Finance: Research, Policy and Anecdotes

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.

While I was convinced early on that Brexit would be a never-ending tragic soap opera, I had been more optimistic about US politics after Trump lost in November.  I was clearly wrong.  But even though the US president has changed while the Tory/Brexit government continues in power, there are lot of parallel political developments in the US and UK and they are not exactly reassuring.


There have been comparisons between Donald Trump and Boris Johnson, but I think these comparisons do not quite get to the point.  In the US, there is a personality cult around Trump, while in the UK, there is a cult around the idea of Brexit.   There is also an element of obsession, of not being able to let go.  In the case of Trump, it is the constant relitigation of the 2020 elections, which Joe Biden clearly and fairly won, ranging from questionable election audits over calls for a military coup to rumours that Trump will be reinstated as president in August. In the UK, it is the obsession with the EU, even now that the UK has left; the Tory/Brexit press (Daily Express, Daily Mail, Sun) cannot go a week without blaming the EU for some (perceived) problem in the UK (most recent: the EU conspired to give the UK representative zero points in the most recent Eurovision contest).


There has also been a rewriting of history on both sides of the Atlantic.  In the US, Republicans are now pretending that the insurrection of 6 January was either just a bunch of tourists taking photos in the Capitol or antifa protestors dressing up as Trump supporters (obviously, these two explanations cannot be reconciled). In the UK, the rewriting of history refers to “the UK being frozen out of the Single Market”, the Northern Ireland protocol being imposed on the UK etc.  It does not seem to matter that the same columnists praised the Northern Ireland protocol just a bit more than a year ago and that is was the UK that decided to leave the Single Market.


Another parallel is that the focus on Trump and Brexit has served as façade to hide an incredible degree of corruption and nepotism.  Trump as private person has benefitted substantially from staying as president at his own properties; rather than draining the swamp in DC as he promised, he filled it with his friends and family members; and he regarded the Attorney General of the US as his private attorney, a role that William Barr was too happy to fill, even though the events of 6 January were even too much for him. Similarly, in the UK, the pandemic has resulted in private citizens (including a former prime minister) using their access to ministers to gain advantages in the form of overpriced contracts (with Michael Gove’s recent case just one of several examples).   Maybe this best summarised by Tommaso Valletti in his tweet on Italy 20 years ago vs. UK today.


A final parallel is the role of media in both countries. In the US, it is Fox News who has played the role of facilitator of Trumps lies and alternative facts; in the UK, it is the Tory/Brexit press (Daily Express, Daily Mail, Sun), which continues to spread lies on the EU and the Brexit process on a daily basis. It is sometimes hard to tell who is the dog and who is the tail in this relationship; then, again, in the person of Boris Johnson, mis-leading journalism and politics have merged. It has become clear, however, that the Brexit supporting press in the UK would make any authoritarian leader proud!


What about the role of academics/experts?  Most economists have pointed to the negative effects of Brexit. There has been a small number of economists and legal scholars who have been happy to lend their academic reputation to support questionable statements, alternative facts and conspiracy theories. Unfortunately, university media departments are always excited to see their academic staff being cited in newspapers, even if it is on conspiracy theories that can be easily proven wrong, which creates perverse incentives for such academics to get quoted as often as possible, no matter how nonsensical their comments are.


While the above seems more like an academic comparison between the transformation of two political parties and movements on both sides of the Atlantic, there is obviously a dangerous element to it, that of undermining democracy. Recently, in the U,. a group of political scientists and historians recently signed a statement of concern, related to Republican attempts to undermine voting rights under the cover of election integrity.    And in the UK it has become similarly clear that an unwritten constitution that relies on norms is not sufficient against a government that is keen to tear up democratic norms and traditions and get rid of checks and balances.


Turning to the latest development in the Brexit soap opera, the conflict between the UK and the EU on the Northern Ireland Protocol (which used to be known as the oven-ready deal in the UK) has serious possible implications for Northern Ireland, the relationship between UK and EU but also the global standing of the UK (as became obvious during the G7 meetings). The British government has managed to destroy any of the remaining trust that the EU and European countries might have had after the bruising Brexit negotiations.  It is becoming clearer and clearer that the British government signed up to the Northern Ireland Protocol and thus the border in the Irish Sea knowing well what this implied but without the intention of ever implementing it.  Statements such as “we underestimated the costs” are contradicted by former government officials at the centre of the discussions in 2019 (also here). And it is this perfidious behaviour and break-down in trust that ultimately makes further compromises from the EU side so much more difficult – given that the British government has no interest in complying with the spirit (much less with the letter) of this agreement, any compromise by the EU would lead just to further undermining of the Protocol and controls by the British government.


Why does this matter?  When the UK decided to leave Single Market and Customs Union, it was obvious that there had to be a border somewhere. Imposing a border in the Irish Sea is easier than imposing a land border between Northern and the Republic of Ireland (and one can argue is much more compliant with the Good Friday Agreement). And while some British 19th century nostalgics would like to see the border between Ireland and the rest of the EU, this shows a degree of foolishness hard to beat even after five years of Brexiters’ stupidity. And while there has been a lot of focus on unionist resistance in Northern Ireland against the Irish Sea Border, it remains to point out that (i) 56% of Northern Irish voters voted against Brexit in 2016, (ii) the unionist parties do not represent the majority of the voters in Northern Ireland and (iii) Northern Ireland’s voters support the Protocol 47% to 42% according to a recent poll.


One can envision many different ways how this will end.  If the UK government continues with its aggressive stance, one can expect sanctions from the EU, with a tit-for-tat conflict emerging. And if the UK government insists on unilaterally deviating from the NIP agreement or even suspending it completely, there will be no other choice for the Republic of Ireland (and, yes, there will be pressure from Brussels and other European capitals) to start controls at the land border with Northern Ireland. It is easy to see that this will not calm but rather further raise the temperature.  As much as I hope for peace, I also hope that no one will forget who triggered this conflict – Boris Johnson who first refused (during the campaign) to acknowledge that Brexit might constitute problems for peace on the Irish island and then signed up for an international treaty he never intended to comply with.


Ultimately, Brexit is primarily a domestic politics show in the UK. David Cameron called the referendum to settle the EU dispute within his own party, Theresa May started out with a hard Brexit stance in 2016 to polish her credentials vis-à-vis the European Research Group, and Boris Johnson signed up for the Northern Ireland Protocol to win an election. Even the resistance to actually implementing what has been signed seems to be purely driven by political considerations – keep alive the conflict with the EU to divert voters’ attention

Fresh off the press, as CEPR Discussion Paper and with a Vox column, Miguel Ampudia, Alex Popov and I are gauging the impact of  introduction of centralised bank supervision in the euro area on corporate investment. Following an asset quality review and stress tests (together referred to as Comprehensive Assessment), a number of significant euro area banks became supervised by the SSM in late 2014, while others remained under the supervision of their national authorities. While previous research has shown that the shift to centralized supervision resulted in stability-enhancing actions by the affected banks our research shows the impact of this change in supervisory architecture on the real economy.


Our results show that firms borrowing from SSM-supervised banks experienced a significant reallocation across different types of investment, relative to firms borrowing from banks that remained under the supervision of national authorities, namely from intangible to tangible assets and cash. These results are robust across a number of sensitivity analyses, including a parallel test analysis and a placebo test where we apply our empirical setting and estimation to European countries whose banks did not fall under the SSM from 2014 onward – there is no significant difference between firms borrowing from SSM-eligible banks and other banks. The decline in intangible investment is particularly pronounced in innovation- intensive sectors. Finally, we find a reduction in lending, both using firm- and bank-level data. These findings are consistent with theories that predict more rigorous supervision by a centralised supervisor resulting in less lending by banks, with a consequent move by firms towards more collateralisable assets.


In summary, this points to a trade-off between growth and stability – yes, the move towards a European safety net has helped increase banking sector stability. On the other hand, the shift away from intangible to tangible assets suggests that centralised bank supervision can slow down the shift from the "old", capital-based, to the "new", knowledge-based, economy .