Professor Charles Goodhart

5 JUNE 2007

  Q1  Chairman:   Welcome, Professor Goodhart. Thank you very much for coming to help us with this inquiry, which will be very useful. It sounds awfully police like, but I would like to warn you that everything you say will be broadcast. It goes on the website. You will receive a transcript of the evidence afterwards and you will have a chance to look at it and say, "No, really that did not quite work," but it is being broadcast live, as we speak. We have a list of questions, which I am sure you have, and we have all read your papers, but would you like to start with a general statement or to start with questions?

  Professor Goodhart: I have not prepared a general statement, so would you like to go straight into questions.

  Chairman: We will go straight in.

  Q2  Lord Cobbold: Good morning. In your paper Some Lessons from the Eurozone you support the German economists' theory which says that currency unification should be one of the steps in a much longer process of harmonisation. If we had done that, is it not the case that we would not have a single currency in the Europe now?

  Professor Goodhart: I do not think that we would now have a single currency in the Eurozone. That might have been a good idea. I think it is highly possible that the optimal arrangement in Europe would be two zones, one for north/central Europe and one for the Mediterranean members of the Euro area.

  Q3  Lord Cobbold: Then you would have a currency fluctuation between the two. Surely the main benefit of a single currency has been the enforced discipline on avoidance of competitive devaluation, which was one of the scourges of the 20th century, so it has been positive.

  Professor Goodhart: That argument does not follow in North America—where, as you know, they have the North American free trade area—which is a free trade area. Currencies do fluctuate between the Canadian dollar and the US dollar and between the Mexican peso and the US dollar, and that does not seem to be a particular problem for them. The argument that you would have to have a single currency in order to maintain an area of free market and free movements of goods, services and capital, does not seem to me to be at all proven. Again, there is this fear of competitive devaluation but that occurs usually when there have been periods in which the exchange rate has been pegged and the government decides to lower it by a step-change, and the step-change is frequently large enough to induce an initial competitive advantage. If the currencies are floating and the authorities are not intervening (for example, we do not have a Chinese situation, where the Americans argue that because of intervention, the Renminbi is significantly devalued) the idea that there is a competitive devaluation when the exchange rate is determined by free markets does not seem to me to hold or to follow.

  Q4  Lord Blackwell: You make the point that a single currency area, to be effective over the long run, depends on, in particular, a flexible labour market.

  Professor Goodhart: Yes.

  Q5  Lord Blackwell: You argue that the movement of capital is probably not going to be adequate to make up the inadequacies in the labour market. Europe, as of now, does not have the same kind of free movement of labour for a whole set of cultural as well as economic reasons, as America. Do you conclude from that that, unless some action is taken—and I am not sure what action could be taken to create that kind of free movement of labour in Europe—the single currency area covering north and south is ultimately doomed or not going to work effectively?

  Professor Goodhart: I think it will face great difficulty, but as I think Samuel Johnson said, "there is a great deal of ruin in countries". Countries can go through really very difficult times without that causing separation. For example, it is arguable that it would have been better if Italy had never been unified and southern Italy had been able to operate as a separate state and vary its exchange rate against the rest of the world, including northern Italy. Nevertheless, the Italian state has survived, despite the fact that southern Italy has had a fairly difficult and a rough time. If one takes into consideration the very considerable penalties that would be applied on any country that would seek to exit the Euro, one can see that it is perfectly possible for the Euro area to continue almost without limit but probably with a significant number of regions in the Euro area, including countries within the Euro area, probably having a far less beneficial economic outcome than there would be if they had gone their own way.

  Q6  Lord Blackwell: Is there anything that could be done, do you think, at this stage to reduce the pain on those countries or areas?

  Professor Goodhart: There was of course always the possibility of trying to have greater fiscal centralisation. It does not need to be the complete harmonising of all taxes and expenditures on employment benefits and other public goods, but there was an attempt that was made by the Commission, to consider the fiscal measures that would accompany the single currency and they set up a special committee with external members, of which I was one, in 1991/1992 to consider what was the minimum fiscal centralisation necessary to provide fiscal support that would enable the Eurozone to carry on effectively. I think that we did, in fact, a very good exercise. It was the paper which was called Stable Money: Sound Finances. It was published in the European Economy and the supporting papers were published in another issue. We advocated that we could provide stabilisation, but not redistribution, effects for a relatively small amount of money. The amount of money that was required was to shift the proportion of funds going into the central budget in the Euro area from about 1.3 or 1.4 at the time to about 2.25 or 2.5% of GDP—which did not seem very much to me—but when the report was considered it was thrown out absolutely, at which point, I must say—this was back in the early 1990s—I came to the conclusion that if there was not enough political harmony and fellow feeling between countries within the Euro area to have a minimum degree of fiscal centralisation to ease these kinds of adjustment problems, then it was going to be very difficult for a monetary union flag to fly.

  Q7  Lord Steinberg: You mentioned Italy going through a severe spell a couple of years ago. Do you believe the reasons that Italy weighed up the consequences of coming out were the reasons they decided to stay in: because the penalties would have been too great had they gone out?

  Professor Goodhart: I do not know, I accept, what went through their minds, of course. I think there is a danger of some populist-type politician going to the electorate, the public, and saying, "We can get away from all these problems we may be facing". The problems have not reached, as yet, a particularly serious stage. That was partly due to the fact that that when the Eurozone started with the single currency in 1999, Germany—which is a very difficult country to live with because they manage their economy rather well and everyone else has to keep up with them—in fact had a very overvalued currency, owing to the problems it had faced with unification. That means there has been a great deal of room for Germany's competitiveness to improve and the Mediterranean countries' competitiveness to get worse, as a trend, without putting too much pressure on the system as a whole. In the meantime, the countries that have been losing competitiveness, like Spain and Italy and Greece, benefited during this period from a very considerable reduction in interest rates which led them to have a considerable housing boom—for example, in Spain, an enormous housing boom. If you take into account the fact that the trend started favourably for the Mediterranean countries and they had the benefit of very sharply declining interest rates, the adverse trends arising from fact that the competitiveness has been getting systematically divergent between Germany and the Mediterranean countries has not yet really shown up. The fear is that the housing boom may come to an end as the ECB starts to raise interest rates, and that, combined with the low competitiveness in countries like Spain, could lead Mediterranean countries fairly rapidly to move into a much more difficult condition than they have faced recently. If the politicians and their advisers weigh up the costs of leaving the Euro area I think they would have to think many, many, many times before escaping.

  Q8  Chairman: Could I ask a supplemental question. We have started to talk about housing and capital mobility. You do not set great store in your paper by the ability of free movement of capital to aim off, as it were, some of the difficulties of adjustment. I believe we know the movement of capital has greatly helped the stabilisation pact. If we all go and buy houses in poor countries, that moves capital. Do you believe in general in capital mobility? Do people say, "I will go and set up a factory in a very poor part of Italy" rather than moving those people?

  Professor Goodhart: My version is that, if anything, the reverse happens, that people move to areas that are successful. There is a kind of conglomeration effect in areas that are successful. In the City of London there is a sort of conglomeration effect. You do not move your investment bank to, shall we say, Bucharest because there are a lot of low-paid bankers in Bucharest. Capital tends to follow success rather than failure.

  Q9  Lord Cobbold: The existence of membership of the single currency is a useful discipline and has worked with the national governments to help improve the way they manage their own economies, has it not?

  Professor Goodhart: The fiscal record improved very considerably between 1990 and 1999, in most cases, when they were trying to achieve entry, but that was partly as a result of a reduction in interest rates, so the amount of interest they had to pay, in the cases where they had quite large debts, declined. Since then, I think, the Stability and Growth Pact has led to the deficit being lower during the relatively slow growth of recent years than it might otherwise have been. It has had some effect on fiscal discipline. I am not quite sure what other kinds of discipline you had in mind.

  Q10  Lord Cobbold: I was thinking particularly of fiscal discipline and complying with the Stability and Growth Pact which is obviously an important part of the whole picture which you have not really talked about.

  Professor Goodhart: I think the Stability and Growth pact gets a somewhat unfair press, if you compare what happened in the Euro area to what happened in other countries such as the United States and, indeed, in this country. The turnaround in the scale from surplus to deficit in the United States was almost unparalleled between around 1999, when there was a surplus, and 2002. At that time there were those in the US Treasury worrying about what happened when they bought back all the bonds, and there were no more government bonds outstanding. Between 1999 and about 2002/2003, I think there was a shift from surplus of about 2% to a deficit of about 6% GDP. I take the numbers slightly from the wall but the turnaround in the US was huge. The turnaround in this country was quite large too. The turnaround in Europe was very, very much less. The Stability and Growth Pact might not have been met in detail by major countries; they may have gone through the limits that they were supposed to uphold; but the argument that it had no effect therefore, I think, is wrong. I think it had quite a considerable impact.

  Q11  Lord Blackwell: But you could have had the Stability and Growth Pact directly without the single currency area.

  Professor Goodhart: Yes.

  Q12  Lord Blackwell: The UK was a member of the Stability and Growth Pact. Some of the governments may not have taken it as seriously but it does not necessarily go along with the single currency.

  Professor Goodhart: Indeed. There was always the question with the Stability and Growth Pact whether the sanctions were realistic. I doubt very much whether we in the UK would have taken much more notice of the broad economic policy guidelines brought forward by the Commission than they did in Ireland. When the Irish had a large surplus, they were told by the EEC to have an even larger surplus, and the response was "Get lost"—which I must admit I have a certain sympathy for.

  Q13  Chairman: This question relates to the previous discussion. How do you feel about the ECB's monetary policy? Has it been too restrictive? For instance, how do you feel the policy of upper inflation limit rather than a target zone (as in the UK) contributes to this?

  Professor Goodhart: There is, again, a very considerable difference between the conduct of policy and the measures they took, and the presentation of policy. I think the presentation of policy was poor, in that the ECB did not appear to commit itself to a symmetric policy in which undershoot was as important as overshoot. They did not ever clearly indicate the limits of their ranges with which they would be happy—they had no sort of upper and lower bands. It is fairly clear that they get a bit uncomfortable when inflation, as measured by their harmonised CPI, goes significantly over two and it is clear that they do not want it to go below zero, but it is not symmetric and it has never really been made clear. There is another problem as well, which is that they set the target for themselves. I think it provides enormous protection for a central bank to get politicians to set the target because it then commits the politicians to it. When I was on the MPC I always used to say that, if anyone wrote in to say that they did not like what we were doing, the way we should answer was: "If you disagree that our policy was the best way to achieve the target set by the Chancellor, we would be very interested in your technical arguments. But we guess that what you do not like is the target, in which case go and talk with the Chancellor." A central bank can deflect most of the criticisms by getting the politicians to set a target. I do not believe that the Euro-group ministers of finance would set a target which would be much different from, shall we say, the UK target of one to three, with a central point of two. That would have both protected the ECB and prevented the rather undignified squabbles that we get still between ministers of finance, or some ministers of finance, and the ECB. I think the presentation of policy has not been well done by the ECB. In terms of conduct of policy, I do not think the claim that they have been systematically deflationary stands. Interest rates, both nominal and real, have been very low systematically and the inflation outcomes have, on average, been clearly above what the ECB would want and probably what a Euro-group set of ministers of finance would have asked them to achieve. On balance, I think the ECB has done as much as it really could to support growth within the Eurozone, conditional on the fact that it has been given the primary target of achieving price stability. I would give the ECB a grading of C minus or D for presentation and a pretty high grading, in the As, for the conduct of policy.

  Q14  Chairman: Could I pursue your idea about having the Euro-group or ECOFIN set an inflation target. I was thinking about this before the meeting and I could not work out how you would achieve what would probably be needed—that is, unanimity—unless within a range so wide as to be not useful. Have you given some thought on the mechanics of this?

  Professor Goodhart: It is the same problem as you get in the mechanics of almost any other Euro decision. If it is by unanimity, you would get into difficulty. If it is by qualified majority, there would be those who would feel it is too important an issue to be managed by qualified majority. I understand the problem, and I take entirely the point you are making, but I think this is on a much more general issue of the governance of Europe and the Eurozone as a whole, which goes much more widely than just monetary policy.

  Q15  Lord Blackwell: Does this not reflect back on the earlier point you were making, that if you do not have the conditions for a natural single currency area then a single interest policy or a single monetary policy will be right for some areas but wrong for areas and the ones for which it is wrong will ideally want to set different conditions.

  Professor Goodhart: The problem has been made worse by the fact that the single interest rate in the countries which are already somewhat deflationary and, in the German case, have had low consumption and are gaining competitiveness, and this makes monetary policy tight, whereas in the countries which are already more inflationary, monetary policy becomes easier. This is known as the Alan Walters' critique of a single monetary policy and still has some force.

  Q16  Lord Steinberg: Professor, this may not be something directly relevant but it is something which is occupying people's minds, and that is the strength of sterling at the moment against the dollar. Can you see any danger resulting from that in regard to the euro?

  Professor Goodhart: I am not sure whether you want me to respond to the question: Is the euro dangerously high against the dollar? Or: Is sterling dangerously high against the dollar?

  Q17  Lord Steinberg: Either or both.

  Professor Goodhart: Let us take the euro first. There are certainly fears that the global imbalances and the large current deficit of the US will involve at some stage a further depreciation of the dollar, perhaps because central banks will not wish to go on putting a lot of money into a depreciating currency. Under that circumstance, if the Asian economies continue to try to control their exchange rates, by and large, particularly the Chinese, then the counterpart of the depreciation of the dollar would fall primarily on the euro because that is, in a sense, the alternative and so the euro would have its exchange rate rise a lot against the dollar. Again, there are qualifications. If you take the Euro area's effective exchange rate, it trades a lot with local areas in the East, the Middle East and Africa, which are probably likely to move with the euro rather than the dollar. The effective exchange rate will not get as much variation as the euro to the dollar exchange rate, nevertheless it is perfectly possible that the exchange rate of the euro relative to the US dollar could become uncomfortably high. What is uncomfortable, I do not know, but at some point it is quite likely that a significant number of leading politicians in the Eurozone, notably, I would think, the new President of France, Monsieur Sarkozy, will say enough is enough and will then try to use the rather ambiguous phrases in the Maastricht Treaty to require the ECB to intervene to prevent the euro appreciating any further. Whether and when that would happen and whether that approach that Monsieur Sarkozy has clearly outlined would get sufficient support elsewhere in the Eurozone, for example from Germany, nobody knows.

  Q18  Lord Cobbold: Pressure is being put on the Chinese, for example, to revalue gently their prices so as to stop the build up of dollar reserves and the switching from dollars into euros, is it not? Is pressure being put gently on the Chinese to help the problem?

  Professor Goodhart: The Chinese tend to be rather resistant to pressure.

  Q19  Lord Cobbold: They have done a bit already. They have made two steps in the right direction.

  Professor Goodhart: One of the problems for them is the more they revalue their Renminbi the greater the fall of the value of their massive existing reserves. The likelihood that the Chinese will allow a floating exchange rate or any significant jump, I think, in the value of the Renminbi is quite small. It will go on trending upwards against the dollar but relatively slowly.