Finance: Research, Policy and Anecdotes

The European Council has come to a compromise on the European recovery support, after four days of negotiations. The main pillars as proposed by Macron and Merkel some time ago still stand – joint financing and an important grant element. But the grant amounts have gone down and several forward looking programmes, including support for climate change, have been reduced. So, is this a glass half empty or a glass half full?  Taking the viewpoint that a year ago none of this would have been even imaginable is a valid point if one takes the long-term view towards a slow move towards European fiscal policy integration. As my good friend Sony Kapoor points out, however, this does not take into account that the COVID-19 crisis constitutes an enormous risk to the whole European project, starting with the euro, if there is asymmetric recovery and divergence across the EU (and again, especially the euro area). Many economists, including yours truly, have therefore called early on for a joint recovery effort on the European level, on economic, political and social grounds. And as ten years ago with the banking union, when these calls were first dismissed as unrealistic, it ultimately did happen. Angela Merkel and Emmanuel Macron have stepped up to the challenge.


But the same economists (and other observers) would have preferred a bigger and more courageous deal; the GDP drop is too large for a minor effort. And though 1.75% GDP stimulus per year over the next three years sound large, it pales in comparison to a GDP drop of up to 10% this year and a potentially sluggish recovery. So, economically it might indeed not be sufficient and thus might not achieve the objective by itself.


In addition, there was the rather unpleasant picture of 27 heads of governments haggling over little details (a million here, some rebates there) and fighting tooth and nail for their national interests. This did not really inspire any positive feelings for the European project, when they are needed most. However, this is not necessarily that surprising; positive cross-border externalities of a big joint COVID-response are not taken into account by governments responsible to national electorates. And the fact that this was ultimately a political compromise among 27 governments (and to be ratified by 27 national and the European parliaments) clearly puts to the rest the accusation (often heard on this side of the English Channel) that the EU is already some kind of super-state that imposes its will on individual countries.  Rather, this compromise ensures that there is ownership for  this common recovery effort across the 27 countries of the EU!


What about the political repercussions? Yes, a failure would have strengthened populists in the South further and enabled them to openly campaign against the “useless EU” (which they might do anyway). However, one should not forget the populists in the North (EU-sceptics in the Netherlands, Finland and other countries). Having this deal be owned by 27 democratically elected governments can certainly help; seeing their head of government fight for their supposed national interest counters populist accusations of a sell-out. One may call this dirty politics, but politics has never known to be the cleanest of all professions!


Then there is the kicking the can down the road (often an outcome of EU/euro summits) – how will the joint effort be funded (to be more precise: how will the borrowing be repaid)? There is talk of Own Resources, new taxes, but no firm agreement.  More haggling and more compromises ahead, but also more possibilities for a common fiscal policy. It is clear that this was a first step and nothing else; a very small step indeed, but looking back in the future it might have been a very big step, indeed!


So, at the end, I am coming down on the glass half full side – no, this is not the big f*** deal (to quote VP Biden), it is not enough to overcome the COVID-19 challenges in the EU and even less so in the euro area.  There will have to more.  BUT: it is an important first step!  It clearly shows that fiscal policy makers are willing to step up and not leave the ECB alone. It might not have been the Hamiltonian moment, but at least it is a Hamiltonian glimpse behind the curtain, at new fiscal policy possibilities.

With Burton Flynn and Mikael Homanen, my current and former PhD students, respectively, I just published another COVID-19 paper, this time on the impact of the COVID-19 crisis on firms in emerging markets and their reaction.


Using survey responses across 488 listed firms in 10 emerging markets from early April, we find that the vast majority of firms were negatively affected by COVID-19. Firms have reacted primarily reducing investment spending and much less through layoffs. Meanwhile, some firms cut back on executive compensation, and more firms expanded employee benefits than cut them. The large majority of firms have acted before their governments imposed measures and there is a surprising degree of support vis-à-vis employees, customers, other stakeholders and broader society, in line with hypotheses stressing the importance of informal long-term relationships in emerging markets. Although stock prices initially reacted to the impact of the crisis, delayed stock price reactions suggest evidence of inefficient markets. Furthermore, we find evidence that stakeholder-centric firms (which showed flexibility vis-à-vis business partners and made donations related to the pandemic) experienced lower stock price declines during the crisis drawdown, suggesting that the financial markets valued these stakeholder-centric corporations more than their counterparts during the crisis.


This paper was made possible by ground work of Burton who is in his real job is a portfolio managers of a Finnish-based emerging markets fund, spending a month each between June 2019 and March 2020 in ten emerging markets and requested one-on-one private meetings with the CEOs of almost 1,500 listed firms.  Expect more great research with data from these meetings!


And if you are interested in Burton’s travel collecting all these great data, check out his journal:

Over four years after the Brexit vote and as the reality of a “sovereign” UK slowly emerges, even the British government has woken up and started its preparation for the end of the year when the UK will exit the transition period and thus the Single Market and Customs Union. Not that the country will be ready by the end of the year, as recent announcements have shown! It seems for at least 6 months if not longer, sovereignty will not really be enforced after all.


The need for customs arrangements will arise independent of whether or not an agreement with the EU will be struck or how such an agreement will look like, but the aim is still some kind of free trade agreement, with fishing rights and a level playing field (mostly related to state aid in the post-Brexit UK) being the critical issues (both also spelled out in the political declaration, signed by both UK and EU, though it seems only the EU actually read the text, see below). While the opposition against the ECJ and other European institutions having too much control over the UK is understandable (given the lack of British representation), there is little trust left in Brussels in assurances by the UK government to not undermine the level playing field, given experiences over the past year. One recent example is the letter by Mark Francois (head of European Research Group) to Michel Barnier pointing to the desire for complete sovereignty completely, which ignores the special position of Northern Ireland (with EU institutions continuing to have an important role) in the legally binding Withdrawal Agreement and the aspirations for a level playing field (implying a role for the ECJ in interpreting EU law) signed by both UK and EU in the Political Declarations. It seems the ERG did not quite do their research before voting for WA and PD.


At the same time, there is a new movement emerging, to revise if not default on the Withdrawal Agreement with the EU (and embarrassingly enough, a colleague from City’s Law School seems to be part of this group). What used to be alternative arrangements and new (non-existing) technologies to avoid a physical customs border in Ireland, followed by GATT Article 24 (tariff-free trade with the EU in expectation of future deal), has now been replaced by Article 62 of the Vienna Convention on the Law of Treaties, which supposedly gives the UK the right to simply withdraw from the Withdrawal Agreement to thus avoid the Northern Ireland front stop (which was agreed with the objective to avoid the need for a border on the Irish island)! While one can only see these as creative (if not ridiculous) attempts to escape the Brexit Trilemma, the latest round takes on a darker notion, as it is basically an appeal to violate international treaties. And while this latest legal Brexiter nonsense has been already debunked, it obviously does not exactly send the signal of the UK being a reliable international partner.  


Notwithstanding all this sabre rattling and with the caveat that economists are typically not good at predicting things (at least not before they happen), my bet would still be for some agreement, where (as in late 2019) the Johnson government will yield to some if not most of the EU’s demands while at the same time selling such agreement as major victory against evil Brussels.


The other major news is that the government has now decided to come finally clean with the British population and introduce them to changes after 31 December that many of them won’t like. Packaging new customs control (at a cost to the tune of 250 million Pounds per week for UK’s private sector – what about putting this on a bus?), loss of European Health Insurance Card, and mobile roaming charges as “seizing new opportunities” (as done by Michael Gove), however, seems quite a stretch and reminds me a bit of how the East Germany referred to its armed border with West Germany as anti-fascist protection wall!


On the upside, I have been enjoying over the past weeks a new literary genre – the twitter short story: @archer_rs has been the telling the story of a British family clashing with the reality of Brexit (which they voted for). I am not sure whether or not to believe the story (though parts of it ring true), but I think he paints a realistic picture of the situation which many British will find themselves in, at some point during the next few years, when they realise how many rights they have lost.

Few used to know the person after whom Cass Business School, Sir John Cass, is named, including yours truly. People often think that CASS is an abbreviation; I was once asked at a conference in Asia, whether I worked for the Chinese Academy of Social Sciences. The reason why Cass Business School bears the name of Sir John Cass is that in 2002 the Sir John Cass Foundation made a major donation to the school.


When news emerged that Sir John Cass was a major actor in the British slavery trade, there were calls to change the name. The foundation itself decided to change its name. So, I was certainly happy to see that on July the university announced to immediately remove the name Cass. Problem: not only was there no decision on a new name, but it was not clear what the name would be during the transition period. It very much was and appeared a panic decision, which did not take into account the operational implications or the impact on stakeholders.


The loudest opposition has been voiced by alumni and students who “invested in a Cass education and degree” and now claim a loss of this investment. Petitions have been started, lots of protest email written, and it has become clear that rather than take the opportunity for positive rather than reactive change, the process has been bungled.


This shows the problems of a purely fee- and market-based university education system, especially for schools that rely so heavily on overseas students. While I have been a supporter of tuition fees, the commoditisation of tertiary education certainly carries its risks, as when investment in a brand name is seen more important than education and public policy concerns.  Let me make clear that I am not dismissing the concerns of students and alumni who feel under distress because of their investment, to the contrary! There is clearly a trade-off, which should have been addressed up-front and cannot be ignored!  And there is a broader debate to be had about the private and social values of education and its funding and  pricing!


It also shows the problem of a business school linked to a university that is significantly ranked below the business school. City University London (now known as City, University of London) does not match the reputation or ranking of Cass Business School, a problem not faced by students of the former Woodrow Wilson School of Public and International Affairs at Princeton, which also just changed its name.


To end on a broader note, universities (including business schools) have a critical role in the public discourse. Their advantage should be that of independence and competence; the Black Lives Matter movement reminds us, however, that we are not just part of the discourse, but of the problem itself. And as this specific event has shown, there are no easy solutions!

I have written a fair share of papers on the real sector implications of financial sector development in the early part of my career, so this new paper provides a bit of a flashback; but then again, as I (and many others) have dug deeper and deeper into the finance-growth relationship, more and more non-linearities have emerged.


In this new paper with Robin Doettling, Thomas Lambert and Mathijs Van Dijk, we focus on one specific function of banks – converting liquid liabilities into illiquid assets, thus providing liquidity insurance to depositors and enabling long-term investment.  Using a large cross-country sample of up to 100 countries we show that liquidity creation is positively associated with economic growth, with an effect that is stronger for industries more dependent on debt finance (thus following the seminal Rajan-Zingales technique).  However, liquidity creation helps growth by boosting tangible, but not intangible investment, a finding which we confirm both on the country- and industry-level. Finally, we find that countries with a higher share of industries relying on intangible rather than tangible investment benefit less or not at all from higher liquidity creation by banks.


Our findings thus speak to the role of banks in the new ‘knowledge economy’ and suggest that they will have a more limited role, compared to other types of financial intermediaries and markets. These findings are also consistent with both theory and previous empirical evidence that banks are less well positioned to help innovative industries and firms.


We rationalise our empirical findings with a theoretical model, adding liquidity risk and moral hazard to the seminal Diamond and Dybvig (1983) model. Information asymmetries allow investors to divert assets and default on bank loans, a problem that is particularly strong if asset tangibility is low, for two reasons. First, intangible investments can be more easily diverted as they are harder to assess by outsiders. Second, failing intangible investments leave the bank with relatively low collateral value, reducing the value of claims on the bank. This makes it attractive for investors with successful projects to divert even if the bank can seize their deposit claims. The effect of liquidity creation by banks on investment is thus hampered by asset intangibility, as it is harder for banks to make loans against intangible assets, in line with our empirical findings.


For a somewhat longer summary, here is the Vox-column.