 to everybody and also from my side a very warm welcome to beautiful Cintra it's of course an extraordinary pleasure to be here and see you all in person this is just fantastic I hope you all enjoyed the first course of the dinner and are now looking forward to our dinner conversation as the president already said this year we are not going to have a conventional dinner speech but we're going to have a hopefully lively discussion with our dear guests Elaine Ray and Richard Portes on the topic threats to financial stability the topic clearly has regained relevance the war has pushed inflation further up and has lowered growth expectations sovereign and private debt are high also as a result of the pandemic and some asset prices are difficult to reconcile with fundamentals when interest rates rise sharply fragilities may appear with different types of assets regions financial intermediaries being exposed in different ways and to different degrees so what better time could there be to discuss these issues with two of the best experts in the field and there is of course no need for an introduction but I will have a short introduction anyway both Elaine and Richard are professors of economics at the London Business School and have made numerous ground-breaking contributions in their respective fields let me mention Elaine's work on the global financial cycle which turned the classical tri-lemma of international macroeconomics into a dilemma and it remains an important concept today jointly Elaine and Richard wrote a highly influential paper on the determinants of equity market integration pointing to the geography of information as the main determinant of cross-border equity flows but these examples of course are necessarily selective let me also stress another reason why we are so happy to have the two of you here which is your deep commitment to Europe and your deep interest in fostering the exchange between researchers and policy makers which is obviously what was the founder and president of the Center for Economic Policy Research CEPR he also initiated the very successful logbox EU as well as the journal economic policy moreover he contributed and he still contributes greatly to the advisory scientific committee of the European systemic risk board where I had the pleasure to work with him several years. Elaine is currently vice president of the CEPR and has put an enormous effort into the women in economics program which I think is a fantastic initiative thank you so much for doing this with great enthusiasm and of course Elaine is also a very important voice in the European policy debates but let us now dive into the topic of today's conversation I will try to keep my questions relatively short because it's not about me it's about you about your answers not my questions and I would like to start with a question on recent market dynamics so maybe I start with Richard so what I'm your views the main reason for the increased volatility that we have observed in financial markets thank you Isabel some of you will be familiar with a quote from Harold McMillan when he was Prime Minister of the United Kingdom for several years a successful Prime Minister until things went bad but they always do don't they and when asked what was his most important challenge in his role he said events dear boy events well that's exactly what's happened we've had COVID continuing in particular in China we've had Ukraine commodity markets major disturbances elections Germany France coming in the United States none of the United States has been conducive to financial financial stability we've got a shift to the risk-off environment with both equity and bond market sharply down but I think also and I was a bit skeptical about this when it was first raised several years ago the idea that deep structural factors in have reduced liquidity and thereby created more volatility I'm still I'm still waiting to see the evidence of that but I think there's enough informal evidence from the markets that this is that this has been important thanks Richard so let me ask a bit so what do you think you learn how does all of this affect the macroeconomy may as maybe also monetary policy or the other way around very much is about so so far so good I kind of agree with what Richard said we did try to find areas of disagreement so yes risk on risk off we we see volatility having an effect on financial friction so tightening of financial constraints whether you think about value at risk constraints you think about financing constraints and we know that this is a powerful transmission channel to the macroeconomy so this has an effect on credit creation this has an effect on capital flow with an effect on investment and aggregate activity so that's definitely a first amplification channel to the macroeconomy but then of course there are direct effects so we have this volatility events in particular for the commodity markets and there we have direct effect on the production process global value chain we have direct effects which are affecting very much the supply side of the economy in an environment where the rebound from the COVID has come an unbalanced rebound with some bias towards towards goods so inflationary pressure which you know you have to deal with and on the demand side we also see inflation eating away the purchasing power of households in particular modest households both because of the energy prices and food prices which are constrained expenses and I think also something we have to keep in mind as macroeconomists is that very important general equilibrium effect aggregate effect coming from precisely the decrease in purchasing power of this category of households who also happen to usually work in cyclical sectors and this has in turn aggregate effects on the economy so powerful amplification mechanisms that we need to quantify for macro for macro policies okay so this is certainly very important so the question then is does all of this lead to acute risks for financial stability Richard I don't think we have yet such risks we're not like 2008 when the banks were severely undercapitalized and when markets froze because no one could trust counter parties that counter no one could be sure that their counterparties wouldn't default overnight and so nobody wanted to deal with anybody it's not like 2020 either when we had the dash for cash in March 2020 at that point Vicks and high yield spreads both went above the 2008 levels but but sorry all you central bankers out there I do see some risks for the central banks in particular that you may have to act as market makers of last resort we still have not properly fixed the money market funds in my view I know there are others that disagree with this but and we put a lot of effort into it but I don't think it's been totally successful and if stress were to come I think that would be a first point of call we have pro cyclical still pro cyclical center counter central counterparty margins on commodity derivatives and there are dangers for the central counterparties themselves if things go bad so and there again central banks would have to step in so I think if I were in your shoes all you central bankers out there I would be concerned about this possibility that you may yet again be called upon to act as market makers of last resort yeah one particular type of market dynamic that of course is on many people's mind here in the room is the threat of fragmentation in the euro area so it seems that this is a very euro area specific thing so why why is that so well so I think so I'm gonna say it's your area specific in a minute but I'm gonna say something actually not quite in a way because we are used to a fact that when interest rate go up and when we withdraw liquidity which is something that is you know happening here right now there's more differentiation in asset markets and so we see a spreads widening we see market segmentation coming up this is partly due to the less liquidity for arbitrageers various financial frictions playing some capital flight behavior so we see that in the international economy when you look at a segmentation of emerging markets compared to to advanced economies we see a phenomenon like that we see also in the corporate bonds sector think about high yield investment rate and where it is quite specific to the euro area is that there this is advanced economies sovereign bonds and indeed why do we see these dynamics where we see increases in spread we see more differentiation in the pricing well it's kind of normal because a different credit risk and why are they different credit risk because we are not a fiscally integrated area right so that's that's the basic structure financial architecture of a euro we all know about we are a currency union but we are not fiscally integrated and therefore we have heterogeneity in credit risk and it's normal that this heterogeneity be priced and it's gonna be more priced when we withdraw liquidity from the system so that's okay to have spreads what is dangerous in terms of that's where we go to the fragmentation theme is when these spreads take on a life of themselves when they become self-fulfilling when they become there's a dynamics that settles in and that is an unstable dynamics this this we don't know and we we don't want and we have seen that we have seen that in the past so that's that's the danger and that is what is specific to the to the euro area because of lack of fiscal integration because we haven't finished the banking union a big a big theme but a lot of us have contributed to but we haven't finished it and we we have no no capital market union effectively we have still no euro area safe assets so because of all that it's normal that we see some spreads but we don't want instability in those spreads this said we are still in a situation in which yields are low we are yields are low and therefore you know we should not panic we should just watch what is happening and and make sure we have the tools to deal with whatever could come and so if I may so how would you distinguish what is just like this effect of the general repricing and what is kind of more very sound so clearly when you it's always the same gray area that you know we have to deal with in macroeconomics when we talk about fundamental driven issues versus self-fulfilling the pricing if we have dynamics which seems to be unstable and not warranted but we believe our fundamental variables whatever that might be and I'm aware that there we we have to deal with issues with the models and views about the world then of course even stability takes on speed or we have to intervene and and the issue then is to do that in an environment in the in the euro area where we have to both have at the same time risk sharing and at the same time still some some physical discipline so that has been a little bit the dilemma of a euro area for a very long time as as you know so that somehow reminded me of the 7 plus 7 report very much so very much so Richard would you like to add anything on that specific point no I think we want to talk about the general repricing in financial markets perhaps and I would just say by the way president that lower for longer is still with us very much real rates are even lower than when we wrote the lower for longer report so and I think that is an important factor that mitigates some of the tensions that we are seeing out there and should do in future but so what has changed it's not just the tightening of monetary policy it's the shift to risk off of course the two are related but I think you can conceptually and in practice distinguish between them to some extent and that the process that we are seeing is as a lens said in some respect it's gradual the rise in high yield spreads that we've seen it's there but it's been very slow very gradual nothing like what we see in the crisis periods similarly euros on sovereign spreads after all come on let's get serious here I know that everybody gets terribly worried about these things but but Italian spreads this afternoon when I looked we're 199 basis points over the book there were 120 years a year ago is this a dramatic deterioration not obvious Portugal is up from 75 a year ago to 107 basis points today again not exactly dramatic is it so I see the widening is due at least as much to the general risk environment as to monetary policy and in particular not the fundamentals Italian fundamentals in some ways some respects are better than they were a year ago and you know it could things could indeed be worse according to a survey of asset managers conducted last month's the asset managers showed perceived higher financial risk now then in 2008 or in 2020 after the events okay wait a minute here there's a psychology out there that is very strange and maybe just one small comment on because you you mentioned the risk of moves I mean one thing that we haven't really seen that we've seen in previous episodes is these kind of safe haven flows at the moment we are not we're not indeed I think that's important important point but let's yes we always have to be very careful and watchful for certainly I can I can assure you but indeed if you look at the debt to GDP ratio also of number of indebted economies it goes down because of a nominal GDP growth it's true yeah so let me switch to a completely different topic which is crypto assets so of course we have seen some interesting dynamics in that market as well so the market capitalization has decreased quite dramatically over the past month so one question that is of course on our mind is whether these movements in crypto markets have any implications for financial stability so whether we should be worried about systemic risk and maybe we should broaden the whole topic a bit and talk not only about crypto asset but really decentralized finance more generally as you know is it all I've been thinking about these things too much over the past six months and some of you out there have been very helpful in that respect but yeah risk off has among other things caused a shift out of crypto perfectly normal perfectly natural and the Bitcoin prices the ether prices are way down and even things that are written just a month ago you said a month actually this has been going on for several months but even something written by Bloomberg intelligence last month it's embarrassing what these guys write you know when they hype up how you know Ethereum is going to go to two thousand three thousand four thousand now soon right well ether but it ain't happening and so the question is what are the risks I think the risks are now small because of the relatively limited size of the crypto asset space but given the rates of growth that we saw until this plunge given those if that trend comes back that was very very rapid growth and we could indeed see fairly soon something a space that is is quite dangerous so what are the risks well the problem is that crypto assets crypto markets do what the traditional financial assets and markets do but they don't have the regulation they don't have the backstops they don't have the fiduciaries and all all these things that we have very painfully over decades over centuries discovered are essential but if you look closely if they were properly regulated they might just disappear think about that think about that so maybe let's let's try that well you said it not me I just I just work here you know some examples of instability you will be familiar with the most important stablecoin so-called stablecoin tether actually broke its peg to the dollar at one point very recently and its assets people aren't saying much about it but its assets are falling moreover about a third of those assets are in commercial paper with an average residual maturity of 44 days that is according to their Cayman Island accountants there's Celsius a major bank that lends which had to gate withdrawals there's Tara everybody knows about the Tara Luna coming back down not down to earth below us both are now worthless so there are big dangers out there potentially if this space gets big and on some I'd like to dimension on some crypto exchanges believe it or not Binance it is possible to achieve leverage of between 100 and 125 and we thought Deutsche Bank in 2008 at 65 was really a problem yeah right about it here and finally at least as dangerous in my view at least as dangerous in my view are the so-called smart contracts smart contracts are code okay they give automatic execution without recourse that is not smart excuse me we have contract law we have commercial courts for good reason because you can't write all contingencies properly into a contract we learn that you know basic basic economics but anyway at some point we learn that and and not having any structure like that it seems to me for the so-called smart contracts the danger of just fat fingers not being able to call it back that seems to me a problem so I heard some skepticism over there so is there anything positive we could think about in the crypto asset world I mean something I mean could it lead to more financial innovation could there be financial inclusion you have any any positive ideas what positive effects crypto assets could have so I would love to try you know if you're need to contradict Richard right I mean I can I'm gonna really try hard but indeed if I if I want so first of all to think about you know crypto so anything that it's called a crypto currency so far including the most popular one has nothing to do with with money I think we all agree with that right we attribute some money are absolutely not represented by in Bitcoin very bad medium of exchange and that's actually by that's really by design in a way the transaction cost are extremely high very bad unit of account very bad store of value so this is not this is not a currency now if we think about the other styles of cryptos we can think about stable coins and all that it is true that one could try to say what is the business model okay is there any business model we doesn't have to do with avoiding regulation or avoiding fiscal dues or indeed not about getting senior age and if you if you try to to think about what are the business model which do not meet these three things avoiding regulation or fiscal avoidance or it's very hard to find I'm afraid so then you could say okay maybe the technology so in the technology we have the the program mobility of that could be I mean Richard seems to be very adverse to that right but you could say you know maybe there's something good in program mobility here but if you think that it's not the crypto object itself the technology can be used with CBDCs as well presumably and so CBDCs if there's something good to be there we wouldn't have all the other inconvenience so then you can think about financial inclusion you can think about possibly cross-border payment but this could also be done with indeed CBDCs with some technological import there so I'm afraid I'm afraid I'm going to come down on the same same side as Richard here and when you mentioned CBDC so who would do the the innovation would it be the central banks themselves so would it be so private I mean there you can you can definitely have private innovation what my point is that it's in the technology it's not in the creation of a new currency right but but you can distinguish between the two and yeah no the public sector doesn't need to do everything no absolutely not so we see that digitalization is posing certain challenges I see I see another challenge which is cyber risk so the the frequency of cyber attacks has increased quite dramatically so should we be afraid that this could become systemic so on cyber it's another of these very difficult risks to to assess because simply we don't have much data at all so far on these issues so we have to be a bit look outside the box and try to find alternative data sources to try to even measure the threat so we can we can do that because you know the problem when we we look at reported incidents is that there is a lot of underreporting obviously people don't want to report when the cyber attacks so we can we can find maybe some data elsewhere there are some for example we can analyze the call of analysts and we can with many many companies and see how often and what they talk about when they discuss cyber risk etc so there's information in that which seems to be able to predict indeed some actual cyber threat so we can use this type of data and when we do that so what I think what we realize is that cyber risk has increased quite a lot in particular since 2016 and also that cyber risk has been migrating a little bit it was more centered on the US to the rest of the world to Europe to Asia as migrated to more sectors in particular to the financial sector to the insurance sector it seems and we start to see a little bit of it being priced but of course the pricing must be very approximate so not really too much on that but we start to see some some pricing in in stock prices in option prices and indication of contagion across companies so to your point on or your question on systemic risk we start to see that there is a bit of contagion that's obviously not the only channel for which this risk could become systemic can be systemic if it if there's an attack of a systemic financial institution straight straight on I mean that's that's gonna be there can be systemic if there's correlated attacks or attacks on on companies which relies on the same data provider or same IT systems and and there we simply don't have a data to really assess these issues so there are some different avenues I think by which this risk would easily become systemic and we are just starting to see it happening and we have to be very creative about the data I think thank you very much so we've talked now a lot about advanced economies let's maybe just very briefly also talk about emerging markets and we know that times as today can be challenging for emerging markets when interest rates are going up in advanced economies one could expect to see capital outflows potentially even leading to financial crises so how how do you see things currently maybe Richard well you asked this question on the day that Russia defaulted the first time since 1917 on its international obligations 17 but we can check that Wikipedia out there go ahead I don't mind being wrong on this one it's also the 250th anniversary as pointed out by bloggers at the New York Fed 250th anniversary this month of the outbreak of the first modern global financial crisis the credit crisis of 1772 73 so I don't feel terribly comfortable addressing this question two major emerging market debt crisis in the past came when US rates went up Latin America 1982 Mexico 1994 95 both of them required action by the United States and the IMF and actually the second one was some good for me because with Barry Eichengreen I ended up writing a piece called crisis what crisis that proposed collective action clauses which were ultimately adopted but have they made the world safer some I think in fact so but there are still dangers we have rising rates and a rising dollar and these raise the dangers of debt defaults bank failures and exchange rate crises in emerging market economies and it's the interconnections among those three that really give rise to major financial crisis now are there systemic countries that are threatened I think the first in line and I don't hesitate to say this for a moment I'll name a name Turkey right it does not look good and it would not be the first time as we know so I think whether Turkey has global systemic relevance whether there would be any contagion not at all clear you had Argentina go down in 2000 and it hardly ruffled any feathers except in New York way but but still Turkey might be a serious case and so far if you look at the data the capital outflows from emerging market economies have been mild so you know so far so good but you know what that story is yeah thanks Richard so you pointed to this kind of stylized facts of when rates go up then these are the times that become risky and then of course that's not just a true in emerging markets but if we look for example at the US and when financial crises happened they basically always happened when interest rates were going up and so the my final question to both of you would be so when when we go to bed tonight after a wonderful dinner with many nice conversations can we still sleep well or should be we should be worried depends on how much we drink so we know what to do as far as I'm concerned no problem for me I don't have to make monetary policy decisions good luck to you all thank you so just let me just thank you for this fascinating conversation it was a great pleasure being with you on stage I will also enjoy it sitting with you at the same dinner table so thanks for coming in at relatively short notice and it was really it was fantastic thank you very much