Dr Andreas Dombret
Member of the Executive Board of the Deutsche Bundesbank
The present state of the euro-area sovereign debt crisis
Speech at the Bank of America Merrill Lynch Global Macro Conference
1 Introduction
Having joined the Board of the Bundesbank only two years ago after a
long career in banking, I am, once again, delighted to address senior
market participants. I am acutely aware of the importance to exchange
information on the euro-area sovereign debt crisis not only among
central bankers and policymakers but also with the markets.
First of all, before commenting on the sovereign debt crisis, I would
like to remind you of a success story. More than 330 million people in
the euro area are benefiting today from a single currency, which was
introduced in 1999. The euro is not only our most visible symbol of
European integration. While the motivation for its introduction was
predominantly political, the euro has been a success in economic terms,
too. Since its introduction, its internal value has been at least as
stable as the earlier national currencies. The average inflation rate
has stood at 2%. I call this a true success.
That is all well and good, you may say, but some of you may be
wondering whether such a positive verdict has not been refuted by the
most recent upheavals in the euro area. Indeed, some investors are
sceptical about the euro, and more than just a few are predicting the
break-up of the currency union, or at least the departure of individual
member states.
In plain language, the central question in my remarks today is “Can
the euro make it, and how?” The answer to the first part of this
question is crystal clear: “Yes, it can and it will.” To answer the
“how”, I shall proceed in two stages: first, by explaining how the
crisis came about and, second, by describing Europe’s response so far
and, to our mind, future actions needed.
2 Analysis of the crisis
There is no doubt that the euro-area sovereign debt crisis, which was
triggered by the global financial and economic crisis, has been the
greatest challenge ever faced by European Monetary Union. The European
Monetary Union is certainly at a crossroads. The more pressing question,
though, is what European Monetary Union will look like over the medium
to long term. Will monetary policy, for example, be able to deliver
price stability as it did in the past? And how should it be organised in
order to do so?
When it comes to solving the current crisis, it is essential to take
account of the root causes as well as of the particular features of
European Monetary Union.
The root causes of the crisis are well known by now, so I shall be brief on this.
The convergence of long-term interest rates at low levels attracted
large capital flows to the peripheral countries of the euro area. Yet,
those member states failed in many respects to put these funds to
productive use. Instead, they spent the cheap money on public or private
consumption – as in Greece and Portugal – or they allowed their
residential construction sectors to boom, which eventually led to
oversized and vulnerable banking sectors – as in Ireland and Spain.
Sharp reversals of credit booms or persistent losses in competitiveness
can very easily put the solvency of governments at risk – which is
exactly what happened.
And this is of particular relevance in a monetary union, since member
states are no longer capable to offset losses in competitiveness by
devaluing their exchange rates. Higher-than-average rises in unit labour
costs therefore require internal and often painful adjustments in order
to regain price competitiveness in international goods and services
markets. In a nutshell, several member states failed to meet the
requirements of European Monetary Union membership. They did not
implement the necessary adjustments.
The inherent risk of monetary union was recognised right from the
outset, however. Specifically, the combination of a single monetary
policy with national fiscal policies distinguishes the euro area from
federal republics like the United States or unitary countries like the
United Kingdom. This setup increases the deficit bias and implies the
incentive to take advantage of central bank balance sheets to mutualise
sovereign debt in one way or another among the taxpayers of different
nations.
The founding fathers of European Monetary Union had these
disincentives very much in mind when they agreed on the institutional
arrangements. First of all, the eurosystem was mandated with a single
primary objective, namely maintaining price stability in the euro area
as a whole. Moreover, the no bail-out principle, the prohibition of
monetary state financing by the eurosystem, and the fiscal rules of the
Stability and Growth Pact were all put in place to prevent idleness on
the part of member states.
Nevertheless, the crisis also made obvious the shortcomings of the
institutional framework of European Monetary Union. The set of rules did
not prevent the member states from making the errors I mentioned.
Implementation of the fiscal rules was too lax. Moreover, the fiscal
rules of the Stability and Growth Pact were, in effect, relaxed some two
years before the financial crisis broke out in 2007, following a
strident campaign by Germany and France to make the pact “smarter”.
Furthermore, the designers of the framework turned a blind eye to the
emergence of macroeconomic imbalances and their risks to fiscal
sustainability as well as to financial stability.
3 Europe’s response to the crisis
3.1 Crisis resolution in the short run
Euro-area fiscal and monetary policymakers have taken extraordinary
measures to contain the crisis and maintain financial stability. First
of all, the euro-area member states and the
IMF supported Greece with bilateral loans. Then, a temporary stabilisation mechanism was established, the
EFSF.
As you know, its beneficiaries have been Ireland, Portugal and,
including a second adjustment programme, Greece. Over the course of the
sovereign debt crisis, the effective lending volume of the
EFSF has been increased, the lending conditions have been relaxed, and the toolbox of the
EFSF has been extended. A permanent mechanism, the
ESM, with a more resilient funding structure, has been established; it is scheduled to replace the
EFSF in summer of this year and to operate temporarily alongside the
EFSF. Recently, the euro-area finance ministers agreed to raise the ceiling for combined
ESM and
EFSF lending to €700 billion. Moreover, the
IMF member countries pledged over $430 billion in new loans to the Fund in order to erect a global firewall.
The European and global firewalls alike have been substantially
strengthened over the past two years. Are their levels now sufficient?
Or should European leaders increase their volume even further?
My opinion in this regard is that policymakers should refrain from a
wild goose chase in pursuit of ever higher firewalls. Making the
firewalls higher and higher will not resolve the crisis. Instead,
policymakers should care that firewalls do not fall into a credibility
trap owing to unavoidable political or financial constraints.
Generally speaking, a firewall cannot extinguish a fire. It only buys
time until sustainable measures become effective. Therefore, the fire
has to be extinguished by other means.
Monetary policy cannot extinguish the fire either. This is not to
deny that the monetary policy of the eurosystem has helped to stabilise
the financial system of the euro area and beyond. Our policy stance
remains rather accommodative. In effect, monetary policy is more
expansive than the key interest rate of 1% might suggest. Owing to
excess liquidity, market rates are well below that margin. The large
excess liquidity results from the non-standard policy measures of the
eurosystem. These include an extended list of eligible collateral, the
full allotment policy and the provision of very long-term refinancing
operations with maturities of up to three years. The Securities Markets
Programme and the Covered Bond Purchasing Programme are additional
non-standard eurosystem measures. All these measures, I wish to
emphasise, are temporary in nature.
The recent setback in equity and credit markets, along with still
strong flight-to-safety and flight-to-liquidity flows in sovereign
bonds, are mainly the result of political uncertainty in Europe. This
reminds European governments that they cannot afford to ease off in
their reform and consolidation efforts.
But let me also point to the inherent risks and side effects of the
central bank measures. Over the medium to long term, continued provision
of ample liquidity might, through various channels, de-anchor inflation
expectations, which would translate into higher inflation risks. It
could also pave the way for new asset bubbles, thereby sowing the seeds
of the next crisis.
Pointing out the risks and side effects of crisis measures does not
imply that the Bundesbank wishes to obstruct the stabilisation of the
euro. Quite the opposite. We are aiming to strengthen the framework of
the euro and to ensure that we continue to have a stable euro in the
future. Recurring suggestions to the contrary, for example by George
Soros, are therefore ill-advised.
A disintegration of the currency union would be linked to extremely
high costs and risks. That’s why such a scenario cannot be anyone’s
goal. Yet this does not imply that Germany becomes open to blackmail and
promises guarantees without control. This would indeed erode the
stability basis of the currency union.
Some argue, of course, that the eurosystem needs to do whatever it
takes to maintain the euro – particularly those who consider the
ECB
and the national central banks to be the “last men standing”. However,
it should be borne in mind that it makes a substantial difference
whether a non-monetary union central bank – such as the
Fed
or the Bank of England – or the eurosystem uses its balance sheet as a
policy instrument. In the latter case, balance-sheet policies and the
implicit risk of losses would imply a shift of burdens among the
taxpayers of different member states. But since it is taxpayers’ money,
it is up to national parliaments and not central banks to decide on such
a shift.
Hence, monetary policy must not sacrifice its stability orientation
and its credibility in fighting inflation, the more so as monetary
policy cannot resolve the crisis anyway. Addressing the sovereign debt
crisis is and remains, first and foremost, a fiscal policy task.
Nevertheless, the fiscal and economic policy reforms needed to bring
about a lasting solution are, in the short run, costly – both
politically and economically. Therefore, a major challenge for monetary
policy is that its unconventional measures and the temporary relief they
afford are not seen as an excuse to delay, or even reverse, these
reforms. Otherwise, monetary policy risks being taken hostage by fiscal
policy. This would do lasting damage – to central banks’ credibility, to
their ability to maintain price stability, and to public acceptance of
monetary union as a whole.
3.2 Sustainable crisis resolution
But what fiscal and economic policy action is needed to achieve a
lasting solution to the current crisis and to prevent future crises? In
my view, three conditions have to be met.
1. The first of these conditions is the rigorous implementation of
budgetary consolidation and growth-enhancing structural reforms in the
member states of European Monetary Union.
2. The second is a reform of the framework of the European Monetary Union that takes recent experience into account.
3. The third condition is further progress in financial regulation.
Financial regulation is a far-reaching and complex field, and I do
not wish to go into that today. But please allow me to highlight just
two points. The first is that, when European Monetary Union was
established, financial markets were expected to act as an additional
corrective measure against unsound fiscal policies. History has taught
us, however, that because of low risk awareness, markets have not worked
effectively as a timely sanctioning mechanism – and once they finally
became aware of the risks, the response was quick and fierce.
Nevertheless, the watchdog function of financial markets – of all of you
here today – is indispensable. To be effective, financial regulation
has to encourage investors to become aware of the risks and to signal
them at an earlier stage. The second point I would like to mention is
the painful lesson that contagion, via the financial system, has proven
to be the Achilles heel of European Monetary Union. Hence, improving the
resilience of the financial system, even though it is a major policy
goal across the world, is particularly important in the context of our
monetary union.
But let me now elaborate on the first and the second requirements of
the euro area for overcoming the crisis – fiscal and structural reforms
in the member states as well as a better framework for European Monetary
Union. Significant progress has already been made with regard to budget
consolidation and, to a lesser extent, in terms of structural reforms.
This is true of the programme countries which have to comply with the
conditions of the respective adjustment programmes. And it is also true
of Italy and Spain, the third and fourth-largest euro-area economies,
which have seen a significant rise in their bond yields. Their
governments have embarked on labour market reforms and spending cuts.
But there is no room for complacency. Flagging eagerness or too little
disclosure of looming risks will be penalised immediately. We have to
bear in mind that market pressure – together with political pressure –
has fostered reforms and hopefully keeps them on track.
By the same token, however, investors should have some patience for
reform measures to unfold. True, we are now in the third year of the
sovereign debt crisis, and too often precious time has been wasted. But
we should not forget that the adverse developments that led to the
sovereign debt crisis emerged over a decade. Clearly, they cannot be
reversed in a matter of weeks. The road to recovery is long and uneven;
backlashes are to be expected.
Looking at Spain, the country on which markets are focusing
presently, I wish to acknowledge that the government has already taken
bold steps to address structural weaknesses, for example by overhauling
some of the rigid labour rules. Yet it has become clear that the Spanish
banking system needs more capital. Therefore, I appreciate the
intention of the Spanish government to seek financial assistance from
euro area member states. The financial assistance will be provided by
the EFSF/ESM for the recapitalisation of Spanish financial institutions.
Funds would not be provided directly to the banks but, in line with
current EFSF/ESM rules, be channelled through the Spanish state, in this
case the restructuring fund FROB. I am optimistic that this package
will effectively mitigate the negative feedback loops between the banks’
deleveraging and the real economy. But quick and decisive action is now
warranted in Spain, and any further delay should be avoided, as the
longer one waits, the more expensive it is likely to get. Conditionality
only applies to the banking sector, but this makes it all the more
important that the Spanish government itself pushes vigorously ahead
with the reforms to tackle the structural problems of the Spanish
economy.
It is definitely not the task of the eurosystem to substitute for
national fiscal policies. This is true with regard to Spain, and it is
particularly true with regard to Greece. Greece must do everything in
its power to strengthen its competitiveness. The country needs to stick
to the agreed austerity and structural reform measures – no ifs, no
buts. There is no basis for external aid without the agreed reform
program. There can be no exception for Greece in this regard, as this
would inevitably undermine the balance of give-and-take in other program
countries, too. The repeat elections will show whether the Greek voters
still support this way forward. If not, Greece must be aware that it
puts further aid at risk. The consequences would be severe, and most
severe for Greece itself.
As the Bundesbank has stressed time and again, the way Europe deals
with the crisis in Greece will have far-reaching implications for the
nature of European Monetary Union as a stability union. This is a deeply
political question, and we have come to a point where policymakers can
no longer avoid taking sides. Attempting to dodge this decision and
muddling through as before no longer is an option. Rather, a further
muddling through would also be an – implicit – response, and one of the
least desirable ones, both from the perspective of a stability-oriented
monetary policy and with regard to overcoming the crisis.
A crucial question with regard to public finances in European
Monetary Union is whether the right cure is to prescribe frontloaded
consolidation for all euro-area countries. A considerable number of
experts are vehemently opposed to this approach. Paul Krugman, for
example, sees the euro area spiralling into disaster. And George Soros
is accusing many − including the Bundesbank, with its emphasis on
frontloaded consolidation − of destroying the euro.
It will hardly come as a surprise to you that I do not share such
views. Rather, I suggest that dragging out fiscal adjustment would have
major negative effects. Of course, it is correct to say that, in normal
times, consolidation dampens economic growth. Current circumstances,
however, are anything but normal, and it is an illusion to believe that
backloading consolidation would help to restore confidence. The current
crisis is essentially one of confidence. On the other hand, one should
not exaggerate the risks of a more restrictive fiscal policy stance, all
the more so as the rescue packages and the extremely accommodative
monetary policy stance do help to cushion the adjustment. The long-term
benefits of frontloaded consolidation, I am convinced, will
significantly exceed the short-run negative effects.
Nevertheless, there is an ongoing discussion on whether the euro area
should shift its focus from austerity towards growth. Indeed, the
crisis cannot be overcome without growth. This is very much undeniable.
What is now being hotly disputed is the question of what constitutes the
right approach to stimulating growth.
After
ECB President
Mario Draghi proposed a growth compact, he was getting applause from all
quarters as long as he did not spell out what such a growth compact
should comprise. He was not promoting a relaxation of the austerity
course – either in programme countries or in countries facing close
market scrutiny, nor in countries that are considered to have more
fiscal leeway. On the contrary: He denied the existence of a
contradiction between the goals of consolidation and growth. Instead, he
pointed to the need for structural reforms in all member states of the
euro area, in particular concerning product markets and labour markets.
In this sense, I appreciate the Portuguese Prime Minister’s support for
Mario Draghi. He was quoted as saying: “There are no overnight
structural reforms and the effects do not show up immediately, but we
know that our capacity to grow depends on these reforms. They are the
ones we are implementing.” This could not have been expressed any better
and clearer.
And I am confident that, once the implementation of structural
reforms has started, investors will return even before the effects of
these reforms have fully unfolded. Those who are currently short in
European sovereign debt and the euro will have to decide when the right
time has come to go long again.
The second requirement for a lasting solution to the current crisis
and the prevention of future crises is the much needed strengthening of
European Monetary Union’s institutional framework.
For me, right now, it has become evident that European Monetary
Union’s constitutional setting is far from being sustainable. To make
European Monetary Union sustainable two paths can be followed that I
will briefly discuss subsequently: truly improving the Maastricht Treaty
or building the foundations of a fiscal union.
With respect to the shortcomings that I have mentioned, we have
already seen a number of accomplishments. The fiscal rules of the
Stability and Growth Pact have been reinforced. The introduction of a
reversed majority rule, for example, makes it more difficult for
countries with excessive deficits to avoid sanctions. Second, member
states have agreed to launch a Macroeconomic Imbalances Procedure in the
euro area. The purpose of macroeconomic surveillance is to identify
potential risks early on, to prevent the emergence of harmful
imbalances, and to correct excessive imbalances that already exist.
Third, the Heads of State and Government of the euro-area countries have
agreed to “move towards a stronger economic union” and have announced a
fiscal compact. The key component of the fiscal compact is a further
strengthening of the commitment to bring the budgets of the member
states at least close to balance in structural terms. To this end,
fiscal rules will be tightened further at the
EU level, and new rules will be introduced nationally. The
UK has, unfortunately, not agreed to the fiscal compact. However, I appreciate that the Irish voters have given their clear “yes”.
While the fiscal compact is certainly a major step in the right
direction, it is far from being the cornerstone of a “fiscal union” in
the euro area. The fiscal compact aims at strengthening the current
framework, but its success will hinge crucially on the member states’
willingness to implement and apply the rules. European authorities are
not equipped with a supranational right to intervene in national budgets
when member states do not apply the rules properly. Therefore, the
fiscal compact – which has not been ratified by all member states yet –
does not justify calls for monetary policymakers to further extend
central banks’ balance sheets. Nor does it substantiate any extensive
joint liability.
Against this background the recent proposals of a so called banking
union appear to be premature. Such a banking union, potentially
comprising a euro area deposit-guarantee system, a euro area resolution
fund and common euro area supervision for the largest and systemically
important banking groups could very well represent a sensible step
forward. Yet it has to follow a deeper fiscal union as it would imply
significantly increased risk sharing amongst countries. Introducing a
banking union without having established a genuine, democratically
legitimated fiscal union would risk undermining the no bail-out clause
and the disciplining effects of financial markets on fiscal policy. From
a formal perspective it necessitates amending the
EU
Treaty – meaning it is very unlikely to be a short-term fix to the
current challenges mainly related to recapitalisation needs in some
banking systems, to political risks and to contagion effects within the
euro area.
The same is true regarding the proposed introduction of eurobonds.
This is where I respectfully disagree with Olivier Blanchard, the
IMF
chief economist, who was quoted as saying: “… the Germans had good
reason to reject bearing the brunt of irresponsible policies by other
states. But now we have a fiscal treaty.” And he concluded: “The Germans
should accept that the eurozone is going by way of eurobonds.” Under
the current framework, the issuance of commonly guaranteed sovereign
bonds would actually increase the existing mismatch between liability
and control. I think, that, at least for the time being, euro-area
governments have been reluctant to surrender their fiscal autonomy to a
European authority.
4 Conclusion
The euro area consists of independent member states. Each member
state has its own constitutional tradition which has to be respected by
its government. To some extent, the status of the euro area is similar
to the Articles of Confederation drawn up in the late 1770s, which
legally established the United States of America and served as its first
constitution.
We do not necessarily have to become a United States of Europe. It is
quite possible that a reformed Maastricht framework of truly
self-responsible member states – in other words, the European Monetary
Union as it was planned to be – will guide us to a sustainable monetary
union. Or the peoples of Europe might indeed make the leap to a
substantial deepening of European integration, particularly in terms of
economic and fiscal policies. Both options are viable.
The decisions taken up to now do not yet indicate which direction
Europe will take. However, there is absolutely no doubt as to the
political will to ensure the continuity of European Monetary Union.
Especially to observers from outside the euro area, and given the often
slow decision-making processes, the strength of this commitment is
underestimated.
We in the euro area believe in the continuity of the euro. And if the
euro area embarks on the necessary reforms that I have outlined today,
it will emerge from the crisis stronger than ever.
Thank you very much for your attention.