Finance: Research, Policy and Anecdotes

I was recently invited to discuss “Europe's pathway to the future: challenges and opportunities” – a very general title, which I took as opportunity to put together some general thoughts about economics, politics, finance and “what has the EU ever done for us”.

Politics vs. economics

It is a longstanding belief among economists that economics trumps politics.  Put differently: politicians might be able to fool voters but cannot fool markets. Examples are ample: decisions during the eurodebt crisis taken late on Sunday night were soon dismissed by the sovereign debt markets as insufficient and resulted in further support packages soon after.  You can also see it in the reaction of exchange rate markets to the Brexit referendum and – over the weekend – the budget plans of the new PM – markets are not convinced and have incorporated a risk premium for the UK, something that even the Tory spin doctors cannot explain away. 

Economists, however, have learned that economic policy decisions can have important effects on the political environment, which in turn affects economic policymaking. As Jean Claude Juncker’s once said: we all know what is the right thing to do, but we don’t how to get re-elected afterwards.  The rise of populists across the globe has been related to economic growth being linked to rising inequality, something that has become even more striking after the Global Financial Crisis.  Or as the former Chief Economist of the Bank of England Andrew Haldane found out when he discussed GDP data in the North of England and someone in the audience told him: that’s your GDP not ours. And this populist backlash in turn can influence economic policy making, mostly to the worse: Trump’s tariffs on China, Greece flirting with sovereign default and the Brexit referendum all had negative effects on the respective economy and ultimately the people who voted for these decisions

However, there are also moments when politics trumps economics and the current crisis is one of these. We cannot sacrifice peace on the altar of cheap energy prices no matter how cold the winter. We cannot sacrifice human rights on the altar of global supply chains, no matter how efficient they are. Freedom and peace always trump the laws of economics; something we might have forgotten over the past decades but what the struggle of the Ukrainians have reminded of us.  Maintaining freedom and democracy should be important constraints for any economic policy decisions.

It also provides important lessons for externalities imposed by some member states on others. During the eurodebt crisis in the early 2010s, there was a lot of (partly justified) criticism of some periphery countries imposing stress on the euro area due to their boom-bust credit cycles and sovereign overindebtedness. Now we are in a similar situation: As Thomas Philippon has pointed out, Germany and other European countries have imposed externalities on the rest of the European Union by making themselves too dependent on Russian energy. So, there is an important lesson here: If you think you own the moral high ground during one crisis, you might want to be careful with throwing stones as you might end up in the glass house during the next crisis.  Solidarity towards others in one decade might have to be reciprocated the next decade.

Markets vs. social objectives

As Isabel Schnabel pointed out in her Jackson Hole speech last month, the period of the Great Moderation seems over and we might be entering a period of the Great Volatility. While economists do not have a good track record in predicting events, I am rather convinced that the pandemic, Ukraine war and energy crisis will not be the last shocks this decade will see, both on geopolitical grounds but also on the account of climate change.  A sudden return to 2% inflation or below seems rather illusionary under current circumstances. And even though tight monetary policy might not be the best tool to address supply-side shocks, it is important to keep inflation expectations anchored. At the same time, there is a case to be made for a stronger role of fiscal policy, especially when it comes to distributional implications of this shock. One important positive development during the Covid crisis was the launch of the Next Generation EU package, recovery package in what I called a Hamiltonian glimpse at what kind of European fiscal policy is possible. Given the continuous shocks and crises Europe has been facing, I very much doubt this will be a one-off and it should not. 

The Covid crisis has clearly put shown the important role that governments have to play during crisis periods, as insurer of last resort. And as during the Covid crisis support for the real economy during repeated lockdowns helped the private sector recover quickly afterwards, the role of government in helping during an energy crisis and avoid people freezing to death is an obvious one, in my opinion. The question, however, is how to go best about it. 

Many economists, including this one, would argue that simple price caps for energy prices are not useful. We need price signals even if we don’t like them, both on a personal level and for society. I would therefore argue – as suggested by Isabella Weber, a German economists in the US- that a price cap up to a certain consumption threshold representing the needs of a representative household – or transfer payments to off-set the negative impact of high energy prices of low-income and middle-income households would be more useful, more efficient and much less costly. Another interesting recent proposal has come from the Bachmann et al. group, giving households a credit in the amount of energy consumption during the last winter, which gives households then the choice how much energy to use. High energy prices signal scarcity; eliminating the function of such price signals to reduce demand might have the negative result of necessary wide-spread rationing. 

The role of finance – beyond bailouts

The European financial sector has performed much better during the past three years than many expected; among the reasons for that, two stand out, in my opinion: one, the post-2008 regulatory reforms that have strengthened the resilience of banks; two, the support programmes introduced by governments across Europe in spring 2020 that affected the financial system indirectly. And as reassuring as it might be that the financial sector is not at the core of either Covid nor Ukraine/energy crisis, it is important to stress that it still has a critical role to play in helping the resilience of the real economy. And even though many of the support packages are on the national level, it is important – again – to maintain the Single Market in banking, which allows for proper risk sharing and allocation efficiency.   It is also important to stress that banks and other financial institutions and markets will have an important role in the reallocation process, away from energy-intensive sectors, but also towards more resilient supply chains. A strong and efficient financial sector is thus critical for both minimising the effect of a coming recession as for a robust recovery. 

Talking about a Single Market in Banking, everyone here is aware that we are still far from it.  We still have German banks, Italian banks, French banks.  Out of the original objectives of the banking union project, none has been achieved completely: resolution with bail-in – barely; sovereign-bank link: alive and kicking and only kept in check by the ECB ; European banking: we are seeing rather a retrenchment towards national markets. And so at the risk of sounding as repetitive as the Elder Cato, let me stress that I think that the banking union has to be completed and hopefully before the next financial crisis, whenever it comes.  

But even that would be a necessary but not sufficient condition for a truly European banking market – another important element is of course the politics.  And we see it here in Italy, Monte dei Paschi, or in Germany, with the ill-conceived idea of a merger of Deutsche and Commerzbank.   For better or worse, banking will always be close to politics, but I would argue it might be better on the European than and the national level. 

What has the EU ever done for us?

When academics discuss (or rather criticise) policy decisions, their counterfactual is often a world without political tensions. As I have critically accompanied the construction of the banking union, I have often been guilty of this approach.

However, there is an alternative counterfactual.  Imagine the Covid vaccine roll-out in 2021 without the EU, imagine the Western European sanction policy without the EU, imagine the current energy crisis without a common European energy market – a rather nightmarish scenario of constant conflicts between 27 nations.  We live indeed in very volatile times, but working within the European framework gives our part of the world an enormous advantage compared to previous centuries.

The important thing to keep in mind that the macro-level European politics has to be supported on the grass-root level. European citizens have to see the benefit of European integration. In this context, the UK might have done the EU a favour with Brexit – people in the UK are less likely to link inflation and recession to Brexit (given many other recent developments) but clearly live the Brexit of little things, the Brexit of daily life: long passport queues, customs duties for packages coming from the EU, roaming fees when abroad.

So, I think it is important to keep in mind and alive the benefits of European integration in daily life and the unity on the political level. Which gets me back to my starting point: politics and economics go hand-in-hand. The political support for the EU goes hand in hand with economic benefits, both on the level of voters as on the level of governments.

26. Sep, 2022