Jens Weidmann: Striving for a stable framework for monetary union - an
old debate revisited
Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, to the Ambassadors
Conference, Berlin, 26 August 2013.
* * *
1 Introduction
Your Excellency Dr Guido Westerwelle
Minister of State Ms Cornelia Pieper
Minister of State Mr Michael Link
State Secretary Ms Emily Haber
State Secretary Mr Harald Braun
Heads of Germany's missions abroad
Your Excellencies the Ambassadors
Ladies and gentlemen
Thank you very much for inviting me to this conference. I'm delighted to have the opportunity
to speak to you here today.
Inviting the President of the Bundesbank of all people to an ambassadors conference might
appear somewhat unusual at first glance. After all, central bankers are hardly renowned for
having the most thrilling of professions. "Boring is best" is how the former governor of the
Bank of England Mervyn King once aptly put it.
But whether we like or not, my profession has been attracting ever greater attention. Rarely
was monetary policy such a topic of intense public debate in the international arena as it is
today. And incidentally, there are many channels which connect the Federal Foreign Office
and the Bundesbank.
These notably include the secondment of Bundesbank employees to embassies and
consulates in the major financial centres. As representatives at Germany's missions abroad,
they provide information to interested local parties on European monetary policy, on the
Bundesbank's role in the Eurosystem and on the German banking system. But information
naturally flows in the opposite direction, too. These representatives regularly report on the
latest economic and monetary developments in their host countries. This benefits the
Bundesbank's analyses and, I would hope, those of the Foreign Office as well.
And the extent to which an additional perspective can broaden our perception of economic
relationships was illustrated not least by the financial crisis. The outbreak of the crisis was
not just a painful wake-up call reminding us that our theoretical models sometimes paint only
a very incomplete picture of reality. Work is therefore quite rightly under way - at the
Bundesbank and elsewhere - to develop a superior analytical toolkit that can be deployed in
day-to-day work. This crisis has also been a stark reminder for us economists that looking
back can offer valuable pointers for the future.
"History does not repeat itself, but it does rhyme." This saying by Mark Twain quite aptly
describes economic developments as well. And it applies to the European debt crisis in equal
measure. Twenty-five years ago, the European Council tasked a group of central bank
governors chaired by Jacques Delors, then President of the European Commission, with
identifying ways in which a European monetary union could be structured. The Delors
Committee's insights can teach us a number of key lessons to this very day. For many of the
problems weighing down on monetary union today had already been flagged and discussed
by the Delors Committee all of 25 years ago. That makes it worthwhile taking a look back in
time.
My talk today will therefore be made up of three sections. In the first section, I would like to
look at the Delors Committee's key insights. In the second part, I would like to examine why
monetary union began to flounder, and I will then use these conclusions in the third section
to develop proposals for strengthening the existing framework.
2 New problems, old questions
A single currency fosters economic relationships between different countries. Yet at the
same time, it also increases the dependencies between them. This insight was a recurring
theme throughout discussions within the Delors Committee. Their line of thinking was based
on the economic policy experiences of the 1970s and 1980s. That era of oil price shocks
posed a major challenge to monetary policymakers. It became evident that countries with
independent central banks had significantly lower inflation rates than those in which central
banks followed politicians' instructions - while simultaneously achieving equal or even higher
levels of growth. What we learned back then was that price stability does not run counter to
economic prosperity, but complements and steadies it.
But we learned something else, too. That an independent central bank is necessary for
stable prices; but more than that is needed. A country suffering excessive public debt and a
lack of competitiveness can cause upheaval within a currency area, and this can also impact
on monetary policymakers' ability to fulfil their primary objective of ensuring price stability. In
a currency union, monetary policy can only serve its purpose if each member state's
economic policy is consistent with the requirements of a single currency.
The members of the Delors Committee discussed two possibilities of ensuring sustainable
economic and fiscal policies. The first option was to transfer these decisions to the European
level. This line of thinking was supported, among others, by Alexandre Lamfalussy, then
managing director of the Bank for International Settlements (BIS).
The other option was the principle of individual responsibility, under which member states
would remain largely independent in their choice of policies, but would be liable for the
decisions they made. This liability principle promised to have a disciplinary effect. Member
states running unsound fiscal policies or dubious economic policies would only be able to
borrow at worse terms, since investors would demand compensation for the risk they were
taking.
To make provisions in case the capital markets' disciplinary effect was insufficient, the fiscal
scope was to be narrowed further still by way of a common set of rules. Jacques de
Larosière, then governor of the Banque de France, was a notable proponent of a strict fiscal
regime.
Both options were coherent on paper. Political considerations were the main reason why the
principle of individual responsibility ultimately prevailed. The bulk of member states were not
prepared to relinquish any sovereignty in economic matters. It was widely feared that
referendums held to change member states' constitutions would not produce a majority that
favoured a large-scale transfer of sovereign powers.
And this was how the architecture of monetary union made up of sovereign nation-states that
we are familiar with today, came about. As before, national parliaments bear full
responsibility for such vital areas as tax policy, budget policy or labour market regulation.
3 Vulnerabilities in the original framework
Ladies and gentlemen, what the Delors Committee tried to achieve back then was to find an
architectural model capable of accommodating this inherent tension. They sought to
construct a stable European house, knowing full well that tremors in individual member
states might shake the structural soundness of the entire building. Why was the draft made
back then unable to prevent the crisis we are experiencing today?
First, it should be noted that although one key point - the risk of macroeconomic imbalances
- was indeed recognised by the Delors Committee, consideration was not made for it to be
incorporated into the final Maastricht framework. The Maastricht framework instead focused
on the one central supporting pillar: the fiscal rules designed to curb government deficit and
debt levels. These rules were complemented by the no bail-out clause - that is, the principle
of individual responsibility. But this pillar proved unable to provide sufficient support. The
rules designed to curb government deficits didn't have sufficient binding force. Repeated
breaches knocked more and more stones out of the "fiscal rules" pillar, with Germany
bearing much of the responsibility for this.
In the end, other pillars supporting the structure likewise proved to be brittle. Banking
supervision remained a national responsibility, which meant that there was no institution
which set the same high standards for banks, irrespective of their home country, and took
account of cross-border interactions which were outside the field of vision of national
supervisors. While it is true that a few members of the Delors Committee, like Wim
Duisenberg, later President of the ECB, spoke out in favour of common banking supervision,
their proposals fell on deaf ears.
The capital markets' disciplinary effect on governments likewise proved to be inadequate.
Why that didn't work is quite easy to explain. Back then, a different committee, which like the
Delors Committee also met in Basel - the Basel Committee on Banking Supervision - made
what turned out to be a momentous decision for the euro area. The new common set of
international capital rules stipulated that government bonds be valued as risk-free assets,
which meant that banks did not have to back them with capital.
This decision affected monetary union in two ways. First, it cast doubt over whether the no
bail-out clause could ever be enforced, given the huge differences in economic power and
indebtedness between the member states. Second, sovereign insolvency became less
credible for reasons of financial stability. But if banks do not set aside any capital for
government bonds, a sovereign default can hit the banking sector head on, potentially
triggering a financial crisis.
4 A new home for monetary union
As we can see, the home shared by the member states of the euro area needs renovating in
more ways than one. Of course, numerous methods are conceivable for constructing a stable
dwelling. That's just as true today as it was then. As an alternative to the "Delors house", one
could also imagine building a dwelling that does without the supporting pillars known as
"fiscal rules" and "individual responsibility" and is instead held up by the "fiscal union" ring
beam.
However, a properly functioning fiscal union would depend on the member states transferring
a substantial degree of national sovereignty to the community level by giving the community
the necessary right to at least intervene in the event of unsound public finances. Transferring
sovereignty on this scale would be a radical change that would require wide-ranging
legislative changes nationally and at the European level. And above all, such a step towards
greater integration would require not just political support but public backing as well. On this
point, however, we should remain realistic. The will to do so is barely discernible at present -
in the midst of the crisis - not here nor in any of our partner countries. Seen from this angle,
the situation has hardly changed since monetary union was launched.
All that remains, then, is to stabilise the building we have, focusing our renovation efforts on
the current supporting structures. This means, first, strengthening the common set of rules.
And, second, it means lending renewed force and making enhancements to the principle of
individual responsibility, which has been further eroded by a number of the crisis measures.
Construction activity is already largely complete on the fiscal rules. But only actual practice
will show whether the new Stability and Growth Pact and the Fiscal Compact will really make
lasting improvements to the structural soundness of the building - that is, whether the
patched-up pillars can bear the weight.
After all, it is not enough to merely have a "new" set of tighter rules; these rules actually have
to be applied and filled with life. This is a matter in which the European Commission has a
particular responsibility because it has considerable discretionary powers in interpreting the
new rules. I would not consider it appropriate to stretch the flexibility of the rules to the
absolute limit from day one.
In its August Monthly Report, the Bundesbank examined the recent decisions by the Ecofin
Council regarding the excessive deficit procedures for euro-area countries from a critical
perspective. Spain, France, Slovenia and Cyprus were each granted longer deadlines to
make adjustments than were actually envisaged in the Stability and Growth Pact.
Derogations of this kind should, however, be reserved for well-justified exceptional cases.
For this ultimately results in a weakening of the structural consolidation requirements and
corrective action being pushed into the future. Granting exceptions to a number of countries
simultaneously undermines the disciplinary effect of the fiscal rules.
And the new Macroeconomic Imbalance Procedure should likewise be applied as rigorously
as possible. While the construction of the extended set of economic and fiscal rules is
already at an advanced stage, work on Europe's largest building project is still in full swing.
And by that, I am referring to the banking union. If implemented properly, it can perform two
tasks. First, it can rectify competitive deficiencies in the banking sector; second, it can
enhance the capital markets' disciplinary effect on governments. Both problems are closely
intertwined; neither can be resolved in isolation.
After all, both sets of players - banks and sovereigns - have one thing in common. They
were only subject to the key market economy principle of liability to a very limited degree in
the past. Both were considered to be systemically important. It was feared that if they got into
problems, this might jeopardise the stability of the financial system. In the end, it wasn't the
decision makers who were liable. But this is something that undermines the incentives for
responsible behaviour.
In the midst of the crisis, the weakness of one set of players then became that of the other.
Banks that had run into difficulties on account of distressed property loans in their books,
say, had to be propped up by the taxpayer. The rescue sums required in countries like
Ireland, Cyprus and Spain were so huge that sovereign solvency, too, began to be called into
question by investors. This drove refinancing costs higher.
But the negative feedback loop also works in the opposite direction. Ailing states can bring
down banks that have substantial holdings of sovereign bonds in their books. It is this strong
link between sovereigns and banks that needs to be severed.
Separating the two is all the more important because the nexus between banks and
sovereigns actually even increased at times during the crisis. Studies1 [1]suggest that it was
notably the poorly capitalised banks in the crisis-hit states which took advantage of central
bank refinancing to invest increasingly in high-yield domestic government bonds during the
crisis.
For when the insolvency of the home country is highly likely to bring down the institution in
question as well, it can actually be quite rational to ramp up risk levels further still. After all,
this barely increases the bank's risk of insolvency but distinctly boosts the prospective profits
if the outcome turns out to be favourable.
Hence, this strategy further intensified the negative feedback loop between banks and
sovereigns during the crisis. Several incisions will be needed if we are to sever these links.
The first of these will be the Single Supervisory Mechanism, which is tasked with preventing
banks from getting into difficulties at an early stage.
But these are problems that cannot be entirely ruled out in the future, nor would we want to
do so. After all, the possibility of failure is vital for a functioning market economy. It is
important, therefore, to be able to allow banks to fail without governments - and thus also
taxpayers - having to foot the bill.
And that is why we need the European recovery and resolution mechanism. Its job will be to
ensure that if a credit institution needs to be restructured or wound up, its owners and
creditors will bear a fair share of the losses. This guarantees that those benefiting from
investment income also carry responsibility for the associated risk.
But the feedback loop between sovereigns and banks needs to be severed in the other
direction, too. The close ties linking sovereigns to banks are largely the result of the
substantial volumes of government bonds which banks have in their books. This is where we
need to make a further incision. First, government bonds should be backed by a sufficient
quantity of capital. Second, the volume of loans that banks can extend to individual sovereign
debtors needs to be capped.
In a nutshell, over a medium-term horizon, government bonds should be treated just like
other bonds or loans to enterprises. For the previously held notion that government bonds
are entirely free of risk runs counter to the principle of individual responsibility as well as
recent experience. Appropriate risk-weighting would drive yields higher for unsound
sovereigns and raise their refinancing costs. Hence, the market mechanism would force
these governments to exercise greater fiscal discipline.
Yet the inadequate capital backing required for government bonds is not the only reason why
they harbour risks for financial stability. Risk diversification is a key principle for investors.
But this is a rule which European banks often tend to disregard where government bonds are
concerned.
As I mentioned earlier, European banks frequently only have bonds issued by one
government in their books, mostly those of their home country. In fact, these banks' holdings
of government bonds as a percentage of their total assets are sometimes even higher than
those of banks which spread their exposures across several sovereign debtors. This tightens
the negative feedback loop between banks and sovereigns further still. And that is why we
need limits on large exposures to individual governments as a vital addition to appropriate
risk-weighting.
I am well aware that such a reform at the current juncture of the crisis might exacerbate the
financing problems that some countries are experiencing. That's why I think that transitional
periods might be acceptable as well. But abandoning a reform like this to suit short-term
considerations would be the wrong approach.
Work on the major building project dedicated to constructing the banking union is far from
complete. The capital rules for sovereign bonds are an example which vividly illustrates the
tension that exists between what is right over the long term and the crisis management
measures which appear to be needed in the short term.
5 The role of monetary policy
Yet this must not entice politicians to simply paper over the cracks rather than renovate the
house from top to bottom. As you've probably already realised, I'm talking about the role of
monetary policy. The ECB Governing Council agrees unanimously that monetary policy
cannot solve the crisis.
The most it can do is buy time. Indeed, one of the Delors Committee's insights remains as
valid as it ever was. In performing its task, monetary policy is bound by conditions that it
cannot create itself. Monetary policy has already helped substantially in preventing a further
escalation of the crisis. However, this has taken it a long way into uncharted - and
dangerous - territory.
It's no secret that I am critical of the ECB's government bond purchase programmes in
particular. If Eurosystem central banks buy government bonds issued by countries with poor
credit ratings, this will distribute the risks of unsound fiscal policy among all the euro-area
states. Monetary policy thus weakens the principle of individual responsibility and entails
redistribution, which is really the prerogative of fiscal policymakers. Such redistribution can
only be legitimately authorised by democratically elected parliaments and governments.
Thus, the most valuable contribution which monetary policy can make towards overcoming
the crisis is safeguarding its credibility and upholding public confidence in the euro. It can do
so best of all by focusing clearly on its primary mandate of safeguarding price stability.
6 Conclusion
Ladies and gentlemen
The crisis has caused the old debate over the architecture of monetary union to flare up
again. And yet the construction principles sketched out by the first architects under the
leadership of Jacques Delors remain as valid as ever. But when you take on complicated
major projects like monetary union, things don't always work out at the first attempt - that's
something we're probably not unfamiliar with in Germany.
It is now all the more important to rectify the remaining construction defects. Then it will be
possible to make monetary policy what it once was - a boring task. And as Mervyn King
quite rightly stated with his "boring is best" remark, there is nothing that we central bankers
long for with greater fervour.
Thank you very much.