Lorenzo Bini Smaghi: Addressing imbalances in the euro area
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the Halle Institute for Economic Research, Halle an der Saale, 14 February 2011.
* * *
I wish to thank Fédéric Holm-Hadulla and Beatrice Pierluigi for their contributions to this speech. I remain solely
responsible for the opinions contained herein.
Introduction
It is a pleasure to be here today and share with you my thoughts on a challenging topic: how
to address imbalances in the euro area.
The euro area has been expanding: five countries joined EMU between 2007 and 2011, and
this process will continue in the years to come. The enlargement process is one of the
features that make EMU unique. The existence of a single monetary policy combined with
national responsibilities for fiscal, structural and supervisory policies is the other distinct
characteristic of EMU. But within this unique and evolving structure something has not been
working properly. The accumulation of imbalances and vulnerabilities in some countries
during the upswing culminated, after the global recession, in a severe sovereign crisis. What
has not been working? And what should be done to prevent future imbalances?
To answer these questions I will organise my talk in three parts.
First, I will discuss how and why imbalances and vulnerabilities have emerged in the euro
area. The point that I will make is that fiscal discipline and sound prudential supervision have
been lacking. In addition, many national authorities failed to implement important reforms in
the labour and product markets to make them more flexible and suited for the change of
regime brought about by the adoption of the euro.
Second, I will consider the possibility of overcoming past failures via a more institutionally
integrated monetary union, characterised, for instance, by a move towards a framework of
fiscal federalism for EMU. I will emphasise that a deeper fiscal integration cannot be
considered the only solution for adjusting current imbalances and for avoiding them in the
future.
Third, I will argue that imbalances and vulnerabilities can and should be addressed by
implementing, at national level, much stronger fiscal discipline, better vigilance of financial
developments and effective reform measures that deliver increasing productivity,
competitiveness, employment and long-term growth.
Let me now turn to the first part of my talk.
1. Imbalances in the euro area
The imbalances which have accumulated over the last few years in the euro area are the
result of a combination of "good" and "bad" convergence. The so-called good convergence
concerns the levels of per capita income. At the start of EMU the per capita income levels
between countries differed significantly. Among the countries that joined the euro area in
1999 and 2001, three - Spain, Greece and Portugal - were considered "cohesion countries",
i.e. countries that qualified for very sizeable structural support from EU funds to speed up
their convergence to the European average per capita income levels. In 1999 GDP per
capita (measured in purchasing power standards) was around 80% of the euro area average
in Spain and around 70% in Portugal and Greece. In Ireland, the gap with the euro area
differs depending on whether it is measured in terms of GDP per capita (110%) or GNP per
capita (95%).
Neoclassical growth theory suggests that catching-up countries would experience faster
economic growth. With the disappearance of the exchange rate premium, convergence
within the euro area was facilitated by capital flows originating from wealthier euro area
countries with higher GDP and per capita capital endowments.1 Between 1999 and 2008
Greece and Spain witnessed a significant convergence of their per capita income to the euro
area average. In Portugal this convergence came to a halt in 2003. Ireland continued to
experience a tremendous increase of its per capita income between 1999 and 2007. On
average, between 1999 and 2008 per capita GDP increased at a yearly pace of 3.4% in
Greece, 3.4% in Ireland (GNP) and 2.0% in Spain, much higher than the average for the
euro area (1.4%), which was broadly similar to that of the US (1.5%).
The "bad" convergence I referred to was the speed at which income increased in the
catching-up countries, which largely took place through debt, either public or private. As a
result, their debt with the rest of the world increased tremendously over the past decade. The
most dramatic development took place in Ireland, which moved from a net creditor position of
52% of GDP in 1999 to a net debtor position of 71% of GDP in 2008. Greece increased its
net debtor position from 33% to 76% of GDP; Portugal from 32% to 96% and Spain from
28% to 79%.
The expectation of higher levels of income led to excessive consumption and investment
compared with the supply capacity of the economy. As a result, cost and price increases in
the non-tradable sector exceeded productivity gains.2 Higher inflation differentials in the
catching-up countries could partly be attributed to Balassa-Samuelson effects3. However, the
divergences in nominal developments were further fuelled by four pro-cyclical factors:

First, low interest rates, especially in real terms, which resulted from the single
monetary policy, and encouraged risk-taking behaviour;

Second, fiscal policies assessed on the basis of nominal variables (deficit as a
percentage of GDP) turned out to be pro-cyclical and contributed to excessive
domestic demand growth and the accumulation of external imbalances;
 Third, supervisory policies in many countries did not counteract excessive
risktaking and the related excessive credit growth, which fuelled a housing boom and/or
an overheating process;
1
See, for instance, Blanchard O. and F. Giavazzi (2002), Current Account Deficits in the Euro Area. The End of
the Feldstein Horioka Puzzle?, Brookings Papers on Economic Activity, 2002:2; and Abiad A., D. Leigh and
), International Finance and Income Convergence: Europe is
A. Mody (2007 Different, IMF Working Paper
WP/07/64.
2
For a reference on the real interest rate mechanism, see European Commission (2006), The EU economy:
2006 review. Adjustment dynamics in the euro area - Experiences and
challenges, European Economy No 6,
pages 131-174.
3
The Balassa-Samuelson (BS) effect refers to inflation effects due to differences in relative productivity growth
between tradable and non-tradable sectors. When productivity growth rises in the tradable sector, wages will
follow without putting additional pressures on unit labour costs. However, due to labour mobility, wages in the
non-tradable sector might rise as well and as productivity growth in the non-tradable sector is normally lower
than in the tradable sector, wage increases in excess of productivity growth would tend to put upward
pressures on unit labour costs and ultimately on inflation for some time. Several studies on the BS effect in the
euro area, such as Rabanal (2009), Hofmann and Remsperger (2005) and Katsimi (2004) have found that the
effect has been not very relevant during Stage III of EMU. The literature appears to suggest that the BS effect
may have been somewhat more relevant during the 1990s. For the period 1992-2001, for example, Wagner
(2005) finds a positive contribution of the BS effect which tends to capture the convergence during Stage II of
EMU.

Fourth, financial markets and rating agencies failed to differentiate sufficiently
between euro area countries with different risks, contributing to the significant
compression of risk premia in the sovereign debt securities markets. Ten-year
government bonds were almost equally priced across all euro area countries
between 2001 and 2007, while economic fundamentals continued to be very
different.
Let me now expand briefly on some of these points.
The excessive demand boom, fuelled by private/public consumption and residential
investment spending, led to persistent inflation and unit labour cost differentials, losses of
competitiveness and asset price inflation - notably in the housing market - in the countries
that had to converge to the euro area average and also in Ireland. And it led to a build-up of
large external indebtedness. At the same time, the supply side was not able to catch up with
demand because investment spending was not channelled towards activities able to
generate high future returns, and also because of important structural rigidities, which
policymakers neglected to tackle in the boom years. The accumulation of external indebtedness
was heavily financed by debt instead of FDI, which remained relatively low, another sign that
little effort was being made to increase the supply side of the economies.
Just to mention a few figures, a property worth 100 in 1998 would have been sold in 2007 at
280 in Spain and Ireland and at 230 in Greece. Between 1998 and 2007 bank lending for
house purchases increased by more than 400% in Spain, 500% in Ireland and 800% in
Greece. In 1998 household debt was less than 40% of GDP in Spain and about 50% of GDP
in Portugal, in 2008 it reached 84% in Spain and 96% of GDP in Portugal. In Ireland,
household debt was 55% of GDP in 20024 and reached 110% of GDP in 2008. Corporate
indebtedness also reached alarming levels at the outset of the crisis.
Banks did not seem to care about the rise in household and corporate indebtedness in the
boom years. Lending to the private sector and investment in overvalued assets - namely
construction - continued apace. The surge in lending activities and risk-taking by banks was
facilitated by a sharp increase in cross-border banking flows, as the deepening of financial
integration led banks to search for profitable investment in high-growth countries. And
national regulators did not step in forcefully to curb excessive risk-taking in banks.
Another factor which contributed to the accumulation of imbalances was the rise in public
sector wages. Between 1998 and 2007 civil service salaries increased cumulatively by 90%
in Greece and by more than 100% in Ireland. Public spending growth systematically
exceeded nominal GDP growth up to the 2008-2009 recession. Moreover, in several
countries the authorities failed to implement important reforms in the labour and product
markets to make them more flexible and suited for the change of regime brought about by
the adoption of the euro. The ECB repeatedly warned about the risks arising from such
divergences and called for sound fiscal policies and flexible product and labour markets to
ensure the proper working of EMU.5
When the 2008-09 crisis hit the euro area, all these imbalances translated into higher public
debt, either as a result of a sharp drop in revenues or the transformation of private debt into
public debt. Just to remind you of a few figures, the Irish general government debt increased
from 25% of GDP in 2007, to 97% at the end of 2010. The Portuguese debt increased from
63% of GDP to 83%, the Greek from 105% to 140%. The over-reliance on external borrowing
made financing the increased public debt more difficult.
In Greece and Ireland, the adjustment towards a sustainable government debt path is
currently being made with the help of an external financial assistance programme. In both
countries the EU/IMF programme relies on very strong fiscal frontloading and comprehensive
and far-reaching structural reforms which, in the case of Ireland, also include measures
aimed at an overhaul of the banking sector. These programmes aim to correct the
divergences which have accumulated over the past decade.
One issue which has emerged over the last few months relates to the extent that fragilities in
the national economies that belong to the single currency may affect the overall euro area, in
particular through contagion effects. The events which started last spring show that the euro
area was not ready to face a sovereign debt crisis in one of its members. Since May last
year, a series of measures have been implemented, starting with a €110 billion support
package for Greece and the creation of the European Financial Stability Facility, and
extending to a strengthening of the Stability and Growth Pact and finally a change in the
Treaty to allow for a permanent European Stability Mechanism. Some of the discussions are
still ongoing, and I will not comment further on this issue. The ECB's position has been made
quite clear. We are in favour of a "quantum leap" in the governance of the euro area; it would
ensure greater consistency between economic policies and the single currency.
How big should the leap be? Some go as far as saying that a single currency is viable only if
there is a full fiscal union, with a common budget and a transfer system which can account
for asymmetric shocks and avoid divergences in national/regional fiscal policies. The US
would serve as a model here. There are indeed no precedents for a monetary union without
a fiscal union. Consequently, many think that a monetary and fiscal union should be the
longer-term model for the euro area.
The experience of German unification might also help us to understand whether a move
towards full fiscal integration would indeed be desirable for the euro area.
2. Centralised fiscal policy and monetary union
The desirability of achieving a fully fledged fiscal union to complement monetary union can
be assessed on the basis of the three main criteria characterising economic policy: stability,
efficiency and equity. I would like to consider the first two and omit equity, which has a
deeper political connotation and may be less relevant for the sustainability of a monetary
union.
Let me start with stability.
The key economic rationale for having a fully fledged fiscal union is to establish a common
pool of resources that can be used to insure its members against adverse macroeconomic
shocks and to reduce macroeconomic imbalances. In a monetary union, fiscal policy is the
only instrument that domestic policy-makers can use in response to country-specific
macroeconomic shocks. Since monetary policy is uniform within the currency union, it cannot
be tailored specifically to the economic conditions in each country. If, for example, a
downturn proves to be especially pronounced in one country, the monetary stance adopted
for the entire currency area may not be appropriate. This implies that fiscal policies may need
to play an active role in stabilising macroeconomic developments at the domestic level. At
the same time, the capacity of individual countries to adopt stabilising fiscal policies is very
limited. In particular, if countries enter a downturn with weak budgetary positions, or if
economic developments prove to be very unfavourable, market confidence in the
sustainability of public finances can evaporate quickly. This is the experience of a number of
countries in EMU which - after failing to exploit the good times prior to the crisis to
consolidate public finances - very quickly faced excessive budget deficits when economic
conditions deteriorated. In such a situation, fiscal expansion through the national budget
would be counterproductive as the "negative confidence" effect from a further budgetary
deterioration would outweigh any direct demand effect.
The separation between monetary and fiscal policy in EMU, which prevents the use of
monetary instruments for solving budgetary problems, further tightens the sustainability
requirements for the public finances of the Member States. Rising public debt cannot be
curbed by keeping interest rates low or through inflation, but only through budget adjustment.
Markets might be inclined to test the ability and willingness of the countries to maintain a tight
control over their budgets even in a severe economic downturn. As doubts mount in the
markets and credit spreads increase, self-fulfilling expectations may arise which worsen the
debt dynamics.
A further problem in the euro area derives from the role played by governments as shock
absorbers in the financial sector. Public funds are used to prop up banks which suffer losses
in a financial crisis or to guarantee banks' liabilities in case of bank runs produced by
outflows.
In a fully-fledged fiscal federation these problems do not arise, as asymmetric shocks are
partly offset by cross-region transfers through a federal budget. Furthermore, the stability of
the banking system does not depend on the soundness of local or regional finances, but on
that of the federation. The smaller the size of local or regional authorities' budgets, the lower
the risk that asymmetric shocks will endanger the stability of those authorities' finances as
the stabilisation function is performed by the federal budget.
In essence, this mechanism aims to insure individual countries against idiosyncratic shocks
which in turn could reduce macroeconomic volatility. Theoretically, this mechanism could
even be designed so as to strengthen incentives to reduce macroeconomic imbalances such
as unit labour cost divergence and high and persistent current account deficits. Contributions
to intergovernmental grant schemes or access to joint bond issuance could, for example, be
made conditional on a country's progress with its structural and fiscal reform agenda.
A federal budget does not necessarily mean, however, that the stabilisation function is better
performed at the federal level, in particular when facing symmetric shocks. The experience of
the recent crisis shows that the deficit and debt levels of several countries, some of them
with federal systems, others centralised, have increased even further than in some countries
of the euro area. For instance, both the UK and the US experienced larger deteriorations in
their fiscal positions from 2007 to 2009 than the average in the euro area. Over this period,
the budget deficit of the UK increased from 2.7% to 11.4% of GDP while that of the US
increased from 2.8% to 11.2%. These deficit ratios are comparable to that of Spain, which is
one euro area countries where the public finances have been particularly severely affected
by the crisis.
It can actually be argued that, with the market pressure which arises in a monetary union, its
members have to think more about the long-run stability of their public finances than they do
if monetary policy eliminates the pressure by ensuring the financing of the deficit. Under
pressure from the markets the euro area countries have adopted corrective measures which
are expected to stabilise the public debt-to-GDP ratio in the coming years. In Spain, for
instance, the latest available stability programme (which dates back to January 2010) aims at
stabilising the government debt-to-GDP ratio at a peak of 74% in 2013. Moreover, since
then, the Spanish government has responded to market tensions by frontloaded to 2010 and
2011 some of the fiscal adjustment planned for 2012 and 2013.
To sum up, a federal budget might ensure greater stability in the face of asymmetric shocks,
but when such shocks are large enough to affect the whole economy a federal system might
not necessarily provide greater stability.
Let me turn to the second criterion that characterises economic policy - efficiency in the
allocation of resources. Here the experience of German unification may be interesting
because it helps us understand the challenges that a union composed of countries in
different economic conditions may face in integrating those economies and adopting the
same currency. This experience suggests that a single fiscal regime may impose obstacles
to economic integration, particularly for catching-up regions. In the euro area, countries
which entered with a lower per capita income caught up with the average much more quickly,
maybe too quickly, as I mentioned earlier, than eastern Germany and attracted capital and
labour inflow. There are several reasons for that. One is that the budgetary integration entails
a harmonisation of taxation and public expenditures which may have a differentiated impact
across regions, depending on their level of wealth. A given distribution of the tax burden may
be appropriate for a given level of income but not necessarily for a lower one, and may lead
to larger rather than smaller differences. Regions with less physical capital may for instance
require lower taxation, and maybe also lower expenditure, to attract the capital necessary for
the catching-up. There is extensive literature on these issues, so I won't elaborate further on
this.
Another aspect refers to all the effects that arise, in terms of harmonisation, as a result of
fiscal integration, such as tariffs, administrative costs, public wages, etc. which weigh
indirectly on the costs borne by business. If a country needs to grow faster, such costs
should be reduced.
The same applies to other aspects of legislation which tend to be harmonised as a result of
fiscal union and tend to penalise catching-up regions. These costs are offset by resource
transfers, from the richest to the poorest regions. However, experience in Germany, Italy and
other dualistic countries shows that if these transfers are not well designed and are only the
result of the integration of the tax and public expenditure systems, they may create
disincentives for growth and employment. These distortions lead to labour migration from the
poorest to the richest regions. In countries like the US, labour migration used to be
considered as a "good" and somewhat natural adjustment process, resulting from the
country's westward expansion. The recent housing crisis has shown, however, the costs of
an adjustment process which relies on such a mechanism: migrants have to sell their homes
in depressed regions at depressed prices. In Europe, migration is valued if it represents an
opportunity rather than a lack of alternatives. Given the prevailing cultural differences,
sometimes even within countries, migration entails welfare losses.
In more general terms, some form of competition between regional budgets, in particular in
terms of taxation, but also expenditure, may enhance efficiency and best practice. The fact
that some countries have been able to better control public finances before and during the
crisis may set an example to others. This applies also to the quality of public expenditures
and to the reforms related to the costs of ageing, health care and unemployment.
Decentralisation also enhances accountability and allows better supervision by the voters. It
would be quite damaging if "Brussels" were to be blamed also for the poor state of public
finances, rather than the capitals of the Member States.
To sum up, a federal budget is better capable of addressing asymmetric shocks, but not
necessarily symmetric shocks, and may not be the most efficient approach in an area which
catching-up countries will continue to join. On the other hand, if decentralised budgets are
better attuned to the requirements of the catching-up countries, such budgets may lead to
excessive pro-cyclicality and to instability if the catching-up is too quick and unsustainable.
The above considerations suggest that it would be risky for the euro area to move to greater
fiscal and budgetary integration in order to avoid the instability associated with the current
system. While solving some of the problems of the current system, the new regime could
import new problems which might be politically even more difficult to tackle.
3. The way forward
If it is not desirable or feasible, at least in the current times, to move to a full fiscal federation
- or a transfer union as it is called in Germany - like the US, how can the current system be
made more resilient, in particular in the face of asymmetric shocks?
The crisis is, let's not forget, the worst since WWII. It has shown that some of the elements of
our economic and monetary structure need to be improved. The framework as it used to be
simply assumed that there would never be a crisis. That was done in good faith but proved to
be naïve. The status quo is not an option. But it is precisely to avoid moving to a fiscal
federation that some of the parts of the current system need to be modified.
First, let's consider the monetary part of the Union. It has worked very well. I won't repeat the
statistics about price stability, but simply say that the figures are better than they were
previously. The ECB has proved to be independent. It is a federal institution capable of
acting very quickly, as we have shown over the last three years. The euro is a stable and
safe currency.
It's been said that in some countries, notably Germany, many people feel nostalgic for the
Deutsche Mark and believe that Germany would be better off with its old currency. This
sentiment is purely emotional and not based on statistical or empirical facts.
The euro brought low inflation to Germany during the last decade, lower than ever before.
More importantly, it has kept German exports very competitive, especially in the aftermath of
the crisis. This is contributing to the pick-up in the German economy, ahead of the others in
the euro area. The currency movements of, for instance, the Swiss franc in the last few
months suggest that if the old national currencies still existed, German exports would risk
becoming much less competitive.
Let me hasten to add that Germany's good economic performance is not solely attributable
to the euro. In fact, the country's economy has proved more capable than others of exploiting
the opportunities provided by the euro, in particular by keeping costs under control for many
years and ensuring sound public finances in good times. Other countries haven't exploited
the benefits provided by the euro so well, or they wanted too much too quickly and at a
certain point they came face to face with reality. We need to make changes that prevent such
excesses from happening again in the future.
To sum up, there is nothing to change in the monetary set-up. The problem is in the
economic dimension of EMU. There are two fundamental elements to address to improve the
"E" of EMU. One is public finances. There's been a lot of talk on this subject, and some
decisions too. There is a need for more rules to constrain national budgets. There is also a
need for an effective safety net, one that can prevent a crisis from spreading within the euro
area as a result of a lack of discipline by one of its members. Several changes have been
implemented and a few more are required to ensure that the system is effective. In this field
we don't need to innovate. The IMF's experience should be a useful guide. European
countries, including Germany, have been members of the IMF for more than 60 years.
European taxpayers have never lost money from IMF operations.
The other element to consider is an avoidance of imbalances, such as those which have
emerged over the last decade. They have been the result of a loss of competitiveness and
excessive reliance on external borrowing. These two factors have to be tackled. In my view
they cannot be addressed through simple rules and micro-management, because the various
economies have different structures. They require a change in governance of the euro area
along two dimensions, which I will briefly consider.
The first is competitiveness. The debate has rightly turned to that factor, especially in recent
weeks. It's a welcome move. Last autumn, the European Council adopted a procedure to
enhance macroeconomic surveillance in the euro area, on the basis of indicators such as
unit labour costs, current account imbalances, etc. The ECB contributed to this debate by
proposing a traffic light system to warn about emerging competitiveness losses.
The problem lies in devising a system of governance to assess competitive positions. It has
to be restricted to the euro area, i.e. 17 countries at the moment. It cannot be at the EU-27
level. Why not? Because problems of competitiveness within a single currency are very
different from those of countries with their own currencies. I suppose I don't need to give
concrete examples to convince you of this. Currently, the only 17-country European body is
the Eurogroup, an informal grouping consisting of the finance ministers of the euro area. The
Eurogroup mainly deals with issues for which the finance ministers are responsible, notably
budgetary policies and international financial issues. Competitiveness depends on many
other aspects, such as labour and product market regulations, which generally do not fall
within the competence of finance ministers. The ministers who deal with these other matters
are typically not faced with issues related to the euro area. And all Council formations in the
EU meet in full composition only, i.e. at the 27-member level.
The Heads of State and Government have met, in euro area composition, on numerous
occasions during the crisis, starting in October 2008, when they decided to intervene jointly
in support of the financial system. There was concern about and even opposition, in
Germany as well, to a more systematic role being given to the euro area composition of the
European Council and possibly other formations of the Council. It was feared that this would
interfere with, or be a counterweight to, the ECB, and would undermine its independence.
The experience of the crisis, and of the first decade of the euro, is that the ECB has
remained fully independent and has nothing to fear from a more cohesive euro area
governance. On the other hand, the lack of a strong decision-making body at the political
level may unduly constrain the effectiveness of and overburden the ECB's actions. The crisis
has also shown what the founding fathers of the euro knew all along, i.e. that Monetary
Union means much more than adopting a single currency. It entails a high degree of political
union, for it requires many more decisions to be taken jointly, on account of the externalities
and contagion that can result from sharing a currency.
I personally consider it very important that the political authorities of the euro area countries
have decided to strengthen their ties and are seeking to extend their cooperation to other
areas. Exactly what form this will take is still unclear, but the change in direction is important
and welcome.
The second factor relates to the problems which have emerged in the crisis as a result of the
imbalances that have built up within the national banking systems. Even when fiscal policy is
sound, as it was in Ireland's case, a country's public finances can be derailed if its banking
system is overextended, poorly regulated and insufficiently diversified. Furthermore, given
the integration of Europe's financial system, contagion cannot be avoided. The euro area is
characterised not only by the lack of a fiscal union but also by its decentralised supervisory
system. The two aspects are to some extent linked. Supervision is decentralised, it is argued,
because it is taxpayers who ultimately have to bear the burden of any supervisory failure.
Thus, by extension, if a decentralised fiscal system is to be accountable, then supervision
also has to be decentralised, albeit with cross-border cooperation.
The crisis has shown however that when a national banking system encounters difficulties,
due to insufficient supervision or its size being out of all proportion to the country's economy,
taxpayers may not be able to absorb the shocks and may ask for help from the other
countries' taxpayers to tackle the situation. In addition, given the interconnections of the euro
area money and financial markets, any failure to address the problems arising from the
banking system in one country may quickly spread to the other countries, thereby burdening
their taxpayers. As a result, a national regulator may be inclined not to impose limits on the
size and activities of the respective domestic system, thus creating an externality for the euro
area as a whole. This may in particular overburden the central bank in its role of lender of
last resort.
To sum up, the crisis has shown that it is not necessarily true that national taxpayers
ultimately bear the responsibility for supervisory failures or the foolhardy actions of bankers.
This happens only if the domestic banking system is small and not interconnected with the
other systems, which cannot be the case within a monetary union.
To avoid these externalities there is a need for a system of rules and procedures which binds
the financial system, in the same way as the Stability and Growth Pact binds national fiscal
policies. Some progress has been made towards implementing a single rule book within the
EU, but margins for national discr