed firms, including recent reforms of China's bankruptcy law. Finally, we discuss the main challenges faced by China in the implementation of these reforms, including frictions in judicial enforcement. We also propose potential avenues for future research.