Examination of Witnesses (Questions 20-39)
Professor Charles Goodhart
5 JUNE 2007
Q20 Lord Cobbold: Which would be diversification
out of the dollar into the euro.
Professor Goodhart: Yes.
Q21 Chairman: This begins to open up
what I think is a very interesting area because it is shocks to
the system that we are talking about, is it not? Presumably, if
you call upon the ECB to intervene to stabilise or to prevent
the euro appreciating further, I cannot think of another weapon
open to the ECB other than to drop interest rates.
Professor Goodhart: No, they could undertake
sterilised intervention. They can intervene directly on the exchange
rate. They just buy dollars and sell euros.
Lord Blackwell: Do you think their budget would
allow them to do that?
Q22 Chairman: They would have to buy
lots of dollars.
Professor Goodhart: There is no practical limit.
You can sell the currency that you produce as much as you want.
There is a problem that if they should sell euros and buy dollars
and the dollar should then depreciate nevertheless, they would
make a loss, which might be described as a speculative loss, and
that could be embarrassing because it would reduce the amount
of seignorage that they could then transfer to other countries.
But the loss would have to be very large indeed, I think, before
it actually brought about a significant budgetary problem.
Q23 Lord Blackwell: Could I come back
to the Stability and Growth Pact. If I understand the arguments
you have been making about the single currency area, you are saying
that ideally the single currency area ought to be followed, at
least be ratified, by integration of fiscal policy and political
entities in order to make it work effectively. To the extent that
has not happened and may not happen, that causes strain. Secondly,
ideally you would have free labour movement, which is a constraint.
So we have a system which does not have some of the conditions
fulfilled and is creating various strains, therefore, around the
euro area. The Stability and Growth Pact is an attempt to hold
things together. To what extent do you think the recent reforms
of the Stability and Growth Pact have been useful, appropriate?
Is there anything missing? Is there anything else you would do,
given that some of those fundamental conditions are still not
in place?
Professor Goodhart: I would not have approached
the problem in quite the way that they did. One of the questions
is what is the problem that the Stability and Growth Pact is meant
to deal with. And one of the responses to that is that there is
the problem that a country might get into such trouble that it
might have to default and to prevent that, because it would be
disastrous, the Central Bank might have to undertake inflationary
policies. In practice, it is not the default of a government that
really is disastrous, it is the fact that the value of its debt
goes down really sharply and the financial intermediaries in the
country involved then collapse. For the Argentines, it was not
the default of the Argentinean Government, it was the fact that
their banking and financial system got into really terrible trouble.
Moreover, once you have a single currency and you are a national
state, you cannot pay off all your bonds by simply printing more
money, so they cease to be riskless investments. The regulators
in the Basel Committee and elsewhere never like telling their
political masters that they are anything less than perfect. So
the Basel Committee and the financial regulators treat all government
debt as if it is riskless but, in fact, once you no longer produce
your own currency, and you can therefore always pay it off, it
ceases to be riskless. I would have started in a different way
by requiring a rising capital requirement on the bonds of any
single obligor, particularly one's own government, so that as
the Belgian, for example, banks and/or insurance companies were
getting more and more stuffed with Belgian Government debt—and
I take Belgium as a hypothetical example, not a particular case—the
capital adequacy requirement would rise to a point at which no
national government could, in effect, stuff its own financial
intermediaries with such a lot of its own debt that, if it went
bankrupt, effectively the financial system of that country would
collapse at the same time. Having tried to force a government
to sell its debt on the open market rather than effectively channel
it in to the financial system then I think the interest rates
would rise and you would get a penalty for excessive debt and
excessive deficits. That would be a market discipline to constrain
fiscal positions of the member countries of the Eurozone. There
is still a problem about what happens if they all start increasing
their deficits at the same time. Does that not mean you get an
imbalance in the economy? There I think there is a case for having
some independent body, maybe related to the European Parliament
or the European Commission, considering the question of what the
aggregate deficit over the whole European area might be and then
there are some quite interesting ideas about maybe having tradeable
permits. Say the independent body said that the Eurozone-wide
deficit should be 2% of GDP, and a particular country wanted to
go to 5% of GDP, it might be allowed to subject to a tradeable
permit, so that countries which were prepared to go below the
2% could trade with the countries that wanted to go above. There
are a lot of technical and other problems, but my feeling is that
the Stability and Growth Pact started at the wrong place, that
once you no longer have the ability to control your own interest
rate and exchange rate you need more flexibility rather than less
flexibility in national policies, and they really should have
chosen a completely different route of trying to maintain member
countries' fiscal disciplines. I think the Stability and Growth
Pact is just wrong but I can see why they sought to do it. As
I said before, I think it has had an effect on fiscal discipline.
Q24 Lord Blackwell: The risk is, you
say, that even with that discipline there is not enough sanction
on countries that may over-extend their national debt.
Professor Goodhart: Again, I think the Stability
and Growth Pact was just wrong. The idea that a country will pay
a sanction and hand over money to a European central body and
would impose a tax on its own citizens when its own politicians
think that the deficit is right and are defending it, in my view
was not a credible threat because it was so patently politically
impossible. I can imagine campaigning against paying over a tax
to the central Euro budget. Any sanction I think has to be market
based. This is why I think, for example, that imposing an appropriate
capital adequacy requirement, so that interest rates rise as the
national government within the Eurozone has an increased deficit
or an increased debt, would be a far greater way of doing it because
a market discipline is credible. The kind of discipline involving
the Stability and Growth Pact is just not. It was always a system
with a set of sanctions which were not properly considered.
Q25 Lord Blackwell: Without the kind
of discipline that you propose, do you think there is a real risk
that at some point the market may look sceptically on the equal
risk of all euro debt and start to speculate against the Italian
debt, for example?
Professor Goodhart: I think a lot of us have
been surprised by how small the spread is between the debt of
those who can clearly live within the Eurozone more easily and
those countries which may have some potential problems. But, again,
I think that is partly because the people in the market have looked
at the costs of exit from the Eurozone and reckon that they are
so severe that they will only happen through political miscalculation,
but political miscalculation is always possible.
Chairman: All of us are riveted with interest,
but it takes us to Lord Trimble's question.
Q26 Lord Trimble: In your paper you have
set out the sort of scenario which you have just been touching
on, where some people are having difficulty with the adjustment
that has to take place and because of poor competitiveness make
a political mistake, and then you envisage that there would be
very dramatic events happening in terms of the market that would
take decision-making out of the hands of the particular politicians
and force an exit, rather similar to the situation we were in
back in 1992. You think this could happen simply through a political
miscalculation and yet the consequences for that particular economy
would be massive.
Professor Goodhart: Yes. One hopes there would
not be such a miscalculation but it could happen. One rather dreads
to think what would occur if a country became so uncompetitive
and so depressed within the Eurozone that it regarded continuation
of the status quo as politically unacceptable. What would happen
then, I simply do not know.
Q27 Lord Trimble: You do not think there
is a serious risk of it happening through other investors looking
at the situation and saying, "That economy is having so much
difficulty adjusting that we think there is an added risk on it
of government debt." You do make the point that there is
virtually no spread at all but you think that is going to remain
stable like that and there is no chance of the market taking a
different view.
Professor Goodhart: Again I do not know. The
issue is essentially political. Unless these trends of competitiveness
can get reversed, there will come a point at which a number of
countries, probably in the Mediterranean area, will reach such
a condition of depression and deflation that politically it becomes
unacceptable. The question is what happens next. Then we write
a political scenario. It is not an economic scenario. I have no
comparative advantage in saying what will occur now. All I can
see is unless these trends reverse we are quite likely to get
to a situation where the political outcome could be difficult.
Q28 Lord Trimble: Would there then be
a case for saying that if this is happening, taking the case of
what people call the "Club Med", which is stagnating,
and this looks likely to continue, and if it does continue does
there come a point at which other Member States or the Commission
should say there is going to have to be some major adjustment?
Professor Goodhart: I think this is understood.
I think this longer term concern is well understood within the
European Commission and by many in the Eurozone. For the time
being, the situation is not really serious. The Spanish economy,
the Italian economy, are doing quite well at the moment, it is
just that one foresees that it could become serious. One of the
possibilities is that the German economic machine, which has delivered
extraordinarily low, often negative changes in unit labour costs,
will cease to be such a difficult powerful force to live with.
The Germans are very uncomfortable people to live with because
they bargain to achieve low increases in nominal wages and then
quite high increases in productivity, which means that everybody
else has to keep up with a situation, if they are going to maintain
unit labour costs, where there own unit labour costs are terribly
low. If your productivity is lower than the Germans, which is
the case in Italy, for example, that means no wage increases or
wage declines, if they are going to keep up. There are those who
hope that the German discipline will slip and the German workers
will get, instead of settling for 2 or 3% increases per annum,
will start demanding and getting, say, 5 or 6% or even more. It
is very difficult living with as disciplined a group as the Germans.
Q29 Lord Trimble: There is not much prospect
of the Germans moving in the direction of a large wage increase,
is there?
Professor Goodhart: No, but then, in a sense,
you see the problem.
Q30 Lord Steinberg: Over the last 15
or 20 years, quite a number of countries, including our own, have
had substantial currency fluctuations. Is it not the case that
now we are in a much more benign situation, because we have low
interest rates and because inflation is pretty low, and that this
period of substantial fluctuation in currencies is more a thing
of the past than it was a number of years ago and that we should
not pay quite as much attention now and there have not really
been massive fluctuations recently. Part of that, I suppose, is
the stabilisation of the euro within so many countries in Europe.
Professor Goodhart: We have been going through,
in economic terms, an extraordinary golden age over the last 15
years or so. Output has been growing very steadily, particularly
in this country. Inflation has been low and stable and, as you
say, the exchange rate movements have not been perhaps as severe
as in the past, though they have been still greater than one would
have expected. Given the stability of the various countries and
the fact they have all had constant low and stable inflation rates,
you would have expected almost no changes in nominal exchange
rates and yet there have been quite a lot. The exchange rate volatility
has been greater than one would have expected given the conditions
of the individual countries. The problem is that nobody really
understands exactly why everything has been so stable. It is partly
good policies around the world, including particularly in this
country, but also it has undoubtedly been through some good luck.
The shocks have not been as great as in the past. While we hope
the good policies will continue, there are those of us ho doubt
whether good luck will continue.
Lord Steinberg: Good luck is always important.
Q31 Lord Cobbold: It all depends on the
Asian economies and the growth in China, does it not?
Professor Goodhart: Yes, but as Charlie Bean,
the Chief Economist at the Bank of England, pointed out, the benefit
that you get by having lower manufacturing goods prices is offset
by the greater upwards pressure on commodity prices. The Chinese
are hoovering up all the spare commodities. I do not think one
can necessarily say that China has been an entirely beneficial
agent in world economic development.
Q32 Lord Trimble: Just to take it back
for a moment to the benign situation we have had for the last
decade or so and the way in which inflation rates and interest
rates have been so low, is there not a serious worry at the moment
that inflation here particularly going to get out of hand?
Professor Goodhart: It will not get out of hand.
The Bank of England is mandated to ensure it will not and the
Governor and the Monetary Policy Committee will do everything
they can to prevent that. I think there is a significant possibility
that the increase in interest rates necessary to achieve that
mandate will be higher than is now generally expected. The general
expectation is that there is another quarter per cent there to
come and that might well be the top. Looking at developments in
the world, including the longer run trends in monetary and credit
growth around the world and also the upwards pressures that there
are in commodity prices, which is partly due to the continuing
very fast growth in Asia, I think there is a considerable likelihood
that the required increase in interest rates to maintain stable
and low inflation could be greater than is currently expected
in markets.
Lord Cobbold: We have already covered most of
what I wanted to ask, but I just wondered whether you thought
there were any circumstances in which it might be in the interests
of this country to join the common single currency.
Q33 Chairman: This is not quite what
our report is going to be about but I would nonetheless welcome
your view.
Professor Goodhart: I believe there are two
stable situations. You either move towards a fully federal Europe—federal
in the sense that there is a considerable centralisation of both
democratic, legible mandates in Europe: for example, I would very
much like to see the President of the European Commission democratically
elected rather than appointed by the Prime Ministers. I think
a fully federal Europe would be an attractive possibility. The
alternative, which I think is an entirely acceptable and stable
regime, would be one of a free trade area with free movements
of goods and capital and all the rest of it, but you nevertheless
have national controls over the major economic instruments, such
as interest rates and fiscal policy. For that to work, because
of the concern about competitive devaluation which you mentioned
earlier, I think it would have to be a requirement that all the
governments in this free trade area to provide an exchange area
to float absolutely freely. At the moment we have neither one
nor the other. We neither have a federal system which is clearly
sustainable nor do we have just a free trade area with national
controls. We have a free trade area with the addition of this
unified monetary policy. For the reasons I have been trying to
set out, I think this is going to be subject to very considerable
strain. Again, for reasons I have tried to set out, because of
the costs of exiting, I think it may continue for a long time
but, potentially, very largely at the expense of certain regions
which could become depressed and deflated almost without limit,
like the South of Italy. I do not know whether, if we did enter,
we would be in the Club Med mode or in that part of the Eurozone
which would probably benefit. I think it would be very risky because
I do not think the regime is one which is nearly as sustainable
as the other two which I have described.
Q34 Lord Blackwell: In relation to financial
markets and exchanges, do you think there is any linkage between
the notion of a single currency area and the development of global
scale exchanges in financial markets or, alternatively, does the
experience of London suggest that you can do that without a single
currency?
Professor Goodhart: You can do it without, as
indeed you mentioned, in London. It is perfectly easy to hedge
currency risk and exposures. We have had the development of the
global financial system during periods in which exchange rates
have been capable of moving against each other and potentially
to do so with quite a lot of volatility.
Chairman: I am particularly keen to get on to
the whole area of enlargement and entry criteria for the Eurozone.
Lord Steinberg: People say, and I am inclined
to agree with them, that the entry of Romania and Bulgaria was
too quick because they had not met the requirements, particularly
in relation to their history of rather unsatisfactory, putting
it fairly mildly, dealings, where within the country there has
been a great deal of graft and so on. I am really seriously worried
that we are going to take people into the Eurozone who are not
really prepared for it as yet. And of course we are going to have
another big discussion about Turkey over the next period of time.
Chairman: If I can slightly reformulate the
question, we are really asking about the entry criteria and do
they make sense. It is not a question of us letting them in, it
is a question of them letting them in really.
Lord Steinberg: Yes, the Chairman is being much
more succinct than I was.
Q35 Chairman: Does it make sense?
Professor Goodhart: Could I ask you to clarify.
Are you talking about entry into the European Union or entry into
the Eurozone?
Q36 Chairman: Into the Eurozone.
Professor Goodhart: I do not think the criteria
for entry into the Eurozone do make sense, with one exception.
The exception is a fiscal one. I was recently in Hungary and the
Hungarians have a really very significant fiscal deficit. You
may remember that rather extraordinary occasion in which the Prime
Minister, who had just been re-elected, reportedly told the public
that he had been lying in the morning, lying at lunch and lying
in the afternoon and this was of course about the fiscal position.
The Hungarians are now beginning to rectify it, but they did have
a very difficult fiscal position, and I think it is perfectly
understandable that the Euro-group finance ministers in the ECB
would be very wary of allowing in a country whose fiscal position
was not sustainable and in good shape. The problem is that they
have a lot of other criteria as well relating to relative inflation
rates and relative interest rates. The point is that, unless you
are really quite wildly inflationary to begin with, the moment
that you adopt the euro you get the interest rate and the inflation
rate more or less of the rest of the Eurozone, so those criteria
are really quite unnecessary, and they are in some ways counterproductive.
If you take a relatively fast-growing Eastern European transition
economy, say in the Baltic States, a country like Estonia or Lithuania
or Latvia, because they have had an inflow of new capital and
new technology and so on which they have not had before, they
are very likely to have very fast rates of growth in their manufacturing
sector. That will lead to wages being bigger.
Q37 Lord Steinberg: Presumably from a
very, very low base.
Professor Goodhart: Yes, of course. That will
lead to wages being bid up there which will feed through into
the service sector where productivity inevitably is lower, so
that you are bound to find that fast-growing transition economies
have a somewhat higher inflation rate than there is in Central
and Western Europe. To prevent those economies joining the Eurozone
when they could perfectly easily do so because of a mild difference
in inflation strikes me as simply counterproductive. I have never
really been able to understand why the ECB has taken such a strong
stand on that point.
Q38 Lord Steinberg: I am concerned, as
a great many people are, and I would like your opinion on the
500 euro note which I believe causes money laundering and all
the other kinds of villainy that you could mention. It is far
out of synch with any other currency and I would be pleased to
hear your comments.
Professor Goodhart: I am entirely on your side.
I have written a number of articles, as have many other economists
(Ken Rogoff, for example, who then became Chief Economist at the
IMF), effectively stating that the very high value, large denomination
currency notes issued by the ECB effectively provide a degree
of subsidy or a degree of benefit to the black economy, to the
drug dealers. The increase in the outstanding value and proportion
of these notes is enormous. It is entirely unclear what went through
the minds of the ECB when they agreed to do it. My understanding
is that the ECB has simply modelled itself to a large extent on
the Bundesbank and the Bundesbank had very large value deutschmark
notes. The ECB simply said, "If the Bundesbank did it, we
will do it too." I think it was an entirely mistaken policy.
The only beneficiaries of this are the members of the black economy
and I do not think any normal person would hold one and yet the
increase in the outstanding value of these notes is enormous.
The euro has really taken over from the dollar as being the currency
of choice for every evildoer you can think of.
Q39 Chairman: Perhaps I could be allowed
to trespass upon your time and ask one more wind-up question which
is really about enlargement. What impact do you think the expected
enlargement of the Eurozone will have on the functioning of the
Eurozone economy and the management of monetary policy in the
Eurozone. I think we know who is going to enlarge it but in terms
of the likely entrants into the Eurozone what do you think will
happen?
Professor Goodhart: This is a governance problem
in the European Union that is common and it is not only in monetary
policy. It is very difficult to have a good discussion which has
to-and-fro arguments when you have a committee of, shall we say,
28 people sitting around the table. How the Governing Council
will operate I do not know. As you know, under, I think, the Treaty
of Nice, they had an agreement whereby all the national central
bank governors still attend and can talk but only a smaller proportion
can vote. In some ways, I think this is the wrong way round. In
order to get the discussion going properly and to get agreement
and understanding of what the problems are, you need a smaller
committee. Anne Sibert has done some work on the optimal size
of committee and reckons the optimal size is somewhere between
five and about nine, and when you get into the high twenties it
is very clearly not practicable. The IMF deals with it by having
groupings of countries which are then represented by one director
at the Fund. It is a very serious problem but it is not just a
monetary policy and how that will be handled. That is one of the
backgrounds to what used to be called "the Constitution"
which is going to be supposedly reinvented in a slightly different
format. I wish they had focused on that particular issue rather
than there being so many other issues that get brought together
in a document and one does not really know quite what is involved.
You probably saw my colleague Willem Butler's letter in the Financial
Times today on all that.
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