EU Archives

New Thinking in the News

Why women are crucial to our coronavirus response, how patents impede our progress towards resolving the pandemic, and what an erosion of trust means for our society. That and more in this week’s selection of #NewThinkintheNews.

1 | America’s coronavirus response must center on women. And the Black Plague helps show how in NBC by Lynn Parramore

“Feminist scholars have long pointed out that economists, political scientists and historians tend to think of the market and the state as the key spheres of reality — while regarding the home and the family as afterthoughts. But as the changes in medieval Europe in the wake of a terrible pandemic illustrate, when women are freed from burdens in the home and gain opportunities to participate fully in all aspects of life and work, the future grows brighter for everyone.”

2 | Patents vs. the Pandemic in Project Syndicate, co-authored by Arjun Jayadev and Joseph Stiglitz

“In responding to the pandemic, the global scientific community has shown a remarkable willingness to share knowledge of potential treatments, coordinate clinical trials, develop new models transparently, and publish findings immediately. In this new climate of cooperation, it is easy to forget that commercial pharmaceutical companies have for decades been privatizing and locking up the knowledge commons by extending control over life-saving drugs through unwarranted, frivolous, or secondary patents, and by lobbying against the approval and production of generics. … It’s time for a new approach. Academics and policymakers have already come forward with many promising proposals for generating socially useful – rather than merely profitable – pharmaceutical innovation. There has never been a better time to start putting these ideas into practice.”

3 | COVID-19 and the Trust Deficit, in Project Syndicate by Mike Spence

“The problem, as we warned back in 2012, is that we are living in an era of policymaking paralysis. “Government, business, financial, and academic elites are not trusted,” we wrote. “Lack of trust in elites is probably healthy at some level, but numerous polls indicate that it is in rapid decline, which surely increases citizens’ reluctance to delegate authority to navigate an uncertain global economic environment.” Change those last words to “navigate a highly chaotic public-health and economic shock,” and the statement loses none of its relevance today.

4 | Condivergence: Thinking fast and acting slow in the pandemic war in The Edge Malaysia by Andrew Sheng

“There will be no return to the old normal. Equilibrium was going anyway with the trade war. Technology was already changing the supply chains and business models. The pandemic only destroyed the old offline big mall business model faster as everyone shifts to online business. The only problem is that most policymakers do not have the data, or the understanding as to how, to make that transition without huge costs to jobs and businesses, at least in the short run, other than to run larger deficits…. The real winners will be those who learn, adapt and innovate so that all of us emerge stronger.”

5 | The EU should issue perpetual bonds, in Project Syndicate, by George Soros

“The EU is facing a once-in-a-lifetime war against a virus that is threatening not only people’s lives, but also the very survival of the Union. If member states start protecting their national borders against even their fellow EU members, this would destroy the principle of solidarity on which the Union is built… Instead, Europe needs to resort to extraordinary measures to deal with an extraordinary situation that is hitting all of the EU’s members. This can be done without fear of setting a precedent that could justify issuing common EU debt once normalcy has been restored. Issuing bonds that carried the full faith and credit of the EU would provide a political endorsement of what the European Central Bank has already done: removed practically all the restrictions on its bond purchasing program.”

Every week, we share a few noteworthy articles that showcase the work of new economic thinkers around the world. Subscribe to receive these shortlists directly to your email inbox.

When it comes to sovereign debt, what is the real concern? Level or Liquidity?

“What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?”
Adam Smith

By Elham Saeidinezhad | The anxieties around the European debt crisis (often also referred to as eurozone crisis) seem to be a thing of the past. Eurozone sovereigns have secured record-high order books for their new government bond issues. However, emerging balance-sheet constraints have limited the primary dealers’ ability to stay in the market and might support the view that sovereign bond liquidity is diminishing. The standard models of sovereign default identify the origins of a sovereign debt crisis to be bad “fundamentals,” such as high debt levels and expectations. These models ignore the critical features of market structures, such as liquidity and primary dealers, that underlie these fundamentals. Primary dealers – the banks appointed by national debt agencies to help them borrow from investors- act as market makers in government bond auctions. These primary dealers provide market liquidity and set the price of government bonds. Most recently, however, primary dealers are leaving Europe’s bond markets due to increased pressure on their balance-sheets. These exits could decrease sovereign bonds’ liquidity and increase the cost of borrowing for the governments. It can sow the seeds of the next financial crisis in the process. Put it differently, primary dealers’ decision to exit from this market might be acting as a warning sign of a new crisis in the making.

Standard economic theories emphasize the role of bad fundamentals such as high debt levels in creating expectations of government default and reaching to a bad-equilibrium. The sentiment is that the sovereign debt crisis is a self-fulfilling catastrophe in nature that is caused by market expectations of default on sovereign debt. In other words, governments can be subjected to the same dynamics of fickle expectations that create run on the banks and destabilize banks. This is particularly true when a government borrows from the capital market over whom it has relatively little influence. Mathematically, this implies that high debt levels lead to “multiple equilibria” in which the debt level might not be sustainable. Therefore, there will not be a crisis as long as the economy reaches a good equilibrium where no default is expected, and the interest rate is the risk-free rate. The problem with these models is that they put so much weight on the role of expectations and fundamentals while entirely abstract from specific market characteristics and constituencies such as market liquidity and dealers.

Primary dealers use their balance-sheets to determine bond prices and the cost of borrowing for the governments. In doing so, they create market liquidity for the bonds. Primary dealers buy government bonds directly from a government’s debt management office and help governments raise money from investors by pricing and selling debt. They typically are also entrusted with maintaining secondary trading activity, which entails holding some of those bonds on their balance sheets for a period. In Europe, several billion euros of European government bonds are sold every week to primary dealers through auctions, which they then sell on. However, tighter regulations, such as MiFID II, since the financial crisis has made primary dealing less profitable because of the extra capital that banks now must hold against possible losses. Also, the European Central Bank’s €2.6tn quantitative easing program has meant national central banks absorbed large volumes of debt and lowered the supply of the bonds. These factors lead the number of primary dealers in 11 EU countries to be the lowest since Afme began collecting data in 2006.

This decision by the dealers to exit the market can increase the cost of borrowing for the governments and decrease sovereign bonds’ liquidity. As a result, regardless of the type of equilibrium the economy is at, and what the debt level is, the dealers’ decision to leave the market could reduce governments’ capacity to repay or refinance their debt without the support of third parties like the European Central Bank (ECB) or the International Monetary Fund (IMF). Economics models that study the sovereign debt crisis abstracts from the role of primary dealers in government bonds. Therefore, it should hardly be surprising to see that these models would not be able to warn us about a future crisis that is rooted in the diminished liquidity in the sovereign debt market.

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”. Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

Brexinomics

In analyzing the consequences of Brexit, economists have relied heavily on ‘scenario testing.’ But this tool may not be fit for purpose.

As the UK embarked on Brexit, economists were given a range of opportunities in which to provide some guidance as to how the tricky process of Brexit was going to go. A sub-discipline was entitled ‘Brexinomics’. This article looks at a tool used by economists, known as scenario testing and questions the reliance on this tool to navigate us through Brexit.

On June 23rd 2016, the UK decided to travel on the unknown road ahead known as Brexit. Economists were called on to provide some navigation for policy makers, the markets and businesses. The task was (and still is) to provide policy makers with how the economy will react either a ‘hard Brexit’, ‘soft Brexit’, or any kind of new rearrangement with the EU.

The Treasury and Bank of England have the most influential roles when it comes to acting as an economic advisor to the government. One of the methods that has been particularly relied on by these organisations is referred to generically as scenario testing.

What is scenario testing and what can it actually tell us?

Scenario testing is a broad term given to the use of economic modelling to predict how a certain event is going to impact the rest of the economy. Analysts aim to predict the future impact on the economy arising from any-one number of things. Scenario tests are predominantly conducted using a global econometric model that contains large amount of data and equations that aim to describe the behaviour of the economy. These models are used by governments and central banks alike.

Since the announcement of the Brexit Referendum, scenario tests have been frequently referred to in news articles and senior politicians alike to provide a picture of what a post-Brexit world might look like. In 2016, the HMT published a document titled ‘HMT analysis: The immediate economic impact of leaving the EU’. In this document, they published the table below in which they outline the response of the economy to a leave vote in the referendum.

There are two shock scenario responses listed. These refer to a moderate and severe response of the economy to a leave vote in the referendum. The table shows that in the year following a leave vote 17/18, the economy is expected to contract by around 3.6%. In the severe case it is listed as -6% which would have been worse that the financial crisis of 2009 in the UK which saw a peak decline of -4.2%. In 2017, year growth on change was actually 1.7% (Office of National Statistics). That is a marked difference from the projected values.

This reveals that scenario tests are not suitable to handle something like Brexit, and their poor performance in outlining the economic effects of a leave EU vote is unsurprising.

A better use of scenario tests is to look at the overall impact on the economy of specific one-off economic events or policy changes, like a change in oil prices. A change in oil prices would typically start with changes in the income for oil-exporting countries and rises in costs for oil-importing countries. For the oil importing countries, the initial increase in oil prices would then lead to an increase in inflation as the cost of production increases. These different impacts can be modelled by scenario tests and they can provide a scale of the final economic impact owing to an initial increase in oil prices.

However, the number and scale of policy unknowns in Brexit means that a scenario test is always under-identified. We are dealing with infinite number of policy unknowns.

This leads on to the second issue with scenario tests is that they work under the assumption of ceteris paribus. This assumption is that all other things will remain equal during and after the specific economic event that is being analysed has occurred. With something like Brexit, there is no ceteris paribus, as all other things will not necessarily remain equal.

Brexit has the possibility of creating restrictions on migration, along with restrictions on trade and restrictions on capital flows. These could all happen simultaneously. Even if a scenario test could adequately model each of these events on their own, it is not able to consider interactions between different simultaneous policy changes. It seems unlikely that previous data could be used to show us what would happen in the event of all three of these policy changes simultaneously occurring given that this is not something that has occurred before.

Despite all these shortcomings, there is still often reference in the media to results of scenario tests conducted by key organisations. Scenario tests still seem to be providing some comfort in predicting what a post-Brexit world might look like.

There are two amendments that economists need to make. The first is to limit the scope and expectations of what previous data can tell us. Given the unprecedented nature of Brexit, it seems that historical data might not have the information to show us what could happen in the event of any kind of Brexit deal. It unlikely to accurately provide a percentage point increase/decrease in GDP in the case of any type of new arrangement with the EU.

The second amendment, is to move on from the empirical macroeconomic models and look at methods that will provide a truer reflection of how individuals might behave in response to the new arrangement with the EU.

What are the alternatives?

There have been already a number of surveys conducted that ask individuals and businesses alike, what they would do in ‘Brexit-like’ events i.e. a restriction on migration leading to labour shortages. Piecing together information from macroeconomic surveys is more likely to provide a truer picture as it will give us actual behavioural responses from economic agents.

About the Author
Kanya Paramaguru is a PhD student at Brunel University London. Her current research focuses on using empirical time-series methods in Macroeconomics.