The future of money?
Europe, inflation, interest rates, and a financial crisis
The world is currently going through the greatest financial crisis since the 1930s. To reverse the economic crunch, central banks lowered the rate of interest to reverse the slowdown in credit availability, a popular economic policy. Such approaches are based on solid economic theories. However, the unique crisis could have really changed how economies react.
Stephen Piccinino (supervised by Professor Josef Bonnici) analysed the relationship between inflation and interest rates in the euro area between 1999 and 2011. The economic theory called the Fisher effect defines this relationship, and assumes that if a central bank injects money too quickly into an economy it would simply raise the rate of inflation.
From January 1999 to August 2008, the Fisher effect held true and the rate of inflation increased with the rate of interest in a one-to-one fashion. While between September 2008 and March 2011, this relationship fell apart due to intervention by the European Central Bank (ECB). The ECB lent retail banks large sums of money at favourable rates. It also removed limits on how much banks could borrow and reduced interest rates. These changes influenced the relationship between interest rates and inflation.
During this period, inflation rose faster than interest rates, which meant that money held in bank accounts had a lower return than in previous years. These findings mirrored the Federal Reserve’s policy interventions in the US between 1979 and 1982.
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This research was undertaken as part of a Bachelor of Commerce (Honours) in Economics.
Banking sectors that bounce back
In 2007, the banking sector collapsed. Today, several banks are still struggling to stand on their own two feet. To help shore them up against recurrent catastrophic collapse, the world’s top Group of Twenty economies has proposed a new set of regulations called the Basel III regulatory framework. Local analysis of this framework hints that while beneficial, it would not prevent another bust.
Governments needed to bail out banks in 2007 because banks could not pay back their loans. Banks must make sure that they maintain a ratio of capital (some form of money ranging from property to shares) to the amount of money they lend, called capital ratio. The minimum currently stands at 4% (Tier 1), meaning that banks only need to hold less than one in twenty of the money they are lending, which does not leave much of a ‘cushion’ if things go wrong. A bank’s liquidity can quickly dry up damaging other banks.
The Basel III framework introduces a new set of standards that amongst other things raises the minimum Tier 1 capital ratio to 6%. Marica Bonavia (under the supervision of Mr Michel Said) assessed the impact of the new framework on the American and European banking systems. Her work reveals how the largest American banks already conform. On the other hand, the position of European banks ranges from German banks that are raising new capital, to Swiss and British regulators who want higher capital ratios.
The dissertation suggests that the real impact of Basel III still needs to be seen and although the new regulations are a big step forward, further efforts are needed.
This research was performed as part of a Bachelor of Commerce (Honours) from the Faculty of Economics, Management and
Accountancy.