Exclusive: Credit crunch hits economics research at ECB

The credit market crisis of the past year is prompting the European Central Bank to re-think some of its priorities for basic economic research, bank officials say.

Higher-priority research topics include studying how inter-bank credit markets work, and how instability in the financial market can affect the broader economy, officials said. The ECB studies such matters with an eye to improving its models of how the economy works, and its management of monetary policy.

“I’m pretty sure that over the next one to two years there will be lots of research coming out on the episode, on the working of financial markets, to better understand and draw some implications,” said Frank Smets, ECB deputy director-general for research, in an interview. While he doesn’t expect a bigger research budget for that work, “I think what we’ll see is a redirection” of existing funds.

The crunch also identified, in the words of ECB Executive Board member Jürgen Stark, “a number of lacunae” in the bank’s statistics, such as data on how credit risks get transferred among financial institutions. Speaking at an ECB conference this Spring, Stark said the episode demonstrates “that banks play a distinctive role in creating ‘monetary liquidity’ that, in turn, is an important determinant of developments in credit and asset markets, in the evolution of the economy and ultimately of price dynamics.” The ECB is studying ways to get additional data on financial institutions and markets, in collaboration with the 15 euro-zone national banks and other official agencies.

The ECB’s priorities for research and statistics are vital, though seldom seen, aspects of the bank’s influence in the euro-zone economy. Its own staff is relatively small – its research directorate-general, for instance, has just 58 employees, of whom 45 have PhDs. But their priorities simultaneously reflect and influence the interests of the economists and statisticians at its 15 member banks and the European Commission – and also influence the networks of academic economists across Europe who collaborate on ECB-inspired research. Ultimately, some of this research feeds into the bank’s computer models of how the economy works, helping the bank make forecasts and calculate what-if scenarios.

The credit crunch – triggered in August 2007 by a rash of defaults in so-called sub-prime mortgages in the US housing market – took central bankers by surprise around the world. Even before the extraordinary events of the past week it had set off a run on a major British bank, Northern Rock; forced a distress sale of one of Wall Street’s stalwarts, Bear, Stearns & Co.; knocked holes in the balance sheets of several European banks; and pushed up lending costs around the world as financial institutions grew wary of defaults.

Then the crisis appeared to have passed, overtaken by rising inflation and slowing growth as top financial-market worries. But in recent weeks it has come back, with a vengeance, forcing a US government bailout of two federally backed mortgage-finance companies, the takeover of Merrill Lynch, the collapse of Lehman Brothers, federal life support for US insurance giant AIG and the merger of the UK’s HBOS with Lloyds Bank.

According to Stark, speaking at the ECB conference, the bank has identified four areas of research to enhance its monetary analysis:

• Refining its equations for understanding demand for money, to better explain monetary developments over the past few years.

• Improving money-based indicators of inflation, to understand longer-term cycles.

• Improving its fundamental models of the euro-zone economy

• Developing tools for cross-checking monetary scenarios, using integrated Eurozone accounts (i.e., playing “what-if” games with the data.)

Related research topics at the bank include studying the “operational system.” Understanding how ECB actions affect the money supply has always been important, but the turmoil raises more questions on how the inter-bank market works, how the ECB organizes its auctions – and how the system in Europe connects to and compares with the banking systems in other parts of the world. One research topic now under study, for instance, is how the “spreads” – or price differences – widened between secured and unsecured loans.

“What’s clear from the turmoil is that the interest-rate channel may sometimes be impaired and you have widening spreads, and it’s important to incorporate that into our models,” says Smets.

Another research topic given added weight by the market turmoil is studying how financial and monetary stability affect each other. For instance, the ECB recently published research on how a low interest-rate environment can lead lenders to loosen up on their acceptance criteria – i.e., cheap money can feed the kind of low-quality lending that created the sub-prime mortgage crisis. The research was in Columbia, because the lending data was exceptionally good there for analysis. A similar study of the Spanish corporate credit market was also conducted.

The ECB’s main computer models date to shortly after the euro’s formal launch as a paper currency, in 2000. Generally, they use standard macroeconomic formulae – and the bank is now assessing ways to incorporate more-recent research, such as behavioural economics. For instance, the bank has been trying to quantify what happens when investors “learn” and adapt to a particular market environment, leading to higher volatility or higher prices than conventional forecasts would expect.