Ignazio Visco: The sovereign debt crisis and the process of European
integration
Speech by Mr Ignazio Visco, Governor of the Bank of Italy, at the 32nd Seminar "Federalism
in Europe and in the World", Istituto di Studi Federalisti "Altiero Spinelli", Ventotene,
1 September 2013.
* * *
The introduction of the euro was a fundamental step in European history, a political event
that certified the progress made on the road to integration, a profound economic and social
change. It was only a step, however, and not the end of the road, which is still a long and
difficult one. Tommaso Padoa-Schioppa, who contributed so much to the achievement of
monetary union, was well aware of this. In May 1998, on the eve of the introduction of the
single currency, Padoa-Schioppa wrote in the Corriere della Sera, The European economic
and monetary union's "capability for macroeconomic policy is, with the exception of the
monetary field, embryonic and unbalanced [...]. For the European Central Bank the real
danger will not be too little independence but too much isolation [...], having to operate
almost in a vacuum, with no political power, budgetary policy, banking supervision, or
financial market control function. [...].It is thus right not only to applaud yesterday's step but
also to underline its unfinished nature, the risks and the rashness." Since 2010 this
incompleteness has fueled the sovereign debt crisis in the euro area.
In the absence of political union, the economic governance of the area was based on a
fragile alliance between market forces and rules of conduct. Market forces were to ensure
the economic convergence of the member countries and the definition and implementation of
the necessary structural reforms at national level. Rules of conduct were expected to
guarantee prudent budgetary policies. As early as the 1989 Delors Report, it was thought
that, for the public finances, "the constraints imposed by market forces might either be too
slow and weak or too sudden and disruptive."
Economic convergence was slow and difficult; in some cases the gaps actually widened. In
many economies the delays and obstacles to adjusting to the large-scale global changes
weakened competitiveness and the ability to grow. Mitigated by the improvement in funding
conditions after the introduction of the euro, market pressures alone were not sufficient to
drive the necessary reform efforts. Measured on the basis of unit labour costs in the whole
economy, the loss of competitiveness recorded between 1999 and 2008 in the countries
worst hit by the crisis went from about 9 percentage points in Greece and Portugal to 12
points in Italy, 19 points in Spain, and no less than 37 points in Ireland. Considering only
manufacturing industry and competitiveness indicators based on producer prices, the
competitiveness losses ranged from 7 percentage points in Italy to 22 points in Portugal (14
points in Spain, 16 points in Ireland and 18 points in Greece).
The rules for the public finances defined in the European sphere were not always respected.
In 2007, almost a decade after the introduction of the single currency, only a few countries
reported budgets close to balance in structural terms, i.e. not counting the effects of the
economic cycle on revenue and expenditure. In some cases the public debt was still at an
excessively high level in relation to GDP. For a long time the financial markets
underestimated sovereign risks, thus confirming the doubts about their ability to provide
timely incentives for the adoption of virtuous behaviour. Until the outbreak of the crisis the
spreads between government bond yields within the euro area were close to zero.
In this framework, after the financial crisis in the United States and the very severe global
recession in 2008-09, the full revelation of the unsustainability of the Greek public finances
produced tensions which then spread to the economically weaker euro-area countries,
characterized by excessive public or private debt, a foreign trade deficit, poor
competitiveness, and low economic growth. Tensions grew with the bursting of the property
bubble and the consequent disruption of banking in Ireland. With the announcement of the
involvement of private investors in restructuring Greek debt in the summer of 2011, the
financial markets suddenly became aware of the implications of the ban on interventions to
rescue member states under the Treaty on European Union. There followed a very serious
crisis of confidence in the ability of the single currency to survive, with negative
consequences for the real economies of individual countries and for the area as a whole.
The yield spreads between euro-area government securities suddenly increased in the
second half of 2011; those between Italian and German 10-year government bonds, still
below 200 basis points in the first half of that year, rose to 550 points in the following
November. In the same period, in Italy and the other countries affected by the tensions, there
was a sudden worsening in wholesale funding conditions for banks, whose creditworthiness
was linked to that of their sovereign paper; placement of securities, especially uncovered
bonds, dried up; the CD and commercial paper markets also thinned. The cost of
fundraising rose; in the money market there was a significant increase in the spreads between
the very-short-term interest paid by Italian banks and the average.
Given the real risk of a severe tightening of the supply of credit to the economy, the
Governing Council of the ECB cut its main refinancing rate by a total of 50 basis points in
November and December 2011, introduced three-year refinancing operations (LTROs)
providing unlimited liquidity at fixed rates, extended the range of assets eligible as collateral,
and halved the compulsory reserve ratio. In the two LTROs conducted in December 2011
and February 2012 the Eurosystem supplied funds totaling around €1 trillion to banks in the
euro area; taking account of the smaller volume of funds disbursed in other operations, the
net increase in the flow of resources to the banking system exceeded €500 billion. The large
injection of liquidity contributed to easing tensions in the money market. The excess liquidity
is currently being reabsorbed: deposits held in the ECB's reserve accounts and deposit
facility, excluding the compulsory reserve, now amount to €250 billion, down from €800
billion in March 2012.
Yield spreads between government bonds in the euro area are determined by two factors,
one national and one European, linked respectively to the weaknesses of some countries'
economies and public finances (sustainability risk), and to the incompleteness of European
construction and the attendant fears of a break-up of the monetary union (redenomination
risk). Europe's response to the sovereign debt crisis has consequently been two-pronged: on
the one hand, individual countries have pledged to adopt prudent budgetary policies and
structural reforms to support competiveness; on the other, a far-reaching reform of EU
economic governance has been undertaken.
Not every country needed to consolidate its public accounts; in some cases in the
international fora there was even talk of the possibility of expansionary interventions.
Adjustment was indispensable in countries such as Italy that were experiencing difficulty in
the financial markets and where the margin of confidence granted by investors and market
operators was especially narrow. As I have remarked elsewhere, the volume of government
securities to be placed every year to finance Italy's deficit and, above all, to roll over the
maturing debt is in the order of €400 billion.
The recession has made budget corrections difficult, with their inevitably negative
repercussions for economic activity in the short term. Nonetheless, prudent management of
the public accounts has helped to avoid worse scenarios, to first limit and then lower interest
rate differentials between euro-area government securities, and to prevent new liquidity
crises. It has also proved difficult to implement structural reforms since, while helping to
restore the growth potential of an economy, they can have short-term costs, especially in
terms of employment.
Between the summers of 2011 and 2012 the Bank of Italy's assessment of the prospects for
growth in Italy last year gradually deteriorated by over 3 percentage points; one point is
attributable to the effect of public finance measures, while more than one and a half points
reflects the increase in the spread between Italian and German government securities and its
effect on the supply of credit to the economy and on business and consumer confidence; the
remainder is attributable to the darkening outlook for world economic growth.
The financial results of Italy's fiscal policy have been obscured by the recession.
Notwithstanding an increase in the primary surplus - to 2.5 per cent of GDP, from 1.2 per
cent in 2011 - government debt has risen by over 6 percentage points of GDP, to 127 per
cent, reflecting above all the sharp deceleration in output. Almost two percentage points of
the increase are attributable to the financial support that Italy has given to other EU
countries.
The reform of European governance, which took shape in emergency conditions, along lines
that were not always consistent and marked by uncertainty, overlap and heavy-handedness,
along with the efforts made at national level, have nonetheless begun the process of
rebuilding trust among member states. In the past, the Union's cohesion has been severely
tested by repeated violations of budgetary rules - not only in relation to the most recent
events, but also for those that led to the first reform of the Stability and Growth Pact in 2005
- and by the difficulty of making any in-depth assessment of national financial systems,
which are subject to profoundly different regulations and supervisory practices. The
strengthening of the budgetary rules, above all as regards prevention, and the extension of
multilateral supervision to macroeconomic imbalances have accompanied the establishment
of mechanisms for managing sovereign debt crises and paved the way for the launch of the
banking union, renewing discussion on the budgetary union and plans for a political one.
The agreements reached in the last two years in the matter of public finances have
reinforced the commitments entered into previously but they have not established more
demanding targets. The new European governance has increased the automatism of
coherence checks on policies and objectives and of potential sanctions; countries have been
asked to recognize the European rules in their national legislation. Even the "debt rule",
which calls on countries to reduce by 1/20th annually the amount by which their debt
exceeds the threshold of 60 per cent of GDP, in fact renders operational a requirement
already embodied in the Treaty of Maastricht. For Italy, compliance would not entail the
adoption of a permanently restrictive budget policy stance, but it does imply the return to a
stable growth path and it requires a faster pace of adjustment to the geopolitical,
technological and demographic changes of the past thirty years.
The new macroeconomic imbalance surveillance procedure is an early warning mechanism
based on a scoreboard of indicators and alert thresholds. The indicators are analyzed by the
European Commission in an annual report identifying the countries to be subjected to
indepth review. In the case of particularly severe imbalances, the Commission draws up, for
approval by the European Council, a set of specific recommendations calling for adjustment
measures; failure to comply may lead to sanctions.
Until two years ago Europe had no tools with which to manage a sovereign crisis. The first
measures to support Greece, and to a smaller extent Ireland, involved the use of bilateral
loans. In May 2010 the European Financial Stability Facility (EFSF) was instituted - a
temporary mechanism that was also adopted for Portugal and has remained in operation
until this year; the bonds issued under the facility are guaranteed by the member states. In
July 2011 the EFSF was flanked by the European Stability Mechanism (ESM), a permanent
crisis management tool instituted by international treaty and endowed with capital of its own;
ESM loans to Spain were used to bolster the country's banking system.
The total lending capacity of these two instruments, initially set at €250 billion, has been
raised progressively to €700 billion. When the EFSF was launched the only method of
intervention available was to grant loans under support plans for the countries in difficulty;
this has gradually been extended and now includes, with appropriate conditionality,
interventions on the primary and secondary markets for government securities, opening of
precautionary credit lines, and funding of the recapitalization of financial institutions.
Between 2010 and 2012 the countries of Europe disbursed, either directly or through the
EFSF or the ESM, some €280 billion in loans to their partners in difficulty. Italy contributed
€43 billion, of which €27 billion for EFSF loans, €10 billion for bilateral loans and €6 billion to
provide capital for the ESM. According to official estimates our contribution will rise to more
than €55 billion this year and to almost €62 billion in 2014.
After the need to remedy the asymmetry of a single monetary policy and multiple national
budget and structural policies had been recognized, a further gradual reinforcement of the
Economic and Monetary Union was agreed and set in motion. The Blueprint for a Deep and
Genuine Economic and Monetary Union
published by the European Commission last
November and the report Towards a Genuine Economic and Monetary Union presented in
June 2012 and updated in December by the President of the European Council, working
closely with the Presidents of the European Commission, the Eurogroup and the ECB,
outline the stages of this process. They will lead to banking union, the introduction of
autonomous fiscal capacity for the whole euro area, a common budget and, eventually,
political union.
The time needed to implement Europe's complex strategy to counter the economic crisis will
be long. The distortions that continue to affect the financial markets in the meantime could
undermine the transmission of monetary policy and jeopardize the entire process. In July
2012 the yield differential between 10-year BTPs and the equivalent German Bunds was just
over 500 basis points, compared with a value of about 200 basis points estimated to be
consistent with Italian and German economic fundamentals.
Aware of these dangers, in the summer of 2012 the ECB Governing Council announced the
introduction of a new method of intervention on the secondary market for government
securities, Outright Monetary Transactions (OMTs). Countering an excessive increase in
sovereign yields when it stems from redenomination risk and distorts monetary policy
transmission is fully within the Eurosystem's mandate.
The OMTs are only activated in the presence of severe market strains and are confined to
the securities of countries adhering to a macroeconomic adjustment or precautionary ESM
programme. Their continued operation then depends on observing the conditions attached to
the programme. There are no ex ante limitations on the duration or amount of the
intervention.
This initiative has been made possible by the credibility of the Eurosystem and the progress
made in the reform of European governance. Fears of euro reversibility are linked in the first
place to those concerning the sustainability of public debts and the competitiveness of
member countries. For this reason the activation of OMTs and their continuation are subject
to specific undertakings regarding public finances and structural reforms as part of
assistance programmes. The financing of the programmes with ESM resources is an
incentive to further strengthen the governance of the Union, which is essential to achieve a
permanent reduction in the European component of the differentials. Monetary policy can
guarantee stability only if the euro-area's economic fundamentals and institutional
architecture are consistent with it. Every country must do its part.
The announcement of OMTs produced immediate benefits: medium and long-term yields in
the countries under pressure decreased and the fragmentation of markets along national
borders was attenuated. Albeit with fluctuations linked to the remaining, pronounced
uncertainty about the determination of all the member states to proceed with the
strengthening of the Union, the yield spreads between euro-area government securities
remained on a downward trend. That between ten-year BTPs and Bunds is about 250 basis
points today.
On 19 July a group of economists of various nationalities and affiliations published a
manifesto in support of outright monetary transactions (A Call for support for the European
Central Bank's OMT Programme), arguing that "the success of the OMT announcement
proves that the OMT is primarily a monetary policy instrument ... It is the responsibility of a
central bank and a defining feature of a lender of last resort to assume liquidity risk, including
through the purchase of financial assets when necessary (a step that has also been used by
the Bundesbank itself in the past)."
There are different standpoints; it is understandable that some should question the
compatibility of outright monetary transactions with the constitutions of some euro-area
countries, but the doubts about the possibility of making effective use of ESM resources must
be dispelled quickly in order to preserve the progress made, safeguard the rights and not
thwart the efforts of those who have helped to develop the instruments of financial support.
The OMT announcement prevented a financial collapse with potentially devastating
consequences for the European economy: all the member countries benefited, not just those
at the centre of the sovereign debt crisis.
More than anything else, however, a shared determination to advance towards a full
European Union is essential. The ECB and the national central banks have shown that they
are willing to accompany this advance, by continuing to "produce" the necessary confidence.
But confidence is short-lived in the absence of real progress.
The handling at the beginning of this year of the Cyprus banking crisis, which was only
resolved after difficulties of coordination between European and national authorities had
emerged, further underscored the importance of the banking union project for interrupting the
spiral between sovereign debt and the conditions of banks and credit. The creation of a
single supervisor, in which the ECB and the national authorities play a pivotal role, is the first
step; it must be completed by a common blueprint for the resolution of banking crises and a
common form of deposit insurance.
Beyond banking union there must be the prospect of fiscal union and, ultimately, political
union. In an interview he gave to la Repubblica on 6 October 2008, Padoa-Schioppa noted
that "There is more bitterness than satisfaction in witnessing a prophecy come true. At the
beginning of the euro I spoke of the dangers of a 'currency without a State'. It is clear that we
needed more of a European State, not less of a European currency: without the euro, Europe
would now be living a catastrophe. One reason for the lack of credibility of national politics is
that it keeps on giving people the illusion that national powers are capable of tackling issues
(energy, climate, finance, security, migration, primary goods) which are not national, but
continental and global."
These words, spoken before the outbreak of the sovereign debt crisis, are highly relevant. It
is necessary to further increase the coordination of economic and structural policies and the
incentives for reforms, to shift from an intergovernmental form of management based on the
peer review of national policies to the formulation of truly common policies. The scope of the
project for a common euro-area budget must be defined as well as the timeframe for its
implementation.
Economic and political reforms are not interdependent: confidence in the outlook for
Economic and Monetary Union would benefit greatly from significant new steps towards
political integration, including on a sectoral basis. In an essay written forty-five years ago
("Tecnologia ed economia nella controversia sul divario tra America ed Europa") Nino
Andreatta had already stressed the importance of a serious assessment of the "adverse
consequences of a plurality of national government purchasing policies, which encourage an
inefficient multiplication of research by individual countries and slow the growth in the size of
markets." The reflection on the desirability and necessity of going beyond the stage of
comparison and cooperation and of our governments pooling institutions and policies that
also have a major impact on our public finances - in fields such as defence, scientific
research, infrastructure (and not just material infrastructure) and other fundamental sectors
of government activity - has been under way for some time, the time is ripe for a process of
concrete reform.