José Manuel González-Páramo: Monetary and fiscal policy interactions
during the financial crisis
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at a conference, Madrid, 26 February 2010.
* * *
Introduction
It is a great pleasure for me to be here today in Madrid to deliver the closing remarks at this
important conference on the interactions between monetary and fiscal policies.
Before starting my intervention, let me recall that we are presently in the purdah period, i.e.
within the one-week period before the next decision meeting of the Governing Council. Thus,
nothing that I will say today is intended to have implications on our future monetary policy
decisions, nor should it be interpreted as such.
Undoubtedly, this conference has addressed a very timely topic. Because of the financial
crisis, substantial policy challenges have emerged for which we need to find answers. And I
am not sure whether it gives me much comfort that these challenges are not only faced by
policymakers, but, in a deeper sense, by the economics profession as a whole. I think that for
all of us much remains to be done until we will be able to say that we have "understood" the
lessons from the financial crisis.
The range of topics that have been covered over the past two days is impressive. I will not try
to comment on all the papers. This would be too much for a single speech. In any case, at
the end of an intensive conference this would probably not be in line with your preferences.
Instead, I will focus my remarks today on the monetary and fiscal reaction of the euro area to
the financial crisis. But before doing so let me start by making a few short, inevitably
selective remarks on some of the papers. One paper which I found particularly relevant is the
one by Eric Leeper, because I very much agree that the current crisis is a period in which
uncertainty over future policy regimes poses particular challenges. As government debt
reaches unprecedented levels in peacetime and ageing populations will significantly add to
the fiscal burden in many industrialised countries in the coming years, the notion of a "fiscal
limit" that might be reached at some point in the future is immensely important. And this limit
matters already today because of forward-looking expectations. Another interesting point
which came out of the presentations by Wieland, Corsetti, Lane, Faia and others, is that the
current environment has been conducive to a renewed and very rich debate about the
determinants and the likely size of fiscal multipliers, about which there is still much
uncertainty. Next, it seems clear to me that the paper presented by Loisel addresses a topic
which will stay with the profession for a long time to come, namely the adequate integration
of financial market frictions into state-of-the-art DSGE models. And finally, it may not surprise
you that the paper presented by Cooper addresses a topic which does not escape my
attention these days. By this I mean that monetary unions - which are characterised by the
very special combination of a single, centralised monetary policy and many national fiscal
policies - require a particular monetary and fiscal architecture.
This brings me to the theme on which I would like to devote my attention today, namely the
reaction of euro area monetary and fiscal authorities to the financial crisis. I would like to
focus my remarks on the fact that, while similar in many ways, in certain respects the
reaction of the euro area authorities to the crisis has differed to that of other, major
industrialised economies, such as the United States or Japan. And in this regard, an
interesting question is the extent to which this can be linked to the specific architecture of
Economic and Monetary Union. Before addressing this question, let me briefly recall the
main elements of this architecture.
EMU principles regarding the framework for monetary and fiscal policies
Indeed, when we discuss monetary and fiscal policy in the euro area, we should remember
that we are talking about an economic area sui generis; an economic area within which the
member countries have given up their own national currencies in favour of a single,
areawide monetary policy. Governments do not sign up to such ventures lightly. Monetary union
only became possible in Europe because a sufficient consensus emerged regarding the
basic principles of sound macroeconomic policy. And before going further, it is worth
recalling these basic principles, which were written into the Maastricht Treaty.

Central bank independence.

A stability-oriented monetary policy with the primary objective of maintaining price
stability.

And an obligation for Member States to treat their economic policies, in particular
their fiscal policies, as a matter of common concern.
In order to protect monetary policy from profligate fiscal policies, the EU Treaty prohibits
monetary financing and direct bail outs of governments in financial difficulty; it calls on
governments to avoid excessive deficits, and it provides for an excessive deficit procedure
ultimately leading to sanctions in case of flagrant breaches of European fiscal rules. Before
the introduction of the euro, these rules were further elaborated and strengthened by the
adoption of the Stability and Growth Pact.
In short, the premise of Economic and Monetary Union is a clear allocation of responsibilities
among policy makers; a commitment of both monetary and fiscal authorities to keep their
own houses in order; and a set of safeguards to ensure that all parties abide by the rules.
Any analysis of monetary and fiscal policy in the euro area - not just in normal times but also
in crisis times - should take into account the fact that euro area macroeconomic policy
should be guided by these basic principles; because they are the principles on which the
EMU contract was signed.
Monetary and fiscal reactions in the euro area to the crisis
To what extent has the euro area response to the financial crisis been guided by these basic
principles? Let me first very briefly recall the monetary and fiscal policy actions that have
been undertaken in the euro area since the financial crisis intensified in autumn 2008. I will
then discuss in more detail the rationale behind these actions.
Starting with monetary policy, about which I can obviously say most, during the crisis the
Governing Council of the ECB has taken unprecedented action via both standard and
nonstandard measures. Given rapid changes in the assessment of risks to price stability, the
ECB's main refinancing rate was cut by a cumulative 325 basis points between October 2008
and May 2009 bringing it to its current level of just 1%. This is a level not seen in the
countries of the euro area since at least the Second World War. In addition, to support
financing conditions and credit flows above and beyond what could be achieved through
interest rate cuts alone, non-standard measures were adopted, the so-called "enhanced
credit support". These measures - which for very good reasons are of a temporary nature,
with some of them already being discontinued, as I will discuss at the end of my talk - can be
grouped into five categories:

First, fixed rate tenders with full allotment in all liquidity-providing operations.

Second, additional refinancing operations with one-month and three-month
maturities, as well as the provision of funding at longer maturities of six months and
one year.

Third, a broadened collateral framework, notably the lowering of the rating threshold
to BBB- and the acceptance of selected foreign currency assets and of securities
issued in some non-regulated markets, all these with commensurate additional risk
control measures.
 Fourth, the covered bond purchase programme.

And fifth, the introduction of foreign currency-providing operations.
These extraordinary policy measures represented the ECB's response to extraordinary
shocks. They have ensured adequate provision of liquidity to the euro area banking system
at favourable conditions, so as to support the provision of credit to households and firms and
thereby contribute to the revival of the euro area economy. As a consequence of these
ample liquidity conditions, the EONIA rate is set close to the deposit facility rate, i.e. 0.25%.
Euro area governments also responded to the crisis with exceptional measures.
First, euro area governments committed substantial public funds to support individual
financial institutions and help stabilise the financial sector. Support came in various forms, in
particular recapitalisations, the setting up of "bad banks" to remove toxic assets from balance
sheets, and the guaranteeing of interbank lending, deposits and bond issuance.
Secondly, euro area governments have used (or at least allowed) fiscal policy to support
economic activity through the crisis. In 2007, the euro area government deficit ratio was just
0.6% of GDP. In all likelihood, the euro area deficit reached around 6% of GDP last year and
is likely to remain around this level or even rise closer to 7% this year. This is a significant
fiscal impulse.
The rationale behind euro area monetary and fiscal policies during the crisis
Let me now move from facts to their interpretation. In doing so I will have to be selective,
focusing on aspects related to the conference theme of monetary and fiscal interactions as
well as on aspects reflecting the specific architecture of EMU.
Monetary policy
Focusing first on monetary policy, let me take as a starting point for my reflections an
observation made in a recent overview BIS paper by Claudio Borio and Piti Disyatat (2009).
Borio and Disyatat argue that the unprecedented responses of the world's major central
banks to the crisis have two distinct types of action in common, namely, interest rate policy
and balance sheet policy. To stress this broad commonality is important: from the onset of
the crisis all major central banks shared a broad consensus that an extraordinary monetary
policy response was necessary. And this response went beyond interest rate policy.
Let me cite a few numbers for the euro area, which serve to illustrate what is meant by the
term balance sheet policy. In summer 2007, before the crisis, the total assets of the
consolidated balance sheet of the Eurosystem stood at EUR 0.9 trillion. This was around
10% of euro area GDP. At the height of the crisis, in January 2009, these total assets
exceeded EUR 1.8 trillion. Currently, they stand at around EUR 1.5 trillion. Similar balance
sheet movements can be observed also for other central banks.
However, Borio and Disyatat point out that there are interesting differences between the
particular balance sheet policies chosen. According to their categorisation, these range from
"credit policies" to "quasi-debt management policy", "bank reserves policy" and "exchange
rate policy". The enhanced credit support provided by the Eurosystem is seen as a prime
example of what the study refers to as credit policies. At the same time, the Eurosystem
does not belong to the large group of central banks which have resorted to "quasi-debt
management policy". This reflects the fact that the Eurosystem has not considered buying
euro area government bonds for monetary policy purposes. Similarly, the Eurosystem has
not considered requesting public guarantees to support the expansion of its balance sheet. In
sum, what sets the Eurosystem somewhat apart from other major central banks is a stylised
feature which one may call the "minimisation of the fiscal implications of our monetary
policies".
Let me comment on this feature from a number of perspectives.
Principles
Clearly the avoidance of outright purchases of euro area governments' debt (which in any
case would have been clearly restricted to purchases in secondary markets) respects the
above discussed clear separation of monetary and fiscal responsibilities enshrined in the EU
Treaty. As a corollary of this separation, let me add: in monetary unions, with many
sovereign issuers of government debt, there does not exist a single sovereign yield curve.
Hence, outright purchases of government debt would inevitably be fraught with distributional
concerns between countries to be avoided at the outset.
But the decision of the Eurosystem not to go the route of purchasing government bonds also
reflected a number of additional considerations, of which I would like to stress four in
particular.
History
Differences between the measures adopted by the Eurosystem and, for example, the Fed
reflect different histories and different operational frameworks. In the United States, in normal
times, repo operations are only used to correct temporary fluctuations in the liquidity needs of
the banking system, while outright purchases and sales of treasury bonds with short
maturities are used on a daily basis to implement monetary policy. This tradition is succinctly
summarised, for example, by Marvin Goodfriend's statement that "monetary policy refers to
open market operations that expand or contract high-powered money (bank reserves and
currency) by buying or selling Treasury securities". Given that tradition, it may be
advantageous under non-standard circumstances to refine this procedure by significantly
expanding the volume of purchases and focusing on bonds with longer maturities.
The Eurosystem faced at the outset the challenge to combine various traditions from its
member countries. This has led to a broad-based framework in which "reverse transactions"
- on the basis of repurchase agreements or collateralised loans - are the single most
important instrument in open market operations. Given this starting point it has been a
natural step to adapt the tender procedures of our refinancing operations and to adjust
collateral requirements. Moreover, these adjustments were successful because access to
these refinancing operations has traditionally been granted to a large pool of counterparties
and the range of assets accepted as collateral, including private paper, has always been very
broad since the start of Monetary Union in 1999.
Of course, under the Eurosystem's refinancing operations balance sheet connections with
fiscal authorities are not entirely avoided. But their nature is different from those in the United
States. In particular, it is the counterparties of the Eurosystem's monetary policy operations
who decide which type of eligible asset they pledge as collateral. Interestingly, in the last two
years (i.e. 2008 and 2009) the share of government securities in the total eligible collateral
that has been posted has been smaller than in preceding years (while the share of asset
backed securities, uncovered bank bonds and non marketable assets has increased).
Bank-based nature of the euro area financial system
The enhanced credit support has been tailored to the financial structure of the euro area in
which banks play a particularly important role. Indeed, the bulk of the external financing of
non-financial corporations comes from the banking sector. This feature put a premium on a
broad-based reduction of funding constraints for banks rather than on direct interventions in
multiple market segments via outright purchases of assets. Let me add: this feature also puts
a premium on the recapitalisation and, where needed, restructuring of European banks, as
repeatedly stressed by the Governing Council. Where appropriate, however, direct
interventions were undertaken, as exemplified by the covered bonds purchase programme.
Effectiveness of outright purchase vs. repos
I expect that in a couple of years' time - in light of the then available research on current
events - we will understand much better the effectiveness of the various policy options that
are available under "non-standard" circumstances at which the short-term interest rate has
reached its effective lower bound. I cannot prejudge the outcome of this research.
Nevertheless, let me share with you some questions concerning the effectiveness of the
options that have been on the table. For the sake of the argument, assume there is a
uniquely defined sovereign yield curve. Then, under non-standard circumstances, short-term
government debt and monetary balances are close substitutes in private sector portfolios.
We know from studies in the spirit of Eggertsson and Woodford (2003) that, under well
functioning capital markets, the effectiveness of outright purchases of government bonds
tends to be limited, unless such purchases can be effectively used to steer expectations
concerning future actions. Yet, given the observed market failures, the practical relevance of
this reasoning is controversial, and most central banks were primarily interested in acting
directly on liquidity premia. While this can be done via outright purchases, it seems to me
that this can be done with similar effect via the maturity structure of tenders in a repo-based
operational framework. Indeed, the Eurosystem's experience has shown that a shift towards
long-term refinancing operations can ensure secure funding of activities at low rates over a
predictable horizon. But let me say again: I have touched here on questions for which we
need more guidance from good academic work, both conceptually and empirically.
Exit considerations
The non-standard measures adopted by the Eurosystem were designed with an exit strategy
in mind. The Eurosystem's refinancing operations provide liquidity over a fixed time horizon
and unwind in a fully predictable way. By contrast, the unwinding of outright purchases, in
particular of long-term bonds, typically requires an additional decision, namely whether to
hold the securities to maturity - and if not, when to sell. The route taken by the Eurosystem
limits such decisions to the covered bonds purchase programme, which is limited in size
such that the effect on total liquidity can be easily neutralized.
Fiscal policy
Before addressing exit considerations in further detail, let me first touch upon fiscal policies
during the crisis.
The extent to which the euro area fiscal response to the crisis has been shaped by the EMU
architecture, and in particular the European fiscal rules, is not easy to gauge. One could
argue that the answer is "not much". Most government support granted to the financial sector
was either below the line or off balance sheet, so it didn't affect government deficits
according to the "Maastricht definition". Obviously, there has been no concerted decision to
keep Maastricht deficit and debt levels within the respective ceilings of 3% and 60% of gross
domestic product, regardless of the economic circumstances. If we turn the clock back to
autumn 2008, it was already obvious that most countries were heading towards "excessive"
government deficits in the sense of the Treaty, if not in 2008, then certainly in 2009. Yet most
euro area governments went ahead with fiscal stimulus anyway. More generally, the high
fiscal deficits that have emerged in almost all industrialised countries over the past year
seem incongruous with the 3% deficit limit of the Maastricht Treaty and the Stability and
Growth Pact.
In light of this, to some extent it would be tempting to say that, as far as fiscal policy is
concerned, the Treaty and the Stability and Growth Pact were simply ignored; an
inconvenient obstacle that was brushed aside. But for at least four reasons, I think such a
critical view would be too simplistic and inappropriate.
First, the Stability and Growth Pact has its "flexibility clauses". According to the Pact, an
economic downturn is deemed to be exceptional - potentially warranting a deficit in excess
of the 3% of GDP reference value - in case of negative output growth, or a protracted period
of low growth relative to potential. By this, or any measure, the circumstances faced at the
height of the economic and financial crisis were exceptional and warranted an exceptional
fiscal policy response.
Second, at least some euro area countries - including Spain - entered the crisis with relative
strong starting positions in terms of low levels of government debt and/or budget surpluses.
So in this sense, at least in some countries, there was fiscal room for manoeuvre at the
beginning of the crisis.
Third, the extent to which euro area governments engaged in discretionary fiscal stimulus
generally reflected the strength of their fiscal starting positions. Fiscal stimulus packages
were comparatively large in low debt or surplus countries such as Spain and Germany, but
virtually non-existent in high debt countries such as Italy.
And fourth, the discretionary fiscal stimulus in the euro area has not, actually, been that
large. According to the European Commission, measures adopted by euro area governments
under the umbrella of the European Economic Recovery Plan amounted to about 1% of euro
area GDP in 2009. And even this is probably a slight exaggeration, as it ignores the fact that
there were also offsetting tax increases and spending cuts in some countries.
The bulk of the increase in government deficits in the euro area during the crisis has been
caused not by discretionary stimulus but by the automatic response of fiscal policy to lower
output and inflation. Tax revenues fell as a consequence of lower wages, profits and
consumption, while social spending increased due to rising unemployment. Moreover - and
this is something that tends to get overlooked - the implementation of spending budgets
expressed in cash terms in a context of lower than previously expected inflation has meant
more spending in real terms; and, of course, higher deficits. By contrast, a larger proportion
of the crisis related deficit increase in the United States can be attributed to discretionary
stimulus measures. But this may have been justified given the smaller size of the American
public sector.
The bottom line is that government deficits in the euro area would have reached levels well
above the Treaty reference value of 3% of GDP even in the absence of any discretionary
stimulus. Seeking to prevent this in the midst of the severest recession in many decades and
at a time of intense uncertainty was not really an option for most countries. But even in these
extreme circumstances, the European fiscal rules were not brushed aside. As actual or
planned deficits have exceeded the 3% reference value, excessive deficit procedures have
been launched, as foreseen in the Treaty and the Stability and Growth Pact. The impact of
these excessive deficit procedures is not negligible. They have obliged the countries
concerned, already at a relatively early stage, to put on paper their post crisis fiscal
adjustment strategies.
Monetary and fiscal exit considerations
Indeed, as the major economies around the world appear to be stabilising, the attention of
policy-markers at the current juncture is increasingly on developing appropriate exit
strategies. And in this regard I would argue that, on balance, the euro area is quite well
placed, if anything having something of a head start.
Monetary policy
As I already mentioned earlier, the non-standard monetary policy measures adopted by the
Eurosystem have been designed with their phasing-out in mind. Several of them unwind
naturally in the absence of an explicit decision to prolong them. This applies, for example, to
the temporary expansion of the list of eligible assets. Others have already been discontinued,
such as the provision of non-euro liquidity via swap lines with a number of other central
banks, including the Federal Reserve. These operations have been discontinued against the
background of improved functioning of financial markets over the past year and limited
demand. Moreover, going back to a Governing Council decision already taken last
December, the number and frequency of longer-term refinancing operations is gradually
being scaled back. In particular, the last one-year operation was conducted in December
2009, and one final six-month operation with full allotment will be conducted next month.
Further decisions on the gradual phasing-out of those non-standard measures that are not
needed to the same extent as in the past will be announced in the coming months.
The decision to initiate the gradual phasing-out of these measures reflects improvements
observed in financial conditions. Money markets are performing better, and the past
reductions in the ECB's key policy rates are increasingly reflected in the interest rates on
bank loans to households and corporations. This indicates that the monetary policy
transmission process is broadly functioning.
Looking forward, it goes without saying that the overriding concern for the ECB's monetary
exit considerations is the primary objective of price stability to be maintained over the
medium term. From this perspective, I would like to stress that the operational framework
with its interest rate corridor is flexible, allowing control over interest rates even without the
phasing-out of all non standard measures. In other words, the Governing Council is free to
choose the way in which interest rate action is combined with the unwinding of the remaining
non-standard measures.
Fiscal policy
What about fiscal policy? I think it is fair to say that the "fiscal exit" - or I think it is better to
say "fiscal adjustment" that will be necessary in the coming years is likely to prove even more
challenging for governments than the phasing out of non-standard measures for the
Eurosystem. During the crisis, governments were right to allow deficits to expand so that
fiscal policy provided support to the economy in the short run. But now, government deficits
are high - and indeed very high in many countries; government debt-to-GDP ratios are
mostly high and rising; and the attention of financial markets is increasingly turning to issues
of government solvency. In this context, it is of some comfort that - in part thanks to the
European fiscal framework - the aggregate euro area government deficit is currently
significantly lower than that of most other major economies. But this is only limited comfort.
Prompt action to bring the fiscal house in order is necessary so that high and increasing
levels of government debt do not jeopardise longer-term growth prospects. The next crisis
must not be a sovereign debt crisis!
The key issue for fiscal policy at this juncture is not "whether" but "how much" and "how
soon" to start fiscal consolidation.
Earlier, I argued that the increase in euro area government deficits during the crisis was
largely automatic rather than being due to discretionary fiscal stimulus measures.
Unfortunately, what automatically goes up does not always automatically come down. The
crisis has put our economies on a lower path of potential output, although we still don't know
exactly what this path is. Yesterday's cyclical deficits are, from today's perspective, more
structural in nature. The government sector needs to adjust to the new reality of a smaller
economy. In many countries, this means that challenging decisions will have to be made in
the coming years.
In the long run, fiscal consolidation - in other words moving from unsustainable to more
sustainable public finances - is clearly beneficial for economic growth. I think we would all
agree on this. However, fiscal consolidation is usually not without costs in the short-run.
Does this mean that under current circumstances fiscal consolidation should be postponed
until the recovery is entrenched? Obviously a premature fiscal tightening that plunges the
economy back into recession needs to be avoided. But barring this, the sooner fiscal policy
adjusts the better. As long as fiscal policy is on an unsustainable course with government
debt ratios still rising, the social costs of further delaying adjustment will exceed the costs to
society of acting sooner.
We also have to acknowledge that there is a lot of uncertainty regarding the short run effects
of fiscal adjustment. There is an extensive literature examining this issue and different
studies have yielded quite different results. But broadly speaking, what we can ascertain
from this literature is that the short run costs of fiscal adjustment are likely to depend on a
variety of conditions. Notably, these costs are likely to be more limited:

If the fiscal starting position is precarious and the adjustment is credible;

If financial markets react by lowering long-term interest rates;

If households have correctly understood the need for fiscal adjustment and have
factored this into their spending decisions; in other words, if households are - at
least partly - "Ricardian";

and if monetary conditions are accommodative.
This last condition touches on the very subject of today's conference: monetary and fiscal
policy interactions. And in certain respects, it has to be acknowledged that such interactions
are particularly challenging for the euro area.
Common exit considerations
When we consider the monetary and fiscal exit from a common perspective, it is often
argued that it is preferable that fiscal policy adjusts earlier and more forcefully than monetary
policy. Ceteris paribus, a tighter fiscal stance means less inflationary pressure and more
subdued inflation expectations. For a stability-oriented monetary policy, this should imply a
less front-loaded phasing out of monetary stimulus. Yet, this line of reasoning largely ignores
that by their nature fiscal policies lack strong built-in mechanisms when it comes to the
unwinding of stimulus, and it rests on an assumption that all "players" live up to their ex ante
given promises. We know that in practice this assumption does not always hold.
In the euro area there are, indeed, many players. Hence, this reasoning should be further
qualified in at least two respects.
First, in the euro area there are multiple fiscal authorities, so predicting the future stance of
fiscal policy and correctly factoring this into monetary policy decisions is not a straightforward
task. In such environment it would be particularly costly if delayed monetary action
compromises on price stability, and, not less important, on the remarkably solid anchoring of
medium-term inflation expectations. To put this differently: the stability-oriented monetary
policy of the Eurosystem provides the nominal anchor which acts as the single most
important implicit coordination device for all other actors with their various responsibilities,
including fiscal policymakers. This anchor must not be put at risk.
Second, the task of monetary policy is facilitated if the future stance of fiscal policy is
reasonably clear. In the euro area, the Stability and Growth Pact aims to guarantee sound
public finances and, thereby, a reasonable degree of fiscal certainty. It is not without reason
that the ECB has made repeated calls on governments to abide by their commitments under
the Stability and Growth Pact. These commitments are known to everyone. From the current
perspective, in December the ECOFIN Council established deadlines for most euro area
Member States to correct their excessive deficits. The Council also recommended average
annual adjustment paths geared to achieving these goals. These consolidation paths are
reflected in the stability programmes that Member States have recently submitted to the
Commission and Council in the context of the Stability and Growth Pact.
But a plan or a target is one thing; delivering it is another. In the past, the track record of
some euro area governments in actually delivering promised fiscal consolidation has been
mixed. This has created a credibility gap as far as euro area fiscal policies are concerned.
Conclusions
To conclude, it is therefore essential that consolidation targets are reflected as soon as
possible in specific, detailed tax and spending plans. Credible and detailed fiscal adjustment
plans should reassure investors, creating a more favourable, long-term financing
environment. Credible and detailed fiscal adjustment plans should provide certainty for
households making their saving and investment decisions. Credible and detailed fiscal
adjustment plans would also facilitate the task of monetary policy in maintaining price
stability, while gradually returning to a more normal, post-crisis monetary environment.