Finance: Research, Policy and Anecdotes

There was a time when I did not think I would write another finance and growth paper (maybe except for literature surveys), but write I did and now it is even being published 😊. In joint work with Robin Doettling, Thomas Lambert and Mathijs van Dijk, now accepted and forthcoming in the Journal of Economic Growth (where many years ago I published my co-authored paper on Finance, Inequality and the Poor), we show that liquidity creation by banks (intermediation of liquid liabilities into illiquid assets) ispositively associated with economic growth at country and industry levels. However, liquidity creation booststangible, but not intangible investment and does not contribute to growth in countries with a high shareof industries reliant on intangible assets.  This points to an important non-linearity in the finance-growth relationship but also to the optimal financial structure (mix of banks, non-bank financial intermediaries and capital markets) changing with the economic structure of a country.  And taking these results to the current financial structure in Europe, it points again to the need to strengthen non-bank financial intermediaries and the capital market union as financing modes for intangible assets, which are becoming more and more important.  And as a reviewer pointed out during the review process, it also makes the case for bank bailouts somewhat less obvious if real economy funding relies less on banks.

Last week, I participated in a workshop at the Banca d’Italia on “An EU Legal Framework for Macroprudential Supervision through Borrower-Based Measures” and was invited to give the introductory presentation. The reason for the workshop was the ongoing review of the macro-prudential toolkit in the EU by the European Commission. In this context, there have been calls to explicitly include borrower-based measures into EU legislation. This is also on the background that the counter-cyclical capital buffer might not be sufficient as macro-prudential tool and that ongoing shocks might further exacerbate real estate cycles across member states.  And as different as residential mortgage systems are across countries, there seems to be an increasing degree of synchronisation between residential real estate cycles.


Borrower-based measures include loan-to-value, loan-income, and debt service-income ratios as well as maturity and amortisation requirements. Interestingly, not every EU member state has a legal framework for borrower-based measures and in others it is not complete. Also, the governance structure might give rise to an inaction bias, something I will discuss further below. Another challenge seems to be the lack of good mortgage loan data in some countries as they are not included in the credit registry; this in turn makes it harder to properly calibrate such policy measures.


It is important to keep in mind that borrower-based measures (as other macro-prudential tools) might clash with other policy areas.  Monetary policy might be very loose with the intention to increase aggregate demand, however, this might fuel an unsustainable credit and real estate boom – a situation in some euro area countries over the last years. Fiscal policy measures might also affect housing and thus credit demand – just think of the lowering in stamp duties in the UK last week. More generally, borrower-based measures focused on financial stability might clash with distributional objectives of the government.


This leads me to the big elephant in the room (and something that central banks and macro-prudential authorities understandably do not want to talk about directly): politics. Raising capital requirement to counter a credit boom can be easily justified in terms of financial resilience. In the case of tightening borrower-based measures, the impact is more directly observable.  Households with less resources for a down payment, mostly families with lower income (and often younger households) can no longer take out a mortgage.  This in turn can lead to political pressure, as documented nicely by my former PhD student Etienne Lepers in one of his thesis chapters. When the Central Bank of Ireland wanted to tighten loan-value ratios in the years before the pandemic, there was strong resistance from media, ministry of finance and politicians.  Is a more independent macro-prudential authority (e.g., central bank) less likely to give in to such political pressure and raise borrower-based measures during a credit boom?  The maybe surprising finding is that no. This points to limitations in the political independence of central banks and a much more complicated relationship between central banks and governments, confirmed by the Bank of England’s reaction this week (including through statements) to the new government’s fiscal policy chaos.


This takes me to the governance question, on which Anat Keller from King’s College had some very interesting insights. One important question is who the mandate has to impose borrower-based measures; it might be better to have committees taking these decisions to avoid group-think but also to have broad-based consensus, which might protect decision makers against political pressure. There should be a publication requirement for the underlying cost-benefit analysis to thus guarantee a certain degree of transparency. A final recommendation to have a consultation period before taking final decisions seems to be less useful for me, as it would lengthen the period between announcement and implementation even further and might result in regulatory arbitrage.


Another important question is that about leakage.  Leakage effects of macro-prudential measures have been well documented, as for example by Aiyar, Calomiris and Wieladeck. One might think that such leakage effects are less strong in the case of borrower-based measures, given that (residential) real estate markets are mostly national; however, leakages can still exist, be they through institutions outside the regulatory perimeter (as documented by this fascinating paper by Fabio Braggion and co-authors on China), foreign branches or direct cross-border lending. And while all of this seems of less immediate concern, there is an interesting interaction with the ambition to create a truly European banking market. In such cases, leakage effects might become important and reciprocity arrangements as already exist in the case of counter-cyclical capital buffers become important.


In sum, it is easy to agree on the usefulness of borrower-based measures, but the devil is in the detail. Three challenges loom large: tensions with other policy areas, leakage effects and political pressure.

European politics and economics were quite ‘exciting’ over the past days.  The elections in Italy brought the expected outcome, with a former (?) neofascist ready to become Prime Minister; however, an overwhelming election victory it was not, with the right-wing alliance getting 44% and a large majority in both chambers of Parliament only because of a divided centre-left of Italian parties. Indications so far are that the new government will not do anything too crazy, but only time will tell. In any case I am less worried than I would if Marie Le Pen had won the French presidential elections, given that the Italian prime minister is much less powerful than the French president (at least with current constitutional arrangements). And Italy has strong institutions, among others in the form of a rather powerful president (more than his ceremonial role seems to suggest). But there is the risk that it will put the ECB in an uncomfortable position if spreads on Italian sovereign bonds get out of control again in reaction to crazy policies.


The UK in the meantime has shown how to best crash a currency. The economics behind it is very easy (indeed on the level of an A-level economics course or the MBA economics course I used to teach): Brexit (and the strong reduction in labour supply it has brought) has reduced potential GDP (long-term aggregate supply) and the economy seems currently to be at full capacity (judging from the unemployment rate and labour shortages).  Fiscal expansion will push up aggregate demand beyond potential GDP and result in inflationary pressures. Pretending that tax reductions for the well-off will increase aggregate supply are simply illusionary. And even if the other policies suggested by the new government will increase aggregate supply, this can only happen in the medium- to long-term.  However, I very much doubt that getting rid of environmental and labour regulations will help increase potential GDP; the easiest way to increase it would be to re-join the Single Market and the Customs Union and that is obviously not on the table. Rather, there is still the risk of a trade war with the EU if Liz Truss insists on the Northern Ireland Bill undermining the Northern Ireland Protocol and thus breaking an international treaty. Add to this a large current account deficit and the fact that the UK relies on the ‘kindness of foreigners’ to finance its current and now increasing level of government debt and it is clear why the British pound has depreciated heavily. As I said in my previous post politicians might be able to fool voters (and the right-wing media) but certainly they cannot fool the markets.


The Bank of England as independent monetary authority has stayed calm (in good English tradition?), but their statement on Monday evening suggests that it might be reluctant to raise interest rates too quickly in an attempt to off-set the pressure on the British pound that the fiscal expansion has caused. Another clear example that the independence of central banks has its limits in a country with no written constitution and where the previous government has trampled over long-standing norms and customs thus undermining the same institutions that are now so urgently needed.  Either way, the bill for the reckless fiscal expansion will be paid by a large majority of the British population in the form of higher inflation (due to the depreciation and thus higher import prices) and/or higher interest rates translating into higher mortgage costs. What a way to run/ruin an economy!


Comparing the market reaction to the Italian elections and the UK mini-budget, the world seems upside down – muted reaction to a new right-wing government in Italy and strong reaction to the UK fiscal policy follies.  I am old enough to remember when UK politicians and media declared in March 2020 that the impact of Covid-19 would never be as bad in the UK as in Italy, because the UK is so much better than Italy….   It was a deranged statement then and it seems even more deranged now, when looking back!

I was recently invited to discuss “Europe's pathway to the future: challenges and opportunities” – a very general title, which I took as opportunity to put together some general thoughts about economics, politics, finance and “what has the EU ever done for us”.


Politics vs. economics

It is a longstanding belief among economists that economics trumps politics.  Put differently: politicians might be able to fool voters but cannot fool markets. Examples are ample: decisions during the eurodebt crisis taken late on Sunday night were soon dismissed by the sovereign debt markets as insufficient and resulted in further support packages soon after.  You can also see it in the reaction of exchange rate markets to the Brexit referendum and – over the weekend – the budget plans of the new PM – markets are not convinced and have incorporated a risk premium for the UK, something that even the Tory spin doctors cannot explain away. 


Economists, however, have learned that economic policy decisions can have important effects on the political environment, which in turn affects economic policymaking. As Jean Claude Juncker’s once said: we all know what is the right thing to do, but we don’t how to get re-elected afterwards.  The rise of populists across the globe has been related to economic growth being linked to rising inequality, something that has become even more striking after the Global Financial Crisis.  Or as the former Chief Economist of the Bank of England Andrew Haldane found out when he discussed GDP data in the North of England and someone in the audience told him: that’s your GDP not ours. And this populist backlash in turn can influence economic policy making, mostly to the worse: Trump’s tariffs on China, Greece flirting with sovereign default and the Brexit referendum all had negative effects on the respective economy and ultimately the people who voted for these decisions


However, there are also moments when politics trumps economics and the current crisis is one of these. We cannot sacrifice peace on the altar of cheap energy prices no matter how cold the winter. We cannot sacrifice human rights on the altar of global supply chains, no matter how efficient they are. Freedom and peace always trump the laws of economics; something we might have forgotten over the past decades but what the struggle of the Ukrainians have reminded of us.  Maintaining freedom and democracy should be important constraints for any economic policy decisions.


It also provides important lessons for externalities imposed by some member states on others. During the eurodebt crisis in the early 2010s, there was a lot of (partly justified) criticism of some periphery countries imposing stress on the euro area due to their boom-bust credit cycles and sovereign overindebtedness. Now we are in a similar situation: As Thomas Philippon has pointed out, Germany and other European countries have imposed externalities on the rest of the European Union by making themselves too dependent on Russian energy. So, there is an important lesson here: If you think you own the moral high ground during one crisis, you might want to be careful with throwing stones as you might end up in the glass house during the next crisis.  Solidarity towards others in one decade might have to be reciprocated the next decade.


Markets vs. social objectives

As Isabel Schnabel pointed out in her Jackson Hole speech last month, the period of the Great Moderation seems over and we might be entering a period of the Great Volatility. While economists do not have a good track record in predicting events, I am rather convinced that the pandemic, Ukraine war and energy crisis will not be the last shocks this decade will see, both on geopolitical grounds but also on the account of climate change.  A sudden return to 2% inflation or below seems rather illusionary under current circumstances. And even though tight monetary policy might not be the best tool to address supply-side shocks, it is important to keep inflation expectations anchored. At the same time, there is a case to be made for a stronger role of fiscal policy, especially when it comes to distributional implications of this shock. One important positive development during the Covid crisis was the launch of the Next Generation EU package, recovery package in what I called a Hamiltonian glimpse at what kind of European fiscal policy is possible. Given the continuous shocks and crises Europe has been facing, I very much doubt this will be a one-off and it should not. 


The Covid crisis has clearly put shown the important role that governments have to play during crisis periods, as insurer of last resort. And as during the Covid crisis support for the real economy during repeated lockdowns helped the private sector recover quickly afterwards, the role of government in helping during an energy crisis and avoid people freezing to death is an obvious one, in my opinion. The question, however, is how to go best about it. 


Many economists, including this one, would argue that simple price caps for energy prices are not useful. We need price signals even if we don’t like them, both on a personal level and for society. I would therefore argue – as suggested by Isabella Weber, a German economists in the US- that a price cap up to a certain consumption threshold representing the needs of a representative household – or transfer payments to off-set the negative impact of high energy prices of low-income and middle-income households would be more useful, more efficient and much less costly. Another interesting recent proposal has come from the Bachmann et al. group, giving households a credit in the amount of energy consumption during the last winter, which gives households then the choice how much energy to use. High energy prices signal scarcity; eliminating the function of such price signals to reduce demand might have the negative result of necessary wide-spread rationing. 


The role of finance – beyond bailouts

The European financial sector has performed much better during the past three years than many expected; among the reasons for that, two stand out, in my opinion: one, the post-2008 regulatory reforms that have strengthened the resilience of banks; two, the support programmes introduced by governments across Europe in spring 2020 that affected the financial system indirectly. And as reassuring as it might be that the financial sector is not at the core of either Covid nor Ukraine/energy crisis, it is important to stress that it still has a critical role to play in helping the resilience of the real economy. And even though many of the support packages are on the national level, it is important – again – to maintain the Single Market in banking, which allows for proper risk sharing and allocation efficiency.   It is also important to stress that banks and other financial institutions and markets will have an important role in the reallocation process, away from energy-intensive sectors, but also towards more resilient supply chains. A strong and efficient financial sector is thus critical for both minimising the effect of a coming recession as for a robust recovery. 


Talking about a Single Market in Banking, everyone here is aware that we are still far from it.  We still have German banks, Italian banks, French banks.  Out of the original objectives of the banking union project, none has been achieved completely: resolution with bail-in – barely; sovereign-bank link: alive and kicking and only kept in check by the ECB ; European banking: we are seeing rather a retrenchment towards national markets. And so at the risk of sounding as repetitive as the Elder Cato, let me stress that I think that the banking union has to be completed and hopefully before the next financial crisis, whenever it comes.  


But even that would be a necessary but not sufficient condition for a truly European banking market – another important element is of course the politics.  And we see it here in Italy, Monte dei Paschi, or in Germany, with the ill-conceived idea of a merger of Deutsche and Commerzbank.   For better or worse, banking will always be close to politics, but I would argue it might be better on the European than and the national level. 


What has the EU ever done for us?

When academics discuss (or rather criticise) policy decisions, their counterfactual is often a world without political tensions. As I have critically accompanied the construction of the banking union, I have often been guilty of this approach.


However, there is an alternative counterfactual.  Imagine the Covid vaccine roll-out in 2021 without the EU, imagine the Western European sanction policy without the EU, imagine the current energy crisis without a common European energy market – a rather nightmarish scenario of constant conflicts between 27 nations.  We live indeed in very volatile times, but working within the European framework gives our part of the world an enormous advantage compared to previous centuries.


The important thing to keep in mind that the macro-level European politics has to be supported on the grass-root level. European citizens have to see the benefit of European integration. In this context, the UK might have done the EU a favour with Brexit – people in the UK are less likely to link inflation and recession to Brexit (given many other recent developments) but clearly live the Brexit of little things, the Brexit of daily life: long passport queues, customs duties for packages coming from the EU, roaming fees when abroad.


So, I think it is important to keep in mind and alive the benefits of European integration in daily life and the unity on the political level. Which gets me back to my starting point: politics and economics go hand-in-hand. The political support for the EU goes hand in hand with economic benefits, both on the level of voters as on the level of governments.

One does not have to be a royalist or monarchist to be touched by the passing of Queen Elizabeth II after 70 years on the throne. And one could have thought that this would be a moment of national reflection on how much the country has changed over the past seven decades and the challenges ahead.  However, it seems it has rather been used by the political class to silence an important discussion on how to address the economic, political and energy crises the country faces. And even worse, this reflection on the past 70 years has now given space to ugly scenes of a rising police state where even holding up the sign “Not my King” constitutes breach of peace, resulting in arrest, and where holding up a white sheet of paper triggers policy action.


Ultimately, this reflects the UK after 6 years of Brexit chaos. To avoid any serious discussion on what has gone wrong and how to address the crisis, politicians and media hide behind wall-to-wall reporting on national mourning and the new King (not to forget about the role of Harry and Meghan). It seems the country has been suspended for ten days, mourning the loss of a monarch that linked it back to the Empire and the more ‘glorious’ days of British history.  It is clear that in the coming years the country will have to face a reckoning, the question is how long it will take to get there.