Finance: Research, Policy and Anecdotes

I read several very interesting books over the summer, among them two books on the challenges for post-GFC and post-pandemic economics and economic policy. The Global Financial Crisis, the Eurodebt crisis and the long-drawn out recovery processes have undermined trust in many long-standing economic concepts and policy prescriptions and are also one important factor in the rise of populist movements across the globe, including Brexit and the Trump election. As shown by Thiemo Fetzer, David Cameron’s and George Osborne’s mistaken austerity policies were a big driver for Brexit support. If economists have learned one important lesson over the past decade, it is that we cannot treat policy solutions independent of their distributional and political implications.  This is the topic of Martin Sandbu’s The Economics of Belonging and Angrynomics by Eric Lonergan and Mark Blyth. Both books were written pre-COVID but their analysis will be as if not even more relevant to address the economic fallout from the current crisis.


Martin Sandbu provides a comprehensive overview of the problems and offers an array of solutions.  He is certainly not the first one to do so (and he makes lots of references to previous work), but ties together lots of different analyses and policy discussions, starting with the distributional and political consequences of 30 years of market-oriented (“neo-liberal”) economic policies.  This includes the changing bargaining equilibrium between labour and capital as results of the decline of unions and the negative consequences of austerity mentioned above.  He makes the strong case that the rise of populism is really a result of economic fault lines rather than cultural trends. Even more important than the diagnosis are policy solutions: First, minimum wages can serve as substitute for collective bargaining, to avoid low productivity jobs persisting, but compression from the top is also needed through progressive income, net wealth and corporate taxation. Interestingly enough, I have used the national living wage (introduced by the same Cameron/Osborne government that forced austerity on the UK) as group assignment topic in my MBA economics class over the past years, requiring students to think beyond the simple demand-supply implications of a price floor. Second, the time of universal basic income might have come as one tool to address economic uncertainty and volatility caused by the move to the gig economy (there are some parallels here to the concept of flexicurity, combining flexible labour markets with income security). Third, policies to counter the trend towards monopolisation, as for example in the digital economy (there might an interesting historic parallel here to anti-trust policies by Theodore Roosevelt in the early 20th century).  Martin also has a very interesting discussion on “left behind places”: while a reversal by attracting big investors is certainly not feasible as strategy for everyone, increasing connectivity of the geographic areas and increasing the attractiveness of such places for investors (through human capital investment) can work; a policy idea very similar to the levelling up agenda in the UK (which unfortunately and as so often is currently only an empty slogan). Finally, on the macroeconomic level, asymmetric aggregate demand policies are critical to avoid hysteresis, i.e., persistent unemployment that results in part of the labour force left behind. While the analysis and policy ideas are the results of the post-Global Financial Crisis, they will be as if not even more important in the post-pandemic discussion. Take the discussion on how to pay for the economic losses of the pandemic – future government spending cuts, taxation or debt?


Angrynomics is not as exciting and satisfactory, at least not for someone who has followed the debate closely over the past decade.  The style is an interesting one – in form of a dialogue between the two authors, though sometimes it reads a bit artificial. The book includes a nice explanation of how the wide-spread anger about recent economic developments came about and how it is correlated with economic thinking (i.e., the move from full employment in the 1960s and 70s as policy goal to inflation targeting), including a discussion on personal distress about rapid changes as source of anger.  The authors also include a nice discussion on the increase in intergenerational inequality over the last decade (a challenge that will only be exacerbated post-Covid-19). The policy discussions, however, are a bit superficial and focus a bit too much, for my taste, on macroeconomic policies and sovereign wealth funds (which can work in the right institutional environment and with the right governance structure), without discussing possible government failures (one of my pet peeves during the Corbyn years was that he was never really forced to explain why the failed UK economic policies of the 1970s would suddenly work in the 2010s). And while I agree on the assessment of Canada and Australia as having escaped the worst of the Global Financial Crisis due to their market and regulatory structure, one has to acknowledge that Australia has also been benefitting over the past 20 years from commodity price boom and increasing economic interlinkages with China.


On the downside, the book is written rather sloppily: for example, in 2004 Ben Bernanke when first referring to the Great Moderation was governor of the Federal Reserve, not Chair (he became Chair 2006) – minor issue, but given that it is early on in the book, one becomes suspicious. Or gems like this one: “the euro crisis… was reprehensible” – well, which crisis is not? Followed by a call to take “policy makers to court and trying them at a human rights tribunal”. Yes, lots of mistakes were made during the euro crisis, but sweeping generalisations like this one are not helpful.   Or simply stupid statements like this one: “centrist politicians, like Emmanuel Macron in France, can only win election because no one turns out to vote”, well, 75% of eligible voters in France who turned out in 2017 beg to differ! Unfortunately, this style might match the title of Angrynomics, but does not foster the necessary calm and evidence-based policy discussion we need!


These are only two out of many books that question economic orthodoxy – Raghu Rajan’s book on the importance of local community comes to mind, even though I have only read about it so far. In summary, there is an important discussion to be had, a discussion that cuts across micro- and macroeconomic and across different social sciences. In terms of politics, Martin’s book also provides an interesting agenda for a new centrist radicalism. It might also serve as interesting starting point for new political agendas, such as for social democratic parties across Europe who seems to have lost their mojo over the past decade.

This year’s Economics Nobel Prize drew as much attention because of the research area where it was awarded (auctions) as it was for the reaction to it.   There were two strands of negative criticisms to it, which I would like to address. One, two old white men from one of the top US elite universities shared the prize, putting in focus yet again the lack of diversity in economics. While I share the concerns on diversity, it seems ludicrous to demand that there be gender and ethnic/national/school quota on Nobel Prizes.  The diversity problem cannot be resolved by starting an affirmative policy programme at the Nobel Prize award level, but progress rather has to be made at the bottom of the pyramid of our profession, undergraduate and post-graduate students in economics, followed by biases in publication and tenure processes and ultimately biases in the appointment processes for senior positions (full professors, editors, presidents of professional associations etc.).


The second criticism is on the topic, auction theory (best illustrated by Branko Milanovic’s twitter thread). First, there is the point that the insights provided by Milgrom, Wilson and others are simply not relevant for today’s problems – here I would strongly disagree (much better documented here and here). Obviously, there will always be debates about what fields are most relevant for humanity’s future and welfare, but dismissing the progress that has been made in this field seems a bit simplistic if not simply wrong.   Second, there is the point that the Nobel Prizes are mostly (though not always, as last year’s award shows) backward looking. Here I am of split mind. The tradition has been to wait for the award of a Nobel Prize until the dust has settled on new path-breaking insights. Not all new attention-catching findings stand the test of time (take the example of the relationship between inequality and growth or the effectiveness of development aid), so the delay in awarding Nobel Prizes might be a healthy one. Such a time gap might also avoid politicising the Nobel Prize – the Peace Nobel Prize has been the opposite: awarding it to President Obama (and I write here as a supporter of him and – in broad terms – his policies) in 2009 was certainly too early. Awarding it in 2016 to the Colombian president for the peace process in his country was premature, given the rejection of the peace agreement shortly afterwards in a referendum and the struggle this process still encounters. One might think that the COVID crisis calls for an award decision that reflects the current policy challenges – this, however, ignores that we won’t know until five or ten years down the road of what has worked and what has not. Similarly, insisting that the prize be awarded for research on currently “hot” topics – artificial intelligence, the future of work, climate change – ignores that this research is on-going and is being vetted as we speak. 


In summary, there are trade-offs in such an award. As I detailed above, I would argue that most of the critiques are simply wrong. Maybe one solution is to simply reduce the focus on such award and go back to celebrate the rigour of on-going and existing research and focus on on-going research and policy debates and treat the Nobel Prize as the equivalent of a life-time Oscar award.

Every year, the Ieke van den Burg prize recognises outstanding research conducted by young scholars on a topic related to the macroprudential mission of the European Systemic Risk Board.  The members of the Advisory Scientific Committee decide on the winner. This year’s award goes to Marcus Mølbak Ingholt from the Danish National bank for his paper “Multiple Credit Constraints and Time-Varying Macroeconomic Dynamics”. It is a great piece that combines theory and empirical work to advance our thinking on the use of different macroprudential tools across the business and credit cycles.


Among the many macroprudential tools that have been the focus of research, two borrower-targeted policies – the loan-to-value (LTV) and the debt-to-income (DTI) ratios – are often interchangeably used. But more likely than not, only one of them is actually binding. Marcus constructs a tractable New Keynesian dynamic stochastic general equilibrium (DSGE) model with long-term fixed-rate mortgage contracts and two occasionally-binding credit constraints: an LTV constraint and a DTI constraint.


Calibrating his model for the U.S. economy between 1984-2019, Marcus finds the LTV constraint is more likely to bind during and after recessions, when house prices are relatively low, while the DTI constraint mostly binds in expansions, when interest rates, which impact debt service, are relatively high.  This results in the policy implication, that a countercyclical DTI limit would be effective in curbing increases in mortgage debt, as these increases typically occur in expansions, while a countercyclical LTV limit cannot prevent debt from rising.  Countercyclical LTV limits can, however, mitigate the adverse consequences of house price slumps on credit availability by raising credit limits.


Marcus further uses a county-level panel dataset covering 1991-2017 across the US to test two key predictions for homeowners facing both LTV and DTI requirements. The predictions are that income (house price) growth predicts credit growth if homeowners’ housing-wealth-to-income ratio is sufficiently high (low), as they will be DTI (LTV) constrained.  His results provide evidence for these hypotheses.

Last week saw the virtual ADBI-JBF-SMU joint conference on green and ethical finance. 13 papers over three days, ranging from banks and mass shooting, to private prisons and institutional investors, and the pricing of environmental risks, plus exciting keynotes by Ross Levine and Laura Starks.  Herewith a short summary with some of the most exciting papers; unfortunately, I do not have the time/space to discuss all of them.


Varun Sharma and co-authors gauge the effect of environmental activist investing on corporate environmental behaviours, using as identification strategy an initiative in 2014 by the New York City Pension System to request the inclusion of proxy access bylaws in targeted firms’ corporate charters.   Using plant-level data in a quasi-experimental setting, they find that firms targeted for their environmental impact reduce their toxic releases, greenhouse-gas emissions, and cancer-causing pollution through preventative efforts, compared to comparable firms that were not targeted. So, activist investing can have an effect, though one wonders about decreasing marginal returns.


Kathrin de Greiff, Torsten Ehlers and Frank Packer test if the risks of climate policy change are priced in the syndicated loan market and find that (i) the premia for environmental risk, as measured by firm-specific CO 2 emissions, are significantly priced, but only since the Paris accord agreement in 2015; (ii) there is a difference in risk premia due to CO2 emissions within as well as across different industries; (iii) only greenhouse gas emissions directly caused by the firm are priced, and not those indirectly caused by production inputs, transportation or use of final products; and (iv) “green” banks—either self-identified or those that lend less to carbon-intensive sectors—do not appear to price such risks differently from other banks.  Another interesting contribution to the literature on pricing environmental risks by financial institutions and markets.


Focusing on the ethical part of the conference theme, Eyub Yegen finds empirical evidence that privatization of prisons in the US deteriorates the quality of prisoners’ lives, leading to higher prisoner suicides and unexpected deaths. However, privatized prisons with higher passive institutional ownership see significant improvements compared to other private prisons.  But why would that be? Eyub shows that an increase in passive institutional ownership leads to a rise in the number of health, education, and suicide-prevention programs offered in prisons. Very innovative work, relying on detailed data collection through freedom of information requests!


Following the conference, the JBF will open the call for submissions for a special issue on green and ethical finance between 1 November and 31 December. Check back on the JBF website in November!

There is an intense debate among economists on zombie firms.  In Germany, this has been framed  as a renewed conflict between Keynesians and ordo-liberals (for non-Germans: card-carrying membership in schools of economic thoughts is still seen as important among some German economists, but even more so in the press). But for obvious reasons, this debate will come across the globe, as we look beyond the COVID-19 recession. Many firms entered the crisis overleveraged and have added further to their debt due to fiscal support schemes and low interest rates, primarily with the objective of surviving. And as revenues in some industries are still depressed and/or highly volatile, large parts of the revenues have to be used for interest and principal payment. It is clear, however, that there are important differences across industries and firms: some will emerge out of this crisis as (if not more) efficient and with as much (if not more) demand as before, while others will not – the walking zombies. How can we distinguish between the two and what is to be done with the latter?


On the one hand, if all firms are being supported for an extended period, independent of their survival chances, this does not only increase the overall costs for society, but also prevents the necessary resource allocation, i.e., Schumpeter’s creative destruction. Subsidising unviable jobs and locking capital in unviable companies delays reallocation of labour and capital to industries and firms that will drive the recovery process.  On the other hand, there is the hysteresis argument: withdrawing support in the middle of a crisis can cause long-term damage in the form of long-term unemployment and, more generally, idle resources.  Support across industries and firms is thus not only necessary for social reasons, but also for economic efficiency.


At the core of the tension is – beyond philosophical differences on the role of government – uncertainty. One, nobody knows when this crisis will be over. When can the market resource allocation process function again? When will the market again allow for the necessary signals? Two, no one really knows what the structural change will look like once the pandemic is over and how it will interact with many other factors that drive structural change, including climate change and a changing international trading environment.


Withdrawing support now seems the wrong moment; the world is still in the middle of the pandemic and (non-financial) markets are certainly not even close to functioning properly. Take the labour market as example– how easy is it to interview and hire new employees, how easy is it for people to move across borders within the Single Market? And who is willing to make long-term investments before the dust of the COVID-19 turmoil has settled?


However, it is also clear that now is the time for preparation to deal with a wave of necessary insolvencies of unviable firms in the near future. It seems unlikely that the regular insolvency regimes can deal with this. And even if they did, not all overleveraged firms are unviable; restructuring (as under chapter 11 in the US) might be more efficient than liquidation (as under chapter 7 in the US). As discussed by Martin Sandbu in a recent FT article, there are different ways to go about this insolvency wave. One would be to convert emergency loans – either direct ones or bank loans guaranteed by the government – into grants; however, this would be costly and might be mis-targeted. A more targeted measure would be government equity support for viable but overindebted firms; however, this will be difficult to manage given the large number of firms and the limited if not negative track record of governments to pick winners. A third  option would be a bank-based restructuring process, as especially for smaller firms in Europe the largest part of their debt will be bank loans, so that banks have the right information and capacity to restructure debt; the doubt I have is whether banks have the right incentives to undertake this role in the societally most efficient way; provide too much debt relief and borrowers might jump ship to other banks afterwards, provide too little and you have the walking zombies, but tie clients to your bank. Regulatory rules (as well as taxation) might influence banks’ actions. Having a central role for banks in this process, however, might also divert their resources from the necessary funding of new companies and thus the economic recovery process. Asset management companies have therefore been proposed; while they have been successful in some cases (e.g., Sweden with mortgage loans), it is uncertain whether they can deal efficient with the heterogeneous bank portfolios of SME loans, especially as it might be unlikely that these assets – unlike real estate – will increase in value back to pre-crisis levels.


Which brings us to the next complication. Corporate overindebtedness and insolvencies will be reflected in non-performing assets on banks’ balance sheets. Allowing banks to delay the recognition of these losses can lead to zombie lending as we have seen it in Japan in the crisis of the 1990s (and will again prevent the necessary reallocation of resources). Forcing them to recognise these losses, however, can result in undercapitalised if not failing banks.  Are regulators and resolution authorities ready for this shock?  I will leave the question of bank resolution to another blog entry.


This points to an important coordination problem awaiting policy makers in 2021: withdrawing fiscal support measures will inevitably result in corporate distress, which in turn can result in banking distress. This interdependence of sectors and interaction of policies requires coordination between governments, legislators/court systems, and regulators. And given the limited fiscal space in some euro area countries, there is also a strong case for coordination on the EU or euro area level.   


Finally, this discussion brings us to the broader question on loss allocation. Aggressive fiscal policy has helped stabilise aggregate consumption while income has plummeted, with the result of rapidly increasing debt levels (primarily government and corporate). Who will bear the losses of this crisis and how will they be allocated? One principle of banking crisis resolution is to “recognise losses, allocate them and move on”. For economies to come out quickly from this crisis (and thus avoid further losses), we need a similar approach. Forcing banks to work out large number of non-performing loans to unviable firms and/or providing perverse regulatory incentives to  roll-over and keep lending to the zombies will prevent banks from supporting the recovery process. While now is not the time to panic about corporate, bank and government debt, now is the time to prepare for the day of reckoning.