By Paolo Garonna, Professor of Political Economy, Luiss Guido Carli University of Rome
As time elapses after the turbulence and bank “non-crisis” of mid-March 2023, a more comprehensive and in-depth reflection is warranted on the strengths and vulnerabilities of the financial sector and their impacts on the real economy. International and national financial communities are already at work on the lessons learned. Loopholes and fragilities in regulatory frameworks and supervisory practices are being looked at carefully and corrected to the extent possible. In the context of growing interest rates and quantitative tightening, the treatments of unrealized losses (whether held to maturity or not), uninsured deposits and exposure to the confidence crises of mid-sized territorial banks have proven to deserve much more scrutiny than in the past from legislators and supervisory authorities. What looks reassuring is the capacity shown by governments and regulatory authorities, notably in the United States and Switzerland, to react swiftly and firmly to prevent contagion.
Moreover, existing frameworks proved sufficiently robust and flexible to enable the adoption of the needed corrective measures, including exemptions, exceptions and creative ad hoc solutions. Market confidence seems to rely more on the authority and credibility of the supervisory institutions than on the exhaustiveness and watertightness of the rules of the game. In a famous quote by economist Paul Samuelson, repurposed and extended by Stanley Fischer (former vice chairman of the Federal Reserve), we read: “I’d rather have Bob Solow than an econometric model”.1 Or, we might say, it is better to have credible authorities than all-encompassing, minute regulatory arrangements.
That is particularly so considering the growing number of black swans that have appeared on the horizon and may lie ahead of the curve. Europe is relatively more vulnerable on this score, with its still incomplete banking union and a Capital Markets Union (CMU) characterized by a baroque and fragmented supervisory architecture. But, as Samuelson added, “I’d rather have Bob Solow with an econometric model than withoutone”. So, we should welcome all efforts to improve regulation and supervision, be they targeted at non-banks, crypto-assets or liquidity provisioning.
However, in my view, one aspect has not been dealt with sufficiently: the impact of confidence shocks of the kind we saw recently on the real economy and specific sectors of the real economy. Some mention was made of commercial real estate and other possible bubble areas. But what about innovation and research financing? Was it simply accidental or a matter of idiosyncratic malpractices that caused the problems at Silicon Valley Bank (SVB), Signature Bank, other banks operating in advanced innovation and technology hubs? Until now, those areas were highly praised and pointed at as models of successful performance, and their “financial ecosystems” were viewed as essential factors in their extraordinary successes.
The unique mix of Ivy League universities and research centers, high-quality and well-capitalized subcontractors, links with global value chains, their capacities to attract brain power and so on was only part of the story of their glowing worldwide reputations. Another fundamental and recognized component was the high concentration of venture capital and venture debt, deep and liquid capital markets, private capital and specialized regional banks—in sum, an advanced financial ecosystem that gained widespread admiration and envy throughout the world. So much so that promising start-ups and scale-ups from Europe and elsewhere often went to Silicon Valley and the United States to receive support and finance and reap the full benefits and opportunities to succeed and prosper.
Why was this specific sector, the “dream financial microcosm”, so severely hit? And to what extent were the remedial actions—the stopgaps that were introduced and the ad hoc solutions adopted—able to address the underlying vulnerabilities? And how can and why should we safeguard or reconstruct the wonder worlds of creativity and innovation that mainstream narratives have described and associated with Silicon Valley and other innovation hubs?
To respond to those questions, we should address a much bigger and more structural issue that concerns both finance and the real economy: that of financing research and innovation. The latter is a quite peculiar sector of the economy. Lato sensu, research and innovation are embodied in many, if not all, successful outputs and outcomes of an advanced economy, since in most product and process innovation, as well as in high total-factor productivity (TFP) environments, there is an element (implicit or explicit) of research and creativity. Stricto sensu, research is an activity that carries high costs and risks and requires sophisticated infrastructures, which few private commercial activities can afford. In most parts of the Mittelstand (the small and medium enterprises sector), we find, therefore, “innovation without research”—i.e., innovation that relies on tacit knowledge and incremental improvements rather than formal inputs of expertise and experimentation. But it is well known that this kind of innovation, albeit important and creative, is not what explains the technological leaps and ruptures that have changed the world and will change it in the future; it was not the gradual and sophisticated improvements in horses and carriages what brought about the revolution in transportation determined by the internal combustion engine and automobiles.
In economic terms, this means that in “research and innovation”, there is a fundamental component of public good (think, for example, of the features of non-rivalry and non-excludability of this kind of output), which has significant implications for financing. It would not be enough, and it may even be impossible, to provide funding for the one-in-a-thousand (or one-in-a-million) breakthrough business ideas or inventions that will revolutionize the market and the economy. Finance must reach out and provide funding to a complex and varied milieu that enables creativity and, through trials and errors and “crazy experimentation”, produces the ideas of the future.
In other terms, the whole ecosystem of an innovative knowledge economy and society must be created, and such a world must be supported by a complex and varied ecosystem of finance. This ecosystem obviously must have both public and private components alongside public and private investments to cater to basic and applied research, private and public initiatives and public-private partnerships. And not only that—even more important is that such an ecosystem is capable of synergizing the different components so that public investment crowds in private investment, promotes applications and technology transfers, and triggers virtuous circles of catalytic and multiplicative dynamism. In other words, the secret to the success of the financial ecosystem of research is “blending” rather than segregation. Think, for instance, of the role of public guarantees on student loans in encouraging meritocracy through university financing. Or consider the experience of the Germany-based Fraunhofer-Gesellschaft institutions, whereby financing arrangements see governments supplying loans and equity while leaving the responsibility for decision-making to private sectors and communities of scientists.
The fact that research is (also) a public good and must therefore be financed (also) by public sources appears from another aspect, which is a typical feature of public goods: underinvestment in research. The market alone, particularly the market for ideas and innovation, does not produce sufficient incentives and motivation for research activities. Typically, investment in research is the first to be sacrificed in downturns, and it is the last to recover in upswings. But the consequences of the public-good nature of research are most visible and concerning in the long run, given the significant negative impacts of underinvestment in research on growth, productivity and employment rates.
A comprehensive analysis of secular trends and equilibrium in economic growth and stability in advanced countries points out what we might call an “impossible trilemma”: We cannot have at the same time and to the same extent disinflation, financial stability and sustainable growth. We face inevitable trade-offs and constraints in balancing policy tools and targets and pursuing what are certainly all desirable policy objectives taken by themselves, but that cannot be achieved simultaneously in the short term and with a given technology. Does this mean that if we focus, as we should, on fighting inflation and safeguarding financial stability, the inevitable consequences we must face are secular stagnation and near-zero or negative equilibrium real interest rates? No. We know very well that technology is not a given, that technological change and innovation have the power to move the trade-offs and loosen the constraints, and that technological change and innovation depend on investment in research. Investment in research, therefore, means aiming at modernization, productivity and welfare in the long run and making our economies and societies more resilient and economic growth more sustainable. Investing in research goes, therefore, to the heart of any “new deal” or ambitious plan for the next generation.
An appeal in that direction was launched and signed by several prominent scientists in what was called the Amaldi Plan or Manifesto for more investment and financing in research. The Plan released in 2021 at the peak of the coronavirus crisis urged more funding for research at national and international levels. It was underwritten by many scientists and researchers and attracted considerable interest and support in the community of researchers and scientists, the policy world and public opinion. But so far, little concrete and significant follow-up has been achieved. It suffices to look at the still marginal role of research financing in both the Inflation Reduction Act of 2022 (IRA) in the US and its counterpart, the Green Deal Industrial Plan, at the European Union (EU) level. Rather than engaging in protectionism and wasteful industrial subsidies, financing research—including public-private partnerships and international cooperation—promises to provide the best opportunities and enhance stability and growth at national and international levels.
To conclude, an appropriate response to the spring 2023 bank turmoil, in terms of mending the cracks that have appeared in financial regulation and supervision, is certainly necessary. But it is equally important to review in depth and strengthen the financial ecosystems underpinning research and innovation, thereby bridging the financing gaps in the knowledge economy and society.
1 Board of Governors of the Federal Reserve System: “I’d Rather Have Bob Solow Than an Econometric Model, But…,” Vice Chairman Stanley Fischer, Speech at the Warwick Economics Summit, Coventry, United Kingdom, February 11, 2017.