MGI Research

Forward Thinking on the rollercoaster of central banking with Hans-Helmut Kotz

In this episode of the McKinsey Global Institute’s Forward Thinking podcast, co-host Michael Chui talks with economist Hans-Helmut Kotz. He is a visiting professor of economics at Harvard University, a senior policy fellow at the Leibniz Institute for financial research at Goethe University, Frankfurt, and on the economics faculty of Freiburg University. He is an MGI adviser. Kotz covers topics including the following:

  • Parallels between the 2007–09 global financial crisis and today’s financial turbulence
  • The balance that banking regulators need to strike to protect the economy but encourage innovation
  • Being prepared by taking eclectic perspectives

Michael Chui: Janet, have you ever watched the movie It’s a wonderful life?

Janet Bush: Yes, I think it’s probably on every Christmas in Britain. And I am now thinking why it’s asking me it’s not Christmas. Ah, I know, it’s because there is run on a bank, right?

Michael Chui: That’s exactly right and we have just the person to discuss this and many other topics related to the role of banks in the economy.

Janet Bush: I can’t wait to hear him.

Michael Chui: Hans-Helmut, welcome to the podcast.

Hans-Helmut Kotz: Great to be with you, Michael.

Michael Chui: Let's start at the very beginning. You have all of these roles where you're able to do research and teach. But how did it get started? Where are you from? What did you study in school? And how did you end up where you are today?

Hans-Helmut Kotz: I'm from a region in Germany pretty close to the Luxembourg–Belgian–French border, which gives me a major advantage. My dialect, my mother tongue, is Luxembourgian, which is a different language, by the way, from German.

What I did between the age of six and 18 was mainly playing what Europeans call football. But we had a very demanding school, nonetheless. It was a little bit of a backwater part in terms of its economics. But we had a very demanding school, and it got me, very early, interested in what Americans now call “place-based policies”—so, regional economics.

That's what I found always interesting: “Why do regions have difficulties? How can one help regions?”

At university, I got fascinated, for a funny reason, in monetary theory, monetary economics. I was taking notes for my fellow students, and it got me hooked. At the time, this was mainly about macroeconomics in terms of monetary theory or monetary policy.

We used US literature, names nobody knows anymore—Gardner Ackley, [William C.] Brainard, Rüdiger Dornbusch, and Stanley Fischer and others. Really great textbooks. And working on that substituted for my incapacity to be a professional football player.

Ever since, I've been very much interested in these issues. Also, teaching them for quite a long while, because the best way to learn is to teach.

Then I was, for a very long time, 16 years, in a bank. That was a bank which had a pretty large balance sheet, not many employees. It was a wholesale bank, and it was mainly about fixed income and public-sector credit. It was one of the ten largest banks in Germany, and I was, very early on, chief economist.

I stayed there until 1999, when I moved on to become president of what one calls, in Germany, Landeszentralbank, which is something like a regional federal reserve, if you like.

And I've been fighting, by the way, having lots of arguments during my time as a chief economist with Bundesbank. I have never shared the Bundesbank philosophy, which was about money supplies driving inflation and nothing else, which was deeply flawed if you might think of it, for example, in the wake, in the upshot of the Great Financial Crisis, when central banks’ balance sheets exploded.

What happened to inflation between 2009 and 2020? We were very much worried about deflation, actually. I enjoyed discussions with friends at the Bundesbank and became, then, part of Bundesbank as president of a regional central bank.

The region has about 12 million inhabitants and had, at the time, 350 banks. Boring. That's Germany. Boring banks. So, public-sector, cooperative-sector, and some very interesting private-sector banks. I wasn’t in charge of the boring part, but I was always involved in some trouble. That gave me lots of learning opportunities about banking.

In 2001, I moved on to become a member of the board of Bundesbank. And there, I was really in charge of the “boring” stuff, namely IT, and the operation of monetary policy, which should be boring. You don't want to be in the news because IT is not working. Or you don't want to be in the news because the stuff which nobody cares about, providing liquidity for the banking sector, is not working. Turned out this became a very hot topic in 2007. So the boring part became, unfortunately, non-boring.

Here, I do think it's important to refer to how to figure out what policy makers should or would like to do. You have to refer and rely first on data and secondly on analytics theory.

Michael Chui: If you just remind us what was happening in 2007, when it suddenly became exciting.

Hans-Helmut Kotz: Let me talk about what was happening in my little country. There was a bank which was deemed to be boring. They were mainly funding, giving loans to robust German hyperspecialized SMEs.

They had a great asset side, seemingly. And they actually had a return on equity, at the time, of above 20 percent, which was seen as brilliant. They were lauded in the media in mid-July. End of July, suddenly it turned out they were in deepest trouble, because they had been investing in a leveraged way, using all sorts of nice gimmicks. We have, meanwhile, forgotten all the acronyms they were throwing around at the time.

They were in deep trouble because one of their major providers of liquidity was not prepared to roll over. There were so many who were investing in these assets who, by the way, had ratings of AAA. And you should know that in the real economy, a very low percentage point, at that time, had AAA ratings—in the corporate sector, about 3 or 4 percent. Any idea how many of those structured products had AAAs, Michael?

Michael Chui: I don't know.

Hans-Helmut Kotz: Go high.

Michael Chui: Sixty percent.

Hans-Helmut Kotz: Plus ten, then you're right. Ten percentage points. Seventy percentage points. And that's where theory comes in.

You could have taken two views on what was going on there. One view, Nobel Prizehonored, was, “This is an issue where information is not distributed in a proper way. Give the market some time to sort it out, and you find a nice, new equilibrium.” The great Joe Stiglitz, and [Andrew] Weiss, and others. Great idea.

The other idea would have been, “This is a run. This is a reluctance to roll over and a massive incentive to run away.”

We took the view “it’s a run.” And it's a run not of Michael and Helmut running to his bank in California to draw out money because somebody who's much more knowledgeable and intelligent than we are is doing it. No. It's a run of big institutional investors who declined to roll over.

The question is, “How can you deal with it?” And what was done at the time was that the ECB [European Central Bank], before anybody else—I repeat, before anybody else—added liquidity, on a massive scale, to the system. And the response to that was remarkable.

A UK paper with a journalist whom I really like, normally, wrote, “The ECB is panicky and hyperactive.” Panicky and hyperactive. Six weeks later, everybody was doing it. And, of course, liquidity from then on was given in more than ample amounts, because the interbank money market, stuff nobody cared about before, imploded. It's still on the balance sheet of the ECB, so much of the intermediation process is now on the balance sheet of the central bank because the trust between banks has evaporated.

Michael Chui: Still, to this day?

Hans-Helmut Kotz: It is. Much of that at the time was non-collateralized, without any backup. Now you have some collateralized part, but much of the banking is coming by central banks. It was terrible at the time.

Trust and liquidity was, at that time, incredibly fragile. A major reason, by the way, why capital flows internationally went down. Half of the reduction in capital flows is interbank money markets within Europe.

That's the crisis I'm thinking of when I'm thinking of what we see now or what we see currently. This phenomenon of stuff you should have seen before. Not many saw it before. And after the fact, everybody—“Well, we all knew that subprime was subprime.”

Well, that’s not completely fair. Those great economists like Robert Shiller of Yale. Karl Case, John Quigley. They’d done a study which was published in 2004 in Brookings Papers on Economic Activity on the expectations of those people buying homes in a few regions in the US. And the expectations were just beyond physics. And that gives you sort of an alarm bell.

We actually did the same. We copied and replicated the same work at Bundesbank at the time—strongly criticized. But after the fact, everybody knew. Everybody, anybody, and his brother, and her sister knew.

That's the important distinction: ex post versus ex ante. And to have an idea about ex ante, you don't need only data, measurement without theory. You need understanding. And understanding comes in varieties. You don't have one model only.

You try to be eclectic, to think about different scenarios. That's the link to today. The idea that if you have long-duration assets, a hike in interest rates will impact economic value—not accounting gimmickry but economic value—is so old. You might have wished to think about that in scenarios ex ante.

Michael Chui: Let's talk about today. As we sit today, there've been a couple of midsize banks that have failed in the United States, to much publicity. And, as you described it, some of the challenges have been around some of the long-duration assets that they held and interest rates that have been increasing.

But as you also said, shouldn't we have thought about that? With that said, if I think about the past decade or so, people have asked, “Will interest rates go up? Will inflation accelerate?” And it just hasn't. And so, how should the decision maker, whether you're the CEO of a bank or a regulator, think about that? Because you've seen these people talk about it for a long time, and then in a long time, it just never seemed to arrive. And then it did. What's the way to think about that?

Hans-Helmut Kotz: Inflation turned out to be nasty, really nasty, beginning sometime in 2020, 2021, when there was debate about Team Temporary, to which I belonged, still belong, and Team Permanent. And what is interesting is to see now, coming up, different views on models, on interpreting the data.

The old-fashioned model was money supply. If money supply goes through the roof, inflation goes through the roof. Didn't happen. Then you had other ideas. Too much demand. We call it demand pull. Third idea was cost push. Costs increasing because of all of these bottlenecks.

A very old idea, which had been forgotten for 30 years, was demand shift. During COVID, we suddenly all shifted to real stuff, now shifting back to services, supply chain constraint. A fourth idea, now, coming up, is about conflict between those who have a claim on the product, claiming more than the product can deliver.

Just recently, a paper came out by Iván Werning and a colleague from MIT, [Guido Lorenzoni], just a few days ago, taking up this idea about social conflict. By the way, a very old idea. A famous American economist—at that time, a famous American economist; nobody knows him anymore probably—Martin Bronfenbrenner, made exactly this argument. Inflation as a device to deal with conflict in claims on a product. He called it inflation as a “social mollifier” in the '50s.

And there was another idea, by Bob Rowthorn, a heterodox economist, to which Werning refers in his paper. This is a conflict about labor, entrepreneurs claiming more than the product delivers. The security valve is inflation.

So here we are. We have lots of different theories.

Talking of Europe, for example, there are environments where you have ways to deal with inflation which are very different across European countries. Let me give you an example. Currently, you have the lowest inflation rate in Luxembourg (3 percent), highest inflation in the Baltics (between 15 and 17 percent). They are faced with the same money supply. They don't have a central bank. Very different inflation rates.

Why? Well, very different fiscal policy responses. Basically no cushioning in the Baltics, very substantial cushioning in France and Spain, not so much in Germany. In other words, in understanding these data, you have to think about the institutional context about what one could call industrial relations, wage negotiations. If you have very strong labor unions calling for compensation, they are not calling for more. They are actually accepting real wage cuts.

In other places, you don't have them. That immediately means inflation divergence. And I think that's one of the beautiful ideas which Jim Tobin developed. Jim Tobin spoke of what he called a “common funnel.” Wage policy, fiscal policy, monetary policy work together, interacting together. And the upshot is some sort of inflation, which is different across economies and time.

Michael Chui: I'm very curious, though, because as you were telling your personal history, you talked about place-based views. And yet, as you know, you went into central banking and monetary policy. In many ways, that's the furthest from being very place-based, because those policies affect whatever the currency applies to.

What's interesting is what you just described, is that you can still have place-based policy that are often fiscal in the individual places. And that can actually have an effect on local inflation rates. Is that where those things intersect?

Hans-Helmut Kotz: Perfectly right. The Fed was discussing its new strategy in 2018, 2019. And they've been looking at regional developments, how they interact with fiscal developments. And that's pretty close to banking structure, pretty close to the importance of small and medium-size banks for the financing of small and medium-size firms in this economy.

They don't have access to capital markets for a good reason: much too expensive, too low volumes. The same held true with European central banks. Bundesbank did it. There's an interaction between money, credit, banking, and regional development.

Much of the capacity of the Northern European economies to adjust to shocks has to do with their access to local banks. And the discussion about credit crunches never really took hold in those economies where you have a banking structure which is close to the locals, which also means that there's much less of a concentration than you have in economies where the overarching funding resource is capital markets, because they cater to the big ones by necessity.

Michael Chui: You've been describing some of the benefits and having small and medium-size banks, but there's been a discussion here in the United States. If, in fact, there are large institutions which are too big to fail, and you're a depositor, well, won't all deposits flow there, as opposed to small and medium-size banks for whom that implicit or explicit backstop doesn't exist?

There are, of course, some markets—Canada, for instance—where it is primarily a small number of very large banks. Do those market suffer, or do those economies suffer, for the lack of these small and medium-size banks?

Hans-Helmut Kotz: Ah, that's a good point, a good push. If the two of us are depositors, and we are beyond the threshold of the FDIC [Federal Deposit Insurance Corporation], and we see anybody running, and everybody, be it money market funds or the bigger ones, there's a good reason for doing that.

The question is, while that is individually rational, does it add up? Is it, from a societal perspective, beneficial? And the societal perspective is not only about the liability side of the bank balance sheet. “The Lord gave us two eyes [to watch both demand and supply],” to cite one of my heroes, Paul Samuelson. We also would like to understand what's happening on the asset side.

That was the point I wanted to make. Small and medium-size banks, local banks, are important for local industry in many places of the US. So there's very much a regional dimension to it, which only underlines your question. How do we deal with the fragility of the liability side?

Now let me give you a reason why you do not see that in the European case. In the German case, you have savings banks. They have an association, which deals with all the economics of large scale, as well as economics of network, so that while they are independent in terms of deciding what they do on the liability and asset side, much of the back office is run as if it were a large institution.

They have one IT infrastructure only, meaning you really capture all the economies of scale you can. And that gives some sort of solidity to them. The fragility on the liability side doesn't arise, because one sees they are highly effective, highly efficient in terms of cost. But they also deliver on the asset side while running with rather slim margins. This is terrible for banks in Germany. It's really terrible.

Michael Chui: You mean banking shareholders?

Hans-Helmut Kotz: You somehow have to find a balance. But it's nice for customers, nice for clients. They have low user cost of capital. But exactly, precisely those banks who delivered on those claims did what in crisis times? They were technically bankrupt. So they were in need of “too big to fail.” They were in need of subsidies. At the end of the day, they are, again, state-owned banks.

The issue is really that we are living probably not in a second-best world but a third-best. It’s a little bit dirty, and clumsy, and so forth. But just look at what happened with this institution in California I never heard of [Silicon Valley Bank]. When they failed, what did they do? They claimed for what? Being bailed out. The guardians of the purest of capitalism, you can imagine.

Michael Chui: I hear you saying banking should be boring. Some people have said it should be a utility. At least the types of banking which are around deposits and loans. Is that your view? And why don't we have that world? Or maybe you're saying that, in fact, the savings banks in Germany are exactly that?

Hans-Helmut Kotz: No, they are not really utilities. There is one view which important people propagated and argued for. Jim Tobin was for narrow banking.

Michael Chui: What's narrow banking?

Hans-Helmut Kotz: Utilities. Deposits are not used for playing around in subprime. Yeah, I would agree. But that's too boring for me. We don't have pure models, pure ideas about that. And you should allow for some sort of accidents at times.

If you want to run a bank without any risk, you're maximizing type II errors, meaning you're maximizing that you do not give loans to businesses which are risky. And many of them might not work out. But then you kill anything which is innovative, so you don't want to have it completely risk-free.

The “utility” part is more about stuff like payments, where, also, issues in terms of competition policy come in. What we at McKinsey call “superstars” has often to do with no competitors and, hence, brilliant margins. And there, you need some sort of balanced approach to it.

But, as to what concerns risks, I do think a certain part of credit which is handed out should fail. If no credits fail, you have not been engaged in proper banking. Ex ante, they shouldn't. But ex post, a certain amount should fail, because somehow, you would like to handle and to deal with risk, and I don't think venture capital can completely substitute for that role.

I've been stressing, too often, “boring” up to now. A boring world might lead us to terrible stagnation, which we don't want. We need innovation in front of all the issues we are dealing with.

Finding sort of a balance between banks who are running very fast and, at times, too fast, and others who are staying behind, that's where regulators come in. Because of this inherent tendency to herd, because everybody is doing it.

One of the best analyses of the 2007–2008 crisis was done by the CEO of a very big bank here in the US. He was asked by a journalist, “Why are you dancing?” And his response was, “Well, everybody is dancing. If we were staying on the sideline, we would be wiped out very rapidly.”

Unfortunately, that's the truth. You might be right analytically for a couple of quarters, but you will be pushed against the wall ex ante. Being ex post right doesn't help you out of that. And that's where some sort of collective wisdom could come in. Don't get me wrong. I'm not defending anything and everything that regulators are doing.

Michael Chui: In that metaphor, dancing is taking these risks, which, ex post, we discovered, this is what caused the problem. And it's funny, from a collective standpoint, it's like a bank run. Everyone does the same thing. Sometimes that's problematic, and other times, it's just what you have to do, I guess is what you're saying. Finding that balance between the risk taking and the boringness, the regulation and the entrepreneurship, it just—the answers aren't obvious, I guess is what you're saying a little bit.

Hans-Helmut Kotz: We won't have an answer to that. Regulators should try to be prepared supervisors for accidents. But squeezing out accidents is, of course, not the way to go. They happen, often, along rather similar schemes.

I'm much more reminded, by the way, of what currently is happening here, of this S&L crisis in the late ’80s, early 1990s, when the regulation was taken out—nobody recalls its name anymore—which prevented banks from paying proper rates on deposits.

So depositors went to money market funds. Hence, banks, savings and loans—which are very different, by the way, from European savings banks—savings and loans had to take some risk on the asset side. These things were, at the time, highly profitable for a while.

Later on, they were called junk debt, ex-ante high-risk assets, and turned out to be highly problematic for the savings and loans industry at the time, because they lost depositors. They had to take more risk on the asset side. Some of these schemes are not difficult to interpret, to understand. So be prepared. Take eclectic perspectives.

Michael Chui: And then it's hard to be completely prepared, because as you've said, if you hedge away—we talk about hedging away maturity risk. But hedging away all risks means someone's taking it on somewhere, right, is what you're saying?

Hans-Helmut Kotz: And it would mean hedging away—hedging comes at a cost. So, it has immediate consequences for your profit and loss account. And if you do that as an individual, there's, in many of these issues, a fallacy of composition. Again, Samuelson. That's actually the textbook I was raised on, somehow.

Michael Chui: Please, explain the fallacy of composition.

Hans-Helmut Kotz: It goes like this. One farmer has a great harvest. He's so happy. Suddenly, it turns out all of his neighbors also have great harvests. Terrible. Oversupply. Prices going down. Fallacy of composition means what might work out at an individual level doesn't turn out to work if you aggregate.

And that was one of the lessons drawn of the 2007–9 crisis. Ever since, we talk of “macroprudential.” Before, it was a forbidden word, although the BIS [Bank for International Settlements] had thought about it, which is about systemic risk. If everybody's doing the same, if everybody's using the same value-at-risk model and selling at the same time, liquidity in markets evaporates.

Individuals cannot take such a collective or systemic view. It would be self-defeating. But that's the charge of regulators and supervisors: to think not the micro prudential but the macro perspective ex ante.

Michael Chui: Thank you for giving us all these different levels of perspective and going everywhere from regions or local areas to, say, the global banking system. If you don't mind, I'd love to ask you a lightning round of quick questions, quick answers, just to have a little bit of fun here. So, let's get started. What is your favorite source of information about the global economy?

Hans-Helmut Kotz: Data.

Michael Chui: Any particular data?

Hans-Helmut Kotz: IMF and World Bank data. Most reliable you find, yes.

Michael Chui: What piece of economic data do you wish was regularly collected and published but isn't today?

Hans-Helmut Kotz: What we don't have, if you do not have access to proprietary data—I would like to see more high-frequency data for students and researchers, not having access to these very expensive sources.

Michael Chui: Can you give an example of what isn't available easily?

Hans-Helmut Kotz: For example, there is always this issue about CDSs, credit default swaps, a very narrow market, prices suddenly moving wildly. And if you knew that there might be just one big trader behind that, that might calm down the game significantly. But then, also, education about financial literacy, about how to read these data, which is really a public policy issue, because we are all concerned, even soccer players.

Michael Chui: Especially some soccer players. What is your deepest cause for concern about the global economy?

Hans-Helmut Kotz: My deepest cause for concern is that I have real difficulties in understanding valuations and the share of an asset which used to be thought of as almost unproductive: real estate.

Michael Chui: Mm, which our McKinsey Global Institute global balance sheet study has revealed is, I think, two-thirds of the global balance sheet, if I'm not mistaken.

Hans-Helmut Kotz: And it has been worsening with the pandemic.

Michael Chui: What's your greatest source of hope for the global economy?

Hans-Helmut Kotz: My greatest source of hope for the global economy would be educating people, would be investing in human capital, would be investing in the capacity of people to adjust. Would be learning, learning, learning, which flies in the face of the stupidity which we now see with regard to all this segmentation of the world, to all this fragmentation. That's a scary environment we are currently living in. But human capital is the most important investment we can make.

Michael Chui: Who's your favorite central banker of all time?

Hans-Helmut Kotz: Favorite central banker of all times? I could name a couple of them. Karl Otto Pöhl, a German central banker, very down to earth. Paul Volcker, quasi German. His heritage is northern German. Mervyn King, who has been a great inspirator. Ben Bernanke. It was so good to have him around at the time of the Great Financial Crisis—I could continue. You know whom I really also like, perhaps not that much known? Ignazio Visco, Governor of Banca d'Italia. Very honestly, he is a great guy. And he's written a fine book on the importance of human capital.

Michael Chui: Very good. I'm sorry. It is like asking your favorite football player of all time—not necessarily easy.

Hans-Helmut Kotz: Wolfgang Overath [FC Köln].

Michael Chui: Oh, maybe it is easy. When do you expect the US federal funds rate will start to decline?

Hans-Helmut Kotz: During this year.

Michael Chui: What's the best way for a business leader to glean what decision central bankers will make?

Hans-Helmut Kotz: Listen carefully to what they are talking about. Which makes you a little bit uncertain. For example, if you listen, and which is important, because it captures the uncertainty of the environment. What you see, two very good central bankers in the US, just talking today in view of the same data. One is suggesting to be careful. Another is putting an emphasis on keeping a lid on inflation. And both have a good view.

Michael Chui: What's one piece of advice you'd give to listeners of this podcast?

Hans-Helmut Kotz: Ah. Read a good introductory principles textbook, start from there to think about data, and take an eclectic view. Don't bet on one horse only.

Jim Tobin: “Don't put all your eggs on one theory.”

Michael Chui: What would you advise a university student to study today?

Hans-Helmut Kotz: I like economics. And I try to convince my students to get away from “government.” But I do think the importance of understanding data is increasing, and it's much easier than it used to be. We have great tools for free. You don't have to pay for research tools. And play around with data, and you get the impression that you shouldn't be too cocksure.

Michael Chui: And what would you be doing professionally if you weren't doing what you're doing today?

Hans-Helmut Kotz: I have no good answer to that. I simply don't. I really like to do what I do. And I don't understand it as work.

Michael Chui: That's wonderful to hear.

Hans-Helmut Kotz: It's a substitute for football.

Michael Chui: Hans-Helmut, thank you so much for sharing your insights and perspectives.

Hans-Helmut Kotz: My pleasure, Michael, really. Thank you so much.

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