Economic policy: the challenge of future crises
Speech by the Governor of the Banco de España at the Barcelona Círculo de
Economía to mark ten years since the Lehman Brothers collapse
Pablo Hernández de Cos
Governor

I wish to start by thanking the Barcelona Círculo de Economía for their kind invitation to be
here with you today, to close this cycle of lectures organised to mark the tenth anniversary
of the collapse of Lehman Brothers. The economic and financial crisis was attributable to a
broad and complex range of factors, but there is no doubt that this event remains engraved
on the collective memory as a moment of particular significance, marking in a way the
symbolic start of the crisis.
The past decade has provided us with numerous lessons for the future, in particular in the
area of economic policy management. Today, in order to identify outstanding tasks, I am
going to devote my speech to a review of the changes that have occurred during these
years, both at international and national level, which determine our ability to prevent the
emergence of new crises or to mitigate their effects should they materialise.
I shall start with the reforms at international level, in particular in the global financial
architecture, and the risks arising from protectionism, the intensification of which may have
significant negative effects on world growth in the medium term. I will then address the
changes in euro governance, before moving on to discuss the role played in recent years
by monetary policy. Finally, I will focus on the case of Spain, to briefly review the events of
the last few years and then outline the main challenges facing the public finances,
supplyside policies and the banking industry.
Progress on institutional design and supra-national economic policies and their
challenges
Reform of the international financial system
At international level, the global financial crisis highlighted the need for far-reaching reform
of the regulatory and supervisory frameworks. The efforts made in recent years in this area
have given economic policymakers updated instruments and new tools with which to
address future risks relating to the financial system, its stability and its relationship with the
economy as a whole. Thus, right from the early stages of the crisis, the G20 set in motion a
series of reforms covering a number of areas, including microprudential and
macroprudential banking regulation, international accounting standards and the regulation
and monitoring of non-banking sectors, among other measures. We are currently in the
phase of assessing the suitability of all these new instruments, some of which are still to be
tested in crisis situations.
In the microprudential domain, the Basel Committee on Banking Supervision undertook a
far-reaching review of the regulatory framework, which would become known as "Basel III",
with the aim of increasing the resilience of the banking system and reducing the impact of
financial crises on the economy. Some of the key reforms introduced include an increase in
the quantity and quality of minimum regulatory capital and the creation of capital buffers.
New prudential requirements have also been introduced, such as the limits on large
exposures, a maximum leverage ratio and two liquidity requirements, at the same time as
the reform of the frameworks for evaluating market risk and securitisations has been
launched.
In addition, last December, a second wave of reforms introduced within the framework of
the Basel Accords was completed. The focus of these measures has been the calculation
of risk-weighted assets, i.e. the denominator of the capital ratio, in order to improve the
comparability of capital ratios across banks and jurisdictions.
Another lesson of the crisis was that it is necessary to prevent and mitigate the effects of an
excessive build-up of risk in the financial system as a whole. An exclusively microprudential
based regulatory framework is clearly not sufficient to achieve this. New instruments were
considered necessary to help moderate and address cyclical systemic risks (such as, for
example, those associated with the credit cycle) and cross-sectional systemic risks (for
example, those linked to the risk arising from, among other aspects, the size, complexity
and density of the interconnections between financial institutions).
With regard to cyclical systemic risks, a countercyclical capital buffer has been introduced,
with a view to preventing risks arising from excessive credit growth at the aggregate level.
As for cross-sectional systemic risks, the Financial Stability Board promoted a set of
measures to strengthen the capital requirements for systemic banks and to establish stricter
supervisory requirements and stronger resolution frameworks for them.
The development of microprudential policy also entailed changes of an institutional nature.
In Europe, the European Systemic Risk Board was created, with the task of microprudential
supervision of the financial system of the European Union (EU). However, at the same time
it was necessary to create a framework for action at national level to enable the different
sources of systemic risk to be monitored and the adequacy of the new macroprudential
policy matters and instruments available to be assessed.
Following this roadmap, the Spanish Government has recently announced its intention to
create a macroprudential authority comprising representatives of the Ministry of the
Economy and Enterprise, the Banco de España and the National Securities Market
Commission. This new authority will be responsible for the macroprudential supervision of
the Spanish financial system, with the aim of contributing to the prevention and mitigation
of systemic risk.
The crisis also highlighted certain vulnerabilities in the international accounting standards,
resulting in the provisions needed to cover risks being recognised late and being inadequate
in amount. In response, an expected loss accounting model was introduced, which, along
with the reforms in the prudential area, helped improve recognition of credit risk and
increasing the resilience of banks to unexpected deterioration in their credit portfolios.
However, the reforms were not only intended to bolster resilience and alerts in the face of
shocks and sources of risk, but also to promote the development of effective resolution
mechanisms. This sought to address the problem known as "too big to fail", a problem that
became obvious during the crisis, when the authorities of various countries were forced to
use public funds to rescue banks, owing to the serious consequences that their insolvency
might have had on the rest of the financial system and on the economy as a whole.
With regard to resolution, a number of principles have been developed in order to guarantee
the orderly management of banks in severe difficulties. These include the development of a
bail-in tool to permit an orderly resolution process that minimises the impact on financial
stability, ensures the continuity of critical bank functions and minimises the need for public
funds.
Apart from the reforms I have mentioned, the G20 promoted stricter regulation and closer
monitoring of the activity of non-bank financial intermediaries. The aim was to improve the
monitoring of developments in this sector, and to assess which regulatory instruments
should be used, taking into account the risks these intermediaries pose to financial stability.
These risks may, in certain circumstances, have similar consequences to those traditionally
assumed banks.
The measures I have mentioned have generally led to a healthier, more resilient and
diversified financial system, without adverse effects on the provision of credit to the
economy. In particular, since 2011, the large international banks have almost doubled their
highest quality capital, from $2 trillion to $3.7 trillion in 2017. Moreover, since the start of
the crisis, they have halved their leverage and improved their liquidity profiles, mainly thanks
to an increase in high-quality liquid assets.
Progress has also been made in other areas, such as simplifying and boosting transparency
in the OTC derivative markets, including through the use of central clearinghouses, and
measures have been taken to reduce some of the risks arising from non-bank financial
intermediation.
Nonetheless, we cannot ignore the persistence of certain risks and vulnerabilities. First,
although large banks are now less leveraged, overall debt levels remain very high. Global
public-sector and non-financial private-sector debt has increased by some 40 percentage
points (pp) since the financial crisis to reach 250% of global gross domestic product (GDP);
public-sector debt has increased significantly in the advanced economies and
privatesector debt in the emerging economies, especially in China.
Second, there has been an increase in the weight of non-bank financing. The weight of other
financial intermediaries (OFIs)1 in the global financial system has been growing in recent
years, and reached 30% in December 2016, according to the latest data available. This
trend is confirmed by the growth in non-bank financial intermediation, which generates
similar risks to banking; its weight in the global financial industry increased from 11.6% in
2010 to 13.4% in 2016. These trends may have potentially important implications for the
functioning and resilience of financial markets, in particular at times of stress.
Third, a number of challenges remain relating to implementation of some of the approved
reforms, in particular the latest package of Basel III reforms agreed in December 2017.
Finally, now is the time to assess whether the approved reforms are effective and to identify
any unintended consequences. In this respect, the FSB is due to launch an assessment of
the policies agreed to address the too-big-to-fail problem next year.
Reviewing globalisation and world trade rules
The political and social consequences of the crisis have had an impact on economic policy
in the area of trade policy, at global level. Trade tensions and the proliferation of protectionist
measures are one of the worst legacies of the economic policy response of some countries
in the current post-crisis period. In fact, protectionism is currently a significant risk factor
for world trade, and given the latest developments, we cannot rule out further escalation of
such tensions, with severe consequences for global growth.
There is a broad consensus in the academic literature on the economic costs of
protectionism. In the short and medium term, economies subject to protectionist measures
suffer reductions in exports and investment, with resulting adverse effects on their activity.
Also, the effects on economies that adopt protectionist measures are far from positive,
owing to the increase in the price of their imports, which, in turn, leads to an increase in
production costs for their businesses and lower purchasing power for households, which
leads to adverse effects on private consumption and investment. In addition, the uncertainty
associated with trade tensions and the possible tightening of financial conditions may
discourage investment further and worsen the negative impact on activity and potential
growth.
The estimates of the main international organisations in relation to the recent trade tensions
between the United States and China suggest that the measures currently in force will have
a relatively moderate impact (less than 0.5 pp of GDP in China and the United States, with
an even smaller effect on global GDP). However, the application of tariffs and additional
non-tariff measures, such as those announced by these two major powers, along with the
foreseeable deterioration in confidence and in the financial markets to which this scenario
could give rise, would involve much higher costs. According to the International Monetary
Fund (IMF), it could, over three years, subtract nearly one percentage point from world GDP,
with a more pronounced impact on China (-1.5 pp) and on the United States (-1 pp) than on
other areas, such as the euro area, where the losses would be somewhat less than 0.5 pp.
Another particularly relevant case at the present juncture is Brexit, which may have very
significant effects on the UK and EU economies. Depending on the future framework for
relations between the EU and the United Kingdom, and whether or not the departure from
the EU takes place in an orderly manner, the latest estimates, published by the Bank of
England just a few days ago, range from long-term GDP losses for the United Kingdom of
around 2% of GDP in the case of an orderly exit and favourable future agreement, to
declines of around 10% of GDP if there is no agreement and the exit is disruptive and
disorderly. The costs for the EU would be lower, although in the event of a hard Brexit the
impact could be significant for those countries with closer trade and financial ties with the
United Kingdom, such as Ireland, Belgium and the Netherlands.
At the same time, the evidence suggests that greater protectionism raises the vulnerability
of economies to domestic adverse shocks. This is because international trade allows
producers to diversify their business and cope with cyclical fluctuations in domestic
demand. This diversification mechanism is even more important in crisis periods, as seen in
Spain, where businesses facing severe contractions in domestic demand during the most
recessionary phases of the last crisis found an escape valve in the form of exports that
enabled them to maintain their activity and limit job losses.
It should also be noted that the negative effects of protectionism tend to grow stronger over
the long term, owing to the damaging impact of trade barriers on competition, productivity,
technological innovation and potential growth.
In the present context, characterised by the risk of heightened trade tensions, the review of
the world trade negotiation rules and reform of the World Trade Organisation (WTO), the
legal basis for the main trade exchanges in recent decades, are of even greater
consequence. In fact, from a broader perspective, the latest political reactions against free
trade come on top of a deeper, pre-existing crisis in the multilateral trade system. The
security provided by trade rules enabled average tariffs between the United States, Europe
and Japan to be cut from 22% in 1948 to 3% in 2000. However, in the latest round of
negotiations between the WTO member countries, which took place in Doha in 2001, very
little progress was made and structural problems currently affecting this system became
apparent. These include, notably, the requirement for unanimity among the 164 members
of the organisation for the approval of new provisions and the existence of a body of rules
that has proved to be inadequate to manage the variety of challenges raised by China's
joining the WTO in 2001.
A possible way out of the current crisis in the system of rules for world trade and the WTO
that has been recently discussed would involve moving from a multilateral system based on
unanimity to a more flexible approach. This would allow resolutions to be adopted in
particular areas by a limited number of countries, with the possibility of other economies
joining them at a later stage.
This multilateral approach could also be used to approve reforms to adapt the WTO rules
to the recent changes in the world economy and thus restore global confidence in a system
of trade based on respect for clear well-defined rules, curbing the proliferation of
protectionist measures and boosting global growth in the long term.
The need to promote the opening up of trade in services, where the potential gains are still
substantial, should also be mentioned. Lastly, in the domestic policy realm, the authorities
need to adopt a number of policies (boosting labour market flexibility, solid social security
networks and education and training opportunities) to satisfactorily address the distribution
of the potential benefits of trade among different population groups.
The new institutional architecture for the euro
One of the structural elements that has changed most as a result of the combined
financialsovereign crisis in Europe is the institutional architecture of the euro area. The financial crisis
revealed a number of shortcomings and deficiencies in various aspects of the design of the
Economic and Monetary Union (EMU), such as the absence of fiscal stabilisation
mechanisms for the area as a whole, the lack of crisis management instruments and the
incoherence of the supervisory arrangements and of national bank resolution, while there
was a manifest need for progress towards genuine financial integration as a logical
consequence of the monetary union. We should recall here the weakness of the euro area's
cross-country risk-sharing mechanisms based on the capital markets and banking system,
especially in comparison with other currency areas of a similar size, such as the United
States.
Especially since the emergence of the sovereign debt crisis, in the first part of the current
decade, these shortcomings have prompted significant progress in reform of the European
institutional architecture, including the strengthening of the mechanisms for surveillance of
the fiscal and macroeconomic imbalances and the creation of the European Stability
Mechanism, the Single Supervisory Mechanism and the Single Resolution Mechanism.
Despite these reforms, significant limitations persist that require further EMU deepening.
First, the second pillar of the banking union needs to be completed by means of the creation
of a common backstop for the Single Resolution Fund to guarantee its financial sufficiency.
Moreover, it is essential to launch a European deposit insurance scheme to ensure the same
level of protection for all depositors throughout the euro area, reducing the risk of bank runs
in situations of financial stress and to weaken the "doom loop" between sovereign risk and
bank risk.
In relation to resolution, in line with international initiatives, the European resolution directive
stipulates a minimum requirement for own funds and eligible liabilities in the event of
resolution. The application of this directive poses a number of challenges, in particular in
terms of the transition towards compliance with these new requirements by banks, which I
shall refer to later when discussing Spanish banks. Also, as the IMF has recently indicated,
it would be desirable to assess the suitability of bail-in strategies in the event of systemic
crises, given their potentially adverse effects on the financial system as a whole, which may
ultimately raise social losses and the cost to the taxpayer.
In order to make further progress in reducing the risk of financial fragmentation within the
euro area, it is necessary to boost private-sector risk-sharing channels, such as the credit
and capital market channels, so that they work alongside the public-sector risk-sharing
mechanisms. This requires, first, removing obstacles to the creation in the medium term of
genuine pan-European retail banks. In particular, a single deposit insurance fund needs to
be created, the euro area needs to be treated as a single jurisdiction for regulatory purposes
and, above all, market pressure needs to reach broad segments of the European banking
system, such as public-sector banks, cooperative banks and savings banks.
Second, progress needs to be made on the various Capital Markets Union initiatives. The
implementation of this project should lead to more efficient and integrated capital markets,
enabling European businesses to diversify and broaden their sources of funding and to
reduce their excessive dependence on bank finance. However, this is a complex objective
that requires action on various fronts, including the development of market infrastructures,
the review and harmonisation of market regulation and supervision and of insolvency
procedures, and the elimination of the bias in favour of debt financing in some countries'
tax systems.
It is also necessary to move towards a fiscal governance framework that allows the
stabilising capacity of fiscal policy in the euro area in times of crisis to be increased. For this
purpose, countries should take advantage of the current upswing to generate scope for
stabilisation in future crises, since national fiscal policy will continue to be the first line of
defence.
In fact, a fiscal union, with shared responsibility for macro-financial risks that are already
subject to common supervision, besides improving incentives would be conducive to the
sustainability of public finances and macroeconomic stability in the area.
However, clear, strict fiscal rules are also necessary for the Member States. Simplification
of the complex web of rules and procedures that currently make up the Stability and Growth
Pact, more automatic rules and stronger independent fiscal institutions, as well as a stronger
European Fiscal Board, could also help achieve this objective. Also, the development of a
common fiscal capacity that enables an aggregate fiscal stance to be defined and applied
in the area would supplement the scope for national fiscal action and, as I have already
mentioned, the stabilising efforts of monetary policy.
Completion of the current design of EMU and providing it with solid governance are priorities
that will, however, require broad consensus and political will.
Monetary policy
I would now like to discuss the role monetary policy has played in these years and that
which it could play in the response to future crises.
When the last crisis broke out, central banks slashed interest rates, which rapidly reached
near-zero levels In some cases, such as that of the European Central Bank (ECB), rates even
turned negative. In this context, central banks had to implement a series of novel, or
"unconventional", measures. These measures included asset purchase programmes,
medium- and long-term lending to the banking industry under advantageous conditions,
and announcements about the future course of monetary policy, known as forward
guidance.
The empirical evidence shows all these measures to have been effective at cushioning the
impacts of the economic crisis and supporting the subsequent recovery, and they now form
part of central banks' toolkit for the future. Against this background, what scope is there for
monetary policy action in the event of a future crisis?
As the inflation outlook improves in the future, interest rates may be expected to rise
gradually towards their long-term equilibrium rate. The distance between this level and the
effective lower bound on interest rates - i.e. the level below which further rate cuts would
be counter-productive as a means of stimulating the economy - will determine the future
scope for conventional monetary policy. We now know that the lower bound on interest
rates in the euro area is not zero, as was traditionally believed, but a negative number which,
although difficult to quantify, is probably not far below the current deposit facility rate of
0.40%.
Economic theory and the empirical evidence suggests that demography is one of the factors
underlying the long-term interest rate. Specifically, demographic developments in recent
decades in comparable countries, characterised by declining birth rates, increasing life
expectancy, and a rising ratio of pensioners to workers, seems to have lowered the
longterm equilibrium or "natural" interest rate and is likely to continue to do so in the future.
Demographic patterns seem therefore to be contributing to a progressive narrowing of the
scope for central banks to lower their interest rates in the event of deflationary shocks like
those suffered during much of the recent crisis.
One tool which can mitigate this foreseeable loss of scope for interest rate policy forward
guidance. In recent years, once short-term rates reached their lower limit, central bank
announcements undertaking to keep interest rates at low levels for long periods proved
effective at flattening the yield curve and reducing the uncertainty over possible future
interest rate developments, thus improving financial conditions for the real economy.
Other tools that also provide stimulus when interest rates are no longer able to do so include
the monetary authority's balance-sheet expansion measures. In recent years, the world's
main central banks, including the ECB, have resorted to them with remarkable intensity. In
particular, in the Eurosystem the expansion of the balance sheet has mainly been driven by
longer-term refinancing operations and the asset purchase programme. These measures
have been effective at easing financial conditions in the euro area and, ultimately, at
adjusting inflation towards its target. The ECB's asset reinvestment policy, the guiding
principles of which were readjusted yesterday, aims to preserve the monetary stimulus
provided by the asset purchase programme through full reinvestment of the assets on the
programme's portfolio as they mature.
In short, monetary policy will continue to have tools with which to tackle future economic
and financial crises, although these tools naturally have their limitations. Therefore, as the
Governing Council of the ECB has been saying in recent years, rather than overemphasising
the role of these tools, they need to be complemented by the implementation of structural
reforms and fiscal policies to foster growth.
Spanish economic policy: progress made and challenges
The Spanish economy has been on a growth path since late 2013 and GDP overtook its
pre-crisis levels in mid-2017. A number of structural reforms implemented during the
recession contributed to this dynamism. On the domestic front, these include labour market
reform, the balance-sheet clean-up and restructuring of credit institutions, pension reform
and fiscal consolidation.
These reforms have undoubtedly helped largely correct some of the Spanish economy's
main imbalances in the pre-crisis period: in particular, high levels of private sector debt, low
competitiveness, the excessive current account imbalance and the excessive weight of the
real-estate sector. Similarly, economic policy measures have enabled progress to be made
on correcting the problems faced by the financial sector during the worst of the recent crisis.
Nevertheless, the recovery has also benefited from a series of factors exogenous to
domestic economic policy with varying degrees of persistence. These factors include the
role played by ECB monetary policy and the significant drop in the oil price between
mid2014 and early 2016, and, until the end of last year, the improvement in external markets, in
a context of a global economic recovery.
However, the effect of these factors can be expected to taper in the future. The foreseeable
loss of momentum by the expansionary effects of demand-side policies is also relevant. In
this context, it is particularly desirable for prominence to be given to a renewed reform drive,
geared towards correcting the Spanish economy's persisting vulnerabilities.
Fiscal policy
I will first mention the fiscal policy situation. Over the past decade the Spanish authorities
have had to make the fiscal adjustment needed to guarantee the sustainability of the public
finances. This process has brought the budget-deficit-to-GDP ratio down from a maximum
of 11% in 2009 to 3.1% last year.
Despite this deficit cut, Spain's public accounts continue to show significant weaknesses.
First, the European Commission estimates the (cyclically adjusted) structural budget deficit
to still be around 3% of GDP in 2018, the highest in the euro area. Second, although
government debt is on a slightly downward path from its historical peak of 100.4% of GDP
in 2014, at around 98%, it is still very high.
The empirical evidence reveals that maintaining a very high level of public debt for a
prolonged period tends to hamper economic growth as it becomes a source of vulnerability
and reduces the scope for the public budget to act as a stabiliser in the event of a recession.
The simulations made in a number of papers published by the Banco de España show that,
on realistic assumptions, the process of reducing Spain's government debt will be very
gradual. It may even take several decades to reach a debt-to-GDP ratio of 60%, which is
the reference value in Europe's current fiscal rules.
In the light of these considerations, priority should be given to taking advantage of the
current favourable economic context to reduce the vulnerabilities deriving from the public
finances and create budgetary room for manoeuvre with which to address future crises.
These efforts should be given the form of a medium-term programme spelling out the
measures enabling the budgetary objectives to be met, and a prudent macroeconomic and
public revenue projections.
This process of reducing the fiscal imbalances also needs to be compatible with an
improvement in the quality of the public finances. In this connection, the composition of the
programme's revenue and expense adjustment is very relevant to achieving its objectives
without hindering economic growth. Combining fiscal consolidation efforts with other
structural reforms should also help in this respect.
Reducing the vulnerability of Spain's public finances is even more important when we
consider the medium and long-term challenge posed by population ageing. The latest
estimates predict a significant increase in public expenditure on pensions, health-care and
long-term care stemming from the substantial rise in the dependency ratio. Even on the
most optimistic demographic projections, this ratio is set to rise from 25% today to 50% by
mid-century.
In the case of the pension system, the 2011 and 2013 reforms included a number of
adjustments that made it possible to significantly counteract the effect of the expected
longterm increase in the dependency ratio. Nevertheless, the latest legislative developments
have eased the implementation of these mechanisms with the postponement in application
of the sustainability factor until 2023 and, above all, the return to a system of annual pension
increases in line with the consumer price index. According to the Banco de España's
calculations, reintroducing this indexing system on a permanent basis would lead to an
additional spending increment of more than 3 pp of GDP in 2050. Consequently,
guaranteeing the financial sustainability of the public pension system will require additional
measures on the revenue or expenditure sides of the system to offset this additional burden.
Pending structural reforms
In the context just described, characterised by the need to pass the baton to demand-side
policies to underpin the current expansionary phase and boost growth potential, it would
be particularly desirable to give more prominence to measures to correct the Spanish
economy's structural vulnerabilities and strengthen its capacity to adapt to future shocks.
The structural reforms undertaken in Spain over the course of recent years have helped
make the economy more robust and adaptable to adverse situations. This is particularly
desirable in an increasingly changeable and uncertain global environment. One of the key
elements providing greater resilience and flexibility is the labour-market reform, which gave
businesses more internal flexibility. This flexibility provides additional tools with which to
adjust labour costs in the event of a short downturn instead of the traditional mechanism
whereby workers - mainly those on temporary contracts - are laid off.
Other reforms have also encouraged better allocation of funds by the financial system to
new, higher potential, investment projects. These include financial system reform and
insolvency law reform, in particular.
Despite these changes, the Spanish economy still faces major structural challenges that
limit its potential growth. I would like to highlight three of these challenges: population
ageing, the high unemployment rate, and low productivity growth.
Population ageing has consequences for the effectiveness of traditional macroeconomic
policies, the sustainability of the public finances, and productivity growth. Addressing this
challenge requires a multidisciplinary policy that creates incentives for older workers to
remain in the labour force, revises migration policy to try to adapt it to the needs of the
labour market, and boosts the birth rate to bring it closer to rates in other European countries
by improving the work-life balance and enhancing job stability in the childbearing years.
Meanwhile, the high un