Auditing the financial crisis: some afterthoughts from the netherlands

1. Auditing the financial crisis:someafterthoughtsfrom the netherlands Bas Jacobs Professor of economics and public finance Erasmus school of economics EUROSAI Congress Netherlands court of audit June 18, 2014

2. The crisis • Not a public debt crisis! • … except Greece • Introduction of Euro caused a capital flow bonanza that led to massive build up of private debt • Risks exploded when US mortgage crisis ignited a banking crisis in the EZ • Sudden stop capital flows triggered systemic problems in construction of EZ • no crisis resolution insolvent sovereigns • no lender of last resort illiquid sovereigns • no banking union

3. crisis due to private debts and construction failures eurozone Source: Shambaugh (2012), BPEA

4. Crisis faded • Draghi saved the Euro (so far): • lender of last resort for solvent but illiquid sovereigns • Rescue funds (EFSF/EFSM) ESM: • restructure debts, reform economies • Bankingunion • supervision • crisis resolution • But, no real burden sharing and no EDGS • ‘doom loop’ between banks and sovereigns not broken • Debt write downs public debts Greece necessary

5. public mismanagement crisis • Totally misguided focus on synchronized austerity throughout EZ • destroyed economic growth • deepened banking crisis • triggered public debt crisis despite austerity efforts • Private debts hardly came down and still very high • Public debts did not come down at all and keep on rising • Banks are still very weak: interventions 6 years too late • Recovery? Secular stagnation and Japanese scenarios are most likely for EZ

6. Why Did this happen? • Creditor countries played the blame game: crime and punishment! • Governments hijacked by financial sector • Lack of knowledge of basic macro-economics: • it’s not a morality tale • not all sectors/countries can simultaneously deleverage • Policy device: ‘austerity above all’

7. Consequences misguided austerity • Austerity policy does not pass social-cost benefit test for all non-GIIPS EZ countries (DeLong and Summers, 2012) • GDP NL in 2015 still below 2008 • Loss = 15% GDP relative to pre-crisis growth • Loss = 10% GDP structurally • Unemployment rate doubled to 9% (CBS) / 7,5% (ILO) • 10% structural GDP loss = fiscal gap increase of 5% GDP • austerity measures largely self-defeating • 2011-2015: 7,5% GDP austerity, 2,2% GDP deficit reduction

8. Public budgets are governed by economically silly rules • Static rules of GSP ignore that GBC is inherently dynamic • Exclusive focus on liabilities ignore asset side • Off balance liabilities are ignored

9. Static rules of SGP • Government budget constraint is dynamic • Example: Netherlands has no long-run sustainability problem in the public budget • sustainability gap (fiscal gap) = approx. +1% of GDP • Public finances sustainable due to • raising retirement age • reform mortgage rent deduction • reforms long-term care • NL embarked on a massive austerity program between 2011-2017: 9% GDP • budget cuts: 5,5% GDP • tax increases: 3,5% GDP

10. Liabilities Gross debt: 74,5% bbp Total liabilities: 74,5% bbp PM Latent liabilities (state pensions, health care) PM guarantees Assets matter for public financesExample: NL government has net assets Assets • Public capital stock: 64% bbp • Financial assets: 27% bbp • Gas stock: 22% bbp Total assets: 112% bbp • PM Tax claim future pensions: approx. 63% bbp Source: CPB (2013) De naaktefeiten over de Nederlandse overheidsschuld

11. Government as a hedge fund • Private risks were socialized • rescues banks and interbank markets • country rescues • Rescue operations required huge off-balance sheet transactions Eurozone governments • deposit guarantee schemes • mortgage insurance • bank guarantees • guarantees for rescue funds (ESM etc) • Arbitrage off-balance transactions public/private sector

12. Sometimes sovereign needs to intervene • Correct market failure = social gain • lacking liquidity banks/sovereigns • lacking risk-bearing capital • Bailing out insolvent banks or sovereigns = social cost • insolvency banks: capital ratios SIFI’s way too low • insolvency governments: public debts unsustainable

13. How to control exposure sovereign to financial risk? • Guarantees financial sector (DGS, mortgage insurance, etc) are public liabilities • need to be transparant • need to be valued as liabilities on public balance sheets • use market valuations as much as possible • Valuation TBTF subsidies to banks as liability on public balance sheet • Reduce TBTF subsidies by increasing capital requirements banks (Admati and Hellwig, 2013) • (Also: remove tax advantages high leverage • interest deductibility mortgage rent • mortgage insurance • interest deductibility corporate income tax)

14. Lessons crisis for public auditors • SGP rules should focus on long-term sustainability, not one-year deficit measures • true measure for sustainability: fiscal gap calculations • theoretically superior, practically more difficult • SGP rules should be based on all assets and liabilities, explicit and implicit • value all liabilities of financial sector for sovereign • Higher deficits possible if • larger assets • lower implicit debts • lower risk-exposure financial sector

15. Lessons crisis for public auditors • Control public liabilities financial sector • no longer off balance: value liabilities • higher bank capital • remove tax advantages debt • stop mortgage insurance