Europe: after the crisis reaction to the lecture of Charles A.E. Goodhart

1. Europe: after the crisisreaction to the lecture of Charles A.E. Goodhart Duisenberg School of Finance Opening Academic Year September 7, 2011 Wim Boonstra Chief Economist Rabobank,

2. Content • Charles Goodhart’s conclusions • Some comments • Some recommendations: common funding of public deficits • Concluding remarks

3. Charles Goodhart’s conclusions • A monetary union needs some minimal centralisation of power. • Current account balances are important! The new Excessive Imbalance Procedure correctly shifts the focus from public finances to the external sector • The enforcement of the EIP is misguided • Interaction between banks and public sector debt is the most severe problem. There really is no good way to resolve this. • There is a case for building up a sizeable euro-zone sovereign wealth fund for use in emergencies

4. Some comments • I agree with Charles Goodhart on almost everything he has said. • “For a country like Japan, with a huge public debt but a CA surplus and a positive NIIP its debt is entirely its own concern”. Is it? Or does it need capital controls in the end? • The corrective arm of the EIP is misguided. Financial sanctions do not make sense. But would an ‘enforced credit rating downgrade’ have a different effect? • What we need is ex ante agreed and automatic political sanctions. Such as: • (temporary) loss of voting rights in the ECB board • (temporary) loss of voting rights in the council of ministers • (temporary) loss of European Commisioner • To summarise, we need: • measures that hurt politicians, not their electorate • measures that are easy to implement • Creation of a wealth fund is a good idea, but it is not enough

5. On average, EMU public finances are relatively good.

6. Financial markets’ binary discipline: a case for eurobonds?

7. The eurobond cacophony • There are manyso-calledeurobondproposals. They have onething in common: the word ‘eurobond’. The differences are huge. • Succesfulleurobondsshouldbring: • Stabilityin the markets • Improvedfiscal discipline (supportedby a more effective SGP) • Clear benefits forallcountries (weakand strong) • A self-financingandpro-active crisis mechanism (via aninsurance premium) • Most proposalsbring at best some benefits for the weakercountries • Benefits for strong countriesmightbe: • Lowerfundingcostsduetoliquidity premium. This is stronglydependent on the exact design. Herethingscan go seriously wrong • Self-financing crisis mechanism Goodhart’s SWF

8. Central funding via the EMU fund • EMU fund issues (euro)bonds and pays market rates • Redistributed to the member states • Countries pay spread over funding costs, depending on fiscal performance • Self-financing mechanism(‘insurance premiums’) • Cross-guarantee essential(not partial guarantees)

9. Pros and cons of this approach • Advantages • Flexibility in debt management (maturities etc.) • Diverging fiscal policies translate into diverging funding costs (restoration of failing market discipline) • Countries are sheltered from sudden swings in market sentiment • Creation of huge and liquid pan-EMU bond market • Weaker countries pay premium to EMU Fund, instead of higher interest rates to markets  financial buffer against future problems  Charles Goodhart’s SWF? • Using cross-guarantee  the average counts, not the problem in the margin  lower funding costs • (Possible) problems • Potential tensions with no-bail out clause  we already have crossed this line • Difficulties in calculation of spread  see below • Practical implementation • Lack of political willingness  voluntary participation • We can start without Germany. Any pair of countries can start and scale up.

10. Computing the spread • A simple straightforward formula will suffice: • R(i) =  [O(i) - O(m)] +  [S(i) – S(m)] • Where: • R(i) = the margin payable by country i over the funding costs of the EMU fund • O(i) = the government deficit of country i, as a % of GDP • S (i) = the government debt of country i, as a % of GDP • The variables O(m) and S(m) represent the acceptable levels for debt and deficits. They could be the criteria from the SGP. • The parameters  and  are coefficients, used to determine the weight of the relative performance on government deficit and government debt respectively in setting the mark-up.

11. Concluding remarks • A monetary union needs some minimal centralisation of power. • Eurobonds can change the interaction between banks and the national public sector debt • There is a case for building up a sizeable euro-zone sovereign wealth fund for use in emergencies  a well-designed eurobond scheme can bring this forward • If fragmentation of EMU’s national public bond markets is not eliminated, EMU will remain vulnerable and may in the end not survive. Some centralisation is essential • A well-designed eurobond scheme can bring advantages for all participating countries: • Deeper markets bring increased liquidity  lower funding costs • Weaker countries benefit from cross guarantee • Self-financing insurance mechanism  no need for additional rescue packages

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