Finance: Research, Policy and Anecdotes

As I am spending a few days in Northern Ireland during half-break term, it might be time to catch up a bit on Brexit, given that this part of the Irish island continues to be at the centre of the ongoing conflict between the UK and the EU. As widely noted, Northern Ireland has not suffered from the same food and fuel shortages as Great Britain (and yes, I can confirm this from own experience), given that it is still integrated into the Single Market. East-West trade has become more difficult and North-South trade has therefore increased significantly, a not surprising consequence of the Irish Protocol that the UK government had signed up for, as part of the Withdrawal Agreement, in 2019. The controls envisioned by the European Commission might initially have gone beyond what was strictly necessary; after extensive consultations with Northern Irish businesses, the Commission has now made proposals to ease these controls. The UK government, on the other hand, is looking for symbolic fights, such as the right to exclusively use imperial measures.  Most importantly, and impossible for the European Union to accept, the British government wants to eliminate the role of the European Court of Justice, in the name of complete sovereignty, even though this seems to have no importance for businesses on the ground in Northern Ireland. There are now indications that even if the British government will eventually back off, they do not consider this issue settled but will bring it up again in the future. Thus, a continuous conflict with the European Union, something that Brexiters promised to end after Brexit, but seemingly cannot let go.

 

In this context, the government has now all but officially confirmed that it signed the Withdrawal Agreement in bad faith, never planning on complying with its part of the Northern Ireland Protocol. Perfidious Albion is raising its ugly head!

 

And as the problems in Brexitland are mounting, the argumentation by the government that labour shortages (i) do not exist, (ii) do exist, but have nothing to do with Brexit, (iii) are actually caused by Brexit but are a benefit of Brexit is becoming more and more absurd; not sure whether to call it Orwellian or Trumpian. And the itching of some right-wing media figures for a trade war with the EU to rekindle the Blitz spirit of World War II stands in odd contrast with the fear of government to impose any Covid restrictions as the population will not be able to take it.

 

As ridiculous as Brexiters look from outside the UK, as naïve looks the ‘re-join’ the EU movement. Completely illusionary, they imply that all they need is a majority in parliament or some referendum to re-join the European Union in a few years. Well, the 27 member countries of the EU beg to differ. While careful with predictions, I would dare to predict that I will not see the UK re-joining the EU in my lifetime (and I currently have no indications nor wishes that I will pass on shortly 😊). All 27 current members of the EU have to agree and many of them will have their specific demands and objections. More importantly, the absence of the UK might have facilitated recent movements towards a fiscal union. And the looming conflict with Poland will make the EU even more reluctant to let back in a country that is not exactly known for its constructive role during the last decade of its membership. So, EU membership is off the table for the next couple of decades, at least with the current structure of the EU. The best the re-join movement can hope for is a Swiss-style alignment with the EU that re-establishes closer links between the UK and the EU in specific policy areas. Even Single Market membership is far away and not easy to achive, as explained here.

 

So, both Brexiters and the re-join movement are stuck in their respective bubbles, with one trying to divert attention from the damage Brexit is doing to the UK by fuelling constant conflict with the EU and the other blaming any problem on Brexit and promising the end to all problems once the UK re-joins the EU (sounds familiar?). Being in Northern Ireland, one is reminded where ideology and religion-like purity tests can lead to, with the two camps living in their own world; while in Northern Ireland they are also physically separated, in England, they live intellectually in their own respective bubbles. With calls that certain positions in the BBC have to be occupied by pro-Brexit journalists, the UK is moving closer and closer to the US model where the two bubbles no longer talk with but only at each other.

After 10 years of fighting the windmills of lose monetary policy, Bundesbank president Jens Weidmann leaves the stage. There are two reactions in Germany (and across Europe) towards the appointment of his successor.  Some lament the possible end to a hawkish Bundesbank that is focused primarily on inflation angst and sees any loosening of monetary policy and the slightest increase in inflation rate as the possible start of a hyperinflationary downward spiral. Others see the appointment of a new Bundesbank president as chance to finally move away from a sometimes confrontational approach towards unconventional monetary policy under Draghi and Lagarde.  Whatever side one takes, it is clear that Weidmann has been in the minority in the ECB’s Governing Council over the past decade and has had therefore limited influence.  At the same time, one can argue that his position has contributed to the increasing hostility of media and public in Germany vis-à-vis the ECB.

 

Trying to stick to orthodoxy in monetary policy when the world around one changes seems at best naïve and at worst dangerous. First, it is important to remember that one important reason for the ECB to take a much more prominent, unorthodox role under Draghi after the onset of the eurodebt crisis was the refusal of ‘creditor countries’ (led by Germany) to give fiscal policy the necessary role in crisis mitigation. Second, monetary policy frameworks have to adjust to changes not just in economic structures but also in analytical insights.  Over the past decade that I have been discussing monetary, financial stability and euro area policies more broadly with my fellow economists in Germany, I have noticed a clear shift away from orthodoxy to a more realistic approach, moving from ‘we show the rest of Europe how to do it properly’ to the recognition that Germany as anchor country of the euro has not only privileges (and big economic advantages) but also responsibilities. Third, the world has moved on from a view that money supply drives inflation and that monetary and prudential policies are independent of each other to the realisation that financial and monetary stability are inherently related with each other, which requires a much more broader central banking approach (reflected also in the fact that with one exception  - Sweden – it is the central bank governors of the EU that have voting power in the General Board of the ESRB, the macroprudential coordination mechanisms of the EU).

 

So, what does this imply for the next president of the Bundesbank? Isabel Schnabel as member of the ECB Executive Board has given an important example, being a bridge between the ECB and often hostile, inflation-averse German media and public. The new president should see him or herself as being in the centre of the euro area system, being the representative of the anchor country of the euro in the Governing Council of the ECB and actively shaping ECB policies going forward.  At the same time, (s)he should be a more active spokesman for the ECB towards the German media and public. The new president can draw on talented staff at the Bundesbank and an increasingly diverse and vibrant world-class economics and finance academic community in Germany.  That’s an incredible opportunity and much more promising than tying oneself to historic orthodoxies.

La Repubblica Firenze has an agreement with EUI to publish op-eds by academics and this week it was my turn – to make the direct link to my new host region, I chose the never-ending saga of Monte dei Paschi di Siena, which for me is a mirror of where Europe’s banks, regulators and politicians have gone wrong over the past 20 years: a rapid expansion before 2008, followed by mounting losses, hidden from auditors and regulators; a government bail-out in 2013, which did not help turn things around and nationalisation in 2017. At the core of this drawn-out failure of MPS has been too close a relationship between politicians and bankers, which has prevented early and effective intervention.

 

What I see as critical mistake and would call the original sin of the banking union was the decision in 2014 to apply the new regulatory framework to a banking system still working through the aftermath of the Global Financial and Eurodebt crises and – in the case of Italy – a triple-dip recession rather than to address legacy losses and force an effective restructuring of European banking.  Yes, supervision has been Europeanised, but banks’ connections with local and national politicians have kept the resolution effectively on the national level and bailouts are still the default solution. And while there is no immediate risk that the sovereign-bank deadly embrace will emerge again in the near future, the risk has not been eliminated because of these national and taxpayer supported resolutions.

 

To link back to MPS and my new host region – as there are concerns about the demise of MPS: Tuscany needs strong banks that serve the local economy and society. However, times have changed and the focus has to move from trying to conserve what is no longer sustainable to building effective and stable finance. Europe should not be seen as the enemy that robs Tuscany of its banks, but as an opportunity to create sustainable provision of financial services.

The World Bank’s decision to permanently suspend the Doing Business project is the sad end to an initially very good idea! My latest Vox column discusses how we got from a research-based data collection effort as an important impetus into policy debate to a ranking exercise that undermined the usefulness of these data. A short summary:

 

20 years ago, the Doing Business project filled an important gap by providing detailed indices on specific institutions (e.g. credit registries) or specific business cases (enforcement of bounced check, registering a property of specific value). Over time, Doing Business has become by far the most successful data collection exercise and report of the World Bank, but also, as former World Bank chief economist Kaushik Basu (2018) stated, the most contentious publication. Controversies over Doing Business resulted in the resignation of Kaushik’s successor Paul Romer and have resulted in numerous inquiries and reviews, ultimately resulting in the pausing of the report in August 2020 and its permanent suspension in September 2021.

 

In order to maximise the impact of the data collection, the Doing Business report included rankings of countries based on Doing Business data. The report and ranking became part of a broader effort of the World Bank and other donors to assess countries’ investment climate and foster private sector development and thus growth in developing countries.  Countries that moved up the most in the ranking were crowned reformer of the year, which in turn has been used by governments to attract foreign direct investment. However, governments that care about these rankings, might start gaming the system – rewriting laws with an eye on improvements in the Doing Business ranking rather than focusing on the most important constraints for private sector development.

 

Credit rating agencies face a conflict of interest if they rate securities while providing advisory services to the issuing companies. Similarly, the Doing Business team faces a conflict of interest if it collects data used for country ranking while at the same time offering advisory services to governments on how to improve their business environment and thus their Doing Business Ranking.  This conflict of interest is not theoretical, but has been clearly shown in the Wilmer Hale (2021) report .

 

However, the conflict of interest is even deeper and cannot necessarily be remedied by introducing a firewall between data collection efforts and advisory services. Ultimately, the World Bank is owned by its member countries who are represented on the Executive Board.  The (ultimately successful) attempt by certain governments to take influence on the ranking (and thus the underlying data) clearly speaks to this conflict of interest.

 

Beyond these conflicts of interest, there is a broader concern of whether the political targeting of the Doing Business ultimately undermines the usefulness of the index.  Charles Goodhart stated in 1975 that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”  Originally, this regularity (known nowadays as Goodhart’s Law) was used in monetary policy, but it can be applied in any economic policy area. Marilyn Strathern (1997) summaries Goodhart’s Law in a discussion on the UK evaluation framework for universities:  “When a measure becomes a target, it ceases to be a good measure”.

 

The events described in the World Bank report read like Goodhart’s Law in action.  As rankings were published on an annual basis and as improvements in the ranking became political targets, so did attempts at influencing ranking and thus data. The conflict of interests mentioned above facilitated such influence-taking; all that was needed were persons in place that would be open to such influences.  Beyond these conflicts of interests, however, it is hard to see how one can get around this more fundamental problem of declaring an index as policy target, without this index subsequently losing its usefulness. 

 

Where do we go from here?  The original idea of collecting data on the business environment in which companies across different countries (or even across different regions within countries) operate continues to be good and important – again for research purposes and to inform the policy dialogue (though not to pre-empt policy outcomes). In a previous VoxEU column in 2013, I called for moving away from rankings and to focus exclusively on data. Researchers do not need rankings, we need data.  Policy makers need data and comparisons, while questionable rankings do not only not help a constructive reform process, but narrows it down to what are not necessarily the best reforms. Finally, Doing Business data should be regarded as one of several gauges of the business environment firms face, forming part of a more broadly-based approach that draws on multiple data sources and analyses. Such an approach might not hit the headlines as often, but might be more effective in driving policy reforms.

Important disclaimer: I am a member of the Advisory Scientific Committee of the ESRB. However, the views expressed below are exclusively mine and do not necessarily reflect the official stance of the ESRB or its member institutions.

 

The General Board of the ESRB decided to allow the revised recommendation on payout restrictions lapse at the end of this month, maybe not a surprising decision given the earlier decision of the ECB Supervisory Board in July. This brings to an end over 16 months of such ‘restrictions’, given that these were recommendations, the restrictions were soft, though it seems that at least in the banking sector, the compliance was high.  Payout restrictions were controversial from the beginning; as discussed in this ESRB report (which was the basis for the first ESRB recommendation in June 2020) , there are good arguments on either side. Many felt that in spring 2020 the arguments in favour of such restrictions were stronger than the arguments against them: extremely high uncertainty (unknown unknowns) and an unprecedented degree of government support for the economy. The situation has certainly changed; there is a clear exit path from the pandemic; bank and corporate fragility concerns are lower than anticipated just a year ago and fiscal support is being phased out. On the other hand, the stress tests published in July have shown quite some variation across banks in terms of possible fragility and the fallout from the pandemic both in corporate and ultimately banking sector will not become clear until next year, the earliest. But importantly, profit distributions are an important part of the market process; a market-based process of bank restructuring and consolidation cannot take place, if equity holders are deprived of their property rights!

 

All of these arguments seem to speak clearly in favour of moving away from blanket (macroprudential) restrictions to more targeted (microprudential) approaches, in the context of the usual supervisory process. There will certainly (and hopefully) research being done in the coming years to assess the impact of these restrictions. The final word is certainly not spoken yet.

 

A related discussion is whether macroprudential authorities should get formal powers to impose such restrictions to distribute profits during crisis times. I am somewhat sceptical on this. Macroprudential tools are designed for the financial cycle; the situation in 2020 was certainly not a financial cycle situation. Prudential authorities have ample tools to intervene into failing banks (the fact that they are not always being used is a topic for a different conversation), formal powers to suspend property rights across the financial sector seems a rather extreme step. There is certainly an important discussion to be had on the use of such a tool outside all but the most extreme economic situations and certain safeguards for the use of such instrument might be needed.