Andreas Dombret: New year, old problems - Europe's sovereign debt
crisis
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, to the International Bankers' Club, Luxembourg, 6 February 2012.
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1 Introduction
Ladies and Gentlemen
Thank you very much for your invitation. I am delighted to have the opportunity to speak to
you today at the International Bankers' Club. As you will know the central banks of
Luxembourg and Germany work closely together and exchange views regularly - this is why
I am here today. Even at the start of a new year, we are still facing the same old problems:
we are battling a crisis which is now in its fifth year and has reached its fourth stage.
The first stage was the subprime crisis which struck the US real estate market. At its heart
were those financial products which spread the risks stemming from US housing loans all
over the world. The loss of confidence within the international financial system following the
Lehman Brothers bankruptcy and the subsequent global economic crisis mark the second
stage. The third stage has been the ongoing European sovereign debt crisis, which became
visible to the whole world in Greece in May 2010. It was initially perceived as a problem of
what is known as the "euro-area periphery". Now, in the fourth stage of the financial crisis,
however, it is no longer limited to these countries.
The sovereign debt crisis, unfortunately, has now spread to the core of the euro area. This
was made painfully clear to us once again in the middle of last month. On the 13th of
January, Standard & Poor's downgraded nine euro-area countries. However, I do not want to
join the chorus of criticism against the rating agencies. Those who would pin the blame on
the agencies are confusing cause and effect. The agencies are merely the bearers of bad
news, and "shooting the messenger" is not only unfair - it does not solve the problem, either.
I would therefore like to take a closer look at the causes of the bad news which has been
hitting us in waves since the outbreak of the sovereign debt crisis. There are three questions
I would like to examine more closely. Firstly, what actually caused the crisis? Secondly, how
do we contain the crisis? Thirdly, where do we want to go with our monetary union in the long
run?
2 The causes of the sovereign debt crisis
Severely unhealthy economic developments had apparently been brewing in several
euroarea countries for many years. These included, most notably, excessive lending, asset price
bubbles and a loss of competitiveness. These structural problems were the breeding ground
for the sovereign debt crisis.
The actual weak link at the launch of our monetary union, however, was the combination of a
single monetary policy and a decentralised fiscal policy. Monetary policy, as you know, is set
at the European level - by the European Central Bank. On the other hand, responsibility for
fiscal policy rests with the individual member states, i.e. at national level. However, in a
currency area where fiscal policy is decentralised, the member states have a relatively large
incentive to borrow. If a country accumulates more and more debt, it does not face the
consequences by itself as these are spread across the entire currency area - for example,
through rising interest rates.
The founding fathers of our monetary union therefore created a framework of rules to
prevent, or at least correct, such unsound developments: the Stability and Growth Pact. This
was intended to keep national fiscal policies in check. One of its tenets was that annual
government budget deficits may not exceed 3% of gross domestic product. The penalties for
breaching this deficit limit could be escalated all the way to financial sanctions.
There is one more key building block in the edifice of the euro area alongside the Stability
and Growth Pact: the no-bail-out principle, which forbids member states from assuming
liability for the debts of other member states. The guiding principle of monetary union was
therefore individual responsibility: member states' individual responsibility for the
consequences of their policies and financial market agents' individual responsibility for the
consequences of their investment decisions.
Despite these rules, however, member states' borrowing has not been effectively contained.
Why not? Mainly, because the rules of the Stability and Growth Pact were not only
circumvented but even stretched to its limit. This was possible thanks to a crucial flaw in the
system: countries that violated the deficit limit were not automatically punished. Instead, the
other member states voted on a sanction. This, of course, encouraged an attitude of "I won't
punish you today if you don't punish me tomorrow".
Looking back, it must also be noted that the financial markets did not exert the desired
disciplining effect on fiscal policy. Investors turned a blind eye to the misbehaviour of some
member states for far too long. By the time the interest rates on government bonds started to
rise, the damage had already been done.
And, faced with that situation, it is extremely difficult to uphold the no-bail-out principle. As
I'm sure you will remember, no member state is allowed to assume liability for another's
debts. This principle was, at the very least, stretched quite a long way when assistance was
granted to Greece. That, however, was not entirely unjustified: the euro-area countries are
now so closely integrated that problems in one country can spread quickly to the entire euro
area in a phenomenon known as contagion. When push came to shove, it appeared
necessary to help other member states. And that is quite understandable in the short term.
However, in the long run it is dangerous if countries with a debt problem can expect to
receive help no matter what. This risks triggering a dangerous spiral of more and more
assistance and less and less confidence in the will of the affected countries to mend their
ways.
3 Routes to a stable monetary union
And such a loss of confidence is just what we are facing right now. The public, and also the
markets, have lost faith - in politics, but also in the architecture of our monetary union. The
question is: how do we go about restoring confidence?
Let me begin by stating clearly what won't work. Setting up larger and larger rescue
packages is not the way to instil lasting confidence. This strategy ultimately has its limits - be
they political or financial. And the proposal of circumventing financial limits by printing money
is dangerous. Of course the resources of a central bank are, in theory, nearly without limit.
Using them to finance sovereign debt, however, does not solve problems but, instead,
creates new ones. Such an approach would endanger the key foundation of a stable
currency: the independence of a central bank dedicated to price stability. This would throw
overboard the very things that need saving.
And, as I said earlier: money can't buy confidence. Even the largest rescue packages can
provide no more than a temporary reprieve. Time, in fact, is the only thing you can buy. But
this bought time must actually be used to eliminate the root causes of the crisis. And this
leads us to three key steps that the Bundesbank believes need to be taken.
Firstly, government budgets need to be put back in order. This goes for all euro-area
countries but is particularly the case for those countries which have put off the necessary
adjustments time and again. This is where the critics jump in to say that excessive saving
damages economic growth. However, I think this is too short-sighted. Of course fiscal
consolidation normally dampens economic activity. But there is no way the present situation
can be described as "normal"! In fact, doubts about the sustainability of government finances
are probably themselves a considerable drag on growth. The critics are right about one thing,
though: consolidation alone is not enough to solve the problems we are facing.
Secondly, the countries affected by the crisis therefore need to conduct structural reforms in
order to become more competitive and to promote economic growth. Such reforms are,
naturally, difficult and painful. Ireland has shown, however, that they are possible, and the
German experience has proven that they pay off in the long run.
And, thirdly, we need a stable architecture for our monetary union. Instead of constantly
patching up the results of fiscal policy mistakes and insufficient implementation of the
Stability and Growth Pact, the framework of monetary union has to be changed in a way
such that sound fiscal policy is also truly guaranteed in future. In my view, there are two
options open to the euro area: either we can return to the founding principles of monetary
union agreed at Maastricht, or we should venture the step towards a deeper European
integration which also includes fiscal policy.
3.1 Returning to the founding principles of monetary union
Regarding the first option - returning to the founding principles of monetary union - I do not
share the frequently voiced fear that the current framework is unsuited to monetary union.
Nevertheless, it does require considerable adjustment. There are three key points here.
Firstly, the Stability and Growth Pact needs to be given "teeth". In particular, stronger
automatism is needed to penalize breaches of the deficit and debt limits.
Secondly, the no-bail-out principle needs to be reinforced: no member state should be
permitted to assume liability for the debt of another member state. Financial market investors
will only punish bad fiscal policy behaviour promptly if they expect to lose their money.
Thirdly, the euro area needs a permanent crisis mechanism. Recourse could be taken to this
mechanism if a crisis erupts and financial stability throughout the euro area is at risk.
However, there are three important aspects to note: assistance to individual countries must
be tied to strict economic and fiscal policy conditionality, it must only be granted with
appropriate interest rate premiums, and private-sector investors have to bear their losses
themselves in the event of a default.
In view of these pressing needs, a "fiscal compact" was agreed upon at the EU summit last
week. This compact includes the introduction of debt brakes which should be firmly
enshrined in national law. At the same time, the Stability and Growth Pact will be enhanced
to be better protected from political influence in the future. Whether these decisions
represent a major step forward remains to be seen. As happened before, the initial
agreements seem to have been watered down during the negotiation process. The rules
regarding the debt brakes leave significant room for interpretation, and their application and
enforcement will not be monitored at the European level. It seems that the new version of the
Stability and Growth Pact might not be followed too strictly at the European level, either.
Altogether, the latest decisions are not entirely convincing.
3.2 Deepening European integration
Besides strengthening the existing framework of monetary union, there is an alternative route
to stabilising the euro area. This would involve deepening European integration. However, it
would not necessarily also mean the wholesale transfer of fiscal policy from national to
European level. National parliaments could retain their independence in deciding on revenue
and spending; European involvement would only affect borrowing and indebtedness if limits
are breached. So what form could this involvement take?
It would be important to set strict deficit and debt limits at the European level for national
budgets. These limits would then apply at all national levels. In Germany, for example, this
includes federal, state and local government and the social security systems. The European
rules would have to be combined with strict powers of intervention as this is the only way to
make them enforceable.
But it has to be crystal-clear: any member state in breach of the predefined deficit and debt
limits would lose its fiscal policy sovereignty. Ultimate budget-setting authority would
therefore no longer rest with national parliaments but at the European level.
In this area, however, the latest EU summits have made little headway. The adopted "fiscal
compact" does not provide for intervention in national fiscal policy even if a country
repeatedly breaches the rules. This means the "fiscal compact" is not the same as a true
"fiscal union". If, for instance, Eurobonds were to be issued now, there would be a mismatch
between liability and control: all euro-area countries would be jointly liable for the debts of
other euro-area countries but would not be able to keep them in check. However, in this
framework, mutual assistance must be granted only as a last resort, must be strictly
conditional and must involve considerable interest rate premiums, in order to give countries
an incentive to balance their government budgets.
3.3 Financial market reform as a necessary addition
National fiscal policymakers are ultimately responsible for convincing market participants to
invest in their sovereign bonds. The recent past has served as a painful reminder that the
status of sovereign bonds as a de facto risk-free asset has to be defended time and again.
And rightly so: the only way to get governments to live within their means is if the financial
markets reward good fiscal policy and punish bad fiscal policy.
However, in order to have a disciplining effect, the financial markets need a firm set of rules -
as was made abundantly clear by the crisis. And significant progress has already been made
in adapting the rules. The reform of the capital framework, which will improve the quantity
and quality of banks' capital and thus their capacity to absorb losses, is certainly a
particularly welcome development. Increasing the amount of losses the banks' investors are
able, and required, to take, reduces the danger of taxpayers once again having to foot the
bill. The phenomenon of systemically important banks, however, also shows that Basel III is
by no means the final step. The internationally agreed rules for dealing with the
"too-big-tofail" issue now have to be implemented quickly - and in an internationally consistent manner.
The oversight and, if necessary, regulation of the shadow banking system remain atop the
reform agenda.
The laundry list of regulatory reforms continues to be very long, and its details are often so
complex that it is difficult to explain to the general public. This opens the door to populist calls
for seemingly simple solutions - such as a financial transactions tax. We at the Bundesbank
are of the view that, if at all, such a tax would have to be introduced at least in all major
financial centres.
Looking at the financial markets and their regulation, however, I would like to mention one
more thing. The sovereign debt crisis is shining a new light on a commonly held assumption,
namely, that crises are caused by unfettered markets and can be avoided only by giving the
state more space. However, the sovereign debt crisis has shown quite clearly that even
sovereign debtors can fail.
Of course, the crisis has opened our eyes to a blind faith in the market that has sometimes
prevailed; however, statism and dirigism are, by no means, the right path to take. Instead, I
suggest we return to a founding tenet of the social market economy: individual responsibility.
Those who take risks must also face the consequences. Attaching more importance to
reviving this principle would represent major progress - including with respect to the
sovereign debt crisis.
4 Conclusion
Ladies and gentlemen, dear members of the International Bankers' Club, I have touched
upon various aspects which I believe to be essential for overcoming the sovereign debt
crisis. At the EU summit last week, policymakers decided to adopt a "fiscal compact"
designed to strengthen, and in some cases go beyond, the Maastricht Stability and Growth
Pact. This is, in principle, a good first step, but it has yet to prove its usefulness and
effectiveness in "everyday use". In any case, the Bundesbank will not cease to call for the
compact to be implemented in a manner which is conducive to safeguarding stability. In this
endeavour, we hope for your support.
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