Future paths for monetary policy in a world of lower inflation

Recap of Professor Jordi Galí’s ECB Forum presentation by Maximilian Magnacca Sancho ’21 (ITFD)

The stage for ECB Forum 2020
Photo by ECB on Flickr

On November 11, 2020 the first day of the ECB Forum on Central Banking began with three exciting talks on how shifts in the global economy have changed the game for central banks worldwide. Among the distinguished guest speakers at the Forum was UPF, CREi, and Barcelona Graduate School of Economics Research Professor, Jordi Galí. While the ECB had him slated to speak on the “Inflation Objective, Structural Forces, and Central Bank Communication,” Professor Galí spent his presentation focusing predominantly on inflation targeting at central banks and whether it should be revised going forward. 

Watch the ECB Forum panel discussion with Jordi Galí, Volker Wieland, and Annette Vissing-Jørgensen, chaired by Philip Lane on YouTube

His presentation spoke directly to an ongoing debate amongst academics and financial-market watchers, as there have been structural changes in the economy since the last update of the ECB’s policy in 2003. Structural changes are a normal function of an economy as it progresses along with society, though it has some troublesome side effects. Most concerningly, they reduce the effectiveness of policy in alleviating economic downturns by influencing the transmission mechanisms of monetary policy. This raises the challenge for policymakers in picking the best policy.

These structural changes ultimately centre around one crucial variable that is influenceable by central banks. The Steady-State Real Interest Rate, colloquially known as R*.  Central banks will be constrained by this rate and hit the zero lower bound sooner if they withhold from changing the inflation target – as argued by Jordi Galí in his presentation. A lower R*, as is being observed, necessitates a higher inflation target so that monetary policy (done through a changing of the interest rate) will have less incidence of the zero lower bound and thus reducing the chance of ineffectiveness.


This is obviously an urgent issue faced by policymakers worldwide during the ongoing COVID-19 crisis from the forefront of monetary economics research, yet what Professor Galí was able to do was bring it back to the basics of economics. He emphasised how the models are built on assumptions, and if assumptions change – as the data indicate they have – then the framework for thinking about these issues need to be updated.

In this spirit, Professor Galí proposed three potential policy changes for central bankers to consider in light of the ECB strategic review: he proposed more countercyclical fiscal support; changing to average inflation targeting; or a higher inflation target from its current position of “below or at 2%”. He acknowledged the challenges and potential pitfalls of all these policies, while also speaking to their potential improvement upon the current policy. 

It was great to see a Barcelona GSE professor invited to speak at such a prominent and interesting event held annually and frequented by policymakers and academics working on some of the most challenging issues in central banking. It highlights the quality of research that is being done at Barcelona GSE and the quality of the professors conducting that research being sought after by policymakers. 

Maximilian Magnacca Sancho ’21 is a student in the Barcelona GSE Master’s in International Trade, Finance, and Development.

This post was edited by Ashok Manandhar ’21 (Economics).

The Effectiveness of Debt Relief in Mitigating the Macroeconomic Consequences of Natural Disasters

ITFD master project by Emma Howard, Kean Murphy, Wouter Nientker, Karim El-Ouaghlidi, and Harry Schmidt ’20

land affected by severe drought
Photo: CNN

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects. The project is a required component of all Master’s programs at the Barcelona GSE.

Overview

Using a dynamic panel fixed effects model, we find that increases of ODA of above 2% of GDP have significant effects on the economic growth of African countries in the immediate aftermath of severe natural disasters. This is a surprising result because we do not find that ODA in times of relative stability has a significant effect on GDP. This suggests that debt relief, at least through the channel of significant increases in ODA, is an effective instrument in promoting post-disaster recovery, even though its effectiveness in raising economic growth more generally is limited. Since increases in ODA inflows of above 2% of GDP only occurred after 1/3 of the disasters we studied, we recommend that international financial institutions concentrate ODA flows on countries that had been afflicted by severe disasters. 

Introduction

One of the biggest challenges facing developing Sub-Saharan African economies is their vulnerability to severe natural disasters such as droughts and floods. Not only do they face on average over 50 disasters a year, but their economies’ over-reliance on agricultural production and weak institutional capacity cause them to experience the effects of these disasters particularly acutely. Worryingly, this vulnerability is likely to rise in the coming years, as the earth warms and climate change increases the number and severity of extreme climatic events. 

While it is difficult for countries to prevent natural disasters, since they tend to arise from exogenous climate conditions, they can take steps to mitigate these adverse consequences through post-disaster rehabilitation. To do so, governments require sufficient fiscal space so that they can borrow and spend without jeopardising budgetary sustainability. However, many African countries suffer from persistently high levels of debt, with 33 of the 39 countries in the Heavily Indebted Poor Countries scheme located on the continent. This constrains government spending on humanitarian relief and reconstruction, which can leave countries unable to recover from the devastation. 

In view of these twin trends – African economies’ vulnerability to natural disasters and their crippling levels of debt – any channel that reduces a country’s debt burden and hence increases its fiscal space should theoretically encourage faster economic recovery. This suggests that debt relief can be a vital policy instrument in mitigating the negative effects of natural disasters. However, corruption and inefficient resource allocation mean that its effectiveness may be constrained in practice. To explore the role of debt relief further, we employ a dynamic panel fixed effects model across the most severe 25 floods and 68 droughts in Africa from 1978 to 2013. As a robustness check, we also include an Anderson-Hsiao style GMM estimation procedure. We define debt relief as any policy that reduces the need for governments to issue new debt or repay existing debt, particularly in the aftermath of a natural disaster. In the context of this paper, this includes debt forgiveness, debt rescheduling and/or increased official development assistance (ODA). Furthermore, we run two different specifications of debt relief: first, using a dummy variable which indicates any instance of the aforementioned forms of debt relief; and second, using a continuous variable for ODA inflows alone. 

Main findings

Surprisingly, when we run our first specification, we find that debt relief in general does not have a statistically significant impact on economic growth. Additionally, ODA inflows in times of relative stability do not have significant effects on economic growth. Instead, they only reduce debt-to-GDP growth, suggesting that they are merely used by governments to pay off existing debt. This is in line with previous research by both Mejia (2014) and Raddatz (2009), who found at most weak evidence that either debt relief in the aftermath of disasters or ODA in general is effective in boosting economic growth. 

In contrast, we find that increases in inflows of ODA of above 2% of a country’s annual GDP, when provided in the year of or immediately after severe disasters, do have statistically significant positive effects on economic growth (see Figure 1). These findings are similarly observed when we interact our ODA variable with the continuous measure of disaster severity. For a given level of ODA, the effectiveness of post-disaster ODA increases in the severity of the underlying disasters. Furthermore, ODA inflows no longer have statistically significant effects on debt-to-GDP growth. This suggests that, unlike in regular times, ODA flows are used fruitfully by governments after disasters to bolster economic recovery rather than to pay off existing debt. 

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Figure 1

This is a notable result because it suggests that debt relief, at least through the channel of ODA, is an effective instrument to promote post-disaster recovery. This result differs from that found by previous research because we focus on ODA increases that a) were larger than 2% of GDP and b) occurred in the aftermath of severe natural disasters. This helps us isolate the specific role of ODA in promoting post-disaster recovery from its general effectiveness as a form of economic stimulus to boost growth. 

Policy implications

Our findings suggest that policymakers in international financial institutions such as the OECD or IMF should step up efforts to increase ODA inflows to developing countries when severe natural disasters hit. This not only has the direct effect of reducing the loss of lives, but is also vital for poverty reduction by ensuring that these countries return rapidly to their existing balanced growth path. Otherwise, countries risk experiencing persistent economic slowdown and skyrocketing debt due to the disasters, which would in turn lead to a vicious cycle of mounting debt and stagnant growth. Instead, increased ODA flows can substitute for the domestic shortfall in resources available to countries to rehabilitate the economy by providing emergency relief to citizens and rebuilding damaged infrastructure. 

Current attempts at mitigating such disasters are relatively limited: in our sample of 92 severe disasters in Africa between 1978 and 2013, large increases of ODA greater than 2% of GDP only occurred after 32 of these disasters. This is surprisingly infrequent, especially considering that we focus only on the largest of disasters which should have ample international media coverage. As highlighted above, larger increases in ODA have greater cumulative effects on the economy, especially for more severe disasters. As this effect is not observed when we study ODA inflows in times of stability or inflows below 2% of GDP, we recommend that existing ODA programmes prioritise large flows to countries which have just suffered from severe natural disasters. This is because the marginal benefit of these targeted flows in promoting development is likely higher than general flows to countries that are relatively stable. 

Finally, although our paper focuses on floods and droughts in Africa, we believe that our results can be generalized to other types of disasters. Although further research is needed to fully establish the causal mechanism by which debt relief improves post-disaster outcomes, it is likely that it will have a similar positive impact in rehabilitating economies that face disasters which leave them with high levels of debt and significantly lower budgetary revenue. Most notably, it suggests that significant increases in ODA flows can play a vital role in helping developing economies devastated by the COVID-19 pandemic by allowing them to mitigate its adverse effects. 

References

Mejia, S. A. (2014, July). Debt, Growth and Natural Disasters A Caribbean Trilogy (IMF Working Papers No. 14/125). International Monetary Fund. Retrieved from https://ideas.repec.org/p/imf/imfwpa/ 14-125.html 

Raddatz, C. (2009). The Wrath of God: Macroeconomic Costs of Natural Disasters. The World Bank. Retrieved from https://ideas.repec.org/p/wbk/wbrwps/5039.html 

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Criminals or Victims? Evidence on Forced Migration and Crime from the Colombia-Venezuela Border

ITFD master project by Maria Dale, Giacomo Gattorno, Andre Osorio, Rebeca Peers, and Kerenny Torres ’20

Photo: George Castellano / AFP

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects. The project is a required component of all Master’s programs at the Barcelona GSE.

Abstract

How does a sudden migrant crisis affect criminal activity, and through which mechanisms does this effect take place? We approach this topic by studying the effect of Venezuelan migration on crime rates in Colombia, in the context of the recent migrant crisis that made more than 1.2 million Venezuelans cross the border. 

Our study focuses on border provinces, where the presence of non-economic migrants is higher and potential assimilation problems could be exacerbated. Building on the fact that Venezuelan migration to Colombia happened due to apparently exogenous reasons and is unrelated to economic outcomes in the latter, we are able to study the causal effect of this large migration wave on crime rates. 

Our results show that Venezuelan forced migration had no significant effect on overall crime, but a positive and significant effect on personal theft in Colombian border provinces. Furthermore, migration had a positive and significant effect on personal theft victimization rates of both Venezuelans and Colombians, while only having significant effects on the criminalization rates of Venezuelans. These results are robust to different specifications and controls, and two placebo tests provide strong evidence in favor of our empirical strategy and results. Finally, we link our findings with the overarching criminal context in Colombian border provinces, and develop relevant policy recommendations based on our findings.

Conclusions

In this paper we analyzed the impact of the Venezuelan migrant crisis, which saw more than 1.2 million Venezuelans cross the border, on crime rates in Colombian border provinces between 2014 and 2018. We focused on the border provinces to study the particular effects of non-economic migration, as we find that migrants in this area did not target areas with specific characteristics but just settled in the closest center to get food, medicine and essential services. This settlement decision strictly based on closeness to border is also illustrated by the figure below: not only is the highest share of foreign-born population in the Colombian regions concentrated in our area of study (the 7 border provinces), but within these border provinces there is also a clear concentration in municipalities on the physical border with Venezuela.

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Figure 1. Venezuelan-born population as % of total population by province and municipality, 2018. Source: Own calculations, based on data from DANE.

The main contribution of our study was presenting compelling and robust evidence on no significant effect of Venezuelan forced migration on overall crime, but a positive and significant effect on personal theft in Colombian border provinces. By also analyzing both the direct and indirect mechanisms through which this migration inflow can have an effect on different crime rates, we’re able to establish a causal effect of migration on both personal theft victimization and criminalization rates of Venezuelans, while only having significant effects on the victimization rates of Colombians.

Besides our key findings, other results hint at a more holistic narrative: migration also had a positive and significant effect on both homicide and personal injury victimization rates of Venezuelans. What could be driving these effects? As seen previously, Venezuelan migrants settled in municipalities right across the border from Venezuela – which, coincidentally, are municipalities where criminal organizations have a large presence: criminal organizations are present in 23 of the 42 municipalities on the border, and in 39 of the 81 municipalities where the change in proportion of Venezuelan migrants between 2014-18 was above the average. 

In these high migration municipalities, as a consequence of criminal activity, homicide rates tended to be much higher at baseline than in other municipalities. Moreover, we see some evidence of discrimination in homicides – after controlling for all relevant socioeconomic covariates, being Venezuelan seems to have a significant and positive effect on being a victim of homicide. 

This additional information could help construct the following holistic narrative and recommendations: 

  • A large wave of migrants arrived in low-income border provinces with little (formal) employment opportunities, and some had to resort to small-scale theft to make a living, which explains the positive effect of migration on Venezuelan personal theft criminalization rates
  • Driven by both opportunity and attractiveness of targets, this caused an increase in personal theft victimization rates for both Colombians and Venezuelans, although it was much higher for the former than for the latter.
  • However, these municipalities were controlled largely by criminal organizations, which started threatening Venezuelans and forcefully recruiting them in large numbers. This could help explain the positive and significant effect of migration on both homicide and personal injury victimization rates of Venezuelans.
  • These findings imply that government policies should focus on reducing the vulnerability of Venezuelans by providing swift access to the formal labor market, either in border provinces or nationwide, so that Venezuelans can avoid resorting to small-scale theft and escape forced recruitment and exploitation from criminal organizations.

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About the Barcelona GSE Master’s Program in International Trade, Finance, and Development

Responding to COVID-19 by prioritising sustainability and wellbeing in the recovery

Elliot Jones ’18 (Macro) and Maximilian Magnacca Sancho ’21 (incoming ITFD)

Photo by John Cameron on Unsplash

Maximilian and Elliot connected through social media due to the Barcelona GSE connection and started working together on this piece due to shared research interests.


The COVID-19 pandemic is changing the way that we live our lives. As time passes it is becoming apparent that even once the lockdown policies have been eased and some level of normality has been resumed, the new world that we live in will be different to the one we knew before. This article focuses on emerging trends within the UK that have largely taken place as a result of COVID-19, or in some cases the pandemic has simply accelerated a trend that was already occurring. We then look to offer a range of public policy solutions for the recovery period where the overarching objective is to increase wellbeing in society in a sustainable way. These are focused towards the UK but several could be paralleled to other advanced economies.

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Chart 1. Consumer spending in April 2020 by category, % change year-on-year

But first, before we get to the policy solutions, briefly, what have been the main economic and wellbeing effects that we have seen as a result of COVID-19? In 2020, it is expected that the fall in overall economic output is going to be larger than during the financial crisis in 2008. Much of this is due to the level of decline in economic activity as a result of the UK governments lockdown policy. This was a necessary decision in order to reduce the spread of the virus and ensure the health service still has capacity to treat those that have unfortunately caught the disease. However, it has led to a significant liquidity shock for both households and businesses. Large portions of the labour market are now out of work and levels of consumer spending have declined rapidly (Chart 1). Alongside sharp falls in measures of economic performance, measures of wellbeing have declined rapidly as well (Chart 2). Increases in measures of uncertainty have mirrored increases in anxiety. While, social distancing policies are having a large impact on measures of happiness.

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Chart 2. ONS wellbeing measures (2011-2020)

Source: ONS. Notes: Each of these questions is answered on a scale of 0 to 10, where 0 is “not at all” and 10 is “completely”. Question: “Overall, how satisfied are you with your life nowadays?”, “Overall, to what extent do you feel that the things you do in your life are worthwhile?”, “Overall, how happy did you feel yesterday?”, “Overall, how anxious did you feel yesterday?”.

The UK government responded to the shock posed by COVID-19 with a range of policy interventions to provide funding to those that have been most impacted. At a macro level, the long-lasting effects of this crisis will be more pertinent if economic activity does not respond quickly after the government’s schemes have ended. Large portions of UK businesses have limited cash reserves to fall back on in a scenario where demand remains subdued for some time. However, even if the recovery period is strong there will still have been some clear winners and losers during this crisis. Younger workers, those on lower incomes and those with atypical work contracts are the ones that have been most heavily impacted (Chart 3). Whilst those on higher incomes, that are more likely to be able to work from home, have increased their household savings during this period, due to less opportunities to consume.

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Chart 3. Impact of COVID-19 on household savings by income and employment type

The policy solutions outlined below aim to be complementary of one another and look to amplify observed trends that are positive for wellbeing and to provide intervention where trends have been negative for wellbeing: 

  1. Climate at the centre of the response: This is less a policy recommendation and more a theme for the response. However, our message here is that increased public spending projects, focused towards green initiatives should be combined with a coherent carbon tax policy which influences incentives and helps to support the UK’s transition to a low carbon economy. 
  2. Labour market reforms: The government should look to develop a centralised job retraining and job matching scheme that supports workers most impacted by COVID-19, helps to encourage structural transformation towards emerging industries and increases the amount of highly skilled workers in the UK workforce. 
  3. Tough decisions on business: Some businesses will require further assistance from the UK government in the form of equity funding, rather than the debt funding seen so far. This should be done on a conditional basis, requiring all these businesses to comply with the UK’s climate objectives and should only be provided to businesses in industries that are expanding or strategically important to the UK economy. 
  4. Modernising the regions on a cleaner, greener and higher level: Looking to build on the governments ‘levelling up the regions’ policy to reduce regional inequalities, our policy consists of government funded infrastructure policies that include green investments for regions outside of the UK’s capital.  
  5. Harbouring that rainbow effect: Building on the increased community spirit that has been observed during the pandemic, this policy solution looks to increase localised community funding to maintain social cohesion and support those with mental health issues. 

Lastly, as the policy recommendations focus on expanding public investment to support the recovery, it is important to consider what this means for public debt sustainability in the UK. The conclusion is that as a result of the low interest rate environment, the most efficient way out of this recession is to borrow and spend on projects that will increase resilience to future shocks and support the UK’s transition to a low carbon economy. 

Please click on the link below to read about this in more detail. Comments are welcome.


Full article originally posted on Exploring Happiness.

Elliot Jones ’18 is a Sovereign Credit Risk Analyst at the Bank of England. He is an alum of the Barcelona GSE’s Master’s in Macroeconomic Policy and Financial Markets.

LinkedIn | Exploring Happiness

Maximilian Magnacca Sancho ’21 is an incoming student in the Barcelona GSE Master’s in International Trade, Finance, and Development.

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COVID-19: Will the world remain flat after the curve flattens?

Reflections on disruption, supply chains, and globalization by Krisha Gandhi ’20 (ITFD)

Photo by Edwin Hooper on Unsplash

In my all-time favourite book ‘Antifragile’, Nassim Taleb divides the world into 3 categories- fragile, robust and antifragile. He refers to fragility as the state of being that involves avoiding disorder and disruption for fear of the mess that threatens to disrupt your life: you think you are keeping safe, but really you are making yourself vulnerable to the shock that will tear everything apart. Robustness is the ability to stand up to shocks without flinching, without changing who you are. But you are antifragile if shocks make you better able to adapt to each new challenge you face. You are antifragile if you can opportune from disruptions, to be stronger and more creative. Taleb thinks we should all try to be antifragile!

On March 11, 2020, declared a world pandemic, the COVID-19, is an epitome of the chaotic disruption Taleb was referring to. The onset of this crisis got me pondering whether populations, institutions, financial bodies, governments and policy-makers -i.e. the world as a whole will be able to be resilient in the face of the aftermath of this crisis? Do we have the acceptance, courage and strength besides the technical, innovative and problem-solving skills to start afresh and turn this disequilibrium around into the most memorable salvation story we have ever seen? Or will we succumb to this dooming, seemingly apocalyptic spiral, and lose everything we take for granted in our day-to-day lives? When the noise of this unprecedented shock dies, will we be left at the inception of a brand new system that will push us to rethink policies, and rewrite mandates that shape, govern and structure the world? 

The outbreak of this global health crisis saw a strong backlash against globalization in the form of acceleration of trends underway. Before COVID-19 slammed the global economy earlier this year, China had adopted selective international exchange rates for political incentives. This had consequently led to US-China trade wars involving up to 25% tariff imposition on Chinese imports.

In March, COVID-19 contributed to this backdrop by declining the number of cargo ships setting off for the United States by 10%. The cost of shipping goods by air nearly doubled, restricting trade further. In order to contain the outbreak of the rapidly spreading virus, countries were forced to close their borders to foreign visitors which severely restricted the movement of people worldwide.

With no signs of the situation returning to normalcy, countries are desperately trying to be “self-sufficient” by ordering factories at home to produce ventilators, banning exports of face masks, and localizing pharmaceutical supply chains even at the cost of added expenses. The declaration of a potential suspension of immigration into the U.S by the President seemed like a final nail in the coffin for the era of globalization.

The world’s response to COVID  comes across as ratifying Trump’s argument for protectionism and supply chain controls. This alludes to a pressing question in such uncertain times: Will the world remain flat after the curve flattens after all? Let’s first look at what does it mean for the “world to be flat”? In the book, ‘The world is flat’ by Thomas L. Friedman, the author endorses his view of the world as a level-playing field, wherein all players have equal opportunity and the world is a global market where historical and geographic boundaries are becoming increasingly irrelevant.

Globalization has persisted in different forms for decades. In my opinion, just like the dotcom bubble, 9/11 debacle, 2008 financial crisis, the COVID-19 pandemic too, is a temporary shock, which will perhaps change the face of globalization but not sink it. In the near future, we will likely either have a vaccine or much of the world will be infected by the virus. Either way, the current restrictions will neither be needed nor sustainable in the long run.

For instance, by the time the curve peaks, most countries will perhaps already have bought or produced enough inventory. In that case, will it really make sense to use tax-payers money on incurring exorbitant production costs to set up ventilator factories at home when their supply is already bolstered by sufficient purchase? Evidently, medical supply chains will change less than politicians currently promise! 

But even after the shock evanesces, COVID-19 will heavily influence the decision-making process with regards to investment and relocation. Many argue that the crisis was an exemplary demonstration of increased risks associated with globalised supply-chains. A flip-side to the dispute is that in the quest to maximize profits and reduce the risk of localized disruption from the crisis, if anything, firms might only expand production lines across the world, creating employment more evenly, and promoting eventual global recovery. In fact, the renowned economist, Obstfeld, who served as IMF’s chief from late 2015 through 2018, said that “While global supply chains will undoubtedly change in a post-crisis economy, much of that change will be in the form of diversification, not on-shoring.”

While layoffs and increasing unemployment in a post-crisis recessive economy are inevitable, they will not mark the end of outsourcing. Turning to autarky-like economies will be too costly to be sustainable for countries world-over. There will be plenty of opportunities to employ people in jobs that demand highly skilled labour to meet the needs of the recovering economies. This will pave the way for Globalisation 3.0, described in Friedman’s book as individuals focusing on finding their foothold in the present global competition and making significant global collaborations. In fact, skill up-gradation of this form, to ensure relevance as demanded by the need of the hour, will push humans towards becoming antifragile, as recommended by Taleb. 

However, “Outsourcing is just one dimension of a much more fundamental thing happening today in the world”, Friedman claims. Experts often view globalization from a one-dimensional perspective- physical goods and services crossing borders. But in fact, many intangibles- data, value, ideas, innovation frequently cross borders. In his book, Friedman emphasizes that “You don’t need to emigrate to innovate”. “Globalization in recent times has created a platform where intellectual work, intellectual capital, can be delivered from anywhere. It could be disaggregated, delivered, distributed, produced and put back together again — and this gave a whole new degree of freedom to the way work is done, especially work of an intellectual nature.” In light of this view of global integration, I believe that the world is going to get flatter. With workforces across nations getting training on Zoom video conferencing, to extensive sharing of knowledge in research on medical advances, the spillover of ideas and innovation is going to witness only an onward spur. The quantity and value of data transmitting between countries are increasing and with the high-value data processing replacing supply chains as the predominant channel of global economic exchange, I see this only increasing further. 

So is the world after coronavirus tending to globalization or deglobalization? I think it depends on where you look. COVID can make it harder to ship Chelsea fan-club merchandise around the world, but no quarantine can contain cryptos from crossing borders! 

COVID-19 US County Dashboard

Charlie Thompson ’14 (ITFD) has built an RStats dashboard that tracks COVID-19 cases in the United States at the county level using the latest data from The New York Times.

Check it out to see how US communities are “flattening the curve”:

Charlie Thompson ’14 is a Data Scientist at Spotify. He is an alum of the Barcelona GSE Master’s in International Trade, Finance, and Development.

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Sectoral risk-weights and macroprudential policy

Publication in Journal of Banking and Finance by Alex Hodbod (ITFD ’12) and Steffi Huber (Economics ’10, GPEFM ’17)

We have a forthcoming article “Sectoral Risk Weights and Macroprudential Policy” in the Journal of Banking & Finance with our co-author Konstantin Vasilev (Essex).

The authors!

Paper abstract

This paper analyses bank capital requirements in a general equilibrium model by evaluating the implications of different designs of such requirements regarding their impact on the tendency of banks to amplify the business cycle.

figure
Interest rate spreads structure. This figure gives an overview of the different interest rate spreads within the model and the factors that affect them. The asset-specific interest rate spreads determine the borrowing costs of households and firms and hence the quantities of specific loan types in the economy.

We compare the Basel-established Internal Ratings-Based (IRB) approach to risk-weighting assets with an alternative macroprudential approach which sets risk-weights in response to sectoral measures of leverage. The different methods are compared in a crisis scenario, where the crisis originates from the housing market that affects the banking sector and is then transmitted to the wider economy.

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Variance decomposition – real consumption during the Great Recession. This variance decomposition shows that the model identifies the productivity shock and the shock to mortgage lending risk to be the main drivers of the crash in real consumption during the Great Recession. In our model, the main channel through which the shock to mortgage risk has a procyclical effect on consumption is through lending and house prices.

We investigate both boom and bust phases of the crisis by simulating an unrealized news shock that leads to a gradual build-up and rapid crash in the economy. Our results suggest that the IRB approach creates procyclicality in regulatory capital requirements and thereby works to amplify both boom and bust phases of the financial cycle. On the other hand, our proposed macroprudential approach to setting risk-weights leads to counter-cyclicality in regulatory capital requirements and thereby attenuates the financial cycle.

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Impulse Response Function – Unrealised news shock. Here, we model both the build-up and crash phases of the crisis and use this to examine how different policy approaches perform in handling the boom phase of the cycle. In periods 1-4 agents start with expectations that a housing boom will occur, but at period 4 a shock arrives as this boom does not materialise. At the top of the chart one sees that the policy setup based on the IRB approach (red) generates the biggest macroeconomic consequences from this shock; it is the most procyclical. The macroprudential approach to risk-weighting (in green) is the least procyclical. An unweighted “leverage ratio” approach (blue) is less procyclical than the IRB approach, but more so than our macroprudential approach.

Conclusions in brief

  • We show that IRB risk-weights can induce procyclicality of capital requirements and amplify both boom and bust phases of the business cycle. This is particularly concerning because procyclical risk weights could undermine other macroprudential tools, as these other tools are themselves based on risk-based measures of capital requirements e.g. Counter Cyclical Capital Buffers.
  • Our alternative approach of macroprudential risk weights could induce countercyclicality of capital requirements, which may offer benefits in terms of smoothening financial cycles. Targeting macroprudential intervention on bank risk-weights is likely to be more effective when it is sector-specific. This will alter banks’ incentives in a sensitive way – thereby tending to attenuate sectoral asset booms.
  • The results complement the ongoing debate about the potential merits of a Sectoral Counter Cyclical Capital Buffer, which is ongoing internationally.

About the authors

portrait

Alexander Hodbod ’12 is Adviser to representatives on the ECB Supervisory Board. He is an alum of the Barcelona GSE Master’s in International Trade, Finance and Development.

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portrait

Stefanie J. Huber ’10 is Assistant Professor at the University of Amsterdam. She is an alum of the Barcelona GSE Master’s in Economics and GPEFM PhD Program (UPF and Barcelona GSE).

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If you are an alum and would like to share your work on the Barcelona GSE Voice, please reach out!

Household level effects of flooding: Evidence from Thailand

International Trade, Finance, and Development master project by Zhuldyz Ashikbayeva, Marei Fürstenberg, Timo Kapelari, Albert Pierres, Stephan Thies ’19

Source: NY Times

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects. The project is a required component of all Master’s programs at the Barcelona GSE.

Abstract

This thesis studies the impacts of flooding on income and expenditures of rural households in northeast Thailand. It explores and compares shock coping strategies and identifies household level differences in flood resilience. Drawing on unique household panel data collected between 2007 and 2016, we exploit random spatio-temporal variation in flood intensities on the village level to identify the causal impacts of flooding on households. Two objective measures for flood intensities are derived from satellite data and employed in the analysis. Both proposed measures rely on the percentage area inundated in the surrounding of a village, but the second measure is standardized and expressed in comparison to the median village level flood exposure. We find that household incomes are negatively affected by floods. However, our results suggest that rather than absolute levels of flooding, deviations from median flood exposure are driving negative effects on households. This indicates a certain degree of adaptation to floods. Household expenditures for health and especially food rise in the aftermath of flooding. Lastly, we find that above primary school education helps to completely offset potential negative effects of flooding.

Conclusion

This paper adds to the existing body of literature by employing a satellite based measure to investigate the long-run effects of recurrent floods on household level outcomes. We first set out to identify the causal impacts of flooding on income and expenditures of rural households in Thailand. Next, we explored and compared shock coping strategies and identified potential differences in flood resilience based on household characteristics. For this purpose, we leveraged a detailed household panel data set provided by the Thailand Vietnam Socio Economic Panel. To quantify the severity of flood events, we calculated flood indices based on flood maps collected by the Geo-Informatics and Space Technology Development Agency (GISTDA) measuring the deviation from median levels of flooding in a 5km radius around a respective village. The figure below illustrates the construction of the index for a set of exemplary villages that lie in the Nang Rong district of Buri Ram in northeast Thailand.

(a) 2010 flooding in Buri Ram and surrounding provinces. Red lines mark the location of the Nong Rong district.

(b) Detailed overview of flood index construction. Red dot shows the exact location of each village with the 5 km area around each village marked by the red circle.

Our results suggest a negative relationship between floods and per household member income, for both total income and income from farming. Per household member expenditure, however, does not seem to be affected by flood events at all. The only exemptions are food and health expenditures, which increase after flood events that are among the top 10 percent of the most severe floods. The former is likely to be driven by the fact that many households in northeastern Thailand live at subsistence level, and therefore consume their farming produce. A lack of production in a given year may lead these households to substitute this loss by buying produce from markets. Rising health expenditures may be explained by injuries caused or diseases obtained during a heavy flood.

Investigating potential risk mitigation strategies revealed that households with better educated household heads suffer less during flood events. However, this result does not necessarily point to a causal relationship, as better educated households might settle in locations of the village which are less likely to be flooded. While our data does not allow to control for such settlement choices on the micro-spatial level, our findings still provide valuable insights for future policy-relevant research on the effects of education on disaster resilience in rural Thailand. Moreover, our data suggests that only very few households are insured against potential disasters. Future research will help to investigate flood impacts and risk mitigation channels in more detail.

Authors: Zhuldyz Ashikbayeva, Marei Fürstenberg, Timo Kapelari, Albert Pierres, Stephan Thies

About the Barcelona GSE Master’s Program in International Trade, Finance, and Development

Brexit, digital money, and (Super) Mario, oh my!

Fall 2019 roundup of CaixaBank Research by Barcelona GSE alumni

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It’s time once again to check in with Barcelona GSE Alumni who are now Economists and Senior Economists at CaixaBank Research in Barcelona. As part of their duties, they regularly publish working papers and reports on a range of topics. Below are some of their latest contributions.

(If you’re a Barcelona GSE alum and you’re also writing about Economics, Finance, or Data Science, let us know where we can find your stuff!)


The «sense and sensibility» of the ECB’s communication

Gabriel L. Ramos ’19 (Finance) and Adrià Morron ’12 (Economics)

Communication is one of the most powerful monetary policy tools. For this reason, CaixaBank Research has developed an index to measure the sentiment of the ECB’s statements.Our ECB sentiment index shows a strong correlation with euro area economic activity indicators and foresees changes in the reference interest rate. The index notes a significant deterioration in ECB sentiment between late 2017 and Q3 2019 and shows how geopolitical uncertainty has affected the ECB’s view of the economic outlook.


The United Kingdom’s potential for Spain after Brexit

Javier Ibañez de Aldecoa ’18 (Economics) with Claudia Canals and Josep Mestres Domènech

In this article, we analyse the extent to which it will be more difficult for Spanish companies to establish relations for international expansion with the United Kingdom following Brexit. We use the CaixaBank Index for Business Internationalisation (CIBI), which classifies foreign countries according to the potential for internationalisation they offer for Spanish companies, and we analyse the impact of the four Brexit scenarios put forward by the Bank of England.


The e-monetary policy of the new digital economy

Adrià Morron ’12 (Economics) and Ricard Murillo ’17 (International Trade, Finance and Development)

Digital technologies permeate the debate on the future of the economy. Monetary policy and its main vehicle, money, are no exception. More and more products are sold over the internet and cash is used less and less. This new digital economy creates new demands on the financial sector and digital money emerges as a new means of payment that appeals to consumers. How does all this affect monetary policy? What can central banks do (and what are they doing) about it?


The farewell of (Super) Mario Draghi

Adrià Morron ’12 (Economics)

Mario Draghi ends his eight-year mandate at the ECB on October 31, leaving the central bank at the cutting edge of monetary policy. Under Draghi’s leadership, the ECB has offered significant support to the recovery of the euro area. However, the latest measures have raised doubts over the margin for action and effectiveness of monetary policy. Christine Lagarde, with a less technical profile but a vision of continuity in monetary policy, will take over in a sombre economic environment in which signs of fragmentation between ECB members have appeared.


Source: CaixaBank Research

Bank Interconnectedness and Monetary Policy Transmission: Evidence from the Euro Area

ITFD master project by Sofia Alvarez, Michael Barczay, Guadalupe Galambos, Ina Sandler, and Rasmus Herløw Schmidt ’19

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects. The project is a required component of all Master’s programs at the Barcelona GSE.

Abstract

Whereas monetary policy in the euro area is conducted by one single authority, the European Central Bank (ECB), the real effects of these decisions provoke different reactions among the set of targeted countries. One common explanation for this finding is structural heterogeneity across the members of the eurozone. The paper assesses how commercial bank interconnectedness – as a specific source of structural heterogeneity – affects the propagation of common monetary policy shocks across the euro countries between 2003 and 2018. While recent research has found that bank interconnectedness can counteract the contraction in loans resulting from a monetary policy tightening in the US, evidence on the effects in the euro area is scarce. The paper tests this hypothesis empirically by constructing a panel data set for the original euro area countries, creating a measure for country-specific bank interconnectedness, and by identifying an exogenous monetary policy shocks based on high-frequency data. Employing local projections we find evidence that – in accordance with the theoretical model we discuss – a contractionary monetary policy surprise leads to a reduction in the supply of corporate and household loans in countries with a low degree of interconnectedness. Conversely, when the banking sector is highly interconnected, the impact of monetary policy is reduced or even counteracted. This implies that a common monetary policy shock can have heterogeneous effects among countries of the euro area, depending on the degree of interconnectedness of their banking industries. These results are robust to the inclusion of a wide set of controls and alternative shock specifications.

Conclusions and Key Results

Standard theory, assuming that the balance sheet transmission channel is at play, suggests that an increase in the interest rate reduces the value of pledgeable assets held by firms and households. This reduction in the borrowers’ creditworthiness consequently induces banks to constrain their amount of lending. A higher degree of interconnectedness of the banking sector, however, makes banks less sensitive to changes in the value of the collateral posted by borrowers since loan portfolios can be traded among banks with different risk exposures. Thus, when banks are highly interconnected, the reduction of the loans supply after contractionary monetary policy is expected to be smaller and the effects of monetary policy are likely to be less pronounced.

The paper tests this hypothesis for the eurozone using local projections and a panel dataset of 12 euro-area countries in the period between 2003 and 2018. The eurozone constitutes an excellent subject to study: It exhibits significant variation of bank interconnectedness – both across time and countries – which makes the hypothesis of bank interconnectedness as a determinant of heterogeneous reactions to monetary policy particularly relevant.

The key findings of the paper are that interconnectedness is in fact an important driver of heterogeneity in the transmission of monetary policy in the eurozone. More precisely, the analysis shows that when bank interconnectedness is low, contractionary monetary policy leads to a reduction in lending. In countries with highly interconnected banking sectors, however, the paper documents that the impact of monetary policy on loans may be offset. Even more so, our findings suggest that the effect of monetary policy may even be reversed at certain points in time after a monetary policy shock (see Figure 1). More generally, these effects seem to persist for approximately 15 months and hold for both household and corporate loans. A potential conjecture for the observed increase in loans, when bank interconnectedness is high, could be that contractionary shocks induce lending from highly interconnected core countries to countries with low bank interconnectedness in the European periphery.

Additionally, higher interest rates may induce banks to increase the loan supply due to higher potential returns in a context of efficient risk-sharing. The analysis also suggests that cross-country variation of bank interconnectedness, in particular, plays an important role in explaining heterogeneous responses to monetary policy. Muting the cross-country variation, by contrast, delivers effects that are  still in line with the theory but which turn out to be statistically insignificant. In other words, accounting for cross-country heterogeneity is essential. Moreover, employing alternative specifications, the results are found to be robust to using alternative shock measures, including additional controls, and excluding outliers.

Figure_1
Figure 1: Impulse response of total loans to a one basis point increase in the monetary policy shock variable (Red: Low bank interconnectedness, blue: high bank interconnectedness)

Using our estimates to predict the country specific responses to a monetary policy shock, we show that countries are expected to react very heterogeneously. While Greece, for instance, is predicted to experience a contraction of loans after an interest rate hike at its 10th, 50th, and 75th percentile of bank interconnectedness, the effect of  monetary policy is almost completely offset in Germany or Austria (see Figure 2).

Figure 2
Figure 2: Implied heterogeneous responses after 6 months to a common monetary policy shock of 1 basis point by each country’s degrees of interconnectedness

In sum, the analysis contributes to the understanding of how monetary policy is transmitted across countries in the euro area. The paper shows how heterogeneous responses can be explained by the variation in countries’ individual levels of bank interconnectedness. Furthermore, it provides a potential explanation for why recent research has found rather modest responses of the loan supply to monetary policy. Such observations appear inevitable given that many countries display levels of interconnectedness at which the reaction of loans to monetary policy is predicted to be only small or even nonexistent. Only by incorporating interbank lending into the analysis, sizable effects of monetary policy become apparent again. 

Authors: Sofia Alvarez, Michael Barczay, Guadalupe Galambos, Ina Sandler, and Rasmus Herløw Schmidt

About the Barcelona GSE Master’s Program in International Trade, Finance, and Development