Finance: Research, Policy and Anecdotes

I have discussed in several occasions that the Brexit soap opera will never end, no matter that Johnson won the 2019 General Elections with the slogan Get Brexit Done! Brexit is an on-going process and given last week’s suggestion by Johnson’s government to renegotiate the Northern Ireland Protocol (NIP), one even wonders whether this is: Get Brexit Undone!


If one feels that we have been here before, this is certainly the case – it is almost like Groundhog Day.  I went back and checked what I wrote on my blog 25 October 2019, eight days after the agreement on the Withdrawal Agreement, including the Northern Ireland Protocol – most of what I wrote then applies to the current discussion – here are four points I made back then:


“First, the Brexit Trilemma is alive and kicking, with the UK wide backstop negotiated by Theresa May replaced with a Northern Ireland front-stop, taking NI effectively out of the UK customs union and internal single market.”  As many more informed observers have pointed out, the Irish Sea Border is not an invention of the EU, it was critical part of the October 2019 agreement, addressing the Northern Ireland Trilemma. But here we are,  with the UK government again threatening to break international law by walking away from the NIP, critical part of the Withdrawal Agreement that Johnson was so proud of in late 2019. And we are back at the same old discussion on border controls - as pointed out over and over and over again, only two of the following can hold: the UK leaving Single Market and Customs Union, no border control between Northern and the Republic of Ireland, no border controls between Great Britain and Northern Ireland. In true form, the Brexiters are revisiting all of their unicorns (including in the paper underpinning the request for renegotiation), ignoring the fact that the border has to be somewhere between the Single Market (i.e., the EU) and the United Kingdom. And while it is certainly true that there is lots of space to improve the functioning of the sea border between Great Britain and Northern Ireland, the UK government does not seem to want or able to engage in such a dialogue.   Rather it has chosen yet again confrontation, asking for a complete revamp of an International Agreement it happily agree to less than two years ago. Now, one could draw a parallel to the replacement of NAFTA with USMCA, which was rather aggressively pushed by Trump, however, there are two important differences; one, USMCA replaced NAFTA after 26 years; two, the US is certainly a more powerful player vis-à-vis its two neighbours than the UK vis-à-vis the EU. 


“Second, the utter incompetence of Tory ministers has been proven again, such as when not being able to respond whether or not there would be customs control between Great Britain and Northern Ireland” – ok, I might have been wrong here – it is either incompetence or simply lying by Tories. The arguments that the government is using to demand a renegotiation of the NIP (that it is creating unexpected problems) are obviously lies, given the explainer on the NIP published by the UK government in October 2019 (for further evidence, see here by Anton Spisak).   Given the obvious trend towards rewriting history, it seems that the British government does not only want to renege on international treaties but also openly lies about its bad faith with which it signed these agreements.  At the same time, it is asking for trust from the 27 countries that make up the European Union – as has been pointed out excessively, putting trust and Johnson in the same sentence is an oxymoron,  As Dominic Cummings has made clear (and it seems rather plausible) is that Johnson simply did not care about the ‘fine print’ of his Brexit deal – yes, there were lots of warnings back then, but he signed up for the Withdrawal Agreement with the NIP simply in bad faith!  So, why would the 27 countries of the European Union trust him now given that he has shown that his word is not to be trusted.


“Third, the idea that Brexit will help take back control” continues to be wrong – no, the EU will not throw more fuel on the Northern Irish bonfires if the Johnson government reneges on the Withdrawal Agreement, but it will put pressure on Great Britain with targeted trade sanctions; not immediately, but eventually.  We can expect more EU bashing in the coming months – populists need a common enemy and for the Brexit press and the Tories it has been the EU for the past five years.  And given that the UK is about to fall behind the EU in terms of vaccinations (not vaccinating below-18 for example), it cannot boast anymore about being so much better than the EU. So something else has to come up – the conflict on the Northern Ireland Protocol is thus timely for the British government. But obviously this does not mean that the UK has taken back control; it shows the lack of such control!


“Fourth, the idea that once Brexit has been ‘achieved’, it will all be done, the nation can find again together and the government can turn its attention to more pressing issues.”  Well, I started this blog entry noting that this idea was wrong in 2019, it is wrong in 2021 and it will be wrong for many years to come.


In sum, not much substantial news: Brexit continues to be true to its nature as soap opera – new actions, new actors, but same plot. However, one interesting development in the past days was Dominic Cummings engaging on twitter, among others with David Gauke (one of the Tory MPs trying to prevent a no-deal Brexit and subsequently purged from the Tory party by Johnson) and Anne Applebaum  – he seems to be taking as much joy as always from ‘owning the remainers’.  His tweets have made clear that for him the referendum and the 2019 General Elections were all just a game – how to win, without thinking about the political consequences, referring to both the 2016 referendum and 2019 general election as ‘heist’.  Now, in every political party, there are campaigners and policy wonks – it is just that the case of Brexit, the campaigners were really good (if not brilliant I would admit), while the policy wonks were nuts (and they still are).  This, however, is a characteristics of populist movements – whatever slogan-based policy is being invented, there are always some people in the background who come up with the weirdest ideas to underpin these ideas (see unicorn ideas on avoiding the Northern Ireland Trilemma mentioned above).


So, here we are in Groundhog Day, reliving the same circle of grandstanding, confrontation and lies that has come to dominate British politics.

This year’s Ieke van den Burg prize goes to Karsten Mueller and Emil Verner for their paper Credit Allocation and Macroeconomic Fluctuations and will be formally awarded on 1 October.


This is a paper very close to my own interests.  A long literature has shown the positive relationship between financial development (often measured by credit to the private sector, relative to GDP) and economic growth but also the predictive power of rapid credit growth for financial crises. However, until ten years ago or so, we always focused on aggregate credit.  In one of my lesser-known papers (together with Berrak Bahadir, Valev Neven and Feliz Rioja) we showed tentative evidence that it is enterprise rather than household credit that can explain the positive growth effect of financial development on economic growth. Atif Mian and Amir Sufi have argued that expansions in credit supply, operating primarily through household demand for credit, have been an important driver of business cycles.  That’s where Karsten came in – during his PhD time, he collected detailed data on the sectoral composition of credit across a large number of countries over time. Emil and Karsten use these data to study the relationship between credit expansions, macroeconomic fluctuations, and financial crises. They find stark differences between different types of corporate credit expansions. In particular, while lending to the construction, real estate, and non-tradable sectors are associated with a boom-bust pattern in output and elevated financial crisis risk, similar to household credit booms, there is no such pattern for tradable-sector credit expansions, which are often followed by stronger output growth. There are thus good and bad credit booms! And who receives credit is indeed important for growth and stability! Ultimately, it is not simply about financial development, but the use of the funding by banks.


This paper is not only an important contribution to the literature on the role of the financial sector in macroeconomic fluctuations, but sets the stage for an important research and policy agenda.  It reinforces the call for more micro-data and looking beyond aggregates. It also implies that macroprudential policy should focus as much on sectoral as on aggregate risks.

Every year, the Florence School of Banking and Finance organises an Executive Seminar. This year’s (as last year’s) edition was shortened and virtual, but nevertheless fascinating.  Many economists (including this one) see the current burst of inflation as temporary, result of market imbalances, of repressed consumption and forced savings during the pandemic and (maybe just maybe) generous support payments during the pandemic).  Charles Goodhart and Manoj Pradhan disagree with this assessment, though focusing more on the medium- and long-term, arguing that demographic trends will lead to a long-term increase in inflation.  They lay out their argument in the book “The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival” and presented a summary last Thursday in a webinar. Due to the ageing of societies across the globe, the share of working population has been decreasing and will continue to do so. Previous positive shocks the global working population (entry of women into the labour force in the second half of the 20th century and China’s entry into the world economy towards the end of the 20th century) had positively contributed to the dampening of inflation in the late 20th century – no such shock is on the horizon right now. And while the working population in some parts of the work (especially India and Africa) is still increasing, political constraints prevent them from reallocating where they would be needed most – in the ageing societies of Europe.  A higher share of old population in turn requires higher government spending, both for pensions (unless the retirement age is pushed significantly than it is today) and due to higher medical expenses.  The question on how to finance these expenditures is a politically sensitive one – higher taxes on wealth (which would hit primarily the older generation) is politically hard to implement (the triple lock in the UK, where state pension increases each year in line with the rising cost of living seen in the Consumer Prices Index (CPI) measure of inflation, increasing average wages, or 2.5%, whichever is highest, will increase pensions by over 8% this year and shows the political power of the older generations), and increasing income taxes on the working population could be growth dampening. 


Remains the inflation tax and that is where Charles and Manoj see the inflationary pressures coming from. While the Covid crisis might have made these trends worse, the increase in debt due to the pandemic might ultimately turn out to be only a blip in the longer-term trends lines.  The higher debt burden (and the deteriorating savings-investment balance) will tend to increase the long-run equilibrium interest rate (r*), increasing pressure on central bank independence. But even though central banks will feel compelled to keep short-term interest rates low, long-term rates will rise, with a steepening yield curve as consequence.  I would add that this could play out even more aggressively in the euro area with its variation in demographic structure and debt-to-GDP ratios. Overall, a rather scary picture. 

I have discussed the issue of long-term finance in previous occasions (here and here). After many years of work, yesterday saw the formal launch of the website.  While not formally involved anymore, I was invited as panellist to discuss the importance of this initiative during the launch event. While the main focus of the event was to describe the website, with the available data, tools and country reports, we also discussed the importance of long-term finance as part of the overall financial deepening process and, more importantly, as critical for infrastructure, housing and private sector development in Africa. Unlike the development success stories of East Asia, African countries are unlikely to ever be able to exclusively rely on domestic savings for long-term financing and will have to attract foreign funding, both private and public. The bottleneck, however, is more in the intermediation capacity, in channelling funds to where it is needed most – this is both due to lack of adequate institutions, markets and products, but also due to missing ‘infrastructure’ to better manage risks, including effective collateral and credit registries. Another important element (and here we can certainly learn from the East Asian success stories) is an important role for private-public partnership, including public guarantees to lengthen the maturity of funding. While it is always tempting to try to identify the one silver bullet that will unleash a stream of long-term finance, it is a long agenda and in many aspects a very country-specific one.  It is therefore important to look at the two components of this initiative as complementary – the scoreboard, based on cross-country data, and the country diagnostics. Quantitative data can only go so far to produce a good picture – it is like a picture from 30,000 feet, which has to be complemented by on-the-grounds assessment, both with country-specific granular data and qualitative assessment.


If you want to change something you have to measure it first. However, it is not sufficient just to collect data and make them available, but these data have to become part of the conversation. So, having data and presenting them in a reader-friendly way is a necessary but not sufficient condition for informing the conversation on long-term finance. Dissemination is key, but also full of pitfalls, as I discussed here – specifically, the scoreboard is not about ranking, but about stock-taking, identifying bottlenecks and policies to address constraints.


Last week saw the second edition of the London Political Finance Workshop, as last year on-line.  There were eight outstanding papers; as I won’t be able to do justice to all of them, a quick overview of some of them.


In Power, Scrutiny, and Congressmen’s Favoritism for Friends’ Firms, Kieu-Trang Nguyen and co-authors question the standard wisdom that “power tends to corrupt and absolute power corrupts absolutely”. Rather, using a Regression Discontinuity Design of close Congress elections in the US, they find evidence a politician’s win reduces his or her former classmates’ firms stock value by 2.8%. This adverse effect is most prominent among younger candidates, when career concerns are arguably the strongest. They explain this result with politicians reducing quid-pro-quo favours towards connected firms to preserve their career prospects when attaining higher-powered positions. Certainly a surprising result, but it clearly underlines the importance of scrutiny in restraining favouritism in politics.


In Does Political Partisanship Cross Borders? Evidence from International Capital Flows, Larissa Schäfer and co-authors gauge whether partisan perception shape the flow of international capital. Using data on syndicated loans and equity market funds, they  show that the ideological alignment or distance of individual investors/lenders in the US (based on political contributions by banks and voter registration for fund managers) with foreign governments affects the international capital allocation by large institutional investors. Specifically, considering investment in the  same country around the same foreign elections, the authors show that US banks reduce lending after an increase in the ideological gap after the election between their own (Republican or Democratic) political stance and the political stance of the foreign government and charge higher interests (while they do not face higher default); similarly, US mutual funds decrease portfolio allocation, again with no difference in performance. The authors also confirm the results for non-US investors (Canada and UK), even though with less granular data. Quite striking results, as partisan politics used to stop at the water’s edge; but it seems no longer so.


In Political Polarization in Financial News, Ryan Israelsen and co-authors find strong evidence of political polarization in corporate financial news.  Comparing coverage in the Wall Street Journal and the New York Times over 30 years on the largest 100 companies, they document that newspapers are more likely to cover and write positively about politically aligned firms (as measured by campaign contributions by employees and corporate political action committees to Democratic and Republican Party candidates). For example, an article in the WSJ about a firm that donated only to Republican Party candidates in the previous election cycle uses 20% more positive words than an article in the NYT, while an article in the WSJ about a firm that donated only to Democratic Party candidates uses 10% fewer positive words compared to the NYT.  And this different reporting also has implications for investment and trading. Specifically, there is more trading on days where there is more politics-induced disagreement in the reporting on a specific firm.  Finally,  matching data on individual investor trades from a retail brokerage data set to newspaper circulation data based on the zip code location of the investors, the authors find that when news about a stock appears in the newspaper an individual investor is more likely to read, the investor trades more and in the same direction as other investors who read the same paper.


In The Political Polarization of U.S. Firms, Elisabeth Kempf and co-authors show that executive teams in U.S. firms are becoming increasingly politically homogenous, based on voter registration records for top executives of S&P 1500 firms between 2008 and 2018.  This seems to be driven by politically misaligned executives more likely to leave, especially between 2015 and 17 and the effect is stronger in states where there is no legal prohibition of political discrimination, in firms with lower institutional ownership and for firms with CEOs with longer tenure.  The authors also show that differences in executives' political views manifest in differences in beliefs about the company's future stock price performance after political events, such as the surprise win by Donald Trump in 2016, with Democratic executives having a significantly higher likelihood of selling the firm’s share than Republican executives of the same firm after this specific event.


One of the highlights of the workshop was a keynote lecture by Renee Adams – to describe it as provocative would be an understatement.  Rather than presenting a paper, Renee decided to discuss her experience with the politics of finance academia – in her specific case, how a paper on the governance structure of Federal Reserve Banks ran into push-back (and rejection recommendations) by referees from the Federal Reserve system (who outed themselves as such). There is certainly a bias in our academic community to ‘not rock the boat’ and a risk of getting too close to authorities such as central banks that provide us with data and consultancies. The good news is that unlike ten years ago, this is now being openly discussed; the bad news is that we have only taken the first (baby) step in addressing this problem.