Jean Tirole: “A banking union is an excellent policy move, but the devil is in the detail”

Jean Tirole2TC

Jean Tirole, professor at the University of Toulouse, received the prize at the Stockholm Concert Hall on December 10. The 61-year-old academic is well-known for his research in a wide range of areas, including industry organizations, regulation of oligopolies and financial markets.

At the awards ceremony, Tore Ellingsen, chairman of the economics prize committee, referred to Tirole as a blacksmith who “forged many swords, each of them stronger and more flexible than any we had seen before.”

Tirole’s work is great because it helps governments better set regulations “so that large and mighty firms will act in society’s best interest,” Ellingsen said.

Tirole said his wish is to return as soon as possible to his research, and said the failure of economists to foresee and prevent the 2008 global financial crisis is a sore reminder of the dangers of hubris.

The crisis, however, cannot be entirely blamed on economists. “Policymakers and the media must also be willing to listen to economists,” he said in an interview with Caixin soon after he received the Nobel Prize.

In his interview, Tirole offered his views on a variety of issues centering on market power and regulation. He argued that a modern state must cease to be a player in the market and should instead set the rules of the game and ensure they are properly enforced.

– Caixin: The central theme of your work concerns the relationship between the state and the market. What is your idea of a modern state? 

Jean Tirole: The old-style conception of the state had the state intervene in the production of goods and services. However, with a number of exceptions, state-owned enterprises (SOEs) have on average not proved efficient and have been characterized by high prices, shady quality and income shortfalls. The problem is one of governance. Governments impose a number of costly requirements on SOEs and bail them out when needed. SOE managers’ exact mission is also often unclear.

This does not mean that the state should disengage itself from economic affairs. Quite the contrary. First, competition is rarely perfect. Markets fail, and market power – the firms’ ability to raise price substantially above cost or to offer low quality – must be kept in check.

Second, firms may exert externalities on third parties, for instance, environmental externalities or the externality on the taxpayer when a bank performs poorly and demands bailout funds.

Finally, there are a number of goods and services, such as education and health services, that are unlikely to be supplied sufficiently by the market, especially for poor people. Again that does not mean that the state should necessarily produce these goods itself. It can use either public schools or a voucher system, for example.

A modern state sets the rules of the game and enforces them. In the realm of the regulation of market power, it employs anti-trusts law to intervene primarily ex post. Exceptions include merger control and business review letters, and sectoral regulation of network industries, telecoms, railroads, electricity, postal services, most often in an ex ante fashion.

In its regulatory function, the modern state should be independent, independent from industrial lobbies, but also independent from the government. This is why in the last 20 years, competition authorities, sectoral regulators and central banks have been granted their independence in a number of countries. But it is then particularly crucial to guarantee the competence of theses regulators. In-depth hearings in parliament for the selection of top regulators make sense.

– You say the state should be light but strong. Does it mean that regulators should set rules that account for all contingencies, which allow them to keep intervention to a minimum, but when they do need to intervene, the measures would be predictable and forceful?

This case-by-case approach can be daunting for regulators, who are often more comfortable with simple rules which they can apply mechanistically. Economists must therefore offer a rigorous analysis of how markets work, embodying theoretical considerations as well as, whenever feasible, empirical analysis, and taking into account the specificities of particular industries.

Economists must also be careful to reflect in their prescriptions what regulators do and do not know, as well as enforcement costs. This calls for “information light” policies, that is, policies that do not require information that is unlikely to be available to policymakers. More generally, we must develop broad organizing principles. These principles can offer some default rules or warning signals prompting further scrutiny.

Economists finally must participate in the policy debate. The financial crisis, whose main ingredients could be found in academic journals, is a case in point. But of course, the responsibility here goes both ways. Policymakers and the media must also be willing to listen to economists.

The French government has traditionally attracted top talent through its grandes ecoles, for instance, and it has played an extensive role in economic life. It also is very sensitive to the pressure of public opinion. While accounting for public opinion is quite reasonable in social matters, provided that minorities be protected against the whims of the majority of course, it may be detrimental in technical matters, for which the public is likely to be poorly informed. This is why we have created independent agencies, precisely to protect public decision-making from demagogic tendencies.

– Do you think regulators need to hire more professionals to be able to do their jobs? 

I would not say “more” necessarily. But it is clear that our modern economies are complex and require well-trained regulators. It is important that universities provide top-level training to a sufficient number of students in economics, all the more that regulators often don’t have the financial means to compete for top talent with industry.

– What do you think of the revolving-door phenomenon between regulators and professional institutions? 

The revolving door issue is complex. Often, the best experts in an industry have worked in the industry for many years and face a conflict of interest. One has to make sure at least that the ultimate decision-makers are independent. Then they can consult experts who do have a conflict of interest, provided that this conflict is fully transparent. One should also emphasize their legacy concerns. For example, if they are independent, asking them to express their opinions – as is the case for U.S. Supreme Court judges, for instance – gives them an incentive to give decisions more thought and not to give up to the temptation to be in league with specific lobbies. One cannot underestimate the embarrassment factor, even though it is of course an insufficient incentive on a stand-alone basis.

Creating a prestigious position of a “chief economist” can be quite useful to the credibility of a regulatory agency.

Finally, the U.S. agencies, such as the Department of Justice, often borrow for a couple of years top academics, who later on return to academia. These external economists carry a lot of weight and often have direct access to the agency’s boss.

– Your research has primarily focused on market monopolies and natural monopolies. Any thoughts on government-granted monopolies?

There are several forms of government-granted monopolies: those that result from competition for the market – an auction of a concession – and those that result from intellectual properties.

The beneficiary of a highway, harbour or airport concession may have acquired its monopoly power through a competitive, well-designed auction. Then there is no concern. By contrast, the monopoly position is not deserved if it has been acquired free of charge or through a biased or silly auction design.

Similarly, an owner of a patent should be allowed to exploit the patent itself or grant an exclusive license if the patent is major, but not if it lacks novelty or is obvious, or else is minor, but has become major only because it has been incorporated into an industry standard.

– How should monopolies be broken up? 

It is all a matter of balance. The regulator should not be captured by historical monopolies. Nor should it try to create competition for the purpose of it by all means. For example, when an industry is restructured to allow competition, a regulator may feel its mandate is to create competition. This is a fine mandate, but one has to check that it is fulfilled in the proper way. First, the regulator should not “bring in numbers.” That has happened several times, with regulators favoring an inefficient entrant just for the sake of creating competition. Another example is that of a regulator of electricity subdividing the physical rights to a limited-capacity interconnection between two regions or countries to create competition in transmission, without actually allowing more electricity to flow through the line.

– You came up with the concept of prudential regulation and warned about the moral hazard of bailing out financial institutions as early as the 1990s. Are you disappointed that your and others’ similar work did not get enough attention from regulators? 

It is interesting to see that many of the 2008 crisis ingredients were described in academic research: the role of informational asymmetries, undercapitalization, liquidity shortages, hazards of excessive securitization, cross-exposures and the dangers attached to retail banks’ and insurance companies’ involvement, soft budget constraints, and so forth.

Most economists, including myself, however, had little clue as to the magnitudes, for example of cross exposures in the over-the-counter market or of the extensive use of special purpose vehicles created in the securitization process.

We economists also should try to do a better job at explaining the outcome of our research. But the responsibility here goes both ways. Regulators and the media should likewise stand ready to listen to economists.

– What would you say to financial policymakers now? 

A key observation in my research is that the costs of a loose monetary policy are economy-wide. They resemble a fixed cost. Consequently, the central bank is willing to incur these costs if there are enough fragile banks. When everyone engages in maturity transformation, authorities have little choice but facilitating refinancing. The more other institutions – especially ones that a central bank will be eager to rescue, such as large or too interconnected-to-fail institutions – gamble on the yield curve and adopt an illiquid balance sheet, the more an individual bank is expecting to face a low interest rate and thus favourable refinancing conditions, and so the more its return on equity is raised by an illiquid balance sheet.

We more recently have worked on the deadly embrace between banks and their sovereign. Europe has witnessed a renationalization of its financial markets in recent years. Their banks now hold large amounts of domestic sovereign debt, and little of other countries’ sovereign debt. A priori, that might not be a bad thing, as it makes the government more accountable. If they default on their sovereign debt, they default on their own financial institutions. However, we have unveiled the reasons for this evolution and warned about its hazards. In addition, we feel that the creation of a banking union is an excellent policy move, but the devil is in the detail and only experience will show.

(Rewritten by Wang Yuqian)


*Image by: IMF

About the Author

The Corner
The Corner has a team of on-the-ground reporters in capital cities ranging from New York to Beijing. Their stories are edited by the teams at the Spanish magazine Consejeros (for members of companies’ boards of directors) and at the stock market news site Consenso Del Mercado (market consensus). They have worked in economics and communication for over 25 years.

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