Carl-Ludwig Thiele: The euro - past pitfalls and future challenges
Speech by Mr Carl-Ludwig Thiele, Member of the Executive Board of the Deutsche
Bundesbank, at the People's Bank of China School of Finance, Tsinghua University, Beijing,
22 September 2015.
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1. Introduction
Dear Professor Li,
Dear Professor Kang,
Ladies and gentlemen,
I am delighted to have the opportunity to be here in Beijing to talk to you about Europe and
the euro - about the background and particular features of European monetary union, its
pitfalls, which have placed Europe under great strain, and the challenges that we need to
overcome if Europe is to remain a reliable player.
European monetary union has its peculiarities, which makes it difficult to compare it with any
other single currency area. It is only when one is aware of these particular features and the
historical backdrop against which this currency area has emerged that it is possible to
understand the causes of the crisis in the euro area - and the steps needed to overcome
them.
In my presentation, I will attempt to view European unification, a stable European monetary
union and a prosperous euro area through the eyes of a realist. However, Walter Hallstein,
the first President of the European Commission, apparently had a special kind of realist in
mind when he said: "Whoever does not believe in miracles in European matters is not a
realist."
I will come back to this at the end of my speech.
2. European unification
Ladies and gentlemen,
A united Europe is of major significance to Germany. This is not only because Germany is an
integral part of Europe but also because the Germans feel a particular obligation to promote
European unification. The reasons for this are largely historical.
A glance back in history shows just how important mutual understanding and amicable
relations are for the countries of Europe.
The First World War broke out just over 100 years ago. This war has been etched into the
memory of so many Europeans. The grim consequences of war are still fresh in our minds: a
disturbingly high number of civilian and military victims, the wartime economy, hundreds of
thousands impoverished or starved to death and survivors deeply traumatised. This list could
go on and on.
And the Second World War began only 21 years after the end of the First World War. It was
a war in which unprecedented crimes were perpetrated, millions were left dead and Europe
was subsequently divided into two blocs.
After suffering so much at the hands of war, the west European countries strived for deeper
European integration, for a united Europe.
The reasons for this were many and varied. Securing peace within Europe was undoubtedly
the dominant rationale.
The relationship between European neighbours France and Germany played a key role in
this context. Hostility between the two nations, be it overt or latent, had persisted for
centuries. This so-called "Franco-German enmity" was surmounted in the wake of the
devastating Second World War and developed over time into a Franco-German friendship,
an engine driving the process of European unification and integration.
However, belonging to a community of values was of particular importance to Germany
following the Hitler dictatorship and the Holocaust.
Konrad Adenauer, the first Chancellor of the Federal Republic of Germany, expressed this as
follows: "The unity of Europe was the dream of a few. It became the hope of many. Today it
has become a necessity for all of us."
But there was also a desire to sustainably improve Europe's economic prosperity.
It is not incidental that European integration began by stepping up economic integration.
After the Second World War ended, progress was made on various fronts, culminating
initially in the single European market.
The foundations of this single European market were the "four basic freedoms": the free
movement of people, goods, services and capital.
But it became evident at an early stage that economic integration in Europe could only really
take off if it was accompanied by a stable single currency.
As far back as the start of the 1970s, there existed a plan to establish a European economic
and monetary union that was to be fully implemented by 1980.
Ultimately, progress was not so rapid after all. No serious attempt to establish monetary
union was made until Jacques Delors took over the presidency of the European Commission
in the late 1980s.
The Maastricht Treaty was later signed by EU member states in 1992.
3. European monetary union and its regulatory framework
In 1999, the long-cherished dream of European monetary union became true, marking a
major step towards deeper European integration.
Introducing a single currency had tangible benefits.
Prices of goods could be more easily compared throughout the member states.
Exchange rate risk was eliminated and transaction costs fell.
This in turn promoted trade, not only within the monetary union but also with the
rest of the world.
Money and capital markets converged further.
And, last but not least, the euro brought with it a period of remarkable price
stability for the member states.
At this point, it is important to understand that the European monetary union is a thoroughly
unique single currency area. While the 19 sovereign states within it have committed to
comply with a single monetary policy, they remain responsible for their own fiscal and
economic policies.
This means that a single monetary policy, which has the clear objective of ensuring price
stability, is accompanied by 19 national fiscal policies.
As you can see, the principle of subsidiarity is constitutive for Europe: as many decisions as
possible should continue to be made at the national, or even the local, level.
Former United States Secretary of State Henry Kissinger once highlighted the EU's complex
structure by asking: "Who do I call if I want to call Europe?"
Nowadays, he would have to call 19 telephone numbers to discuss fiscal policy matters, as
19 national governments make decisions regarding public spending and any borrowing
required for financing purposes.
The universal rule that political processes can easily lead to increased spending and, as a
result, to excessive borrowing as well applies far more to a monetary union with independent
national fiscal policies than to central governments.
This is because, in a monetary union, the negative effects of a sharp rise in debt in one
country can spill over, at least in part, to the other member states.
Why is that the case?
Generally speaking, the same rules that apply to a private borrower also apply to a country:
the higher the debt burden, the lower the creditworthiness.
So, in a properly functioning capital market, a country that is more indebted is generally
required to pay higher interest on its sovereign debt.
However, things are different in a monetary union, as capital market participants assume that
the member states belong to an "inseparable union with a common destiny" as part of which
they will help each other out financially in emergency situations, forming a kind of
jointliability scheme.
As a result, debt interest rises not only for the individual, more indebted country, but usually
also for the other member states, which are expected to provide solidarity and financial
assistance.
Yet, for the country creating more debt, interest rates tend to rise less strongly.
Monetary union, therefore, holds incentives for an individual member state to run up higher
debt as the negative effects of greater indebtedness - meaning higher borrowing rates - are
partly borne by the other member states.
This can be compared with the overfishing of the seas as it, too, affects both the community
of neighbouring countries as well as the country causing the problem.
The architects of monetary union were well aware of the problem of incentives. Which is
exactly why they took precautions.
It was, therefore, laid down from the start in the Treaty of Maastricht that a country is
forbidden from assuming the debt of another country or the community of states. In other
words, this laid down the foundation for a general no bail-out principle.
The Maastricht Treaty is, thus, guided by the principle of individual responsibility, or the
balance of liability and control.
In the concise words of German economist Walter Eucken: "Whoever reaps the benefits
must also bear the liability."
Or, in very down-to-earth terms: Whoever orders, pays.
An additional security threshold for monetary union as a stability union is the prohibition of
monetary financing of governments. The central banks of the Eurosystem, that is the
European Central Bank and the 19 national central banks, are forbidden from directly
financing euro-area countries.
In order for this ban on monetary financing of governments to be implemented in practice,
the independence of the Eurosystem from political instructions was enshrined at the same
time.
Political decision-makers cannot, therefore, force the central banks of the Eurosystem to
grant member states loans or directly purchase their sovereign paper. Ultimately, these
measures could contravene the mandate of ensuring price stability, causing lasting harm to
the Eurosystem's credibility and thus to the very foundations of a successful monetary policy.
Germany has, in the past, had bad experiences with central banks which were not free of
political lobbying. For example, expenditure on arms in the First World War was financed
directly by the central bank, which essentially catered to the needs of the government. The
consequence was a complete devaluation of the Reichsmark.
By contrast, the independence of the Eurosystem was firmly anchored.
First, institutionally, by prohibiting national and supranational institutions from issuing the
ECB or the national central banks with instructions.
And second, functionally, by awarding the sole prerogative regarding strategies and
measures to ensure price stability to the Eurosystem.
The independence of the central banks is further safeguarded by specific debt ceilings, which
are intended to prevent member states from accumulating excessive debt.
A country's public deficit is not supposed to exceed a maximum of 3% of its GDP
within a one-year period.
Moreover, a country's overall sovereign debt should not go beyond 60% of its
annual GDP.
These rules are designed to prevent governments from exerting pressure on monetary policy
makers, as lower interest rates allow governments to borrow more cheaply. Or due to the
fact that existing debt is devalued by a higher rate of inflation. So far so good.
4. Crisis
However, things turned out differently than expected - above all because the carefully
drafted financial policy rules were not complied with.
Most countries were far from having a balanced budget, and public deficits often even
exceeded the three-percent threshold.
Debt levels in the member states were often not lowered either. The exact opposite was the
case in some countries for that matter.
At the same time, market participants did not trust sufficiently in the no bail-out principle I
touched on earlier.
Despite the very large differences in debt levels and economic developments among the
euro-area member states, they aligned their risk premiums to a great extent, which, in turn,
led to the already strongly indebted countries becoming more indebted.
In the end, confidence in the capital markets vanished with regard to whether the future crisis
countries would still be able to service their sovereign debt in accordance with the rules. This
culminated in investors granting these countries loans only at very high interest margins or
withholding them altogether.
At the same time, it became clear that the countries that were later hit by crisis had failed to
set up sound and sustainable economic structures that were beneficial for growth.
Instead, enterprises and households often took advantage of the substantially lower interest
rates as a result of joining the euro area and ran up great amounts of debt.
And rather than investing this money in expanding competitiveness, it was used for private
and government consumption.
Wages increased to a considerably larger extent than productivity, with price competitiveness
eroding as a result.
And last but not least, cheap loans and capital inflows fuelled the real estate bubbles in
Ireland and Spain.
This is why this "special boom", which was caused by low interest rates, was anything but
sustainable and sparked the crisis in Europe. Although, to be precise, "the crisis" was a
conglomerate of various crises, encompassing financial market crisis, economic crisis and
sovereign debt crisis.
Above all, however, it is a crisis of confidence, the complexity of which is also reflected in the
fact that the euro area has been battling to overcome this crisis for seven years now.
5. Overcoming the crisis
How can this finally be achieved? Or, put differently, what lessons are to be learned from the
crisis?
To win back the confidence lost and to return to a path of sustainable growth, we need to
tackle the root causes of the crisis instead of treating the symptoms.
The economic situation in the euro area may be recovering, but there are still some structural
challenges to resolve. And until the causes of the crisis have been eliminated, we cannot be
sure that it will not pop up again. The most recent discussions on Greece have shown this
only too well.
5.1 Measures in the member states
First of all, the crisis countries themselves must eliminate the causes of the crisis at home.
For one thing, they have to ensure that their public debt is sustainable. This needs to be
done before consumer and investor confidence can return.
Indeed, as the saying goes, "you can't borrow your way out of a debt crisis".
Therefore, lasting confidence can only be built on a foundation of sound public finances.
In addition to having budgetary rigour, member states also need to implement
growthenhancing structural reforms.
Many of these have already been set in motion as a result of the sovereign debt crisis. As
such, not only have structural budget deficits been significantly lowered, but the deterioration
of international competitiveness has also been largely reversed.
But there is still some way to go in terms of making the labour markets more flexible, further
liberalising the goods and services markets and cutting bureaucracy.
To begin with, these adjustment processes are a burden on the economic recovery of many
of the crisis countries. However, the subsequent positive growth effects more than make up
for this.
Spain, in particular, is currently experiencing this first-hand and is already reaping the
benefits of the structural reforms it has implemented. Since 2009, its structural budget
balance has improved by roughly seven percentage points and its labour market has been
made more flexible. Both of these achievements were decisive factors in enabling the
Spanish economy to lift itself out of recession quite some time ago and to exhibit its current
strong growth. The oppressively high levels of unemployment are also gradually decreasing.
The benefits for Spain will be all the higher in the coming years if it remains fully faithful to
this reform process.
There is a saying I like that practically passes as a Chinese proverb in Germany. It reads:
"When the winds of change are blowing ... some people build walls and some people build
windmills." Well, the Spanish have built quite a few windmills in recent years.
In the first half of this year, the world's attention was focused on Greece to a much greater
extent than on Spain and its successful reform process. In light of the refusal of the Greek
government to accept the bail-out conditions, and due to acute financing needs, there was
even speculation about whether the country would potentially have to leave the euro area or
even the European Union itself.
This risk has since vanished, thanks to the adoption in August of a third assistance
programme for Greece, which is subject to strict conditions and temporarily resolved the
country's funding bottleneck. However, further payments are contingent on Greece fulfilling
these conditions.
In addition, the central challenge facing Greece lies in implementing structural reform
measures for greater competitiveness as well as achieving sound government finances in the
long term and establishing a functioning administration.
Only then will Greece overcome its current period of weakness and embark on a path of
growth.
5.2 Reforming the regulatory framework
However, aside from the unsound developments in European periphery countries, the euro
area's regulatory framework also needs to be strengthened. The principle of aligning liability
and control must once again be more rigorously enforced.
This is because, over the course of combating the crisis, the element of joint liability has
been increasingly expanded. This, in turn, has severely disrupted the balance between
liability and control.
The crisis countries were granted large-scale emergency loans by other member
states and the European Stabilisation Mechanism.
But the Eurosystem also reacted, for example by not only lowering interest rates,
but also by loosening the requirements for monetary policy collateral.
In addition, the Eurosystem acquired government bonds of crisis countries on the
capital markets in order to ensure monetary policy had a more uniform impact.
However, this propelled the Eurosystem deep into uncharted and dangerous
territory, blurring the boundary to prohibited monetary financing of governments.
That being said, all parties are well aware that monetary policy is unable to resolve the crisis
in the euro area, and is merely buying time for policy makers to implement the necessary
measures.
In order to permanently safeguard monetary union as a union for stability, it is important to
bring liability and control back into a more balanced position.
Essentially, this can be done in two ways:
either the euro area evolves into a genuine fiscal union, where fiscal and tax
policies are coordinated centrally at European level ...
... or a Maastricht Framework 2.0 is established in which the principle of
individual responsibility is reinforced.
However, I do not see a majority in any euro-area country supporting the communitisation of
fiscal and tax policies. At the current juncture, reinforcing the existing regulatory framework
and strengthening the principle of individual responsibility therefore seems like a more
realistic way of bringing liability and control in Europe's monetary system back into
equilibrium.
Europe has already taken some steps in the right direction in this regard.
For example, the refined fiscal rules require balanced budgets or even slight
surpluses.
In addition, procedures have been introduced to identify and rectify
macroeconomic imbalances.
However, these rules need to be enforced.
And this is where we have a clear deficit. "Flexibility" is the European Commission's new
watchword when it comes to interpreting how the fiscal framework should be implemented.
And the scope for flexible interpretation has actually widened over the past few years on the
back of changes to the budgetary rules.
However, sustained economic growth cannot be built on a foundation of resurgent expanding
public debt. For as I already mentioned, lasting confidence and long-term growth are only
possible through sound public finances.
Ladies and gentlemen,
Thus far I have touched on two key areas where there are lessons to be learned from the
crisis:
first, that individual countries need to implement reforms themselves and
second, the need to strengthen and strictly adhere to a regulatory framework in
which liability and control at the national level are balanced - as envisaged for
the euro area from the start.
5.3 European banking union
Moreover, as the crisis unfolded, the financial system was exposed as the Achilles' heel, not
just in Europe but on an international scale.
As a result, steps were taken at the G20 level to tighten banks' capital and liquidity
requirements, thus giving rise to Basel III.
Compounding this, weaknesses were identified in Europe's banking supervision structures.
National supervisors were often found to assess their own country's banking system too
favourably, with the effect that failing banks and stumbling states dragged one another down.
Only by destroying the harmful nexus between banks and governments will we be able to
manage these contagion effects.
And this is where the nascent European banking union comes into play. It represents a major
step towards deepening European integration and consists of two elements:
The Single Supervisory Mechanism (SSM), which operates under the aegis of the ECB, has
been in place for just under 12 months. Its purpose is to ensure consistently high supervisory
standards so as to prevent banks, at an early stage, from getting into difficulties.
But such problems cannot be entirely ruled out, not even under a stringent regulatory regime.
After all, the possibility of failure is a hallmark of any market economy.
It is therefore important to be able to allow banks to fail without governments - and thus also
taxpayers - having to foot the bill. For banks must also be subject to the liability principle,
without which no market economy can function properly.
This is the rationale behind the launch of the European Single Resolution Mechanism (SRM)
in 2016. The mechanism will make sure that non-viable institutions can be withdrawn from
the market in an orderly fashion provided this does not jeopardise financial stability. And this
will be done according to a clearly defined liability cascade.
If a bank is wound down in future, shareholders and creditors will be first in line to
bear the costs.
Only when this source of funds proves insufficient will there be recourse to a
single resolution fund financed by the entire European banking sector.
And only as a last resort will taxpayers in the respective country, or even in other
member states, be called upon to help shoulder the burden.
In other words, beginning in 2016, institutions subject to supervision at the European level
will also be resolved at this level. This will facilitate closer European integration.
Together, these two constructs, the SSM on the one hand and the SRM on the other, form a
meaningful whole, in which liability and control are balanced.
5.4 Abolishing the preferential treatment of government bonds
If the close ties between governments and banks are to be loosened, in future loans to
sovereigns must no longer be deemed free of risk in regulatory terms.
It follows that government bonds should henceforth be treated similarly to loans to
enterprises and households, meaning they should be backed by capital commensurate with
the risk. And limits also need to be applied to such exposures, as is the case with loans to
private debtors. This would prevent risk from becoming concentrated on banks' balance
sheets.
These topics are now being deliberated by the Basel Committee on Banking Supervision and
the European Economic and Financial Committee, and rightly so. I appreciate that capital
requirements and large exposure limits make the task of financing governments more
complicated and consequently more expensive. Thus, gradual phase-ins are undeniably a
good idea. However, this is no reason to refrain from change.
5.5 Sovereign insolvency code
Looking ahead, there is an additional area where new regulatory provisions are required. In
extreme cases, sovereigns, too, must in future be able to declare themselves insolvent, as
the liability principle should also apply to them. Otherwise, the Eurosystem could come under
pressure to finance cash-strapped governments at knock-down terms.
So what happens when a sovereign defaults? It doesn't mean that the country concerned
disappears off the map in the way that a company might.
Rather, the government in question finds itself no longer able to service its debt as
contractually agreed, normally meaning that this debt has to be restructured.
The legal basis for this would have to be provided by a sovereign insolvency code. In my
opinion, this is an essential prerequisite for an enduringly sustainable regulatory framework
in which fiscal policy remains a national responsibility.
6. Conclusion
Ladies and gentlemen,
In my presentation, I have shone a light on the history of European integration and the crisis
in the euro area. I have also looked towards the future, and outlined the challenges that lie
ahead and how we might best deal with them.
The most significant aspects are as follows.
It is the member states who hold the key to sustainably overcoming the crisis in
Europe.
The European banking system, the member states and the European regulatory
framework have to be made more crisis-resistant so that the euro area can return
to a path of sustainable growth.
As I mentioned earlier on, there's plenty of good news at all three of these levels.
But that doesn't mean we can declare the crisis over.
The adjustment process in the crisis countries is likely to continue for quite some
time.
The tightened regulatory framework needs to be applied more forcefully in
practice and additional measures will have to be introduced.
Ultimately, the only way to overcome the crisis ...
... is to gradually rebuild confidence.
But this is only possible if the euro area consistently maintains its stability course.
As far as the euro area is concerned, I see no reason to be overly pessimistic. What matters
is that the member states continue to muster the will to rigorously tackle the root causes of
the crisis.
I began this speech with a reference to Walter Hallstein's conviction to the effect that:
"Whoever does not believe in miracles in European matters is not a realist." But where do I
stand with regard to this quotation now that my speech is coming to a close?
Well, as I see things, we do not need any miracles in Europe today.
The foundations for achieving stability in the euro area are already in place.
However, these need to be enhanced in some important respects and they
should be rigorously enforced.
It will not be a walk in the park. But neither is it the stuff of miracles.
Thank you for your attention.