Mario Draghi: The monetary policy of the European Central Bank and its
transmission in the euro area
Speech by Mr Mario Draghi, President of the European Central Bank, at the opening of the
academic year 2012-2013, Università Bocconi, Milan, 15 November 2012.
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Financial markets and the disruption caused to the transmission of monetary policy
The year that is about to end will be remembered not only for the effects the European
sovereign debt crisis has had on the euro and for the significant weakening of the European
economy, but also for the responses to these challenges by the ECB, national governments
and the European Union.
The artificial calm in the markets prior to the crisis had, in Europe, for a long time allowed
misguided economic policies or simply encouraged inaction in countries that had profound
need for fiscal consolidation and structural reforms. The outbreak of the crisis substantially
increased risk aversion: the weaknesses of these countries were exposed; in an environment
of already weak growth, investors turned away, sovereign spreads started to rise.
Soon, the solvency of the governments of these countries was questioned, and with it the
solvency of the financial institutions located there. Within the euro area, less and less money
circulated between banks in different countries. Doubts about the future of the euro area in
its current form encouraged a speculative movement which lead to further increases in
sovereign spreads. All the governments of the weaker countries responded with fiscal
consolidation policies, initially hesitant, then more vigorous. But economic activity continued
to weaken and spreads continued to grow.
It was a situation which has brought into focus the nature of the "ideal" fiscal consolidation -
one which reduces the deficit and the debt with the least negative consequences for a
country's GDP.
The prevailing evidence indicates that it should be concentrated on reductions in current
spending and not on tax increases. Even those who do not share this approach agree,
however, that it is essential that the process be perceived as credible, irreversible and
structural so that it can affect sovereign spreads, and that price stability conditions as well as
conditions on financial markets are such that they do not interfere with fiscal consolidation.
In response, the ECB lowered its benchmark interest rates. Under normal circumstances,
such reductions would have been transmitted in a relatively uniform way to households and
firms across the euro area. But that's not what we found.
In some countries, the rate cuts were fully passed on. In others, the interest rates charged on
bank loans to the real economy declined only little, if at all. And in a others still, some lending
rates have actually risen.
Why this divergence? The concept of "monetary policy transmission" is fundamental to the
activities of a central bank, i.e. the process by which changes in the benchmark rate of
interest of a central bank are transmitted through the financial system to the real economy.
In a system that is working properly, there is a stable relationship between changes in the
central bank's rates and the cost of bank loans for households and firms. Central banks can
thus influence the overall economic situation and maintain price stability.
But the financial system of the euro area has witnessed a severe fragmentation of the single
financial market. The costs of bank financing differed greatly in different countries. Many
banks, and in some countries the entire banking system, have in fact had no access to the
euro area interbank market. Increases in interest rates on government securities have
exacerbated the funding costs of domestic banks and severely limited their access to
markets.
This has made difficult the transmission of impulses coming from an accommodative
monetary policy through adjustments in interest rates on loans to households and firms by
banks. Interest rates do not have to be identical across the euro area, but it is unacceptable if
significant differences arise because of the fragmentation of capital markets or the perception
of a break-up of the euro area. In an economy like that of the euro area, where about
threequarters of corporate finance comes from the banking sector, the impact on the real
economy, investment and employment are serious. The fragmentation of the single financial
market has led to a fragmentation of the single monetary policy.
For this reason, the countries most exposed to the crisis of confidence were not able to take
advantage, except to a limited extent, of the low rates of interest: they had entered a vicious
circle.
Economic growth was falling. Public finances were deteriorating. Banks and governments
were being forced to pay even higher interest rates. And credit growth was falling further,
leading to rising unemployment and reduced consumption and investment.
The outlook for the euro area economy as a whole was increasingly fragile. There were
potentially negative consequences for Europe's single market, as access to finance was
increasingly influenced by location rather than creditworthiness and the quality of the project.
The disruption of the monetary policy transmission has profound implications. It threatens the
single monetary policy and the ECB's ability to ensure price stability in both directions. This
was why we acted.
Restoring the proper transmission of monetary policy
To decide what type of action was appropriate, we had to make two key assessments. First,
we had to diagnose precisely why the transmission was disrupted. And second, we had to
identify the most effective policy tool to repair those disruptions, while remaining within our
mandate to preserve price stability.
The countries most affected are those where the economic policies of the past tended to be
inappropriate, where the response of governments at the start of the crisis was half-hearted
and hesitant. It is up to the governments of those countries to make a major effort to regain
credibility.
The responses of all these governments have been remarkable for its intensity and speed,
and yet interest rates continued to rise. There was a fear factor in the market valuations that
governments alone did not seem able to dispel.
A situation of systemic instability was occurring; it was undermining the euro area and
dashing hopes for the positive effects of the reforms undertaken to restore the transmission
of monetary policy. It was necessary to allay the unfounded fears about the future of the euro
area. It was necessary to create a credible support mechanism capable of averting
destructive scenarios, and the exercise of that support falling within the mandate of the ECB.
The OMTs have been designed for this purpose, to restore the transmission of monetary
policy.
The OMTs provide for interventions in the markets for government securities, with no ex ante
limits, but not in an uncontrolled or unconditional way. These interventions relate to bonds
with a residual maturity of up to three years. It is a clear signal to investors that their fears
about the future of the euro area are unfounded.
But we have not forgotten the origin of the problems of the sovereign debt market in Europe.
One of the requirements for conducting OMTs is that the countries concerned must have
negotiated with other governments in the euro area a programme under the European
Stability Mechanism (ESM) which imposes strict, effective and credible conditions over an
extended period of time. In this way, governments are obliged to continue the necessary
reforms, even in a scenario where the ECB intervenes. The participation of the International
Monetary Fund (IMF), with its experience in monitoring adjustment programmes, is an
additional safeguard.
The consequences of the ECB's actions
First, OMTs will not lead to disguised financing of governments. We have specifically
designed our interventions to avoid this. They will take place solely on secondary markets,
where bonds that have already been issued are traded. If interventions take place, they will
involve buying government debt from investors, not from governments. All this is fully
consistent with the Treaty's prohibition on monetary financing. Moreover, they will focus on
shorter maturities and leave room for market discipline on longer maturities.
Second, OMTs will not compromise the independence of the ECB. The ECB will continue to
take all decisions related to OMTs in full independence. It will decide whether to intervene
based on its own assessment of monetary policy transmission and with the aim of
safeguarding price stability. The fact that governments have to comply with conditionality will
actually protect our independence. The ECB will not be forced to step in because of a lack of
policy implementation.
Third, OMTs will not create excessive risks for euro area taxpayers. Such risks would only
materialise if a country were to run unsound policies. This is explicitly prevented by the ESM
programme. And we have been very clear that each time a programme starts being
reviewed, we will routinely suspend operations and resume them only if the review has been
concluded positively. This will ensure that the ECB intervenes only in countries where the
economy and public finances are on a sustainable path.
Finally, OMTs will not lead to inflation. We have designed our operations so that their effects
on monetary conditions will be neutral. For every euro we inject, we will withdraw a euro. In
our assessment, the greater risk to price stability currently is associated with the possibility of
falling prices in some euro area countries. In this sense, OMTs are not in contradiction to our
mandate: in fact, they are essential for ensuring we can continue to preserve price stability.
Moreover, we have no evidence that the announcement of the OMT programme has affected
inflation expectations. They continue to be firmly anchored. This is testament to our track
record on price stability over the last decade and our credible commitment to preserving it.
We have all the necessary tools at our disposal to maintain it and to withdraw any excess
liquidity in case of upward risks to price stability.
Since the announcement of the possibility to undertake OMTs, there have been several signs
of greater tranquillity in financial markets: the significant decline of sovereign spreads, the
resumption of capital flows by money market funds in the United States, which had stopped
for about a year, some issues of corporate and sovereign bonds from countries that had lost
access to the market for almost three years, such as Ireland and Portugal, the completion of
the financing plans of the Italian and Spanish treasuries, the fact that the share of Italian
public debt held by non-residents has increased, and lastly a stabilisation of TARGET2
balances, which are the true measure of the economic and financial imbalances in the euro
area. Finally, it is yesterday's news that recourse to the ECB by banks in some large
countries that were in difficult funding conditions has declined for the second consecutive
month. It is important to understand that financial stability in the euro area is in everyone's
interest, but primarily in the interest of creditor nations which have greater exposures.
There is no doubt that these improvements would not have been sustainable, nor would they
be so in the future without an extraordinary, persistent and, above all, structural consolidation
of public budgets and structural reforms in all euro area countries.
Completing economic and monetary union
It is worth looking back to remind ourselves of the difficulties that the process of European
integration has encountered in the past, and overcome.
Tommaso Padoa-Schioppa's tenure at the Banca d'Italia and at the European Commission
was punctuated by realignments in the exchange rate mechanism of the European Monetary
System. He famously pointed out the key problem of the "inconsistent quartet" - fixed
exchange rates, free trade, capital mobility and national monetary policies.
The single currency was identified as the solution.
Today, we see that this solution was incomplete. The crisis has exposed the need to
complete economic and monetary union.
In my joint work with the Presidents of the European Council, the European Commission and
the Eurogroup, we have identified four pillars on which to build a stable and prosperous
Europe: a banking union with a single supervisor; a fiscal union that can effectively prevent
and correct unsustainable budgets; an economic union that can guarantee sufficient
competitiveness to sustain high employment; and a political union that can deeply engage
euro area citizens.
Progress is under way in all these directions. Of course, it is not straightforward to implement
such an ambitious vision. But I am confident that Europe will once again emerge stronger
from its present difficulties.
Tommaso was convinced that "a strong currency requires a strong economy and a strong
policy, not only a central bank that is strong and authoritative". I share his conviction.
The ECB's response to the crisis has a clearly defined relationship with the process of
European integration.
With our non-standard policy measures, we have preserved the functioning of the monetary
policy transmission mechanism and thus been able to maintain a steady course for the
objective of price stability inscribed in our mandate. Potentially disastrous outcomes to the
crisis have been thwarted; valuable, though not infinite, time has been gained.
But the ECB cannot replace the actions of national governments with respect to either
economic policy effectiveness or democratic legitimacy. Ultimately, it is up to governments to
dispel once and for all the persistent uncertainties that markets perceive and citizens fear.
The ultimate goal is political union, a stable and integrated Europe with a common destiny.
This will take a long time and the path will be an uncertain one. But in the meantime, it would
be wrong not to act.
A great deal has been achieved already. Governments have implemented corrective actions
for public finances. The fiscal compact envisages the principle of balanced budgets in
national legislations. The ESM provides for the possibility of financial assistance for countries
in difficulty to keep the crisis from spreading. And the ECB's non-standard policy measures
will be complemented by banking union, a single supervisory mechanism for European
banks.
It is essential that all parties involved in Europe's large and complex path of reforms stick to
their commitments. We have to proceed along this path with calm pragmatism, asking
ourselves what the minimum requirements for completing Economic and Monetary Union
are. They are all within our reach, including fiscal reform and structural policies to support
competitiveness and growth.
Along the way, we must remain guided by the principle that no country is justified in pursuing
policies that harm other members of the community to which it belongs. The construction of
an institutional architecture for Europe based on this foundation is not only a response to a
need for responsibility. Without the sharing of national sovereignty at European level, the
very sovereignty of individual states is in danger.
This is the first lesson of the crisis for us Europeans. It is not only a matter of economics and
finance. We can, together with Zygmunt Bauman, extend it to much broader areas.
He wrote: "The European house is not to the detriment of national cultures, but provides a
sort of roof covering local traditions, values and differences. And the paradox is that each
country is much more at risk of losing its specific identity if it is exposed without protection,
that is, without this European shield, to the global forces which are violently and blatantly
supranational, which disregard local issues and specificities".
Let me finish with an anecdote about Tommaso, to whom we are dedicating this
professorship today. As you know, in recent months I have repeatedly stressed the
irreversibility of the euro. This was precisely the sentiment of one of Tommaso's most noted
quips. Speaking in 2004 about the "EMU", an abbreviation for Economic and Monetary
Union, he remarked that it was also the name of an Australian bird rather like an ostrich. And
he added: "Neither of them can go backwards".
Thank you for your attention.