Brexit – too much repetition drives down viewers’ attention
The never-ending Brexit soap opera has entered yet another season – some of the main protagonists have changed (most prominently in London), the tone has somewhat changed, but the themes have stayed the same. The main trade-off is still the same: if you want to play a leading role in European politics, you better be part of the European Union. Staying outside, you make up your own rules at high economic costs or you adapt to European rules without being able to influence them. The latter is the reality that British business has started to adopt to (most recent example: the new bottle caps introduced by EU regulation, but as well in the UK market) and the UK government has started to follow – the previous government only slowly and by stealth, the new Labour government much more open.
At the same time, the Labour government has decided to respect the red lines it has drawn during the campaign to counter any effort by the Tories to accuse it of pushing the UK back towards the EU. So, no move towards Single Market or Customs Union and even proposals that might give the resemblance of freedom of movement (such as a youth mobility agreement proposed by Brussels) are being rejected. At the same time, the UK government seems surprised that Brussels is not immediately agreeing to London’s ideas of a closer relationship.
So, overall, some change in tone but not much change in substance in London’s approach towards the EU. And Labour is continuing in the Tory tradition of aiming to ‘make a success out of Brexit’ with new trade agreements, while at the same time refusing to take back control (as in the case of import controls). Replacing a blue Brexit by a red Brexit won’t change the bad economics of it, however! As before, there is no “having your cake and eating it”; any serious attempt at reverting the damage done by Brexit would involve crossing the red lines. More and more British (especially younger ones) are willing to push for this; it remains to be seen whether and when Labour will feel the pressure.
As in any good soap opera, there are also funny moments, such as Brexiter comments that the only reason why the French president Macron has appointed Michel Barnier (also known as the EU’s Brexit negotiator) as the new prime minister is to annoy London. This idea probably reflects as much the idea of some Brexiters that the UK is still the centre of the universe as back in the 19th century as it does Barnier’s role in showing the naiveté of Brexiters.
15. September 2024
Law and Finance revisited
Ross Levine and I were recently invited to revise our Handbook chapter on the law and finance literature and a draft of the chapter is now available as CEPR Discussion Paper. Building on our 2005 handbook chapter, we summarise research that finds that (1) in legal systems that enforce private property rights, support private contractual arrangements, and protect investors’ legal rights, savers are more willing to finance firms, and financial markets more efficiently allocate capital, and (2) the different legal traditions that emerged in Europe over previous centuries and were spread internationally through conquest, colonization, and imitation help explain cross-economy differences in investor protection, the contracting environment, and financial development.
Compared to the first version of the literature survey, more recent papers have explored interactions between alternative hypotheses to explain legal and financial system development (such as papers by Oto-Peralis and Romero-Avila on Legal Traditions and Initial Endowments in
Shaping the Path of Financial Development) as well as provided within-country and micro-level evidence on the importance of legal origin for financial development (examples include the work by Berkowitz and Clay on differences within the US, notably between former English colonies and former French and Spanish colonies/Mexican territories and a paper by Ross Levine and co-authors on differences between British and French concessions over adjacent and similar plots of land in Shanghai following the First Opium War in the 19th century).
There has also been a large number of papers over the past two decades, exploiting micro-level data (firm and loan-level) and specific policy reforms to gauge the relationship between legal institutions, including collateral reforms, court reforms and strengthening property right protection and access to and cost of external finance. For example, Love, Martinez Peria, and Singh (2016) show that collateral registries for movable assets facilitate firm financing. Berkowitz, Lin, and Ma (2015) show that China’s 2007 Property Law, which strengthened property rights for private firms and their creditors (primarily banks), had a positive effect on firms’ value, especially those with a relatively large share of tangible assets (to be used as collateral) and no political connections. Assunção et al. (2013) exploit a reform in Brazil that simplified the sale of repossessed cars used as collateral and find that strengthening the usefulness of this form of collateral expanded credit to riskier, self-employed borrowers and led to larger loans with lower spreads and longer maturities. Finally, Brown et al. (2017) exploit externally imposed differences in legal institutions across Native American reservations: The U.S. Congress assigned state courts to adjudicate contract disputes on some reservations, leaving other reservations in the hands of tribal courts. State courts resolve contract disputes more efficiently and predictably than tribal courts, and credit market development is significantly higher in reservations assigned to state courts.
We end on a forward-looking note: “New technologies (digital finance, big data and artificial intelligence) yield new financial products and new providers of financial services, challenging existing legal institutions. Which legal institutions will best adapt to these challenges to foster investment, innovation, and improvements in living standards? How will political systems shape the adaptation of legal institutions and financial development to these technological innovations? These are some of the questions that researchers and policymakers must now address.”
9. September 2024
Back to the future – the rise of pro-Russian extremists in Eastern Germany
In 1989/90 it was hard to imagine such a title only a generation and half later. But today’s state-level elections in Eastern Germany give rise to serious concerns, for the region’s society and economy, for Germany’s democratic future, and for Europe’s resistance against Russia’s aggression and thus peace. Two pro-Russian, anti-immigration and anti-European parties have won almost 50% in Thuringia and over 40% in Saxony; including the post-communist Die Linke results in over 50% in Thuringia and almost 50% in Saxony. While these parties have also gained strength in Western Germany, there is certainly a huge gap between East and West when it comes to the tendency to vote for extremist parties.
How did we get here, 35 years after the fall of the Berlin wall and the end of 40 years of communist dictatorship? Why are East Germans voting against democratic parties? Why are they voting in favour of parties that embrace the former colonial overlord Russia? The discussion about the reasons for what can only be described as dramatic reversal from the peaceful German revolution of 1989/90 has led to what I would describe as a second historian debate (the first back in the 1980s was about the uniqueness of the holocaust)
One hypothesis focuses primarily on demographic characteristics, with Eastern Germany’s population being older and more male than Western Germany’s population. Another relates back to the unification process, when Eastern Germany was incorporated into existing structure of West Germany’s constitutional structure rather than undertaking a unification of equals, the rapid post-1990 deindustrialisation of Eastern Germany and the more general feeling that the East was taken over by the West. This explains why Die Linke was so strong over the past three decades in the East, to the point where one of the state governors came from this party and it participated in several regional governments. However, now it has been pushed aside by the neofascist AfD and the Pro-Putin authoritarian party Buendniss Sahra Wagenknecht.
The historian Ilko-Sascha Kowalczuk has an interesting alternative hypothesis, as detailed in his new book Freedom Shock (admittedly, I have not read the whole book, yet!) but also in several recent articles and talk show contributions. His argument is that most East Germans correlated West German democracy and freedom with more income, higher wealth and better quality of life, not taking into account that a shift away from the paternalistic planned economy also implied higher responsibility and – possibly – also higher income inequality. To put it in economists’ term: while average income has gone up, the second moment (standard deviation) also has. The ‘losers’ (mostly in terms of jobs) quickly became disillusioned and the perceived correlation between democracy/freedom and income levels turned them into voters for anti-democratic parties.
And while many younger East Germans left for the West (Eastern Germany lost millions of people over the past 35 years), the remaining population is the more disgruntled demography. The lack of civil society organisations has further contributed to a complete disconnect between voters and democratic system. Thus an open field for extremist pied pipers who have identified the scapegoat for any (real or imagined) problems – foreigners, especially immigrants – but have few if any other policies to offer.
One cannot turn back the wheel in terms of the unification process or political education, but the question at hand is what to do with lack of support for democracy in Eastern Germany. Is a more confrontational approach needed against at least one of the two parties (AfD, which in Eastern Germany is considered extremist)? Is a more open discussion on expectations and disappointments in Eastern Germany needed?
However, beyond academic debates, analysing the reasons behind the rise of anti-democratic parties in East Germany has critical implications for European democracy and security. These three parties are pro-Putin, want to undermine the Ukrainian resistance against the Russian aggression, and are also mostly against the current European democratic order (in line with Hungary’s Orban, Donald Trump and Nigel Farage). This makes a stronger influence of these parties in Europe’s anchor country so dangerous. The next 12 months leading up to the next federal elections in Germany will be tense!
1 September 2024
Lessons from the 2023 banking turmoil – a new ASC report
At the ESRB’s Advisory Scientific Committee we just released a new report (joint with Vasso Ioannidou, Enrico Perotti, Antonio Sánchez Serrano, Javier Suarez, and Xavier Vives), titled: “Addressing banks' vulnerability to deposit runs: revisiting the facts, arguments, and policy options”. This paper is not a post-mortem of the bank failures in the US and of Credit Suisse, but – based on these episodes – a broader discussion of bank fragility and possible policy options. Herewith a short summary:
First, deposit runs are a major source of bank fragility and are almost always the result of a combination of weak fundamentals (concerns about the solvency or liquidity position of a bank or the banking system) and strategic considerations by potentially withdrawing depositors when processing the relevant information (in plain English: no one wants to be the last one to get to the cash machine). The runs in spring 2023 unfolded much more rapidly than previous runs, fuelled by the concentration of the depositor base and by the role of social media and the feasibility of making fast (instant) payments and transfers from the accounts of the affected banks, and thus forced supervisors to intervene much more rapidly than in previous crisis situations.
Second, exposure to interest rate risk (critical for the failure of Silicon Valley Bank) is a direct consequence of banks' involvement in maturity transformation. While there is evidence for a natural interest rate hedge for banks (Drechsler et al., 2021), due to the deposit franchise, individual banks or business models may fail to be effectively hedged against interest rate risk, as the bank failures witnessed in the US in early 2023 illustrate. These failures also show that the franchise and hedging value of deposit funding is vulnerable to any force that leads depositors to withdraw their funds or suddenly requires banks to pay much higher rates for them to roll over their deposits.
The optimal prudential treatment of interest rate risk might therefore interact with banks’ funding structure. If the system can guarantee the stability of a greater fraction of deposits during crises, the minimum capital that ensures that a bank stays solvent declines. Alternatively, imposing a minimum fraction of highly liquid assets provides an immediate buffer to accommodate outflows without having to sell longer term or less liquid assets, but holding more liquidity reduces banks’ expected net interest rate income and may result in a reduced capacity to accumulate loss-absorbing capacity. In sum, the existence of multiple margins along which interest rate risk interacts with banks’ funding structure calls for considering it in conjunction with the safety guarantees and the capital and liquidity positions of each bank rather than with a single dimensional tool.
Finally, we analyse a number of policy options. The first list of categories includes options that could be further considered without major structural changes in the current regulatory and supervisory framework, and might be implemented in the form of adjustments within the margins of discretion of Basel III:
The second list of categories includes those with policy options that would imply deeper structural transformations of the institutional setup or the banking industry and that either we do not promote as the most desirable or would require further analysis:
In summary, we see the first list of policy options as input into ongoing discussions at regulatory and supervisory authorities in Europe, while the second set of policy options might be the basis for further (currently more academic) discussions.
29. August 2024
2024 Ieke van den Burg Prize
Each year, the Advisory Scientific Committee of the ESRB awards a prize for research on systemic risk by young researchers. This year’s winner is Tsvetelina Nenova for her paper “Global or regional safe assets: evidence from bond substitution patterns”. A truly impressive paper!
Using a granular dataset of global government and corporate bond holdings by mutual funds domiciled in the world’s two largest currency areas (USD and euro), the author estimates heterogeneous and time- varying demand elasticities for bonds. She shows that safe assets such as US Treasuries and German Bunds face especially price-inelastic demand from investment funds compared to riskier bonds. However, there are important differences between these two safe assets, when it comes to spillover effects from them to global bond markets. Funds substitute US Treasuries with global bonds, including risky corporate and emerging market bonds, whereas German Bunds are primarily substitutable within a narrow set of euro area safe government bonds. US Treasuries are thus global, while German Bunds regional safe assets.
The paper is not only characterised by incredibly carefully collected granular data, but also by its policy relevance. Demand elasticities of safe assets are critical for monetary policy transmission. Identifying which fixed income assets are considered safe havens and by whom is critical for crisis planning. Not surprisingly, the same paper also won the 2024 Young Economist Prize at the ECB’s Forum on Central Banking in Sintra.
26. August 2024