Finance: Research, Policy and Anecdotes

I am off to a well-deserved summer break, with a full and exciting fall schedule coming up.

 

Where do we stand in terms of the populist revolt against liberal democracy?  The US and the UK have been seen as the two countries most “affected” with the Trump election and the Brexit vote, an interesting observation in itself that is worthwhile some analysis. The last six months have certainly been depressing for both countries – in the UK a government that supposedly wanted to keep its cards close to the chest has turned out to have no such cards and making up policy on the go; in the U.S. a narcissistic and incompetent president who is attacking the institutions that have underpinned US democracy for more than 200 years and a Republican party that (with few exceptions) puts party above country.  On the other hand, a resounding victory in France against the extremist right-wing Front National and an increase in positive attitudes towards the EU in many countries.  Certainly an important opportunity for Europe and liberal democracy.

 

I was recently asked by a Greek blog site about my opinion on the Greek and Eurozone crisis, in case you are reading Greek.  Or use google translate as I did.

 

I was also asked to write a quick blog entry about government’s role in banking:    It is a very quick and somewhat superficial summary, but somewhat summarizes my thinking on this critical issue in finance.  

 

On a personal note: I am spending the first two weeks of my summer break in Colombia, visiting my in-laws.  City maps in Colombia have a certain system to it, with carreras and calles.  All good, and even the navigation system bought into it; unfortunately, I forgot to tell it that I meant to be in the South part of Medellin rather than the North part, with the result that instead of ending up in our hotel we ended up in the middle of a comuna (aka favela). Oh well, at least we got to know Medellin extensively and saw for ourselves how this city has transformed itself over the past 25 years, since Pablo Escobar was killed.  A metropolitan city with lots of things to offer.  One of the (many) highlights: El cielo, a restaurant that goes beyond food and drink to offer “experiences” – if anyone ever happens to be in Medellin, a must-go (the same chef has also restaurants in Bogota and Miami).

 

Coming up in September, a new e-book on German ordo-liberalism (jointly edited with Hans-Helmut Kotz) and later this year a Handbook on Finance and Development, edited by Ross Levine and me.  I will also start a one-year appointment as the Tun Ismail Ali Chair at the University of Malaya (jointly supported by UM and Bank Negara Malaysia, the Malaysian Central Bank, whose governor Dr. Tun Ismail Ali was for 18 years in the 1960s and 70s) and will spend a total of 10 weeks or so in Kuala Lumpur over the next 12 months, which will certainly be an exciting and insightful experience.

 

The events of the last weeks – first the take-over of Banco Popular by Santander in Spain and then the bad-bank-good-bank solution for two smaller banks in Italy can be seen as first test for the young banking union in the Eurozone.  In a new Vox column I assess these first tests.  The title summarizes my opinion: a toddler with tantrums.  More specifically:

 

  • The case of Banco Popular has shown that SSM and SRM can work well – quick intervention, quick resolution, no taxpayer money. One-nil for the banking union.
  • The case of Italian banks has shown that it is naïve to think that taxpayer money will never ever again be used – there are situations where this is necessary. In this specific case, it should have been done much earlier. No winners here, only losers – the banks and their equity and junior bondholders, the Italian government, and the banking union.
  • The case of the Italian banks has also shown that a crisis should be cleaned up first before imposing a new regulatory regime.  Clean the field before starting the game.
  • Finally, both cases show that we are still far away from a Eurozone-wide financial banking system, which both complicates the completion of a Eurozone-wide safety net and a complete cut of the bank-sovereign deadly embrace.  It will take more than a common regulatory regime and supervision and resolution framework to get there.
  • Italy is a problem and will continue to be for some time coming (continuous banking problems, sovereign indebtedness, and political uncertainty). As the past weeks have shown, the future of the Eurozone might very well go through Italy.

 

 

For teachers of Business Economics to MBA students, like me, the current macro-economic situation in the UK gives plenty of material for class room discussions. The rising inflation we are observing are driven by higher import costs rather than by demand, with lower growth and higher inflation as result. The public discussions among MPC members on what to do about this shows the conundrum they are facing: raise interest rates to counter inflation and you might slow down the sluggish economy further – lower interest rates to increase growth and you might get even more inflation. No surprise that observers now focus on the profiles of individual MPC members, as recently the FT.

 

On top of this comes the discussion of whether sluggish growth is ultimately part of the adjustment process to a permanently lower GDP per capita level in the UK after Brexit.  Paraphrasing the Bank of England governor Mark Carney, monetary policy can help smooth the process towards the new equilibrium but it cannot make up for the damage that is being and will be done with Brexit. An important reminder for politicians as they negotiate Brexit with the European Union.

 

Then is there is the issue of private indebtedness, which has been increasing, especially due to car loans and (somewhat less) credit card debt. Is this part of the adjustment process towards lower income levels or driven by the prospect of a bright future?  Declining consumer confidence suggests it is the former.  Higher interest rates would simply squeeze consumers further, so the application of macro-prudential tools (counter-cyclical capital buffers, to be more precise) seems adequate.  They do not seem binding in most cases and have to be implemented over a 12-month window anyway. But the FPC has already provided some forward guidance to the effect that these buffers might be increased further, thus sending a clear signal to banks to dampen credit growth.  This application of monetary and macro-prudential tools shows the clear advantage of coordinated monetary and macro-prudential tools, by having overlap in membership of FPC and MPC.

 

What about fiscal policy? The recent elections have sent a clear signal that the electorate had just about enough of austerity and there is increasing pressure to loosen the public purse. The FT has calculated that the 1 billion pounds promised to Northern Ireland to buy Theresa May 2 more years in 10 Downing Street would translate into 60 billion if applied across the UK or 0.2% of GDP; not a big number prima facie, but significant as the fiscal deficit is still at 2% (eight years after the end of the last recession) and debt above 80% of GDP.  Though relaxing austerity might have the benefit of reducing pressure on consumer and thus their tendency to incur more debt, it might put more pressure on interest rates. Certainly challenging times for everyone! 

As most of my generation, I have a very ambiguous relationship to Helmut Kohl; on the one hand, he was not considered to be on the same intellectual level as his predecessor Helmut Schmidt, he was seen as opportunist who relied on relationships rather than principles. On the other hand, he is rightly considered as the father of the German unification – where others hesitated, he saw the unique window of opportunity (which might have closed only a year later with the disintegration of the Soviet Union) to push ahead and achieve what few had considered feasible a few years earlier: a unified, stable and democratic Germany.  Politically the right move, it came with some doubtful economic policy decisions – one of the major decisions was a conversion rate of East and West German marks of one-to-one, which turned East German companies completely uncompetitive and is one of the reason why Eastern Germany was not converted into “blooming landscapes” as he promised in 1990.  It was one of several economic policy mistakes (nicely documented by HW Sinn in his book “Kaltstart”), which came back to haunt the unified Germany in the early years of the 21st century   The second important decision taken in 1990 was that of the introduction of the euro – concession to the French president Mitterand for given his approval for the German unification. While praised as success story for the first 10 years, the governance structure of the Eurozone has been a major cause of the prolonged Eurozone crisis for the following ten years.

 

How ever one might evaluate Helmut Kohl’s policies and politics, he will enter the history book as the last chancellor of Western Germany and the first chancellor of the unified Germany (for the first time a unified and stable democratic Germany); he helped close a chapter of German and European history and push open a new one. For better or worse, he helped shape the political and economic ground on which today’s European policy makers have to play. A European giant!

Two interesting papers from a recent conference in Frankfurt, showing the importance of too rapid expansion for both bank-level and systemic fragility and shedding doubt on whether the focus on higher capital standards should really be a first-order regulatory priority.

 

Moritz Schularick from Bonn likes to go for big questions – so in a recent paper with Oscar Jorda, Bjoern Richter and Alan Taylor, he asks whether bank capitalization can predict systemic fragility?  Using data for almost 150 years, the answer is: NO. Banks’ solvency has no value as a crisis predictor; liquidity indicators, such as the loan-to-deposit ratio and the share of non-deposit funding, have some predictive power, but the most robust and clearest crisis predictor is loan growth.  One consolation prize for the higher-capital-buffer-lobby: recoveries from financial crisis recessions are much quicker with higher bank capital (consistent with the recent experiences in U.S., Japan and Eurozone, I would add).

 

And to complement these macro findings with some micro-evidence, Rudiger Fahlenbrach, in joint work with Robert Prilmeier and Rene Stulz, uses bank-level from the U.S. over 40 years and shows that stocks of banks with high loan growth significantly underperform banks with low loan growth over the following three years, mostly due to higher loan losses stemming from riskier lending associated with rapid loan portfolio expansion. It is interesting that neither markets nor analysts pick up this phenomenon in time.

 

So, yes, capital buffers are important, but so is macro-prudential trying to affect the credit cycle!