Jürgen Stark: EMU - weathering the perfect storm
Speech by Mr Jürgen Stark, Member of the Executive Board of the European Central Bank,
at the German-British Chamber of Industry & Commerce, London, 25 June 2009.
* * *
The economic crisis - where do we stand?
Let me start by saying that none of my remarks should be interpreted in terms of the future
course of monetary policy. Indeed, we are in the one-week "purdah period" before the next
Governing Council meeting.
The world economy is facing its most severe crisis for 80 years. But why are we in this
position? What have been the driving forces behind the dynamics of the crisis? Several
forces have been at work: a combination of macroeconomic factors and significant
deficiencies in the regulatory and supervisory architecture prepared the ground for this crisis.
More specifically, expansionary macroeconomic policies over a protracted period of time
allowed financial imbalances to build up at the global level in the context of globalisation,
financial liberalisation and a lack of regulation. At the same time, complex financial products
flourished, with investors on the hunt for ever higher yields in the presence of robust
economic growth, low inflation, low interest rates, low default risk and ample liquidity
worldwide. In particular, the expectation that this favourable environment would continue for
some time prompted investors to systematically underprice risks in their search for yields.
Thus, instead of contributing to better risk diversification, these new financial instruments
simply disguised those risks.
We were aware of these imbalances. There was no shortage of early warnings. As long ago
as 2005 the ECB warned of the excessive growth of credit. There were also warnings on the
other side of the Atlantic that the US economy was skating on thin ice.1 These concerns
regarding the lack of political will to remedy this unsustainable situation proved to be
extremely prescient. However, such early warnings went unheeded.
In August 2007 the concerns that many people had been harbouring for a while were
abruptly translated into financial turmoil. The problems first emerged in money markets, with
banks preferring to hoard cash rather than lend to each other because they feared that their
counterparties would not be able to repay them. The situation deteriorated following the
collapse of Lehman Brothers last September. The financial turmoil then quickly turned into a
full-blown financial crisis, with adverse effects on the real economy and negative
secondround effects on the financial system. This has led to the most severe and synchronised
economic downturn since the 1930s.
The euro area has not been spared. Economic activity has declined sharply since the second
half of 2008, and the euro area economy has contracted by more than 4% in the last two
quarters alone. Inflation is at its lowest level since the launch of the euro. However, recent
business confidence indicators, both within the euro area and at the global level, suggest that
the pace of the decline in economic activity has slowed somewhat. Most forecasters expect a
gradual economic recovery both in the euro area and globally in 2010. Inflation is expected to
remain very low in the euro area. Risks of deflation in the short to medium term are
extremely limited. Inflation expectations are firmly anchored in line with our definition of price
stability. The outlook for price developments over a longer horizon will largely depend -
among other factors - on the right timing of the exit from very expansionary macroeconomic
policies.
What we are experiencing is a fundamental correction of the global imbalances and
excesses of the past. The world economy was in an unsustainable position, and because
that was allowed to go so far, the correction process will necessarily be painful.
To give you an example: banks have suffered heavy losses so far, and total losses are
expected to increase in the coming quarters. Banks' total writedowns on securities worldwide
now stand at more than USD 1 trillion, and US banks account for around 60% of this amount.
Around one-fifth are writedowns by euro area banks, and around one-fifth are writedowns by
UK and Swiss banks. Projections of future losses are uncertain. Recognising this uncertainty,
ECB staff forecasts, as published recently in our Financial Stability Review, suggest that euro
area banks could potentially lose around USD 280 billion between now and the end of 2010,
largely as a result of their loan exposures. This is substantially lower than IMF staff forecasts.
While the general approach underlying the ECB's forecasts is similar to that adopted by the
IMF, the ECB has used data relating specifically to the euro area for the calculation of
potential losses on loan exposures.
However, this correction is necessary and should allow economic conditions to eventually
stabilise and improve.
The policy response in the euro area
In response to the crisis, policy-makers across the globe have taken extraordinary and
unprecedented steps. In particular, the euro area and the EU as a whole have demonstrated
their ability to act decisively and promptly in difficult circumstances. National measures have
been coordinated in a pragmatic manner with a view to enhancing their effectiveness through
mutual reinforcement.
I am therefore surprised to hear voices here and there arguing that policy-makers in the euro
area were - or still are - "behind the curve", have done too little, too late, and ought to have
learnt more in terms of responsiveness from their colleagues in other parts of the world.
I do not want to talk about this issue in any detail. As a matter of fact, the epicentre of the
current crisis lies outside the euro area, and the euro area has not had to deal with the failure
of a major financial institution or a bank run.
Let me begin with the response of the Eurosystem, which has fully respected - in terms of
the allocation of responsibilities - the distinction between monetary policy and fiscal policy.
Since the very start of the tensions in the euro area money market almost two years ago, the
ECB has taken forceful, timely and pre-emptive policy action to counter the adverse effects
of the financial crisis.
Against the backdrop of rapidly receding inflationary pressures and without compromising on
our mandate to maintain price stability over the medium term, we have cut the interest rate
on our main refinancing operations by 325 basis points since last October. That interest rate
now stands at 1.0%, the lowest level since the launch of the euro.
In addition to these extraordinary rate cuts, the ECB has adopted a number of non-standard
measures allowing it to provide banks with substantial amounts of liquidity and thereby
support the flow of credit to the real economy. I would just like to remind you that in terms of
financing, the banking system plays a more important role in the euro area than in other
major economies. The non-standard measures we have chosen are therefore directed
mainly at banks. This means that the Eurosystem's response to the crisis cannot be
compared directly with those of other major central banks. We have our own approach.
More specifically, we have provided the banking system with unlimited amounts of liquidity at
the main refinancing rate against an expanded list of eligible collateral. Coupled with the fact
that more or less all financially sound euro area credit institutions are able to participate in
the Eurosystem's refinancing operations, this has significantly eased banks' balance sheet
constraints, helped to bring down money market rates and, most importantly, prevented the
emergence of a systemic crisis. More recently, we have introduced further non-standard
measures to enhance our credit support to the economy through banks. This week we
performed our first refinancing operation with a maturity of one year and, as announced
following the Governing Council meeting earlier this month, in July we will begin purchasing
€60 billion worth of euro-denominated covered bonds issued in the euro area.
Overall, the measures adopted so far, which have been unprecedented in terms of their
nature, scope and timing, have had a positive, stabilising effect on the economy.
However, it is obvious that we cannot maintain the current degree of enhanced credit support
indefinitely. Macroeconomic conditions will improve, and when they do, we will make sure
that the measures adopted are unwound swiftly and the liquidity provided is absorbed, so as
to maintain price stability over the medium term. As a result, it is also important that the
financial sector does not become dependent on the ECB's long-term financing. The financial
sector itself has an important role to play when it comes to restoring confidence among
banks.
Let me now turn to the fiscal policy reaction to the economic crisis. It is important to
distinguish between measures intended to support the banking sector and measures aimed
at stimulating demand.
Following the adoption of a concerted European action plan on 12 October last year, euro
area governments announced national measures to support the banking sector. These
measures, which were approved by the national parliaments of euro area countries without
delay, consist of guarantees for interbank lending, recapitalisation, increased deposit
insurance and asset support schemes. These steps were necessary and have been
successful in safeguarding the stability of the financial system.
In addition to this support, euro area governments have also adopted substantial stimulus
programmes to counter the negative impact that the financial crisis has had on the real
economy. This is in addition to the automatic stabilisers, which are relatively strong in the
euro area. The total fiscal support for the euro area economy is estimated by the European
Commission to be around 4.6% of GDP in 2009 and 2010,2 or around €400 billion. Around
60% of this is due to the automatic stabilisers.
Although it is mitigating the economic downturn, this extensive fiscal stimulus implies
significant worsening of public finances. According to the European Commission, 13 of the
16 countries in the euro area are expected, in both 2009 and 2010, to have budget deficits in
excess of the reference value of 3% of GDP agreed in the Stability and Growth Pact.
Furthermore, the euro area debt ratio is expected to increase to more than 80% of GDP by
2010, some way above the reference value of 60%. Some countries' debt ratios will be far in
excess of 100% of GDP. Even with some fiscal consolidation in 2010 or 2011, the euro area
debt ratio will continue to rise for several years.
These numbers are dramatic and their implications are clear. Euro area governments must
reject calls for further fiscal stimulus. Instead, they need to focus on implementing the
measures already adopted as quickly as possible. Increasing deficits even further is likely to
prove counterproductive, for two main reasons.
First, increased fiscal deficits could fuel market concerns regarding a country's ability to
repay its debt, thereby placing upward pressure on interest rates and leading to worsening
financing conditions for everyone. We have already seen a number of euro area countries'
long-term government bond spreads widen substantially vis-à-vis Germany, which
demonstrates financial markets' ability to distinguish between countries on the basis of their
creditworthiness. Second, increases in budget deficits could raise concerns about an
increased tax burden in the future, leading consumers to save rather than spend any
additional income. This would also undermine the effectiveness of any further fiscal stimulus.
Looking ahead, the main priority for euro area governments must be to devise exit strategies
that remedy those large fiscal imbalances and reduce governments' direct involvement in the
financial sector. The adoption of credible exit strategies may even make the current
measures more effective, as it will indicate to financial market participants that governments
are able and willing to reverse unsustainable policies and help to limit the upward drift in
long-term interest rates. The most credible exit strategy would be for governments to clearly
demonstrate their commitment to returning to sound fiscal policies, in full compliance with the
Stability and Growth Pact. The adjustment process should start in principle in 2010 and in
any case not later than the economic recovery. The efforts should be stepped up in 2011.
Why has the euro area been so badly affected?
You may wonder why the euro area economy has been so badly affected by the current
crisis, given that it originated outside the euro area and the response by euro area
policymakers has been timely and effective. One answer to this question can be found in the
structural features of the euro area. The euro area economy is more open than that of the
United States, for instance. Thus, we cannot expect to escape the negative consequences of
such a large-scale synchronised global downturn.
Furthermore, the manufacturing sector is more important in the euro area than in the United
States, and the manufacturing sector has fared particularly badly in the current crisis. The
combination of the correction in housing markets, the need for households to increase their
savings and the problems in short term financing has led to a collapse in demand for durable
goods - particularly cars. As a result, countries with a stronger manufacturing base have
tended to be hit harder by the downturn. Germany is a case in point.
When we compare ourselves with other regions, we have to remember, for instance, that the
downturn in the US economy preceded the economic slowdown in the euro area. Thus, it is
misleading to look only at developments in the past few quarters. In some economic regions,
moreover, households' exceptionally low saving rates in the years prior to the crisis and the
need of rebuilding life-cycle household wealth may mean that the correction process is more
protracted than it is in the euro area, where we have not seen the same build-up of
imbalances.
The world economy after the crisis
Let me now try to provide some thoughts on how the economic and financial landscape
might look once we have recovered from the current crisis. This is a very difficult question,
but it is also a very important one, because any policy decisions and changes we make in the
wake of this crisis are likely to influence the economic and financial landscape for decades to
come. One example of this is the US Glass-Steagall Act of 1933. It was introduced in
response to the banking crisis of the 1930s and established clear barriers between
commercial and investment banking. This part of the bill was not repealed until 1999 under
President Clinton. It is therefore necessary to think a little about the kind of framework we
would prefer. I would like to make five points in this respect.
First, the global growth model of the last 15 years has failed. This has been an exceptionally
long period of strong growth in the world economy, but that growth has been based on large
and unsustainable global imbalances. As a consequence, the composition of global demand
must adjust to more sustainable growth, which in the end will probably lead to lower growth
rates in the years to come. But I would disagree strongly with those who claim that the
current crisis has demonstrated the failures of the model of export-led growth. Countries with
a high degree of openness to trade are of course suffering these days. But at the same time,
these are the countries that are likely to benefit the most once sustained growth resumes.
Second, the current crisis may dampen economic growth in the future and lead to a
prolonged reduction in the level of output. This may be driven by slower growth - or even a
decline - in the capital stock. The crisis may also have negative repercussions for labour
markets. Some sectors are likely to be downsized more permanently, which will mean that
workers need to acquire new skills and look for new jobs. For instance, it is reasonable to
assume that the financial sector, the car industry and the construction sector are likely to
shrink. In my view, the economies that will suffer the most are those where the financial
sector has expanded significantly in the last 20 years in connection with the boom in the
housing sector. However, it is very hard - impossible, even - to clearly predict growth
prospects in the longer term. This will depend, among other things, on the level of innovation
and the degree of market flexibility.
Third, the process of globalisation that we have experienced in recent decades has been
driven by an increase in global trade following the integration of emerging market economies
into the world economy and the liberalisation of financial markets. However, the increased
integration of economies across the globe has also been a major factor in the global financial
turmoil and the highly synchronised downturn that we are currently experiencing. There is
clearly a risk that the current crisis could lead to an increase in protectionism. Here, I would
just like to emphasise how important it is that policy-makers remain committed to free trade
and don't try to counter the crisis by erecting trade barriers aimed at supporting their own
industrial sectors. Although they may seem attractive in the short run, protectionist measures
will only exacerbate the downturn, delay the recovery and reduce income potential for
everyone.
Fourth, the government's role in the economy and the question of what should be left to the
markets will be key. The crisis has given governments a more prominent role in the
economy. Governments have become heavily involved in the banking sectors of a number of
countries, and in some countries they have also taken on a significant role in other sectors,
such as the car industry.
It is clear that governments must become more actively involved in the regulation of financial
markets in the future - both at the national level and, even more importantly, at the
crossborder level. We need a more rule-based approach, but the rules should be based on the
principles of market economics. At the same time, we must not jump to conclusions. The
crisis we are currently facing was caused not only by market failures, but also, to a large
extent, by policy failures.
Besides the need for improved regulation and oversight of financial markets, the case for
increased government involvement in the economy is weak. Government intervention
changes the behaviour of market agents and leads to the distortion of competition. If exit
strategies are not clearly defined, governments risk becoming part of the problem, rather
than part of the solution. It is particularly important to avoid large budget deficits. Otherwise,
the recovery will be hampered and we could end up with a whole sequence of crises, rather
than just the one we are facing now.
Fifth, the financial system clearly needs a fundamental overhaul. Financial institutions have
to take a different approach and adopt appropriate incentives. Risk-takers should be liable
and not only reap the rewards of their actions but also bear responsibility for their
consequences. We need to strengthen the regulation of the financial system and, in
particular, we must improve the international cooperation between national supervisors of the
financial sector. International bodies and Governments should not lose momentum in their
efforts to strengthen financial regulation and supervision.
The financial sector will obviously become smaller, particularly in those economies in which it
has expanded significantly over the past 20 years. The crisis has already led to substantial
structural changes in the financial sector and, as discussed, an increase in regulation is not
only very likely, but also necessary. We also need to consider the size of banks. Evidence
suggests that banks may have become too big to fail, too complex to be managed and even
too big to be rescued.
The simple statement that "if banks are too big to fail, they are probably too big to exist" is a
reasonable rule. In any case, the post-crisis financial system is likely to be more risk-averse,
less leveraged, less complex and also less profitable, at least on the basis of short-term
measures of profitability. The prevailing business model will probably place greater emphasis
on traditional banking activities, which tend to produce lower margins, but are also more
robust, less risky and less volatile. In this respect, the crisis may well turn out to be a catalyst
for a paradigm shift, transforming the global financial landscape for the better.
Conclusion
To conclude, there is no doubt that we have enormous challenges ahead of us and the
Eurosystem faces the toughest test it has ever encountered. But this is also true for other
economic regions and policy-makers across the globe. The best contribution the ECB can
make is to remain fully committed to ensuring price stability over the medium term, which is
our sole mandate. In order to fulfil this mandate, we have been made independent and are
therefore free from political influence. In this respect, we will remain an anchor of confidence
and stability in difficult times.