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In July 2019, Professor Martin Hellwig was invited to RMI to give a keynote lecture at the Thirteenth Annual Risk Management Conference and visit with RMI’s staff and students. During his visit he also hosted a seminar on the subject of Banks, Governments, and the ECB in the ‘Euro Crisis’. During the two-hour speech, Prof. Hellwig took the audience back to review the causes and development of the Euro crisis, and also discussed the role of the European Central Bank (ECB) in the past and the dilemmas it faced. After the speech, Prof. Hellwig met with NUS MFE students and RMI staff to discuss in depth the issue of the Eurozone economy and gave insights into his career and personal inspiration. Below is a small snippet from his chats.
Q: You mentioned that interest rates at or below zero are problematic. So do you think there is better action that ECB can take other than lowering interest rates?
A: First, it is not clear to what extent long-term interest rates reflect the evolution of the real economy and to what extent they reflect monetary policy. Some economists claim that equilibrium long-run interest rates are actually negative because many people are saving and holding assets to provide for old age and real investment of firms had slowed so that, at positive interest rates, it is too small to absorb savings. This theory is in line with the observation that the enormous money creation of central banks has not caused any serious inflation. Perhaps this money creation has merely provided additional paper assets in which to hold savings. Second, my criticism focuses on central bank interventions at the long end of the market. By buying long-term securities, central banks act as competitors to commercial banks and squeeze their margins. Given that commercial banks have not yet recovered from the crises of the past decade; I consider that to be problematic. The underlying question is whether one should prioritize the real economy or the financial system when both are in bad shape. I would prefer prioritizing financial stability, by limiting interest rate policy to the short end of the market and by cleaning the financial system, closing banks and putting non-performing loans into government-run “bad banks”, with losses imposed in incumbent bank owners and (some creditors) and a reprivatization of healthy banks that can again make healthy loans. Delaying the cleanup, as we have done, is likely to make it much more expensive. Exiting the current regime is more and more difficult as financial fragility is steadily increasing.
Q: Why do central banks still want an inflation rate at two percent given that the interest rate is much lower?
A: What should the alternative be? Zero or four percent? Both numbers have been proposed. Two percent because then prices would “really” be stable. Four percent because factors justifying something above zero have become stronger. What are these justifications? One is that measured inflation is actually too high because the quality of goods is increasing and the quality increases are not sufficiently taken into account. The other is that prices and wages tend to be inflexible downward, which makes it difficult to adjust relative prices in response to changes in the environment; if the average price change is positive, the difficulty is smaller than if the average price change is zero. The two-percent target was chosen with regard to this consideration. People who believe that rigidities have increased actually propose four percent.
Q: You mentioned that Draghi prioritized the real economy over financial stability. Why are you critical?
A: Take the example of Japan in the 1990s. There were many insolvent banks and many insolvent non-financial firms. The banks did not foreclose on the non-financial firms because they did not want to write down the loans in their books. And the supervisors did not force banks to write down the loans in their books because they did not want to close the banks. As a result, entry of new non-financial firms was restrained, partly because funding went to incumbents, even they were insolvent, and partly because you don’t want to compete against someone with deep pockets that are likely to be refilled by the banks. The lack of entry explains why Japan’s productivity growth in the1990s was much below the OECD average. In contrast, Sweden cleaned up their banking system right away and got going again three years later; in the US Greenspan gave commercial banks the opportunity to earn record profits from 1990 to 1994, so they could rebuild their solvency and, by 1993, the real economy began to recover as well.
Q: What stops the central bank from investing in the financial system in order to rescue it? Why is there no pick up in the real economy?
A: The answer to the first question is that, as government institutions, central banks are supposed to abstain from choosing investment project or privileging certain firms, financial or non-financial. As for the second question, one reason for the discrepancy in the developments of central bank money and real economy is that commercial banks have dramatically increased their holdings of reserves with central banks. In the crises of the past decade, they have learnt the hard way that central bank money is the only really reliable source of liquidity. Before 2008, if you needed money you got an overnight loan in the market. After the Lehman bankruptcy, all of a sudden, overnight borrowing was almost impossible. So they prefer to hold reserves, even if they have to pay (!) interest on them. This explains why bank lending and bank money (deposits) have not grown in parallel with central bank money. Some say the lack of new lending is due to increased capital requirements. In fact, however, bank capital has not been so much increased. Moreover, in the US, where the banking system has been cleaned up more thoroughly and significantly more new equity has been raised, lending and growth have recovered much more than in Europe where many banks are still very weak.
Q. You are an academic through and through. Did you always know that you wanted to be an academic and what inspired you to join academia?
A. I liked the challenges involved in thinking about the things I learnt and became a professor before I even had time to think about alternatives. With hindsight I am very satisfied with this choice because, as an academic, I enjoy enormous freedom to choose the things I want to think about.
Q. Last but not the least, what according to you has been the highlight of your career so far?
A. Answering this question is hard for me, as I do not have one particular event or anecdote that I consider to be a career highlight. It is rather the fact that as a researcher, it is my job to see or anticipate a problem and to figure out a solution for it. The gratification one gets from this is unparalleled in my opinion. Another side to this is that as a teacher and a mentor I got to inspire and guide many students over the years to pursue their one line of enquiry.
Written by MFE Student Jiang Xiaojing and RMI Staff Shivani Nakhare
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