Exorbitant privilege or exorbitant burden?
The former French president Valerie Giscard d’Estaing coined the expression ‘exorbitant privilege’ in reference to the benefits that the US derives from the US dollar being the international reserve currency. Among these benefits are the US not having to fear a balance of payment crisis due to current account or fiscal deficits as the threat of sudden stop does not really apply to the issuer of the global reserve currency. The US government can also borrow at lower interest rates given the high demand for dollar-denominated assets (Barry Eichengreen and co-authors quantify this advantage in this paper). The position of the US dollar also makes US monetary policy a decisive driver of global financial cycles.
Other economists (e.g., Michael Pettis already in 2011) have re-interpreted the role of the US dollar as exorbitant burden rather than privilege. Most importantly, the position of the US dollar as global reserve currency results in its overvaluation, hurting US exports. These commentators explain the persistent current account deficit and the decline of the US manufacturing industry with the role of the US dollar as global reserve currency. Martin Sandbu recently dismissed many of these arguments, popular with US politicians on both sides of the aisle, especially the argument that a strong US dollar explains the decline in GDP’s manufacturing share in the US.
I would rather like to focus on the link between the reserve currency status and current account deficit. It is hard to come up with a counterfactual, as this would require either comparing the US to the UK pre-World War I (two very different periods) or to an alternative universe with a different global reserve currency today. But, some lessons can be learnt from looking at Switzerland (considered as safe haven country) and Germany (the anchor country of the euro).
Take first Germany; it has benefitted from its status as anchor country and its government bonds being the safest and most liquid in the euro area (as documented in this prize-winning paper by Tsvetelina Nenova), resulting in record low interest rates in the 2010s. Did Germany run an internal or external deficit, as the US did? Well, it did run a current account deficit during the 1990s, right after the unification. Since 2000, however, it has run increasing surpluses, related to the debt brake but more generally due to a cultural aversion against debt finance and its obsession with the Swabian housewife concept who always has to balance her books. Ultimately, this obsession with self-imposed austerity hurt not just itself but also the rest of the euro area. And unlike the US, Germany’s safe haven status did not come with an overvalued euro. But this example clearly shows that internal imbalances are not only driven by external factors but by political decisions and broader societal trends.
Take next Switzerland; given its political neutrality, strong institutions but also bank secrecy (partly lifted), the Swiss France is considered a safe haven currency. This has put continuous upward pressure on its exchange rate and in turn on its exporters. Nevertheless, Switzerland continues to run a current account surplus and its manufacturing sector contributes almost 20% to its GDP, comparable to Germany.
Obviously, these comparisons are not completely valid, but they provide some arguments that the causality does not really goes from reserve or safe haven currency to current account deficit. Put differently, arguing that the USD as reserve currency has resulted in internal and external imbalances is like arguing that US polity and society are not capable of passing the marshmallow test. Low interest rates have enabled consistently high fiscal deficits and a thriving credit culture cum low household savings rate. But blaming the rest of the world for this is taking away agency from political players in the US who have fostered these imbalances.
And as I have argued before, the even higher fiscal deficits projected with Trump’s second round tax cuts will do nothing to reduce this internal imbalance.Driving the US into a (deep) recession might help reduce the savings gap by reducing consumption and investment. Similarly, making the US a less attractive place for foreign capital and undermining its safe haven status can reduce external imbalances. However, I somehow doubt that this is in the long-term economic and political interest of the US.
27. April 2025
A new threat for financial stability
Vasso Ioannidou and I just published an Op-Ed in Politico, on the U.S. president’s renewed promises of financial “liberation.” Behind this rhetoric, however, lies a deeper threat — and it’s not just to the U.S. financial system and economy. The new administration is actively undermining the independence of financial regulatory and supervisory authorities in the US. This will not only affect financial stability in the U.S., but might have negative spill-over effects for Europe, given higher interconnectedness. It is more, the financial system might become a political weapon, adding financial instability to an already volatile global landscape. We argue that the EU must not only hold the line, but European governments and regulators need to maintain strong, independent oversight over European financial systems.
8. April 2025
Let the turmoil rule
2025 might turn out to be an important year in the history of the 21st century. After the beginning of a geopolitical realignment similar to 1945 (end of World War II) and 1990/91 (end of the East bloc and the Soviet Union) , there seems now also a geoeconomic realignment, similar to 1929 (Great Depression) and 1971-73 (end of Bretton Woods). If the steep tariffs announced this past week stick and are not reversed, the modern international trade structure as we have known it for the past decades is coming to a painful end. Before some people start popping the champagne bottles, let’s just remember that globalisation has helped hundreds of millions get out of poverty, most notably in China but also many other developing countries in the world. Is global trade always fair and just – no; is it better than autarky – absolutely; is it better than a mercantilist regime where military and economic power trumps economic efficiency and benefits as Trump seems to envision it – absolutely yes!
The geopolitical realignment goes hand-in-hand with a decline in democratic and institutional standards in the US and a shift towards tech-oligarchy. The president and his entourage have shown a complete contempt for the judiciary and the rule of law, trampling over the idea of checks and balances that the founding fathers so emphasised (ironically it is the conservative originalist legal scholars who always insist on literal interpretation of the founding fathers’ ideas). Competence and dedication to public service have been replaced with blind allegiance to one man and his family and the idea of abusing public service for immediate and future private gains. Daron Acemoglu elegantly described what will be the long-term consequences of these actions even if there are ‘only’ 45 months left in Trump’s presidency.
As observer of these events and with rather strong views on their disastrous effects, I always have to resist the temptation of thinking: let them do it so they can learn how bad political decisions look like. This was the case for Brexit where most economists predicted the negative consequences that ultimately materialised. Most economists pointed to the complete lack of logic in Brexiters’ arguments and warned against the economic damage Brexit (especially the hard Brexit that ultimately was engineered) would impose on the UK. We were proven right. Rather than feeling vindicated, we should ask ourselves why we were not listened to and where we failed in bringing our message across. Similarly the current situation – with Trump breaking down the global trade structure and steering the US and the world towards a global recession – can also be seen as failure of economists of not bringing their arguments across in the public discourse.
There are still different scenarios going forward, with a more optimistic one seeing these high tariffs as negotiation tools. Even under this optimistic scenario, the damage has been done – the credibility of the US government in policy management has been seriously damaged; the consequent high policy uncertainty ultimately undermines incentives for long-term investment. A more pessimistic scenario sees the conflict shifting from goods trade to service trade and capital flows, which could further exacerbate the negative economic impact worldwide. In either case, we are at the beginning of a long period of high turmoil, with no short-term winners.
7. April 2025
Banks and beyond
I recently attended a very interesting conference at the Hoover Institute at Stanford, with the added bonus that I did not only get to see my PhD supervisor but also Robert King, my third PhD supervisor whom I had not seen for 26 years. The focus of the conference was on Banks and Beyond and there were some exciting papers on non-bank financial intermediaries, specifically on Private Credit, loans to firms by non-bank lenders.
Private credit has grown to 1.7 trillion USD in 2023, still only one percent of the overall financial system, but rapidly growing. Sergey Chernenko, Robert Ialenti and David Scharfstein try to explain this growth of private credit since 2008, focusing on one important provider of private credit, SEC-supervised closed-end fund Business Development Companies (BDCs). The authors finds these companies to be very well capitalised - 36% risk-weighted capital-asset ratio if one applied the standardised approach to capital requirements. Applying stress test methodologies they show that BDCs are unlikely to fail. This suggests that increased lending by BDCs is not a consequence of tighter capital requirements on banks. However, higher capital requirements on banks post-2008 can explain why it is more attractive for them to lend to BDCs rather than directly to the borrowers served by the BDCs, as loans to BDCs carry a 20% risk weight while direct loans would carry a 100% risk weight. So, ultimately, tighter capital requirements did shift some activity outside the regulated banking system
Sharjil Haque, Simon Mayer and Irina Stefanescu find that a significant portion of private credit borrowers in the US also rely on bank loans (about half in their possibly incomplete sample). Compared to bank borrowers without private credit, these ‘dual borrowers’ tend to be larger and riskier firms, with higher leverage and less tangible assets that can be used as collateral. Their private credit loans are term loans, while they take credit lines from banks. This seems to suggest that while long-term lending has shifted from banks to private credit lenders, liquidity provision through credit lines has stayed with them, consistent with evidence that banks have a comparative advantage in offering such liquidity insurance given their deposit-based funding structure. However, this combination of private credit term loans and bank credit lines also exposes the banks to higher drawdown risks during stress situations; in spring 2020, dual borrowers were more likely to draw down their credit lines than other bank borrowers.
Nicoletta Cetorelli and Saketh Prazad explore the ‘Nonbank footprint of banks’ and show that since the 1980s, bank holding companies (BHC) in the US have added thousands of NBFI subsidiaries, including investment funds, securities dealers, insurers, and specialty lenders. These subsidiaries constitute at least 20% of aggregate BHC assets and 11% of the aggregate NBFI industry in the United States. Their main explanation for this trend is diversification - as long as affiliated banks and nonbanks experience relatively uncorrelated liquidity outflows, diversified BHCs can redistribute liquid assets among subsidiaries and thus reduce overall liquid asset holdings. This is what they show for the pre-2008 period, a result, however, that becomes weaker after 2008 when tighter regulation forced BHCs to scale back their nonbank footprint. They show that these results are driven by explicit and implicit intracompany funding arrangements between affiliated banks and nonbanks. In sum, the expansion of banks into the nonbank sector can be explained by the search for liquidity diversification and synergy effects.
5. April 2025
Moving on from Brexit
In the previous blog entry I had already mentioned the panel debate in London I participated in. While the focus was on financial integration within the EU, the role of London as European financial centre naturally came up. With Brexit, there has been understandable reluctance by EU policy makers to rely too much on a financial centre outside its jurisdiction, especially among strong early signals of active divergence by UK authorities. However, attempts to create an alternative to the financial centre London within the EU have not really been very successful, while active divergence has not been that aggressive on the UK side. At the same time, circumstances have dramatically changed. First, after a decade or so, the UK finally has again a government that seems more interested in serious policymaking than populist slogans; this is an excellent basis on which to rebuild trust between the UK and the EU, something clearly missing before. Second, the geopolitical circumstances are dramatically different than even a few months ago: the UK and the EU are certainly closer to each other than either of them to the US in terms of geopolitical interests.
During the Brexit negotiations (which even most UK observers would call a success more for the EU than for the UK) the primary interest of the EU was to protect its single market – mission clearly accomplished. However, there are now challenges far beyond economics (though even here more is needed to deepen the single market), including defence and strategic autonomy, where EU and UK interests are certainly aligned with each other. And while the interest of EU policy makers is clearly on strengthening the capital markets within the EU, this does not necessarily exclude relying partly on and cooperating with financial markets and their regulators in London.
What is needed? I would argue, primarily, flexibility on both sides. As outlined in my paper with Christy Petit, the EU is somewhat tied to certain forms of regulatory cooperation (including equivalence decisions); is there space to push the boundaries of that? Back in 2018, then UK Prime Minister Theresa May asked for a ‘collaborative, objective framework that is reciprocal, mutually agreed, and permanent’ , but was rebuffed by the EU, which insisted on discretionary and unilateral equivalence decisions, contingent, limited in scope (sometimes in time) and requiring reciprocity. Would the EU be willing to move towards a more flexible regime?
On the UK side, moving away from the obsession with sovereignty (almost impossible for a mid-sized economy like the UK) and accepting some role for European courts can be helpful and might allow the EU more flexibility in turn. Most importantly, any closer cooperation and easing of access for the UK to the EU financial market would have to be part of a broader package. In our report, Christy and I pointed to the stand-off on Northern Ireland, which had prevented the MoU on financial service cooperation to be signed. With the Windsor Framework this hurdle was overcome. This clearly shows that one cannot consider individual sectors and policy areas independently.
A reset in the EU-UK relationship is overdue and clearly a win-win proposition, let’s hope the chance for it will be used.
25. March 2025
Is financial integration in Europe good for growth and stability?
Earlier this week, I participated in a panel discussion on Does Financial Integration hold the key to European Stability and Growth? in London. The discussion was organised by the Chatham House, so the well-known rule applies, but I can certainly report my own thoughts. The question is stated somewhat provocative. There is certainly not one specific policy or reform that holds the key to European stability and growth, but financial integration can certainty contribute. How?
First, there is an expansive literature that shows that more efficient financial systems can support economic growth. While most of this evidence shows the biggest economic effect for emerging markets and non-linearities (i.e., smaller, if not insignificant effects at higher levels of financial and economic development), there are also important effects stemming from financial structure, as shown by several papers, but most prominently and directly applied to Europe by Langfield and Pagano (2016): the bank-bias in Europe’s financial system explains the lower growth and the higher fragility in Europe’s economies compared to other advanced economies. Building up non-bank segments in Europe’s financial system is thus critical to achieve higher growth and higher stability. In a recent paper, I show with several co-authors that banks’ liquidity creation helps foster economic growth only through tangible but not intangible investment; as economies shift their sectoral and asset composition towards intangible capital (both within and across sectors), the growth effect of banking sector development turns insignificant. Finally, Ralph De Haas and Alex Popov (2023) show that more market-based financial systems are better positioned to support economies’ transition to net zero. So, strengthening the non-bank, market-based segment of the financial system would allow Europe to better exploit benefits of the new economy and progress faster towards net zero.
Second, public financial markets are more than other segments of the financial markets reliant on scale and network effects, i.e., the more participants on both sides (investors and listed securities), the higher the liquidity and thus benefit for economic growth. We show this effect in a recent paper on nascent stock exchanges. However, this scale effect is not limited to public financial markets; venture capitalists and equity funds depend on exit options through public markets; institutional investors, including insurance companies, pension funds and other investment funds, rely on deep and liquid markets. Looking at Europe, financial markets are fragmented, which holds back their development but also that of other critical non-bank segments of the financial system.
Third, strengthening market-based finance in Europe through integration does not imply that one should ignore the bank-side of Europe’s financial system. Rather, there are important feedback effects between banking sector and financial market integration. Larger and cross-border European banks allow a stronger role for them in investment banking and thus market development. Developing European safe assets helps both banking sector integration (including by cutting the bank-sovereign vicious cycle) and deepen financial markets. Deeper financial markets allow banks more effective securitisation and, more generally, raising funds beyond deposits. So, it is not banks versus market, but banks and markets that we care about for financial integration.
20. March 2025
The bright side of regulatory arbitrage
Banks might shift assets and risk across countries due to differences in regulatory regimes. In a recently published paper, Consuelo Silva-Buston, Wolf Wagner and I show that cross-border supervisory cooperation agreements can also result in such regulatory arbitrage with risks being shifted into a third country. In a new working paper, we consider the real effects of such regulatory arbitrage. On the one hand, countries with weaker regulatory standards may receive capital inflows that allow firms to borrow more, potentially alleviating financial constraints This may be particularly beneficial if countries with less developed financial systems (and hence more constrained firms) are also countries with relatively lower regulatory standards. On the other hand, such benefits are conditional on whether the additional lending is targeted towards well-managed, efficient, and profitable firms, as a purely risk-motivated reallocation might result in negative NPV projects being funded. Regulatory arbitrage can thus also lead to excessive risk-taking and misallocation of resources.
We use the syndicated loan market as a laboratory to explore the effect of regulatory arbitrage on lending terms, as well as firm behaviour and performance. We first show that a subsidiary of a bank group extends larger loans to firms when the extent to which cooperation covers the group’s global operations (excluding the subsidiary country itself) increases (for example, as a result of the parent country of the group forming a cooperation agreement with another country in which the group has subsidiaries). We also consider the effect on loan pricing and find that when cooperation elsewhere increases, the subsidiary also offers lower lending rates to firms. Thus, lending conditions improve on both the quantity and price margin.
We next investigate which types of firms benefit from the improvement in lending conditions. Our results suggest that the firms that benefit most from improved lending conditions are high-quality firms that are less likely to fail and firms with which the bank is less at an informational disadvantage (in our case: because it has an existing relationship with the firm). This is consistent with the literature on foreign bank entry, which has shown that foreign banks often face a disadvantage in making new loans compared to incumbent local banks, because of inferior access to local information.
Finally, we consider whether there are real benefits arising from the shift in lending conditions. Exploiting the same third-country variation in relative supervisory stringency, we show that firms that borrow from banks that receive positive shocks in third-country supervisory cooperation expand their activities. They increase their asset base, have higher capital expenditures, and do more R&D. These firms also see their profits increase. This is consistent with financing constraints being eased at such firms.
Overall, this points towards positive real effects arising from regulatory arbitrage. In particular, the fact that the additional lending seems targeted towards high-quality and safe firms, coupled with the fact that financial constraints are likely to be tighter in countries with weaker supervisory standards (and hence the ones receiving the inflows), allows for the possibility that a reallocation of lending between countries on net alleviates financial constraints, resulting in more desirable projects being funded. This is by no means to claim that regulatory arbitrage overall is desirable. Rather, our results suggest that there are likely to be trade-offs between additional lending and financial stability. It also points to the possibility that the distribution of benefits and costs of regulatory arbitrage are not necessarily equally distributed across countries. In particular, countries may benefit from relatively weaker regulatory standards as that stimulates the domestic economy through higher lending. This may explain the persistence of significant differences in regulatory standards across countries and the fairly low degree to which countries cooperate in the supervision of their banks.
17. March 2025
Reasons to be optimistic for Europe
The breath-taking realignment of the current US Administration away from democratic Europe towards autocratic Russia, the lack of European leadership, including a gap in German leadership, and a stagnant European economy give lots of reasons to be gloomy about Europe’s future. However, there are also reasons to be optimistic.
One, not only have the German elections provided the clear option of a two-party government (though I would have preferred the Green party to be the second party), but the new partners have moved forward quickly, acknowledging that unprecedented times call for quick reactions by a functioning government. The previous black-red coalitions (they used to be called Grand Coalitions at a time when they combined more than two thirds of seat in the Bundestag, a time which looks far away in the past) under Angela Merkel are for me synonymous with expansion of the social welfare state and reform stagnation, neglect of infrastructure and geopolitical realities; Germany benefitted from cheap Russian oil, a booming Chinese market for German exports, the US security umbrella and its anchor role in the euro area. Except for the last, all of these are gone, so this black-red coalition has to make a break with the past; at least for the chancellor—to-be, Friedrich Merz, not as much a problem given that he was a critic of Merkel. And it seems that both parties are willing to make a break, starting with the economically damaging constitutional debt brake. Obviously, it is not just about spending lots of more money, but investing wisely, in infrastructure and in defence. But the change in the fiscal stance can also have shorter-term positive effects on both German and European economies, something we need urgently.
Two, the UK Prime Minister Keir Starmer has grown in his role and moved towards partly filling the European leadership gap in defence. Not being burdened by the bad relationships between Tories and European partners due to Brexit, the UK has the chance to take again its natural role in Europe, at least when it comes to defending European values and interests. The first time since 2010 that a British Prime Minister looks truly prime ministerial.
Three, European leaders have accepted the challenge and are coordinating a response. It remains to be seen how far the initial willingness will take us and it is clear that unanimous decision-taking in the European Union is being impeded by certain Central European governments. New forms of cooperation (e.g., involving the UK) have to be found. At the same time as Europe has to ascertain its geopolitical clout, the relationship with US has to be managed carefully, given the current dependence of European armies on US weapons and military equipment. The build-up of a European defence industry, however, is critical. At the same time, a more hard-nosed approach, without losing the moral compass, is needed for European foreign policy.
Finally, the Trumpian America First approach has put its populist and right-wing allies across Europe on the back foot, at least for the moment. The example of Canada, where Trump’s erratic and offensive attitude helped revive the chances of the Liberal Party is telling! The Trumpian threat against democratic Europe, economically, politically and socially, has energised the democratic centre! Let’s hope it is not just a short-term sugar boost.
11. March 2025
AI and Financial Stability
Artificial intelligence has been described as major game changer, for economies and societies, including for the financial system. And there are certainly lots of opportunities for improving efficiency in financial service provision, for example in investment advice (robo advisors), algorithmic trading and loan application screening. It can also help on the regulatory side, for example in the detection of fraud and money laundering
It is important to understand that AI relies on past data and is certainly less efficient when it comes to completely new situations when it cannot rely on past data and relationships. Further, AI focuses on narrow optimisation problems and does not have an understanding of the broader environment in which humans operate and interact. Both characteristics are an important difference between human and artificial intelligence. This does not take away from the usefulness of AI, however, puts important limitations on its use.
However, there are certainly also risks for financial stability. And that is what I focused on in a recent panel discussion on AI at the Warwick Economics Summit. One such risk is stronger procyclicality in lending, given the data-reliant approach of AI (similar to transactions vs. relationship lending). This might become worse during highly uncertain times (think pandemic shock) when reliance on previous experience is all but impossible. Another risk is that of herding, given model conformity and high correlation of algorithmic traders. This can exacerbate market swings and result in mispricing of risk. There is also the risk of susceptibility to malicious attacks by maliciously modifying the AI model. And it is important to remember that when better risk management tools are available, there is the tendency to also take more risks, which in turn increases the risk of financial fragility. AI might result in an illusion of control that is not really there!
There are concerns beyond stability, related to data privacy; given the reliance of AI on data, concerns on data leakages and breach of confidentiality cannot be ignored. Ultimately, this can result in an increasing segment of the population deciding to opt out of the financial system, refusing to share their data; an endogenous digital divide.
In sum, as many previous innovations, AI has a bright and a dark side to it and has to be used with caution. Having listened both to strong advocates and critics of an increasing role of AI in finance, there is one thing that both group seem to agree on: the need for a strong human oversight. And an increasing use of AI in finance certainly requires an adjustment in regulation and supervision of financial institutions, including for macroprudential authorities.
Some interesting references
Buckman, Haldane and Hueser (2021): Comparing minds and machines: implications for financial stability. Staff Working Paper 937, Bank of England
Shabsigh and Boukherouaa (2023): Generative Artificial Intelligence in Finance: Risk Considerations. Fintech Note 2023/006. IMF
And a very recent eBook, published by the Florence School of Banking and Finance: Digital finance in the EU : Navigating new technological trends and the AI revolution.
8 March 2025
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