Finance: Research, Policy and Anecdotes

I am off to my last Economic Policy panel meeting at the Bank of Finland in Helsinki, before continuing to a week-long trip to China. It’ll be a bit nostalgic for me after 6 years as managing editor, having met so many great people and worked with so many outstanding economists (and just having met Tullio Jappelli whom I replaced, it was really interesting to take stock of what has changed over the past 6 years). But it’ll be again a great programme, with papers on 20 years Euro and the trade war, among others.  There will be also papers on the factors explaining pension reforms, how much bank executives anticipated the Global Financial Crisis by cashing out, and on the divergence in firm productivity and wages.  I will try to tweet as much as possible. This panel will also be the last of my fellow managing editor Beata Javorcik who just became Chief Economist of the EBRD, so that there will be quite some editorial turnover, with Moritz Schularick and Ghazala Azmat taking our spots (and Andrea Ichino and Tommaso Monacelli staying on).  Expect more great panel and papers in the coming years with this refreshed editorial team.


The Ieke van den Burg Prize (for outstanding research conducted by young scholars on a topic related to the ESRB’s mission) was today awarded in Frankfurt and I am very happy to report that I have a link to one of the two prize-winning papers.*  My former PhD student Andre Silva (now at the Federal Reserve Board in Washington DC) won the prize for his job market paper Strategic Liquidity Mismatch and Financial Sector Stability, forthcoming in the Review of Financial Studies. Andre shows the importance of the systemic dimension of liquidity. Specifically, he finds that banks strategically incorporate their competitors’ liquidity mismatch policies when determining their own liquidity position. While it is typically difficult to identify such peer effects due to the reflection problem and unobserved effects, he uses network structures and cross-border ownership linkages to construct a valid IV to account for potential correlated effects.  He also shows that such peer effects in liquidity positions are driven by asset- rather than liability-side effects and asymmetric, with individual banks mimicking their respective peers only when competitors are increasing funding liquidity risk.  And these effects also have important stability implications, with correlated riskier liquidity positions resulting in lower idiosyncratic and systemic bank stability. Together, these results emphasize the importance of regulating liquidity risk from a macroprudential perspective; while Basel III has introduced micro-prudential liquidity requirements, Andre’s paper shows the importance of moving to a more systemic approach.



The other paper awarded the price is by Guillaume Vuillemey and is forthcoming in the Journal of Finance. The Value of Central Clearing assesses the effect of the first Central Clearing Counterparty House (CCP) in 1882 in Le Havre for coffee futures.  This new contractual institution allowed coffee traders to insulate themselves against counterparty risk.  The effect on coffee trade were significant, with more coffee imports channelled through Le Havre, even if subsequently sold to other European countries. There was also a smoothing effect on coffee consumption!  Guillaume shows that the CCP helped complete the market, both reducing asymmetric information between traders and offering insurance against counterparty default (as this is taken by the CCP). The success of this first CCP was soon replicated in other European exchanges. This quite insightful historic study shows that financial innovations such as a clearing house can have positive effects on the real economy.   After the Global Financial Crisis there was another global push to bring more derivatives onto CCPs, though this was mostly for transparency and stability reasons. However, one important lesson from this and one of Guillaume’s other papers is that high equity, high margin requirements, and good governance are critical for the success of a CCP – in a paper with Vincent Bignon, published in the Review of Finance (with me as responsible editor) he analyses the failure of a CCP for sugar futures in Paris in 1974, related to poor risk management and weak governance structures.


Together, these papers show the importance of specific regulations and institutions for systemic stability.  They also show the diversity of tools being used in modern finance research – on the one hand, bank-level data with a carefully constructed instruments; on the other hand, a historical study offering important insights for the present!


*Important clarification – these prize winners are chosen by ASC members; I did not participate in the final voting round given my link to Andre’s paper!

I am trying to avoid writing about Brexit, but somehow cannot help myself.  But I promise a rather unique approach today – that of an economist with interest in comparative legal studies. In the early part of my research career I co-authored several papers in the law and finance literature (together with Asli Demirguc-Kunt and Ross Levine), a literature that shows a critical difference in (i) how legal systems have developed over the centuries across different legal “families” and (ii) how this legal system development has influenced the development of the financial system. A headline finding is that Common Law countries (US, UK and former British colonies) have more developed financial systems than Civil Law countries (pretty much everyone else) controlling for other factors. The critical historical difference between Common and Civil Law lies in the role of the judiciary and the flexibility and adaptability of the legal system. One critical difference in the historic development of the UK and France (two mother countries of their respective legal tradition) was the role of the judiciary in the British and French revolutions in the 17th and 18th centuries, respectively. In short, the judiciary was on the winning side in the conflict between Parliament and King in the UK and on the losing side in the conflict between ancien regime and revolutionaries in France. Siding with parliament over the king (under the motive Lex Rex) helped establish the independence and ultimately supremacy of the judiciary in the UK (unlike in France and other French Civil Code countries where the judiciary has a much weaker role among the different branches of government).  Another critical difference is the role of jurisprudence (past decisions) and willingness and ability of Common Law judges to adapt legal decisions to circumstances, including looking beyond form to intention.


Given this historic background, the UK Supreme Court decision that the prorogation of Parliament was unlawful should not be surprising. The justification of the decision looks beyond form (proroguing parliament to prepare a Queen’s speech) to intention (avoiding accountability of government) and consequence (opening the door to arbitrary prorogation whenever government pleases).  It also confirms the strong role that the judiciary has in the political system of Common Law countries. Finally, it establishes once more Lex Rex – as the Stuart Kings lost in the 17th century, so do Tories claiming to represent the “will of the people” in the 21st century. Those analysts who claim a constitutional coup better read up on British constitutional history.

After many years, Meghana, Mohammad and I finally managed to find a home for our paper Finance, Law and Poverty: Evidence from India, now forthcoming in the Journal of Corporate Finance.  The paper relates to a longer-standing debate on the role of financial development and – even more important for the policy debate – the relative importance of expanding access to financial services versus increasing the efficiency of the financial system.  These are two important though not necessarily correlated dimensions of financial sector deepening.  We use state-level variation in India over the period 1983 to 2005 in rural and urban poverty rates, branch penetration and Credit to SDP to explore these questions. While we do not have perfect gauges for the outreach and the deepening of the financial system, we use branch penetration as a proxy for outreach effort of the banking system (before the arrival of digital and mobile finance) and Credit to SDP as proxy for financial deepening. Our findings suggest that over the period 1983 to 2005 it is Credit to SDP rather than branch penetration that is associated with lower rural but not urban poverty. Branch penetration, on the other hand, does not enter significantly, though it enters significantly and negatively in a regression of rural poverty, when extending the sample period to 1965 to 2003, consistent with the seminal paper by Burgess and Pande.  As interesting as establishing this result (in line with the findings in the paper by Asli, Ross and me) is to explore the channels.  We cannot find any evidence that financial sector deepening reduced poverty by increasing schooling, but find some evidence for more entrepreneurship in the rural areas.  Where we find the most robust evidence is in interstate migration into urban areas and the tertiary sector going hand in hand with financial sector deepening in the target states.  This is in line with most of the additional credit going into the tertiary rather than the primary and secondary sectors. In summary, the story of financial sector deepening contribution to the long-term reduction in rural poverty in India is one of indirect effects going through labour markets rather than through increasing financial sector outreach. This, again, is consistent with some of my earlier work, with Ross and Alex, on the U.S., but also with evidence on Thailand, by Xavi Gine and Robert Townsend.

One reaction to the Brexit win in June 2016 was that this was the result of two decades of anti-EU propaganda in the British yellow press, with everything bad in the UK (including the weather) blamed on the EU.  This was exacerbated by six years of Tories blaming immigrants for declining public services (in reality the results of austerity). As the saying goes… the rest is history.


My co-author Isabel Schnabel has pointed to a dangerous parallel in the German debate on the euro, with the media constantly criticising the ECB. There are justified concerns on whether reducing interest rates further has been the right move by the ECB (I will NOT comment on this!), but declaring the ECB as enemy of German savers seems quite far-fetched.  We had references to Mario Draghi as Count Draghila and repeated references that the ECB is acting against German savers! There is the idea that having an Italian head of the Single Supervisory Mechanism will open the door to Germans bailing out Italian banks (Never mind that Andrea Enria is rather unpopular with Italian bankers as he had been rather robust with them during his tenure at the European Banking Authority).  As I have argued before (and I hope in due course someone will put numbers on this), Germany has benefitted from the Euro being the anchor country of the currency union; there is a clear interest rate advantage for German sovereign bonds – the fact that the German government is not using the advantage is a different story (see below).


There has always been Euro scepticism among German economists; initially healthy, more recently rather shrill if not hysterical.  The debate on Target 2 balances (which many observers wrongly interpret as claims of Germany on other Euro area countries, coming with credit risk) is just one example (as clearly shown here and here: they are NOT). The idea that all the Euro area crisis countries have to do to get out of the crisis is to follow Germany and get as quickly as possible to a balanced government budget ignores the fallacy of composition (a concept any well-trained economist should be aware of).  Last year, Hans-Helmut Kotz and I edited a VoxEU book on ordo-liberalism, noting that there is a lot of merit in the microeconomic insistence on market forces in Ordoliberalism, but less so in the rather outdated macroeconomic thinking.  This is a legitimate debate that contrasts an economic philosophy that reflects the isolation of German economics for several decades after 1945 with the development of modern economics over the past decades in the Anglo-American world.   This discussion has turned even shriller recently, with one of the leading German economists using dog-whistle populism to go against any easing of fiscal policy during a possible recession. Using anti-Semitic references to shut down a debate on the federal government’s debt brake is rather unfortunate, but helps to fuel further Euro-scepticism in Germany.


There is no risk of Dexit any time soon – German policy makers are certainly aware of the enormous economic and political benefits of the Euro for Germany. The question is whether Germany is willing to share the benefits of being the anchor country of the Euro area.  And given that negative or zero interest rates are here to stay for quite some time, the question is whether a prolonged attack by media, politicians and economists against the ECB will result in unwelcome political developments in Germany down the road – again, no immediate concerns, but Brexit also took several decades to develop from a fringe idea to a populist movement.


So to pick up on something I said before I am less worried about the rise of the AfD on the basis of xenophobia in spite of its recent electoral successes in Eastern Germany, I am more worried about the long-term damage the media campaign against the ECB and other Euro area institutions has for Germans’ relationship with Europe and the Euro.