Finance: Research, Policy and Anecdotes

This past weekend (8 and 9 May) brought two anniversaries that are decisive for Europe’s history of the past 75 years. On 8 May 1945, World War II ended and on 9 May 1950, French foreign minister Robert Schuman set out his idea for a new form of political cooperation in Europe, which would make war between Europe's nations unthinkable. These two days are closely linked with each, both for Germany, the aggressor and ‘loser’ of World War II, and Europe. Both days have very personal meanings for me, as I want to discuss in the following. They have even more meaning for me now that I have joined the Robert Schuman Centre at the European University Institute.


For decades, 8 May was an anniversary of ambivalent feelings in Germany – the end of the Nazi terror regime, on the one hand, total military defeat of Germany, on the other hand. My late parents told me that, growing up in the 1950s, this topic was rather avoided in school - history has been traditionally taught chronologically in German high school, starting with Greek and Roman history and ending with the 20th century; but my late mother told me that somehow history teachers always ran out of time towards the end of grade 10 and ended the history curriculum with World War I.  My own school experience was very different – in grades 5 and 6 (even though formal history classes did not start until grade 7), our classroom teacher insisted on discussing with us different Nazi period anniversaries – appointment of Hitler on 30 January 1933, Reichskristallnacht (Night of Broken Glass) on 9 November 1938, start of World War II on 1 September 1939 but also the 20 July resistance plot in 1944 – to sensitise us for recent German history. But there was a continuous ambiguity about 8 May 1945 and heavy discussion among us high school students whether this day was to be a day of celebration or a day of national humiliation. Federal president Richard von Weizsaecker set a clear political signal in 1985 on the 40th anniversary, defining the 8 May as day of liberation, adding that even though younger generation do not bear responsibility for the past, Germans must accept the past – “ there can be no reconciliation without remembrance”.  Over the past decades, Germany has developed a more open relationship to its past - it has become clear that 8 May is as much a day of celebration for us as for other countries in Europe, though also a day of somber remembrance and gratitude; looking at my own children (who have never lived in Germany) it seems obvious that they do not bear responsibility for this darkest of all chapters in European history, but collectively Germans have a responsibility to remember, even more important in the time of rising right-wing populism. Studying history in grades 12 and 13, I read eagerly about German history to better understand a regime that my grandparents did not want to talk about and that seemed so completely foreign to my own little world in late 20th century West Germany. However, it was not until the past few years that I finally learned more about my own grandparents, only after my parents had passed away. And it was only a few years ago, that I learned about the psychological struggles for my parents’ generation (but to a certain extent also for my own generation), as described in this Economist article from 2015.


As much as 8 May 1945 closed the darkest chapter of modern European history, 9 May 1950 opened the most successful chapter in modern European history! This anniversary allows us to remember that the European Union was founded as peace project and continues to be one; it is easy to forget over the daily politics of budget negotiations, parliamentary discussions, and disputes between countries what our continent has collectively achieved! And it is important to remember on a regular basis, as memories  of the dark chapters fade.


Considering these two anniversaries, together, however, also carries an important but maybe uncomfortable message for Germans! The project of the European Community and later Union allowed first West Germany and later a unified Germany to be at the core of building and maintaining peace in Europe, only a few years after having unleashed terror across the continent; however, this also carries a responsibility with it. Being the largest country and economy in the EU and the anchor country of the euro, Germany has benefitted enormously from European integration; we also owe it – even more than other countries -  our full support; we owe this both to history and to future generations.


A third anniversary this weekend was the 100th birthday of Sophie Scholl, part of the resistance group White Rose in Munich, executed (or rather murdered) in 1943 by the Nazi regime. Even though the group failed in its attempt to incite broader resistance against the Nazi regime, their example stands as shining beacon of personal courage in the darkest hours of a country. The more despicable is that some anti-lockdown protestors pretend to be a modern version of Sophie Scholl. Drawing such ludicrous and abusive parallels does as much damage to the process of remembering and learning as simply forgetting history.

Last week, the Lisbon-based CIRSF (Research Center on Regulation and Supervision of the Financial Sector), joint with CMVM (the Portuguese Securities Regulator) and the Florence School of Banking and Finance, organised a very timely and interesting panel discussion on the Supervision of Auditors: Lessons Learned from Landmark Cases, with a number of legal scholars and economists. In the centre of the discussion were recent accounting/auditing scandals, including Wirecard, and how the regulatory supervisory frameworks have to be adjusted. I was asked to provide some concluding remarks, which I used both to summarise the discussion and to provide some additional perspectives.


As economist, my first concern is: why do we care about these scandals? Well, we need functioning capital markets for resource allocation, which is especially important coming out of the pandemic.  This requires sufficient information for investors and investors’ trust in the accuracy of such information. Scandals like Wirecard come at the end of a long misallocation process and undermine investors’ trust.  It is clear that criminal activity such as in the Wirecard case can never be completely prevented; what a functioning regulatory and supervisory framework can do is to detect such fraud earlier and thus minimise losses.


Auditors are supposed to provide a third-party independent assessment of whether financial statements are free of material misstatements and fraud, so have the function of monitors. But who monitors the monitors? And where does the buck stop? It is clear that German authorities have failed, but what are the necessary reforms? One suggestion has been to move from national to supranational supervision within the European Union - similar as in banking, with the additional motivation that a functioning and effective capital market union can benefit substantially from common regulation and supervision.  And as in the case of banking, it is not necessarily about centralisation (which carries not only benefits but also shortcomings) but about diversity of approaches and building a joint European culture.


On a more conceptual level –what is the role of public vs. private enforcement.  Andrei Shleifer and co-authors find in a seminal paper “little evidence that public enforcement benefits stock markets, but strong evidence that laws mandating disclosure and facilitating private enforcement through liability rules benefit stock markets.” This would suggest not necessarily a stronger oversight, but stricter liability rules. In terms of liability, there is a clear trade-off, however,– on the one hand, this might provide auditors with more discipline, on the other hand, it might also raise prohibitive entry barriers into the auditing profession.


The world is always more complicated than in our regression models.  I believe we need both, more supervisory and more market discipline.  Industry self-regulation (as is the case for the first level of auditor oversight in Germany) can work in certain circumstances (closed and concentrated market with high stakes for market participants, as in the case of the German private banking market before 2000), but it is less likely to work in open and competitive markets as we have them now. European markets simply do not work with national regulation and supervision.


Often the argument has been made for more competition in the auditing market, actually an argument that regularly comes up after every scandal. I am not convinced that more competition (in the form of more auditing companies) helps. It might actually drive down standards as long as companies can choose their auditor. More competition can drive down franchise values of incumbent auditing firms and thus lead to auditors being less careful rather than more. What seems urgent is to force firms to change their auditors on a regular basis.


As so often, what stands in the way of meaningful reforms is politics. On the upside, crises are often good moments to trigger change. Unlike in banking, however, the pressure in this case might weaken rapidly, so events such as this one are critical to maintain the pressure.

In a recent (virtual) event at the Florence School of Banking and Finance, Pascal Donohoe, Irelands’ Minister of Finance and the head of the euro group gave a lecture at the Florence School of Banking and Finance, discussing the current agenda of the Eurogroup.  First, completion of the banking union, including the European Deposit Insurance Scheme and the regulatory treatment of sovereign exposures, two topics that many of us economists have focused on for the past decade or so. Second, the introduction of a digital euro, importantly, however, as complement not as substitute for cash; not surprisingly, this as much a question of payment efficiency, as is this a defensive move against private crypto-currencies (I would assume, this refers to Libra/Diem). Third, a strong fiscal response, including the Recovery and Resilience Facility to support the post-pandemic recovery.  Quite an agenda and we appreciated the intention of Mr. Donohoe to interact with academics on these important issues.


I was asked to give some closing remarks after the discussion and focused on three issues, using two aphorisms:

First,  the Spanish philosopher George Santayana is claimed to have coined the oft-repeated phrase: “Those who do not learn history are doomed to repeat it.” Fiscal policy choices made after the Global Financial Crisis ten years ago set the scene for the Eurozone Debt Crisis.  Withdrawing fiscal stimulus, not only in overindebted euro area periphery countries, but also in core countries, most prominently Germany, exacerbated the crisis substantially. Austerity policies in the UK between 2010 and 2016, criticised by economists both in the UK and the IMF, ultimately resulted in the Brexit referendum vote. It is thus critical for democracy and socio-economic sustainability that this mistake not be repeated and that fiscal stimulus and support not be withdrawn too quickly. The example set by the new US administration should certainly be an important signal. Mr. Donohoe was quite defensive when it comes to comparing the European and US fiscal responses to the pandemic and crisis; here I am, however, with Martin Sandbu who pointed to the risks for Europe of an insufficient stimulus.

Second, the Greek philosopher Heraclitus is claimed to have said: “No man ever steps in the same river twice, for it's not the same river and he's not the same man”. As much as we have to learn from history, it is important to realise that the current crisis is different from the previous one and the situation of the European economy is different. While in the Global Financial Crisis the financial sector was at the core of the crisis, this time the financial sector was hit as much as any other part of the economy; however, the financial sector has been critical both as a transmission channel for government support for households and firms during the pandemic and in its post-pandemic role of reallocating capital. As important, the banking sector might also be faced with a wave of corporate insolvencies as fiscal support is being withdrawn and the question arises whether the bank resolution framework as put in place over the past decade in Europe will be sufficient to address with the consequent possible bank fragility.


Finally, an appeal to my fellow social scientists to get more involved in the policy process and beyond the broad debate. My experience with the policy-making process last year at the ESRB was that there are three phases to designing policies (especially if done from a clean slate); the policy phase, when arguments in favour and against are discussed and weighed, the political phase, when the feasibility of actions has to be explored, and the technical/editorial phase, when policy is put on paper and the discussion focuses on detailed wording. Academics are mostly focused on the first phase, but I think we have to get involved in the second if not even in the third phase, where possible. Not getting involved in the second phase risks leaving the public discourse to fringe economists and charlatans; getting involved in the third phase can be an eye-opening but also humbling experience of the sausage-making process.

The first three months after the end of the transition period have passed and we have moved from speculations about the effects of Brexit to the reality of Brexit. What were supposed to be teething problems turned out to be new structural barriers; every week brings a new sector in the UK that finds itself shut out of the Single Market due to non-tariff barriers. British ‘ex-pats’ who had not bothered to get their residence status sorted in time in Spain are complaining that they have to leave the country and the Brexit press is predicting the permanent economic decline of Spain because of their exodus (as, before Brexit, they predicted the permanent decline of the UK because of the inflow of Europeans).


All of this has made it again clear that Brexit will never end and that the Brexit movement has gone fully Trumpian, nourishing a permanent victimhood culture.  Or as Chris Grey nicely summarised it in his blog a few weeks ago: “The country, as represented by Frost, seems increasingly like a stroppy, entitled teenager who has stormed out of the family home in a tantrum and now endlessly complains that his awful parents are disrespecting him. ‘Not only are they no longer housing me,’ he whines, ‘but they are insisting I clear my stuff out just because I promised to when I left. And I’m stuck with paying the rent on my new place because they won’t help me out any more. Don’t they realise I’m an adult now?”   Until the end of 2020, it was all about escaping the EU, now it is all about blaming the EU for the (predicted) consequences of Brexit.


Only a few months ago, the UK government insisted on getting a trade deal with the EU like Canada and Japan have it, insisting that it wants to be treated like any other third country. Now, that the consequences have become clear (in the form of non-trade barriers), they insist that the EU should treat the UK differently, given the geographic proximity and close economic integration. But of course, the government and the Brexit press is not about to take responsibility for what a few months ago they claimed to be the greatest trade deal and Brexit win ever.  Rather, what was once billed Project Fear is now declared Project Revenge by the EU. 


The issue that promises to provide most fuel for conflict is the Northern Ireland Protocol, which effectively introduces an economic sea border in the Irish channel in order to avoid a land border between the Republic and Northern Ireland. The UK government agreed to this in the Withdrawal Agreement (even though it tries to disown it now) and it is the direct consequence of the Brexit Trilemma; leaving the EU Customs Union and Single Market requires establishing border controls somewhere! But it has raised the temperature in Northern Irish politics, with unionists feeling abandoned by the British government and the Tory party. It is certainly a sensitive situation and only cooperative behaviour from all sides (UK, EU and Irish government) will avoid these tensions to become worse.  It does not look promising, though given the low trust in the UK government by other parties and its confrontational approach.


The relationship with the EU will stay central in UK politics for decades to come (though not necessarily the other way around!).  The current government has taken a confrontational approach, under the leadership of an unelected bureaucrat (how ironic!)– David Frost. This will obviously inflict further economic damage on the UK and further undermine its international standing. An alternative approach would be to behave like grown-up adults, take responsibility for the results of the Brexit this government has chosen and try to smooth relationships with the EU.  However, this is a hope that I do not have as long as this Prime Minister and this party is in power.  But even with Labour in power, the UK-EU relationship will be a difficult one; the main challenge for the UK political class will be to move beyond the culture of victimhood, acknowledge that the Brexit campaign promises were false and there are no benefits to be had, and approach the future relationship with the EU with a realistic and constructive mindset.  If one looks at the infighting within the Republican party in the US about a post-Trump future, one cannot be that hopeful that this will happen anytime soon.


One year of pandemic and lockdowns has given us economists quite some material to talk about. In the following a collection of initial thoughts, on lessons learnt, the role of externalities, and post-pandemic challenges.


One first lesson is that few countries (in Europe) have been continuously successful in fighting the pandemic – initial success stories have struggled heavily in recent weeks, such as Germany when it comes to rolling out vaccinations. Initial basket cases have been successful in recent months, such as the UK in both mitigating a third wave and in rolling out mass vaccination.  A second important lesson: there is no trade-off between public health and the economy. Not locking down society or locking down too late, will damage the economy as either the lockdown will have to last longer or aggregate demand will fall dramatically as people are held back by fear of contagion. Third, even if relying on ‘common’ sense is not enough to reduce contagion risks, neither are lockdowns, a combination of both is critical.


What explains the different success of countries and why has it differed over the past year?  I will leave a rigorous answer to future research, but beyond specific country characteristics – smaller countries seem to have an easier time as do countries with no land borders – government reactions have been critical. On the one extreme are countries whose leaders simply ignored the pandemic or talked it down – the US until recently and Brazil come to mind.  Similarly, leaders who have been always late in decisions such as lock-downs – Boris Johnson in the UK comes to mind until recently.  On the other side, the large majority of political leaders who have muddled through, taking into account expert advice, but never sufficiently aggressive to bend the curve and protect lives.  In some countries, it seems governments have learned from past mistakes – Sweden has turned to lock-down like measures after the failure of the initial ‘let’s trust the people’ approach. The UK has learnt from the mistakes of opening up to quickly last summer and allowing mutants to come in through air traffic. I am not as confident that there has been as effective a learning process across countries.  In federally organised countries (e.g., Spain and Germany) there have been conflicts between state and federal governments, which has hindered the necessary public health responses in the second and third waves.  More centralised countries have not necessarily done better, however, as the examples of France or the UK have shown.


One thing has been clear – pre-pandemic rankings of preparedness for a pandemic have proven to be useless, while early rankings of country performance look outdated. It has become clear that it is not only about medical preparedness, but political willingness to act


Lockdown restrictions have not been accepted by everyone, with significant shares of the population across the globe protesting against restrictions of their freedom. As Article IV of the Déclaration des droits de l'homme et du citoyen de 1789 states: ”Liberty consists of doing anything which does not harm others”. Not respecting social distance, not wearing face masks does harm others. Catching the virus because of one’s own actions increases the risk that one can pass it on. A libertarian approach to the public health ignores the enormous negative externalities stemming from individual actions. As it is hard to deny such externalities, opponents have turned to denying the risk of Covid-19, the sad role of social media and some influencers in this context has been widely documented.


The crisis has also resulted in a clash between free market principles and principles of equity and fairness. Hoarding of toilet paper and price gouging in the early stages of the pandemic have led to calls for government interventions; common sense has prevailed in most cases. The production and distribution of vaccines has pitted countries against each other, with threats of (and actual) export prohibitions; vaccine nationalism ignores the important positive externalities of vaccinations and the public good nature of a world without Covid-19; only if the large majority of the world population has achieved herd immunity can the world return to a stable and sustainable global socio-economic equilibrium.


Talking about vaccinations, a recent conversation with an NHS volunteer focused on another interesting aspect – opt-in vs. opt-out – is the baseline assumption that everyone will be vaccinated unless they opt-out for a good reason or do people have to opt consciously into vaccination.  For most adults, this seems less than relevant, but it is an issue for people that might not be able to take their own decisions and for people that have religious concerns about vaccinations. The UK has decided for an opt-out regime, which might be one – of many – reasons why the mass vaccinations has been so successful.


Which brings me to the recent episodes of stopping (and then restarting) the use of the Astra Zeneca vaccine in several European countries. Public health authorities have (correctly) high standards when it comes to the risk-benefit trade-offs of medications and given the limited data available, there is a high degree of uncertainty and possibly risk involved with this vaccine. It seems to me, however, that the broader benefits of rapidly vaccinating large parts of the population might not have been taken into account in these decisions – similar to missing the macro-prudential picture when judging the stability of individual financial institutions.


Which brings me to a final lesson - the roles of experts and governments.  Early on, governments (re-)discovered the importance of experts, in guiding the public health response to the pandemic. It has also been clear, however, that experts have not all had the same opinion and advice (the Swedish non-lock down response seems to have been driven as much by experts as lockdown decisions in other countries). Further, experts cannot take political decisions such as to lock-down a society – these are decisions only for political leaders to take that are accountable to the electorate.  Important is the cooperation between experts and political leaders, especially for latter not to hide behind the former, but rather to own the analysis and ultimately the decisions. Communication is critical, but as important is the personal example and being humble when wrong – again, something where many government leaders have failed, but some have succeeded (and here I would point to Angela Merkel).


Will we ever get out of this pandemic?  Call me a naïve optimist, but I still believe that as in 1918-20, we will come out of this pandemic and – towards the end – it will be quicker than we fear now.  While this might reduce the immediate demand for epidemiologists’ advice, this might be the hour of economists – there will be lots of decisions to be taken – on the right macroeconomic mix of fiscal and monetary policy, on debt restructuring in the corporate sector, on possible bank fragility – but more broadly about challenges that we might be able to address as societies and economies might show some willingness for more radical changes than in normal times – moving towards a green economy and addressing inequality of income, wealth and opportunities, but also between different generations; and ultimately, all of these decisions have strong implications for the role of government.