The Rafael del Pino Foundation and the Observatory of the European Central Bank organised a dialogue on 19 June 2023 at 1 p.m. on "Current dynamics in the Eurozone financial system¨. with Matteo Maggiori, Philip R. Lane and Belén Carreño.
Matteo Maggiori is Moghadam Family Professor of Finance in the Stanford Graduate School of Business. His research focuses on macroeconomics and international finance. He is co-founder and director of the Global Capital Allocation Project. His research topics have included the analysis of exchange rate dynamics, global capital flows, the international financial system, reserve currencies, tax havens, bubbles, expectations and portfolio investment, and very long-term discount rates. His research combines theory and data with the aim of improving international economic policy. He is a researcher at the National Bureau of Economic Research and affiliated researcher of the Center for Economic Policy Research. He received his PhD from the University of California at Berkeley. Among other distinctions, he has received the Fischer Black Prize to a leading financial economist under the age of 40, the grants Carnegie y Guggenheimand the Bernacer Prize for outstanding contribution in macroeconomics and finance by a European economist under the age of 40.
Philip Lane He is a former Governor of the Central Bank of Ireland and a member of the Executive Board of the European Central Bank and its Chief Economist. As a member of the General Board and Steering Committee of the European Systemic Risk Board, he was Chairman of its Scientific Advisory Committee. He was also Director of the Macroeconomics and International Finance Programme from Centre for Economic Policy Research. He received his PhD in economics from Harvard University and was a professor at Columbia University and Trinity College Dublin. Among his many honours, let me highlight: the Gold Medal in Social Sciences from the Royal Irish Academy o the Awards Bhagwati, Barrington y Germán Bernacer.
Belén Carreño Bravo is a journalist, currently a senior correspondent for Reuters Agency in Spain, covering politics and business. She previously held the position of chief economics editor at eldiario.es. Specialising in economic news, Carreño has also worked in the business sections of the daily Público and Expansión. Previously, she held various positions in international organisations such as the United Nations and UNOPS, and in the Spanish Trade Office in New York, thanks to a programme of the Spanish Government and ICEX. She has been a contributor to radio (Onda Cero) and television (laSexta, Telemadrid, Cuatro), where she carried out economic analysis. In the academic field, she holds a Master's degree in International Relations and Communication from the Complutense University of Madrid and a degree in Information Sciences from the Pontifical University of Salamanca.
Summary:
On 19 June 2023, the Rafael del Pino Foundation and the Observatory of the European Central Bank organised the dialogue "Current Dynamics in the Eurozone Financial System", with the participation of Matteo Maggiori, Moghadam Family Professor of Finance at the Stanford Graduate School of Business, and Philip Lane, former Governor of the Central Bank of Ireland and Chief Economist and Member of the Executive Board of the European Central Bank.
Matteo Maggiori: Some twenty years ago, we didn't think about who owns what as a macroeconomic issue, but there are three crises that have changed the way we look at this: the financial crisis, the Covid-19 crisis and the war in Ukraine. We have to be very careful in concentrating risks. For example, who holds sovereign debt when the crisis affects the periphery of Europe, what the ECB has to do. Today, if we want to know who holds sovereign debt in Europe, we have an idea. Fifteen years ago it was impossible. If we want to sanction Russia we have to know who holds its assets and where they are.
Philip Lane: Europe is very open to the rest of the world, with many close links to Asia and the United States. There is also a lot of interconnectedness between member countries. The question is whether this stabilises or is a source of instability in relation to who owns what. There is another question, who owns what. There is a wave of super-aggregated data, which can be national or sectoral. Now, the capacity is higher, especially when we combine official data with data coming from the private sector. This example of public-private interaction is important. But what is important is to know who the global investors are in the euro area, so that we can know the implications for us if there is an event outside; or, if there is a new development in Germany, who is going to be exposed to it in Europe.
There are three ways of looking at the issue of rate hikes. One is what happens at the macro level if rates go up, what is going to happen to employment, inflation. The second is the flow. When we raise rates we make borrowing more expensive, there is a choice between putting the money into a bond or a stock. Then there is the third element, which is the effect on the value of existing investment portfolios. It affects the price of bonds, it affects the exchange rate, it affects real estate or residential value, because exposure to existing assets when the interest rate changes is tricky. Basically, we have seen a world where a lot of people believed that rates were going to be very low for a very long time, which is very important for allocating the value of a lot of things. For example, technology companies and their value. So we have seen various levels of exposure with the change in rates. We are seeing how people respond when the value of their portfolio goes down. To what extent does it matter for someone who is thinking about holding their bond to maturity? The behaviour is different if you hold to maturity than if it is an intermediary who holds the bond and is forced to sell it. That is the risk factor. In Europe everything has gone smoothly, the adjustment has been smooth to high rates.
Matteo Maggiori: When we weigh the destabilisation of financial markets like a car accident, the car slows down if you have more space than when you have little, which softens the impact. If you have too little space, the crash is going to be harder. If customers pull out their money, banks have more risk. In Europe, the adjustment of markets has gone more smoothly. To be able to know if it is smooth, we need to know what is whose. Before, Europe was based on loans, but over the last fifteen years, non-bank intermediation has exploded and is different from the bank because it sells shares to the public, there are no deposits. This solves the problem of bank runs, but there may be other problems. If assets are very liquid and have to be sold, it can be a problem. In fact, the Fed had to invest in ETFs in the open market. Maybe we need to think about how to regulate this sector.
There is an important question globally, which is fiscal sustainability. It is easy to maintain it if rates are low because it is easy to repay, but if rates go up there are going to be problems. Now we see a shift to higher rates. The question is whether we are going to go back to a low or high rate environment and, if it is high rates, what are we going to do about fiscal sustainability, about sovereign risks. This is a major change and we will have to ask ourselves whether we are ready or it is going to have a tremendous impact. In Europe this is important because there is no fiscal union.
Philip Lane: Let's break this down into two separate questions. One is the future of real interest rates. There are a lot of forces in the IMF that want to keep real rates low. But, as far as I can see, they are going to be low for the next few years, but with levels of uncertainty. The other element is inflation. Right now, the market is confident that inflation is going to come down quickly to reach the 2% target. Therefore, ten-year bonds are the average rate for the next ten years with some risk premium. If we don't get there, we run the risk that the market thinks we are not going to get there, they are going to start discounting it and long rates are going to go higher. Higher nominal rates are going to result in different debt. If you look five or ten years ahead, it is priced on the basis of inflation of around 2%. That is the reason why rates would go down. If we don't solve it, rates are going to be much higher.
We do not want to rely only on forecasts. We also have to interpret the inflation data. We have to focus on core inflation, which is going to be with you unless we focus on policy, keeping an open mind. Then, history has not had so many cycles of this kind, nobody is 100% sure how a policy will work in these uncertain circumstances. If there is no material change in the forecasts, we will see another rate hike in July. September is so far away that we have to see what happens then. We don't make decisions on a daily basis, I have to do it at every monthly meeting and not more frequently. We will continue to see the data coming in and there will be another rate hike in the future if we see that it is necessary. If we stop raising rates, we would be saying that this is the last rate hike forever, but that is not the case, because we may decide to raise rates in two or three meetings because the data tells us that we have to raise rates again. The facts will tell us whether we have to pause, whether it is the peak or whether we have to keep going up. We do it meeting after meeting, but it doesn't determine what we are going to do at the next meeting.
Matteo Maggiori: If we see something happening somewhere, we start to worry whether we are going to have the same problem. In Europe, the markets are behaving quite well. The interesting thing in this cycle has been Europe's relationship with the rest of the world. China is slowing down. Many investors are moving out of China partly because interest rates in Europe and the US are now higher. These reasons are weighing, but in Europe there is no particular problem.
Philip Lane: Which non-bank elements are shadow banking and which are not shadow banking at all? A lot of the banks in Europe are in the hands of investment funds, which are not highly leveraged, so they are not banks. A bank is highly leveraged by deposits, but funds are not. If they fail, they can affect someone's wealth, but nothing more. What you have to look at is whether there are failures that can create synthetic leverage. One risk factor is whether investors want to get their money back quickly. So far we have seen a lot of stability in mutual funds. The question is whether we hold them for capital gain or as a long-term asset allocation. In general, in Europe, investors' risk appetite is not as high as in the United States. Many people have allocated their savings in a long-term fund for retirement, whereas in the US there are many retail investors who often expect a good return and do not see it as long term. This lack of risk appetite is a stabilising element.
Matteo Maggiori: Not all funds are the same. Some are highly leveraged. When the UK tried to pass its budget, some funds located in Ireland took the regulators by surprise. The Bank of England had to intervene. Fortunately, the panic didn't last long. If it's a bank, you have to regulate it as a bank. Then there are two other problems. Imagine that a large part of the assets of the economy are in the hands of Italians, and they panic more than the professionals. If you want to rescue the money you have to sell, and that is a problem we are going to have to face again and again. In very liquid markets it is not so much of a problem because they have the capacity to absorb. The problem is if these funds grow a lot compared to hedge funds. Another thing that changes the point of view is that it is not only a problem of what it does, but also how much we can see about the world through these operations. If we want to know what exposure Spanish households have to Italy, as almost all of them buy shares in funds located in Ireland or Luxembourg, which in turn buy Italian state assets, it creates a problem to understand what their risk is, who is exposed to whom. The answer is not easy to come by. In Europe, intermediation takes place in two or three countries, but we don't have fiscal union, we have segmentation. If someone breaks under stress we can have a problem.
Philip Lane: We have come a long way from the previous situation, the 2008 crisis, where we had to understand what the exposures were. The supervisory mechanism has to understand what the exposures of different banks are. I would like to see more progress in developing better quality data. You have to connect the holder with the risk, but the efficiency of having different locations in Europe for financial services is a reality that sometimes makes it very difficult to understand the data. A lot has already been harnessed, but there is still a lot to do. We would be happier if there was more capital union in Europe and more developments in a fiscal union so that there is more balance in Europe. Having Next Generation during the pandemic stabilised a lot. Having a fiscal union is very interesting from a financial stability perspective.
There are some published indicators of financial integration, but they do not answer who owns that risk. What we want to know is how the financial system is going to be an agent of instability. There are two elements, how Europe responds to a common shock, such as a pandemic or a war in Ukraine, and what happens if one or more countries have problems. What is interesting in this cycle of rate hikes is the path of spreads. Inflation is a common problem and it is believed that it is going to return to a normal level of inflation, so there is consistency there. Secondly, we gave ourselves the TPI instrument for investment protection, to see if we have to intervene if there is a banking panic, so that people don't think that what happened in 2010 can happen again because now we have a backstop. With a single supervisor, with more transparency, panic situations are less likely now. We are calmer if the flows come from investments than from highly leveraged investors.
Matteo Maggiori: When we look at Europe in the last twenty years, there have been many successes, but also well-known problems. There is much more integration than before. From the beginning of Economic and Monetary Union we knew that we had a problem of integration without fiscal union. The ECB has done a magnificent job fighting this problem, which can only be solved with more integration. Much has been achieved. The capital markets union still has many problems. Withholding taxes in Europe are not harmonised. The market will use lower and lower barriers to maximise its profits, which need not be social profits. For example, using European jurisdictions with lower taxation for these purposes. But it also raises the question of fairness at the European level. We are going to have to talk about market integration creating prosperity rather than wealth accumulating higher up. To create social value, we have to look at how we are going to treat the parts of the system that generate less social value.
Philip Lane: Until recently we have seen a remarkable growth of value chains. These companies can optimise global production patterns and also the financial set-up. There has been a response, which is the OECD tax reform. It affects us now and other parties will see it in the future. When you have global companies, how do you interpret GDP when they can allocate intellectual property anywhere in the world? In Ireland we have had to look at what are the most useful economic concepts, rather than the ones that are most at hand. With this interconnectivity, we have to accept that, if a company decides to relocate its production, there is going to be a significant misalignment. This is a risk. Large financial companies have to serve their European clients from a European entity. There are fewer flows from outside the euro area and more from inside Europe. This is going to be a classic example in the years to come. Mapping the Brexit effect on the reorganisation of the international financial system.
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The Rafael del Pino Foundation is not responsible for any comments, opinions or statements made by third parties. In this respect, the FRP is not obliged to monitor the views expressed by such third parties who participate in its activities and which are expressed as a result of their inalienable right to freedom of expression and under their own responsibility. The contents included in the summary of this conference are the result of the discussions that took place during the conference organised for this purpose at the Foundation and are the sole responsibility of its authors.
