AUDITING THE FINANCIAL CRISIS:SOME AFTERTHOUGHTS FROM

THE NETHERLANDSBAS JACOBS

PROFESSOR OF ECONOMICS AND PUBLIC FINANCEERASMUS SCHOOL OF ECONOMICS

EUROSAI CONGRESSNETHERLANDS COURT OF AUDIT

JUNE 18, 2014

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

CRISIS DUE TO PRIVATE DEBTS AND CONSTRUCTION FAILURES EUROZONE

Source: Shambaugh (2012), BPEA

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

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

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’

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

PUBLIC BUDGETS ARE GOVERNED BY ECONOMICALLY SILLY RULES

1. Static rules of GSP ignore that GBC is inherently dynamic

2. Exclusive focus on liabilities ignore asset side3. Off balance liabilities are ignored

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

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

Liabilities Gross debt: 74,5% bbp

Total liabilities: 74,5% bbp

PM Latent liabilities (state pensions, health care)

PM guarantees

Source: CPB (2013) De naakte feiten over de Nederlandse overheidsschuld

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

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

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)

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

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