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Guest Contribution: “Charting This Crisis”



Today, we are fortunate to present a guest contribution written by Ashoka Mody, Charles and Marie Visiting Professor in International Economic Policy, Woodrow Wilson School, Princeton University. Previously, he was Deputy Director in the International Monetary Fund’s Research and European Departments. He is the author of “EuroTragedy: A Drama in Nine Acts,” recently updated with a new afterword.


On February 28, I wrote a piece with a premonition: “Italy: the crisis that could go viral.” With events moving so quickly, on March 10, I did a follow-up with a more urgent message: “Italy will need a precautionary bailout—a financial firewall—as the coronavirus pushes it to the brink.” A lifetime has passed since then. I had feared things might go badly but had no special insight into the extraordinary speed at which the virus would multiply and the economic damage it would inflict. But I think the framework that guided the economic and financial analysis of those earlier pieces was, and is, a useful way of thinking how this crisis will unfold. These are its four building blocks:

  • This is the first crisis since the Great Influenza Pandemic of 1918-1920 to begin as an economic rather than financial crisis. Unlike at the time of the influenza pandemic, the coronavirus crisis is occurring in a much more globalized economy. Beginning with China, the virus has—and will keep—disabled some of the nerve centers of global trade.
  • Contemporaneous stock market declines result in enormous wealth loss, but by themselves, do not cause systemic financial crises. Instead, the true financial vulnerabilities are in the credit markets, and those are just emerging onto center stage. A financial crisis was likely even without the corona crisis. Since 2010, a classic debt bubble had built up: borrowers around the world, enticed by low interest rates, had pumped up their debt ratios, a prelude to every financial crisis that historians have recorded. The coronavirus shock is bursting that bubble. The longer the ongoing stress continues, the more severe the eventual debt crises will be.
  • Policy authorities have understood the principle that early action helps prevents an economic and financial crises from snowballing. And while politics gets in the way of implementing this principle, central banks and governments have, in general, responded quickly. The question is, and will remain, one of relative speed. Will the crisis run ahead of the policy response?
  • Europe is particularly vulnerable because European nations depend heavily on trade and they have, with some differences across countries, built up extremely large debt ratios. Their banks are not only huge but also extremely weak, judging by market metrics. Within Europe, Italy is especially vulnerable economically, financially, and politically. As Europeans face an existential challenge to their postwar cooperative enterprise, the biggest question mark will be on how they deal with the forces that will pull them apart.

The economic crisis is centered on global trade nodes

The economists Robert Barro, Jose Ursua, and Joanna Weng report that over its three-year course, the Great Influenza Pandemic caused GDP and consumption to decline by 6% and 8%, respectively, in a “typical” country. The domestic manifestations of that pandemic were similar to the current one. Hardest hit were small, community-based businesses, whose sales fell by between 40 and 70 percent; industrial plants, coal mines, and even utilities suffered from shortage of manpower. Railway transportation was “curtailed.”

The coronavirus crisis, has the potential to be much deeper because it has disabled global trade. Of crucial importance, the new virus originated in China—the global economic locomotive since the turn of this century. The Chinese economy had been slowing since the start of 2018 and, with that slowdown, its imports and exports had decelerated even before the tariff war between China and the United States began. These prior factors had already caused international trade to contract in the final months of 2019. Once the coronavirus began to spread and Chinese authorities started limiting the movement of workers and shutting down factories, Chinese trade collapsed, causing extraordinary additional damage to international trade.

In addition, over the last two decades, trade links had deepened between China and the eurozone, whose member states form some of the other major world-trade nodes. There is some irony in the more intense China-eurozone trade, since the stated purpose of the euro was that it would strengthen trade ties among euro members. But the latest econometric study confirms that eurozone nations did not step up trade with each other. Instead, European trade grew rapidly in the 1990s and 2000s, with non-eurozone countries, especially with the booming China, making Europeans ever-more dependent on the performance of the Chinese economy.

Figure 1: Europe’s increasing trade dependence on China. Source: IMF Data,

Hence, in the last two decades, whenever the Chinese economy slowed, so did the European economies. That link was plainly evident during the 2018-2019 slowdown. While specific features of individual European countries did weigh on their ability to grow—Germany, for example, experienced a wrenching decline of its combustion-engine-based car industry—all European nations began slowing once the China-induced global trade deceleration began in early 2018.

Figure 2: By late last year, falling world trade had pulled Europe into near recession. (Annual growth rate, percent)

When China slows down, European countries are hit twice. Their direct trade with China shrinks; in addition, the knock-on effect of slower growth causes them to import less from each other. This China factor weighed heavily in my initial assessment of the likely severity of an economic crisis in Italy. That shock, I argued, could cause deep damage to Italy, in the same way a disease attacks the feeble most ferociously. Italy has not grown since it joined the eurozone in 1999, it has been mired in near-perpetual recession since 2010, and it was in another recession when the coronavirus crisis struck.

The reason the global economic crisis will likely continue for months is that a number of trade nodes that connect the network will remain impaired. China itself appears to have contained new infections and deaths. And reports suggest that some Chinese factories have resumed operation (semiconductor factories had apparently never shut down). Reports also suggest that Chinese authorities are trying to push out goods that have been waiting in the country’s ports. However, increased activity is not yet evident in financial markets. For example, in the spring of 2009, when the Chinese economy revved up, the Australian dollar, tied to the buoyant demand for Australian commodities, appreciated visibly. In this cycle, the Australian dollar is still testing the lows.

Moreover, even when China resumes something close to normal production, other countries must be ready to buy and sell. If, as now appears, the crisis will persist longer in Europe, China’s ability to pump up global growth will remain constrained. Meanwhile, emerging markets—Argentina, Brazil, Mexico, Turkey—are also financially stressed as foreign capital is fleeing to the relative safety of U.S. dollar assets. For these reasons, restoration of the global trade network and, hence, the global economic recovery will take time. The prospect of a bounce back in the third quarter of this year, as many forecasters had hoped—and continue to hope—seems unrealistic at this point.

Credit markets begin to take note

Not surprisingly, the first impact of the economic crisis was on stock markets, which began reevaluating economic growth prospects. In that initial assessment, stock markets recognized that Italy would be hardest hit.

Figure 3: Stock markets took a bleak view of Italian economic prospects (February 18, 2020 = 100)

Even though stock indices were in free fall, there was yet no financial crisis in the first two weeks of March. For perspective, in September 1998, stock markets took a gut punch when Long-Term Capital Management wobbled. But a U.S. Fed-orchestrated recapitalization of LTCM steadied the markets. Similarly, stock markets fell sharply when the tech bubble burst in the spring of 2000. The lesson is that unless investors have leveraged themselves heavily—borrowed large amounts of money—to buy stocks, a stock market crash does not typically lead to widespread financial distress.

More to the point, risk lurked in the global credit bubble that had built to a dangerous peak. According to the Washington-based Institute of International Finance, the global debt outstanding had doubled from $120 billion in 2006 to $240 billion in 2019, at which point it was 320 percent of world GDP. Virtually every country and every type of borrower took advantage of the low interest rates, especially over the last decade, to gorge on debt. Debt ratios rose especially for corporates and governments, and while the ratios for banks in advanced economies declined from dizzying heights, they remained higher than those for other types of borrowers.

In the second week of March, once it became clearer that the coronavirus would cause a deep and, possibly, extended economic slowdown, credit markets began showing signs of stress. The stress levels then were, and as yet are, relatively modest compared to the levels observed during the most intense phase of the global financial crisis between July 2007 and May 2009. Remember though that in that crisis, financial tensions rolled in waves across various credit markets, starting with the asset-backed commercial paper market. Quickly, the inter-bank market began to ration out borrowers and European banks experienced acute shortage of dollars. Soon enough—as the epicenter of the crisis shifted to the eurozone—the cost of credit to companies, banks, and governments rose sharply.

There is much reason to worry that the already visible credit market tensions will increase and spread in the coming weeks and months. As a general principle, financial crises are severe not just when outstanding debt burdens are high but when growth slows down rapidly, making it hard to repay that debt. Today, with a sharp decline in output and debt burdens high everywhere, a question mark hangs over the ability of borrowers to repay the mountain of debt. That question mark will grow larger, the deeper the economic crisis is and the longer it continues.

 Policymakers have responded energetically

The Fed set the ball rolling by rapidly lowering interest rates (by reducing its policy rate and renewing bond purchases). The Fed has also injected considerable liquidity into the U.S. banking system and made dollar liquidity available on a large scale to several central banks. In its boldest move yet, the Fed has promised to buy U.S. government debt in unlimited amounts, while further backstopping other credit markets. The Bank of England has taken actions to lower rates and provide liquidity. The European Central Bank (ECB) has not reduced its policy rate but has expanded its bond purchases to about a trillion euros for the rest of this year and has added considerable liquidity into eurozone banks.

These are important actions, but they are suited to a conventional financial crisis not to the current problems. As long as people’s spending is constrained by the physical limits on their movements and by the shutdown of factories and services to contain the virus, lower interest rates cannot help. Liquidity into banks will surely support ongoing operations, but will not spur new activity.

Fiscal measures, properly targeted, could be more effective. On March 20, the British Chancellor of the Exchequer set the benchmark with a bold promise: “Government grants will cover 80% of the salary of retained workers up to a total of £2,500 a month.” He promised unlimited interest free loans for 12 months to small businesses, as well as tax cuts and cash grants. Such economic life support is crucial to sustain those who are losing their livelihoods and need to pay for food, utilities, and mortgages. Other targeted help—such as more generous family leave—will also provide a critical safety net. In a second phase, once the worst of the virus contagion is behind us but when financial stress, even a debt default crisis, is still with us, a more generalized spending stimulus will help boost the economy through spending multipliers and by instilling greater optimism.

But there is an immediate task at hand. Borrowers will soon begin defaulting on their loans, creating a new set of challenges for policymakers. The question, at its core, will be: how will the losses due to the defaults be distributed? Will debt be written down, or will debtors be allowed to repay debt over longer periods of time?

Why Europe is so vulnerable

More so than elsewhere in the world, major European economies ended 2019 and entered 2020 in a very weak economic condition. Since then the coronavirus has hit their domestic economies hard. And because they are so enmeshed in global trading relationships, their distress has been acute and will likely continue for some months, at least.

European financial vulnerabilities are also severe. Government debt-to-GDP ratios in the major eurozone nations—other than Germany—are near historical highs. European banks are fragile. While the banks’ non-performing loans (loans not being repaid on time) are down, their profitability is low. The market-to-book value (MBV) ratios of major European banks were below 1 before the coronavirus became so fearsome. Essentially, markets were saying that because of poor medium-term growth prospects in Europe, the banks are unlikely to get full value for the assets on their books. The market’s assessment has turned even bleaker with the spread of the coronavirus. The MBV ratios have fallen sharply. Germany’s Commerzbank and Deutsche Bank are particularly weak, with MBV ratios of around 20 percent. And matters seem set to get worse. Deutsche Bank has warned investors that it will be “materially adversely affected” by the prolonged downturn.

Each of the European weaknesses is particularly acute in Italy: prior economic infirmity, size of the coronavirus economic shock, government debt burden, and fragility of the domestic banking system. The Italian government owes about €2.3 trillion, about 135 percent of GDP. Italian banks have assets with a paper worth of about €5 trillion. But the true worth of the banks’ assets is likely much lower and will fall further as the economy struggles in the coming quarters. Italy’s Monte de Paschi bank has non-performing loans of about 17 percent of its assets. Even the strongest banks—UniCredit and Intesa Sanpaolo—have MBV ratios significantly below 1.

Treacherous moments—and terrible choices—lie ahead for Europe

            In a reasonable scenario, a severe global economic crisis will continue and a financial crisis will intensify. Europe will feel the brunt of the twin economic and financial crises. The Italian government will move steadily to the edge of default; Italian banks will see a rapid accumulation of non-performing loans.

Eurozone governments do not have the fiscal resources to support a prolonged crisis. Even Germany is on shaky ground. The German government is embarked on borrowing about €350 billion, approximately 10 percent of German GDP, to prevent a domestic economic freefall. Fiscal resources to recapitalize the country’s banks may soon impose sizeable additional demands on the German government. The French and Spanish governments, each with debt ratios of around 100 percent of GDP, have even tighter fiscal limits. Possibly, Germany and, maybe France, could increase their budget deficits to 15-20 percent of GDP before credit markets and rating agencies take fright. But will the Germans have the fiscal space and political willingness to aid those unable to spend their way out of this crisis?

A discussion is now ongoing about the possibility of a precautionary credit line for Italy, along the lines I suggested two weeks ago. Anchoring such a credit line would be the eurozone’s bailout fund, the European Stability Mechanism (ESM). I had proposed a credit line of between €500 and €700 billion, but the ESM has a lending capacity of only €410 billion. My proposal, therefore, included not only the International Monetary Fund but also, potentially the United States, perhaps, in a back-up mode. With time running so fast, the size of the bailout requirement has probably grown, making the proposed international political coalition even less likely. And what if Spain also needs similar support soon?

For now, eurozone policymakers seem to be relying entirely on the ECB to save the day. But it is not the central bank’s role to deal with insolvencies. In principle, the ECB can buy the Italian government’s debt to prevent a default. But the ECB is not a normal central bank; it is the central banker to a confederation of nations, each of which maintains fiscal sovereignty. If Italy is pushed to the brink, the ECB will struggle—technically and politically—to help.

Here’s why. The current ECB bond-buying limit of a trillion euros is designated to purchase the bonds of all member states. Italian government debt is over two trillion euros, and the Italian government’s debt will increase further if it is forced to financially prop up the country’s banks. If Italy has to be bailed out, other member states represented on the ECB’s Governing Council will face the choice of buying so much Italian debt that, in effect, the ECB would own Italy. What if the Italian government is unable to service its debt to the ECB? Other member states will end up with the politically charged task of using their tax revenues to replenish the ECB’s capital.

The alternative of leaving Italy to fend for itself could lead to widespread Italian defaults, triggering defaults by those who have lent to the Italian government and banks. A cascade of defaults would go up the chain to European and global pension and insurance funds, setting off a global financial panic.

At this moment of global crisis, the test is going to be whether each nation takes care only of itself or whether the strong help the weak. But will the strong remain strong long enough?


This post written by Ashoka Mody.

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How not to lose your mind in the Covid-19 age



here are as many responses to the Covid-19 pandemic as there are people to respond. Some have of us have children to home-school. Some of us have elderly relatives to worry about; some of us are the elderly relatives in question. Some of us have never been busier; others have already lost their jobs.

One experience is common, however: wherever the virus has started to spread, life is changing radically for almost everyone. It’s a strange and anxious time, and some of the anxiety is inevitable. For many people, however, much of the stress can be soothed with – if you will pardon the phrase – one weird trick.

First, a diagnosis. Most of us, consciously or not, have a long list of things to do. At the virus and the lockdowns have spread, many of the items on the to-do list have simply evaporated. At the same time, a swarm of new tasks have appeared, multiplying by the day: everything from the small-yet-unfamiliar (“get toilet paper” and “claim refund on cancelled holiday”) to the huge-and-intimidating (“organise an inspiring home-school curriculum” or “find a new job”).

The change is so fast and comprehensive that for most of us it is unprecedented. Even a divorce or an international relocation is more gradual. The death of a spouse might be the only experience that comes close. No wonder that even those of us who are safe and well and feel loved and financially secure find ourselves reeling at the scale of it all.

To the extent that the problem is that the to-do list is unrecognisable, the solution is oddly simple: get the to-list back in order. Here’s how.

Get a piece of paper. Make a list of all the projects that are on your mind. David Allen, author of the cult productivity manual Getting Things Done, defines a project as “any multistep outcome that can be completed within a year”. So, yes: anything from trying to source your weekly groceries to publishing a book.

That list should have three kinds of projects on it.

First, there are the old projects that make no sense in the new world. For those that can be mothballed until next year, write them down and file them away. Others will disappear forever. Say your goodbyes. Some part of your subconscious may have been clinging on, and I’m going to guess that ten seconds of acknowledging that the project has been obliterated will save on a vague sense of unease in the long run.

Second, there are the existing projects, some of which have become more complicated in the mid-pandemic world. Things that you might previously have done on automatic may now require a little thought. Again, a few moments with a pen and paper will often tell you all you need to know: what’s changed? What do I now need to do? What, specifically, is my next action? Write it down.

Third, there are brand new projects. For me, for example, I need to rewrite the introduction to my forthcoming book (‘How To Make The World Add Up, since you were wondering). It’s going to seem mighty strange without coronavirus references in it. Many of us need to devote more than a little attention to the sudden appearance of our children at home. Some of us need to hunt for new work; others, for a better home-office set-up. Many of us are now volunteering to look after vulnerable neighbours.  In each case, the drill is the same: sketch out the project, ask yourself what the very next step is, and write it down.

Occasionally, you may encounter something that’s on your mind – the fate of western civilisation, for example, or the fact that the health service desperately needs more ventilators and more protective equipment. For my family, it’s an elderly relative, suffering from dementia, in a locked-down nursing home. We can’t visit him. He can’t communicate on the phone or comprehend a video chat. There is, for now, literally nothing we can do but wait and hope. Acknowledging that fact – that there is no action to be taken – is itself a useful step.

I won’t pretend that in this frightening time, working through your to do list in a systematic way will resolve all anxieties. It won’t. But you may be surprised at how much mental energy it saves – and at the feeling of relief as all these confusing and barely-acknowledged new responsibilities take shape and feel more under your control.

Or so it seems to me. Good luck, and keep safe.


Oh – and in case it wasn’t obvious, this week’s Book of the Week is David Allen’s superb Getting Things Done.

My NEW book The Next Fifty Things That Made the Modern Economy is out in the UK in May and available to pre-order; please consider doing so online or at your local bookshop – pre-orders help other people find the book and are a huge help.

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Guest Contribution: “Banks on the Brink”



Today we are fortunate to be able to present a guest contribution written by Mark Copelovitch  (University of Wisconsin – Madison) and David Singer (MIT).

“The peculiar essence of our financial system is an unprecedented trust between man and man; and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.” –Walter Bagehot (1873), Lombard Street: A Description of the Money Market, pp.158-9.

Why do banking crises occur? In our new book, Banks on the Brink: Global Capital Securities Markets, and the Political Roots of Financial Crises, we seek to understand why some countries are more prone to banking crises than other countries or at different times.

At the simplest level, banks collapse because customers lose trust in them. Trust is ubiquitous in the financial system. Banks trust that customers will repay their loans. Depositors trust that banks will manage their money carefully. And banks trust other banks to provide liquidity and to remain standing day after day. But as Walter Bagehot noted in his famed account of London’s 1866 financial panic, trust in the financial system can erode from “hidden causes.” When trust is weakened, even seemingly small accidents—like the collapse of London bank Overend, Gurney, and Company, which triggered the 1866 panic—can cause systemic financial crises.

The details of individual banking crises vary, but rarely does trust in the banking system evaporate without due cause.  In the Panic of 1907, banks collapsed because they were complicit in speculation and market manipulation that led to massive financial losses. During the Asian financial crisis of the late 1990s, the trigger for the collapse of Thai banks was speculative lending to real estate developers, which led to a boom and bust in the real estate market. And in 2008, after a decade of easy mortgages to borrowers with shaky credit histories and a growing bubble in the real estate market, investors grew fearful that banks and holders of mortgage-backed securities might never get their money back.

Our book highlights two key triggers of banking crises. The first, levels of foreign capital inflows, sets the stage for potential distortions in the financial system. Large capital inflows have been found to be a consistent correlate of banking crises. Indeed, many scholars believe that the malignancy of global capital flows is the most likely culprit behind banking crises.  In Lost Decades, their analysis of the Great Recession, Chinn and Frieden (2011) point to the enduring prevalence of the capital flow cycle, in which “capital floods into a country, stimulates an economic boom, encourages high-flying financial and other activities, and eventually culminates in a crash.” They note that many previous crises fit this pattern, including the Mexican and Asian crises in the 1990s, and dozens of others.  Reinhart and Rogoff, in this This Time is Different (2009), suggest that the pattern has deep historical roots. One of their key findings, backed by data covering 800 years of financial crises, is that large current account deficits, asset price bubbles, and excessive sovereign borrowing are common precursors of crises across space and time.  Moreover, bank failures were relatively rare during the Bretton Woods monetary system from the end of World War II to the early 1970s, when governments enacted strict controls on capital movements (Helleiner 1994). This overall finding—that foreign capital opens up a Pandora’s Box of financial distortions—now has the status of conventional wisdom in academic and policy circles.

The potential dangers of capital inflows are real. But existing research has failed to emphasize that foreign capital is not always destabilizing for the banking system. For every instance of a banking crisis preceded by large capital inflows, there are countless examples where inflows are harmlessly—and even productively— channeled throughout the national financial system.  For example, while the U.K. and the U.S. both experienced large current account deficits in the years preceding the Great Recession. Australia and New Zealand also experienced substantial current account deficits, but their banking systems escaped relatively unscathed.

Why do capital inflows lead to banking crises in some cases but not in others? To explain this, we focus on a second variable: national financial market structure. We argue that the substantial variation in the relative prominence of banks versus securities markets (Figure 1) determines whether capital inflows are channeled safely and productively through the national economy, or whether they instead cause banks to take on excessive risks and increase the likelihood of a financial crisis.  Banks often sit alongside other financial institutions, including stock and bond markets, which provide alternative sources of financing for borrowers and alternative investments for savers. When banks are conservative because of the relative absence of competition for financial intermediation, foreign capital can be safely channeled into the system without causing bank instability. On the other hand, when banks sit alongside viable securities markets, capital inflows exacerbate banks’ risk taking and increase the probability of a crisis.

Figure 1: Market/bank ratio, OECD countries, average, 1990-2011

Source: World Bank Global Financial Development Database, calculated as the ratio of stock market trading volume to total bank lending

To test our argument, we analyze data from the 1970s through the early 21st century for most of the world’s developed economies. Figure 2 illustrates the core result of our statistical analysis: capital inflows are only correlated with banking crises under certain conditions – namely, when they flow into a financial system in which commercial banks compete alongside large and highly-developed securities markets.

Figure 2: Average Conditional Marginal Effect of Gross Portfolio Capital Inflows on Probability of a Banking Crisis, by Market/Bank Ratio (World Bank banking crisis classification), 1970-2011

Coefficient on change in gross portfolio inflows (%  of trend GDP, 5-year moving average)

In this book, we not only explore the determinants of banking crises, we also explore how capital inflows and financial market structure interact to affect banks’ risk taking. The conventional wisdom linking capital inflows to crises emphasizes distortions in the allocation of capital as it is channeled through banks and other intermediaries (Portes 2009).  The question is precisely how this plays out and which distortions are most salient.  Some scholars find a clear link between capital inflows and the volume of credit.  For example, Schularick et. al. (2012), in their groundbreaking work on the long-term patterns of financial instability in industrialized countries, find that 1) domestic credit growth is the single most important determinant of banking crises; and 2) capital inflows, as measured by current account deficits, go hand-in-hand with credit booms, especially in the post-Bretton Woods era.  In contrast, other scholars, such as Amri et. al. (2016), find only a weak relationship between capital inflows and domestic credit growth and notes that this connection is diminishing over the last two decades.

If capital inflows lead to banking crises by triggering changes in the volume of domestic lending, then we should find a similar conditional, interactive relationship between capital inflows, financial market structure, and credit growth as we did with banking crises.  However, we find no such relationship – either unconditionally or conditionally – between capital inflows and the growth rate of domestic bank credit.  While capital inflows are conditionally correlated with banking crises, the relationship does not appear to operate through a simple increase in the volume of bank loans.  Rather, credit booms appear to be a separate channel of financial instability from the one we identify in our analysis.

In contrast, we do find evidence that capital inflows influence the propensity of banks to take on greater risk, through a reduction in capital cushions and/or the assumption of greater insolvency risk – and that this varies depending on a country’s domestic financial market structure. In other words, capital inflows – in financial systems where banks complete alongside large securities markets – affect the quality of bank lending and the composition of bank balance sheets.

Figure 3 illustrates this second core result. It shows the conditional relationship between capital inflows, market structure, and national level averages of Tier 1 commercial bank capital.  These results strongly suggest that capital inflows trigger banking crises not because they cause credit booms (surges in the volume of bank lending), but because they lead banks to reduce their capital holdings and lend to more risky customers.  This decline in the quality of banks’ loan portfolios, rather than an increase in the number and amount of loans, appears to be the “smoking gun” linking capital inflows to banking crises in industrialized countries.

 Figure 3: Average Conditional Marginal Effect of Gross Portfolio Inflows (% trend GDP) on Tier 1 Commercial Bank Capital Ratio, by Market/Bank Ratio

Coefficient on change in gross portfolio inflows (%  of trend GDP)

The political roots of financial market structure

While our statistical analysis shows that financial market structure mediates the effects of foreign capital inflows, it cannot explain how such variation in market structure developed in the first place. To resolve this puzzle, we turn to historical analysis, zeroing in on the political decisions that shape the structure of financial markets that make certain countries especially vulnerable to banking crises. Through detailed historical case studies of Canada and Germany, Banks on the Brink shows how seemingly innocuous political decisions about financial rules can accumulate over decades and solidify a country’s financial market structure for generations.

In our case study of Canada, we show that the country’s remarkable history of bank stability has been attributable in part to its equally remarkable fragmented and underdeveloped stock markets. The Canadian Constitution granted the national government the sole authority to regulate the banking industry, but authority over stock markets was relegated to the provinces. During the economic crisis of the early 1930s, while the U.S. government seized the opportunity to create a national securities regulator and to minimize the role of state regulatory agencies, Canada made few changes to its regulatory system. The government took no steps to create a national regulator, instead reaffirming the authority of the provinces to supervise their stock exchanges in accordance with their particular needs. To this day, Canada is the only industrialized country without a national securities regulator. We argue that the country’s underdeveloped securities markets have had a salutary effect on its banks, which have been successful in channeling foreign capital to borrowers over the last four decades without taking on undue risk.

Like Canada, Germany has a long history of bank stability, but it has recently taken a dangerous turn. Our case study highlights how policy decisions in the aftermath of two major financial crises—the Panic of 1873 and the crisis of 1931—arrested the development of German securities markets and solidified a heavily bank-centric financial system. Interest-group and party politics, rising nationalism and anti-Semitism in the late 19th century, and the Nazis’ ascendance to power in the 1930s all conspired to hobble the development of German stock markets prior to World War II, allowing banks to engage in long-term conservative lending with “patient capital” throughout the postwar era until the 1980s. In recent years, however, financial competitors from within and outside Germany have prompted the large German banks to seek alternative sources of revenue. Deutsche Bank, Commerzbank, and other large banks have become champions of Finanzplatz Deutschland, a single large securities market designed to compete with New York and London. As this market has developed, the conservative bias of German banks has eroded, and many required emergency bailouts in the early 21st century.

Key implications

Banks on the Brink shows that politics is the root cause of financial crises, but not in the way that many observers might imagine. Bankers themselves have political preferences and may express them publicly, and some banks lobby for favorable public policies and donate to political campaigns and political action committees. But at a deeper level, banks are embedded in financial markets, which themselves reflect an accumulation of government choices. Banks today operate in an environment shaped by these political choices, some of which make banks more resilient, others of which make them more prone to crisis. This variation, across space and time, explains why some countries find themselves more vulnerable to banking crises and the dangers of foreign capital inflows than others.

These findings have key policy implications for how to minimize the risk of banking crises in the U.S. and elsewhere. In light of the slow-moving nature of financial market structure, any policy proposal to fundamentally alter the shape and depth of financial markets will likely be dead on arrival. Proposals to re-introduce Glass-Steagall-type regulations which separate commercial and investment banking might be episodically popular in countries like the U.S., but as our evidence suggests, they would fail to address the underlying reasons for banks’ excessive risk taking. We also argue against capital controls. Instead, we suggest that regulators should focus their efforts are tightening bank capital requirements, especially in financial systems with prominent or growing securities markets.  Governments are unlikely to be able or willing to fundamentally alter the structure of domestic financial markets in the short- or medium-term. But they can ensure that financial institutions act more prudently, especially when foreign capital inflows flood into the country and the temptation for  banks to engage in more risky behavior is greatest.



This post written by Mark Copelovitch and David Singer.

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Quotation of the Day…



… is this March 21st, 2020, tweet from Thomas Sowell:

It is so easy to be wrong – and to persist in being wrong – when the costs of being wrong are paid by others.

DBx: Indisputably true, both as a matter of logic and as a proposition that consistently succeeds at explaining a great deal of human history.

Note that Sowell’s point is general. Those who are convinced that today’s government-engineered lock-down of much economic activity is appropriate can nod their heads approvingly at the thought that those who are convinced of the opposite fail to account adequately for the costs that would be paid by others were this lock-down less draconian. Ditto the other way ’round: those opposed to this lock-down nod their heads approvingly at what they take to be Sowell’s explanation of why government officials seem now to be so glibly and irresponsibly imposing massive economic costs on hundreds of millions of strangers.

But whatever your position on the lock-down – whether you think it to be worth its gargantuan costs or not worth these costs – you cannot fail to recognize the deep dangers that lurk within any system that allows a handful of people to act in ways that impose massive costs on others.

My own sense is that the benefits of this lock-down are not worth their costs. (And, by the way, I do not reckon as costs only – or even chiefly – financial flows, such as lost profits, and the monetary values of foregone goods and services. Among the many kinds of costs of this lock-down are worse-than-otherwise health in the future, and the innumerable problems inevitably to be created by governments with yet more discretionary powers.) Yet even if I am mistaken – and perhaps I am (I say sincerely) – we should all be deeply suspicious of discretionary power exercised by government officials – power the costs of the exercise of which are borne almost wholly by third parties.

The grade-school fiction – one embraced also by many PhD-sporting intellectuals – is that majority-rule democracy is sufficient to ensure that all decisions made by government officials in democratic nations are without any such negative externalities, that is, without any undue ill-consequences imposed on third-parties. “We the people” make these decisions ourselves through our elected representatives and the assistants that they hire to help them. Problem avoided!

Anyone who believes in this above account of democracy is too naive for words. He or she is wholly ignorant of even the most basic principles of public-choice economics – an ignorance, note, that itself imposes negative consequences on third-parties by encouraging the naive to impose the costs of political superstitions and of the resulting dangerous policy-making regimes on their fellow citizens. Such people should read Buchanan, Tullock, Downs, Olson, SchumpeterArrow, Stigler, Wagner, Niskanen, Higgs, Holcombe, Yandle, Brennan & Lomasky, Caplan, Lee, Simmons, Munger, and Achen & Bartels, among others. Oh, and do read also Sowell’s own great magnum opus.

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