The Spring 2023 Crisis and What Can Be Done About It

As time goes on after the turmoil and "non-crisis" in banks in mid-March 2023, it's important to think more deeply about the strengths and weaknesses of the financial industry and how they affect the real economy. International and state financial groups are already working on what they can learn from what happened. Loopholes and weak points in regulatory systems and ways of keeping an eye on things are being carefully looked at and fixed as much as possible. In the context of rising interest rates and quantitative tightening, how mid-sized territorial banks handle unrealised losses (whether they are held to maturity or not), uninsured deposits, and exposure to confidence crises have been shown to need much more scrutiny than they did in the past. What seems to be a good sign is that governments and regulatory agencies, especially in the U.S. and Switzerland, have been able to move quickly and firmly to stop the problem from spreading.

Also, the frameworks already in place were strong enough and flexible enough to allow corrective measures to be taken, such as exemptions, exceptions, and clever ad hoc solutions. Market faith seems to depend more on the authority and trustworthiness of the institutions that keep an eye on things than on how clear and strict the game rules are. "I'd rather have Bob Solow than an econometric model," said economist Paul Samuelson. Stanley Fischer, a former vice chairman of the Federal Reserve, used and added to this quote.1 Or, we could say it is better to have trustworthy leaders than detailed rules covering everything.

This is especially true because more and more black swans are showing up on the horizon and may be ahead of the curve. With its still-unfinished banking union and a Capital Markets Union (CMU) with an elaborate and fragmented supervisory design, Europe is relatively more at risk in this area. But Samuelson said, "I'd rather have Bob Solow with an econometric model than without one." So, we should be happy about any effort to improve control and oversight, whether it's for non-banks, crypto-assets, or providing liquidity.

But I think one thing hasn't been discussed enough: how confidence shocks like the recent ones affect the real economy and certain parts of the real economy. Some talk was about commercial real estate and other places in a bubble. But what about funding for new ideas and research? Were the problems at Silicon Valley Bank (SVB), Signature Bank, and other banks working in high-tech and innovation hubs just coincidentally or resulted from a few bad apples? Until now, these places were held up as great examples of how to do things right, and their "financial ecosystems" were seen as a key part of their amazing success.

They had a unique mix of Ivy League universities and research centres, high-quality and well-capitalised subcontractors, links with global value chains, the ability to attract smart people, and so on, which was just one part of why they had such good names worldwide. Another important and well-known factor was the high concentration of venture capital and venture debt, deep and liquid capital markets, private capital, and specialised regional banks. All of these things made up a sophisticated financial environment that people all over the world admired and envied so much so that many potential start-ups and growing businesses from Europe and other places went to Silicon Valley and the U.S. to get help and money and take advantage of all the benefits and chances to succeed and do well.

Why did this "dream financial microcosm" area take such a big hit? And how well did the temporary fixes and ad hoc ideas fix the problems? And how and why should we protect or rebuild the amazing worlds of creativity and innovation that popular stories about Silicon Valley and other innovation hubs have told us about?

To answer these questions, we need to talk about how to pay for research and innovation, which is a much bigger and more structural problem that affects both the financial world and the real economy. The second is a very strange part of the business. Lato sensu, research and creativity are a part of most, if not all, of an advanced economy's successful outputs and outcomes; this is because research and creativity are a part of most product and process innovations and high total-factor productivity (TFP) environments. Research, in the strictest sense, is a risky and expensive activity that needs complex infrastructures that few private businesses can afford. So, in most parts of the Mittelstand, which comprises small and medium-sized businesses, we find "innovation without research," or innovation based on tacit knowledge and small changes instead of formal inputs from experts and experiments. But it is well known that this kind of innovation, while important and creative, does not explain the technological leaps and breaks that have changed the world and will continue to change. For example, the internal combustion engine and automobiles did not change transportation because horses and carriages improved over time.

In economic terms, this means that "research and innovation" has a basic element of a public good (think of the fact that this kind of output is not a competitor and can't be excluded), which has important implications for how to pay for it. It wouldn't be enough, and it might even be impossible, to fund the one in a thousand (or one in a million) breakthrough business ideas or products that will change the market and economy. Finance must reach out and give money to a complicated and varied environment that encourages creativity and produces the ideas of the future through trial and error and "crazy experimentation."

In other words, an innovative knowledge-based economy and society must be built, and a complicated and varied finance ecosystem must support this world. This ecosystem needs public and private parts and funding to support basic and applied research, private and public projects, and public-private partnerships. Not only that, but it's even more important that such an ecosystem can make the different parts work together so that public investment brings in private investment, encourages applications and technology transfers, and starts virtuous loops of catalytic and multiplicative dynamics. In other words, "blending" rather than "segregation" is the key to making the financial environment of research work. Consider how public student loan guarantees help promote equality in university funding, for example. Or, look at the experience of the Fraunhofer-Gesellschaft institutions in Germany. To pay for them, the government gives loans and shares, but the private sector and communities of experts make the decisions.

Research is (also) a public good, so it must be funded (also) by the government because research is underfunded, a characteristic of general public goods. The market alone, especially for ideas and innovations, does not provide enough incentives and inspiration for research activities. When times are bad, research spending is usually the first thing to go and the last thing to return when things get better. But the long-term effects of research being a public good are the most obvious and cause for worry. Not investing enough in research negatively affects growth, productivity, and job rates.

A thorough look at long-term trends and the balance between economic growth and security in developed countries shows what we could call an "impossible trilemma": We can't have low inflation, stable finances, and steady growth all at the same time and in the same amount. We have to make choices and face limits when balancing policy tools and goals and following policy goals that are all good on their own but can't be reached simultaneously in the short term with our current technology. Does this mean that if we focus on beating inflation and making sure the financial system is stable, we will have to deal with secular stagnation and real interest rates that are close to zero or even negative? No. We know very well that technology is not a given, that technological change and innovation can change the trade-offs and loosen the constraints, and that technological change and innovation depend on spending on research. So, investing in research means looking for long-term modernisation, productivity, and welfare and making our economies and societies stronger and economic growth more stable. Investing in research is, therefore, at the heart of any "new deal" or bold plan for the next generation.

In what was called the Amaldi Plan or Manifesto for more investment and funding in research, scientists with a lot of influence asked for this to happen. The Plan, which came out in 2021 at the height of the coronavirus crisis, called for more national and foreign money to be spent on research. It was backed by many scientists and experts and got much attention and support from the scientific community, policymakers, and the general public. But so far, not much has been done to follow up in a real and important way. It's enough to look at how small the role of research funding is in both the Inflation Reduction Act of 2022 (IRA) in the U.S. and its European Union (E.U.) equivalent, the Green Deal Industrial Plan. Instead of protectionism and wasteful industrial subsidies, funding research through public-private partnerships and international cooperation will likely provide the best chances and improve stability and growth at both the national and international levels.

To sum up, a proper reaction to the trouble in the banks in spring 2023 is needed to fix the holes that have appeared in financial regulation and supervision. But it is just as important to look closely at and improve the financial environments that support research and innovation; this will help close the funding gaps in the knowledge economy and society.