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Putting academic theory into practice is key if economists are to play their part in securing stability, says Lucrezia Reichlin
As a Professor of Economics at London Business School, Lucrezia Reichlin is regularly asked the same question: is another financial crisis on the horizon? But she’s the first to admit that she and her fellow economists deal in probabilities, not certainties – and no one can see around corners.
“Economists didn’t forecast September 2008 because they didn’t see the accumulation of risk building up,” she says. “We all bear responsibility for that, but that’s not really a matter of forecasting – it’s understanding what’s going on at present.
“At the time, the importance of the interaction between financial markets and the real economy wasn’t well understood. There’s more awareness now, though we are perhaps underestimating risks that are different from the ones we’ve seen in the past. Crises happen. We need to think about crisis management.”
Reichlin’s observations are based on more than academic theory. Before becoming Chair of London Business School’s economics faculty in 2008, she was Director-General of Research at the European Central Bank (ECB), with responsibility for divisions covering forecasting, monetary policy and financial analysis.
During her four years at the ECB in the lead-up to the great financial crisis, she saw monetary policy and the role of the central bank shift. More dramatic changes have occurred since.
“Over the past 10 years, monetary policy has done a lot in trying to stabilise the macro economy and financial markets, with the result that central banks have become extremely powerful with large balance sheets,” Reichlin explains.
"A financial asymmetry exists between the US and the rest of the world because the dollar is at the centre of the financial system"
“But the nexus between monetary policy and inflation seems to be broken. I think one reason is there’s a lot of risk aversion around. A lot of liquidity doesn’t find its way through to the real economy.”
Monetary policy has helped by easing financial conditions, but Reichlin warns that this also has side-effects. “In some places, they’re experimenting with negative interest rates, but that creates distortion in financial markets. There’s this paradox that a lot is being done, but it doesn’t seem to have much effect on inflation or expectations of inflation. It’s important to understand the formation of expectation, which is one area of my research.”
From her earliest days, Reichlin, now 65, was politically motivated and driven by a desire to affect change. She considered history for her undergraduate degree, but opted to study economics at the University of Modena because she felt the subject had greater potential to engineer social progress. After graduate school in New York, she specialised in econometrics while teaching at the Université libre de Bruxelles.
She soon put this relatively abstract subject to practical use when she developed a form of short-term forecasting based on real-time data while working at the Federal Reserve in Washington in the early 2000s. Operated by a company called Now-Casting Economics, still run by Reichlin, the model is in use today by most of the world’s central banks.
Reichlin’s determination to see the practical application of ideas in the real world is hardly surprising. Her parents were prominent left-wing politicians in Italy and her mother was a member of both the Italian and European parliaments. Strong female role models run in the family. Her grandmother set up her own real-estate business in Rome at a time when a woman’s place was still considered to be firmly in the home. Reichlin has an adopted Chinese daughter who is studying at university in the US. She adds: “I come from a matriarchal family with a mother who was active in all kinds of things and a grandmother who was very strong.”
Reichlin is a pioneer in her own field, being a successful woman in the still male-dominated world of economics. However, she points out how much things have improved since she started out. She recalls one symposium in the Eighties where she was the only woman attending and was in high demand as a dance partner at one of the evening events. She believes economists can still be in danger of appearing out of touch – and crucially she feels this can have a material effect on their work.
She says: “There are many things economists don’t understand. They don’t understand how expectations are formed and they don’t understand the implications of financial frictions. That’s true of all of us. Textbook models can’t take into account a lot of the things we’re observing today, which is why empirical research is essential. But, at the same time, it’s important we look at theory without getting caught up in a purely self-contained academic world.”
The theme of the practical application of academic reasoning and the need for thinkers to ground their work in reality is one to which Reichlin frequently returns. Explaining the complexities of economics has become a passion for her as she has progressed through her career and she now writes regular newspaper columns about economic issues.
“I’ve become much more interested in communicating with the public at large by writing for newspapers,” she says. “Communication is very important and I think business schools have a role. We teach people who don’t necessarily have a background in economics, but we still have to communicate the big problems to them. We’re educating potential future leaders, but I think we could play a part in demystifying things for the wider public.”
As well as her academic work, Reichlin sits on the boards of several European banks. She is also in the process of writing a book about the ECB. “Diversification is important,” she says. “I think it’s a great privilege of becoming older that you can have a bit more freedom.”
A key concern of Reichlin’s book is how the central bank has changed and where it is headed. “In the Nineties, there was a consensus that you had central banks with a narrow mandate in terms of price stability,” she explains. “They had to be independent institutions and they didn’t mess around with fiscal or financial policy. But when the crisis came it blew apart that distinction. The central bank started to address monetary policy and financial stability to support states in a sovereign debt crisis.
The ECB, like other central banks around the world, has experimented with new tools, such as asset purchases, quantitative easing, negative interest rates and the like – in an attempt to influence the position of the markets.
"If there is another crisis, will central banks be able to cooperate in order to provide dollar liquidity to banks, as was the case in 2008?"
“This is all new. Particularly in Europe, one has to ask if the Maastricht Treaty is still a sufficient framework to continue to guide us. Should we be rethinking the ECB’s formal mandate and what is needed now to provide financial stability while maintaining democratic accountability?”
In the rare moments between these competing professional commitments, Reichlin tries to find time to tend her garden at her home in north London and to read. This summer she enjoyed the Italian bestseller M, Antonio Scurati’s fictional account of the rise of Mussolini. Whenever possible, she also runs, skis and swims.
“I did a lot of swimming when I was younger, but now I only get to swim when I go to Sicily,” she says. Although she was raised in Rome, Reichlin has strong Sicilian ties, not least through the Ortygia Foundation, an educational institution she set up on the island in 2013. She explains: “I always thought that the south was important for the development of Italy and it gets forgotten. The south of Italy is relatively poor in relation to the rest of the country and education there is weak. A lot of people leave to study and simply don’t come back.”
She chose Ortygia on the east coast of Sicily for its Baroque beauty, history and location. She adds: “It’s a very beautiful place and where Archimedes was born, which has a strong resonance. But it’s also facing Africa, so I liked the idea that it was a bridge across the Mediterranean.
The foundation has a very broad mandate in terms of education, but we also do work with refugees, which is very relevant to that part of the world. The school does some executive education and what we earn from that goes into the foundation, which is purely non-profit. The idea is to create a network, with the hope that the alumni can be used as mentors for kids from local schools.”
Returning to the possibility of another economic downturn, Reichlin believes progress has been made since the last crisis, now the ECB has responsibility for banking supervision. But she fears unpredictable global factors that have emerged in recent years could stymie institutions’ best efforts to maintain financial stability.
“No matter how good your supervision, a crisis can still occur,” she muses. “And there’s an international dimension. If there is another crisis, will central banks be able to cooperate in order to provide dollar liquidity to banks, as was the case in 2008? Even then, one of the reasons the euro area ended up worse than the US was because fiscal policy wasn’t in tune with monetary policy. We need to consider how we can construct governance so central banks remain independent while still cooperating with fiscal authorities.”
Reichlin sees a threat to the current multilateral framework that enables cooperation between different countries and central banks: “Trump is attacking his own central bank and the principle of the independence of the Federal Reserve. Against that backdrop, if the Bank of England or the ECB needs dollar liquidity in due course, who knows?
“We need a safe, cooperative framework that provides stability. We’re financially integrated, but a financial asymmetry exists between the US and the rest of the world because the dollar is at the centre of the financial system.
“This is all part of the discussion about how we should be preparing for the next crisis, whenever that happens. In the end, all economists can say is be careful. But, ultimately, it’s a political question.”
Lucrezia Reichlin is Professor of Economics at London Business School and was Director-General of Research at the European Central Bank between 2005 and 2008. She is one of the pioneers of econometric modelling and is the founder and Chair of Now-Casting Economics, which delivers short-term forecasts for the world’s major economies.
“We crave certainty. We look at forecasts and we want them to be right. We want to trust them. And when forecasts – of the weather, next year’s inflation rate, the outcome of an election – turn out to be wrong, the public feels let down. Forecasters are ridiculed.
People may want something certain but, to be realistic, they’re not going to get it. So, should we give up? If we can’t have confidence in predictions, does that make them useless?
It’s true that forecasts that try to predict with confidence how things will look in the medium term – say, two years ahead – are likely to be wrong. Or rather, the margin of error is likely to be so large as to make the forecast almost meaningless. But that doesn’t mean that economists shouldn’t try and create the forecasts in the first place.
I believe the process of forecasting is useful because of the rigorous framework it creates for institutions, such as central banks and other influential financial organisations, to try to answer various ‘what if…?’ questions and test the different possible outcomes and what policy moves could respond to different economic scenarios.
In the end, there are likely to be too many external variables over which the central bank has no control which will affect the result. But that doesn’t stop the forecasting process from being useful from an internal perspective, creating the discipline to keep abreast of the relationship between key data sources. For example, are exchange rate predictions consistent with what is being forecast for inflation? We know from the past relationship between these variables, among others, that there must be coherence.
Constructing an economic forecast forces the discipline of bringing these data points from different sources together so that policy-makers, investors, businesses and individuals are as prepared as they can be for the possibility of different economic outcomes. Even then, there are huge uncertainties. But one key element of the whole process – and perhaps one which the public doesn’t fully appreciate – is that forecasts typically acknowledge the intrinsic uncertainty baked into their DNA.
The external variables are based on approximations, and then of course the relationship between different variables is going to be unstable – and the further ahead the forecast, the greater the uncertainty.
It is possibly this element of forecasting that the public doesn’t properly understand and helps to explain why forecasters get such a bad press. And it’s fair to say that as forecasters try to look further and further into the future, their predictions become ever more uncertain. For example, an investment bank may predict that China will become the world’s largest economy in such-and-such a year. Well, maybe, maybe not. This is the sort of forecast that makes a stab in the dark look like laser surgery. That still doesn’t mean those forecasts aren’t useful, but to rebuild public confidence in forecasting generally, it could be helpful if the forecasters were clearer about the variables and approximations they used to create these stories about the far-ahead future.
The principle of ‘nowcasting’ has been used for a long time in meteorology, but I became interested in it from an economics point of view while working at the US Federal Reserve in the early 2000s. The methodology draws from a much wider data pool, published at higher frequencies, than forecasters used previously.
With nowcasting, the idea is that using hard and soft information that tends to be published regularly, like industrial production surveys and even real-time data, will provide an early indication of the current developments in economic activity and so can quickly flag when things take a new turn.”
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