Economic Viewpoint

The search for a policy device which will yield the benefits of monetary discipline without the pain is as old as it is fruitless, and the central message of this Economic Viewpoint is that going into the EMS will not provide a magic answer to our problems. However we believe that if we go into the EMS at today's rate, and pursue monetary policies consistent with maintaining that rate, the authorities' target of 3 per cent inflation by 1988 is well within reach… Our analysis of the experience of other countries, inside and outside the EMS, over the floating rate period suggests that membership of the EMS should also reduce exchange rate fluctuations and help to create a more stable environment for business planning. However, sterling's vulnerability to oil-related fluctuations cannot be eliminated just by joining the EMS. We therefore suggest that an oil bond, which capitalises the value of our North Sea assets, is created and sold to our EMS partners, thus equalising the exposure to fluctuations in oil prices and removing one major cause of exchange rate instability.     

The Extreme Future Stock Returns Following I/B/E/S Earnings Surprises

We investigate the stock returns subsequent to quarterly earnings surprises, where the benchmark for an earnings surprise is the consensus analyst forecast. By defining the surprise relative to an analyst forecast rather than a time‐series model of expected earnings, we document returns subsequent to earnings announcements that are much larger, persist for much longer, and are more heavily concentrated in the long portion of the hedge portfolio than shown in previous studies. We show that our results hold after controlling for risk and previously documented anomalies, and are positive for every quarter between 1988 and 2000. Finally, we explore the financial results and information environment of firms with extreme earnings surprises and find that they tend to be “neglected” stocks with relatively high book‐to‐market ratios, low analyst coverage, and high analyst forecast dispersion. In the three subsequent years, firms with extreme positive earnings surprises tend to have persistent earnings surprises in the same direction, strong growth in cash flows and earnings, and large increases in analyst coverage, relative to firms with extreme negative earnings surprises. We also show that the returns to the earnings surprise strategy are highest in the quartile of firms where transaction costs are highest and institutional investor interest is lowest, consistent with the idea that market inefficiencies are more prevalent when frictions make it difficult for large, sophisticated investors to exploit the inefficiencies.     

Servicing De-industrialisation

Government figures have recently revealed that, while investment in manufacturing industry has fallen by 25% since 1979, the service sector now accounts for 70% of all investment in the UK. Russell Lewis finds that attitudes in Whitehall lag behind this startling change in economic activity.     

BANK RUNS: DEPOSIT INSURANCE AND CAPITAL REQUIREMENTS*

Diamond and Dybvig provide a model of intermediation in which deposit insurance can avoid socially undesirable bank runs. We extend the Diamond–Dybvig model to evaluate the costs and benefits of deposit insurance in the presence of moral hazard by banks and monitoring by depositors. We find that complete deposit insurance alone will not support the first‐best outcome: depositors will not have adequate incentives for monitoring and banks will invest in excessively risky projects. However, an additional capital requirement for banks can restore the first‐best allocation.