Jean-Claude Trichet: Reflections on the European Economic and
Monetary Union
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the
Evangelische Akademie Tutzing, Tutzing, Bavaria, 13 November 2010.
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Ladies and Gentlemen,
I would like to thank the organisers for inviting me to speak here today.
This is a crucial time for the European economy and for the global economy. Vital debates
about the state of and interactions between the world's major economies have been taking
place at the G20 meetings of Ministers and Governors a few weeks ago and at the
G20 summit in Seoul yesterday. Within Europe, there is a particularly vital debate about the
framework of governance for Economic and Monetary Union.
Both debates touch on the importance in these challenging times for the design of
appropriate policies. Throughout the global crisis, we have all striven to avoid a repeat of the
economic policy disasters of the 1930s - and to foster a close cooperation between
policymakers around the world. Working together towards a common goal must continue to guide
our actions. Today, I would like to put some of the key issues into a broader context.
First, I will focus on the experience of economic and monetary union in Europe. Second, I will
briefly describe the origins and impact of the financial crisis and outline how the European
Central Bank (ECB) has responded to the crisis. And finally, I will touch on the current
economic situation and conclude with the key challenges that lie ahead of us in achieving an
effective economic governance policy in Europe.
Price stability in the euro area
Let me begin with price developments. The quality of a currency is reflected in its value. As
you know, this is what in German is called Geldwertstabilität. There is one single benchmark
to measure such stability within an economy and that is the degree of price stability or,
expressed the other way around, the rate of inflation.
As the guardian of price stability for the euro area, the ECB has set itself a very clear
numerical benchmark to measure the degree of price stability. It has defined price stability to
be an annual rate of inflation of consumer prices in the euro area of below, but close to 2%,
over the medium term - that is, over an average of several years.
We now have almost 12 years of experience with the euro - enough time to judge whether
the ECB has been successful in delivering its mandate. Over these 12 years, the average
annual inflation rate in the euro area has been 1.97%. We have achieved price stability in the
euro area over what has already been quite a long horizon. It is the best result of any of the
larger countries in the euro area for at least 50 years.
The conditions for achieving price stability have not always been easy. In 1999, we began
with a completely new institution - the ECB -, a new currency - the euro - and a new
framework for monetary policy-making. Over the years we had to cope with highly volatile
developments in many components of the consumption basket - including oil prices of up to
$145 per barrel - considerable variations in exchange rates, and the burst of the internet
bubble, to name but a few. Hence, the track record, with 12 years of price stability, is worth to
take note of.
For Germany, the inflation rate has been even lower than the average in the euro area over
the past 12 years: 1.5% per year on average from 1999 to September 2010. By comparison,
the average rate of inflation in Germany in the 1990s prior to the introduction of the euro was
2.2%. In the 1980s, it was 2.8% and in the 1970s 4.9%.
If the strength of a currency is measured by the degree at which it preserves purchasing
power, the euro is stronger than the most stable currency that preceded its inception. Not
stark wie die D-Mark but stärker als die D-Mark is the right characterisation of the euro in a
historical context.
The second element that is important for the solidity of a currency is its external value. The
reason is simple: a significant and persistent depreciation over time will ultimately lead to
higher import prices and hence inflation. Therefore, abstracting from the large swings that
foreign exchange markets are known for at times, over a longer period the exchange rate is
an important ingredient in shaping domestic inflation outcomes.
In 1999, the euro was introduced at an exchange rate of 1.18 vis-à-vis the US dollar. You
know what is its value today. It needs no further commentary.
But the euro is more than this. It is the uniting monetary element of no fewer than
16 countries that together form a monetary and economic area of 330 million citizens. It has
contributed to a further integration of Europe's economies and I do not forget that as soon as
1 January next year we will be 17 countries and more than 330 million fellow citizens.
Challenges for Economic and Monetary Union
But as its name indicates, our Economic and Monetary union rests on two pillars: an
economic pillar and a monetary pillar. The fundamental concepts of the monetary pillar are
the full independence of the ECB and its crystal clear mandate to pursue price stability in the
euro area.
The fundamental concepts of the economic pillar can be summarised as follows: first, the
need to determine macroeconomic policies in line with the rules governing the participation in
a monetary union that is based on price stability; and second, the need to set fiscal policies
in line with the requirements as laid out in the Stability and Growth pact.
I have already described the contribution of the monetary pillar. Unfortunately, the
contribution of the economic pillar is at times much less flattering. Much of the problems we
face today see their origins in insufficient discipline of fiscal policy makers and an
inappropriate setting of macroeconomic policies.
For several years, fiscal policies in many countries have not been in line with the letter and
the spirit of the Stability and Growth pact. The pact calls for balanced budgets over the cycle,
maximum deficits of 3% and a debt level of below 60%. When a few years ago it became
clear that fiscal policies would not be able to meet the rules of the Stability and Growth pact,
it was not policies that were changed but the pact.
In 2004 and 2005, several heads of states and governments were actively trying to dismantle
the Stability and Growth pact. One of the countries in the lead of these endeavours was
Germany. It was supported by France as well as other countries. It was a very fierce battle at
the time, and the ECB voiced publicly its grave concerns.
The second area of policy slippage concerns macroeconomic policies. In a monetary union,
national developments in prices and costs have to take account of the fact that the union is a
union of monetary stability. Therefore, national price and costs developments significantly
higher than the union average entail significant losses over time in competitiveness that are
painful to reverse.
By the same token, fiscal and structural policies - including appropriate supervisory policies
(today we would say macroprudential policies) - need to keep domestic demand and credit
growth in line with rates of sustainable growth and price stability. Otherwise, booms and
busts are the inevitable consequence.
Both areas, fiscal and macroeconomic policies, are monitored by the peers, supported
mainly by the Commission. The Eurogroup and Ecofin meetings of finance ministers are the
fora for such peer monitoring. Of course, effective monitoring requires adherence by
members to the policy framework, it requires peer pressure and consequences to deal with
deviant behaviour and it requires reliable statistics.
It is in these areas that the biggest deficiencies have been revealed. Fiscal policy conduct
has quite often not been in line with the pact, macroeconomic policies have been too loose
and peer pressure has been too weak. These problems were visible well before the financial
crisis, but the crisis has of course aggravated them, and massively so.
I will come back to how we deal with these problems in a moment. But first let me turn
directly to the crisis and say a few words about its origins and developments, and how the
ECB has responded to it.
The financial crisis: origins, development and policy responses
Robert Merton - one of the architects of modern financial theory - once said that: "Any virtue
can readily become a vice if taken to excess, and just so with innovations".1 There is unlikely
to be a more compelling proof of this dictum than the developments in financial innovation
that led up to the crisis that started in 2007 and became most acute in the autumn of 2008.
Historically, the financial industry has been at the forefront of economic progress because of
its ability to offer funding to those who take on economic risk. Without credit, the innovation,
production and trade of the real economy are severely constrained.
But in the recent past the focus of finance has gradually shifted. From helping the real
economy manage economic risk, the focus of finance has quietly moved toward the creation
of financial risk. Financial risk is different from economic risk. It is deliberate exposure to
expected asset price changes.
Building exposure to changes in the value of an asset is not bad per se. But we have to
distinguish between arbitrage and directional positioning. Arbitrage is an essential market
force. Indirectly, it supports production and trade.
Directional positioning, instead, can amplify and even create gaps in asset prices. It does so
by acting on expectations of future price changes. Unlike in the case of arbitrage, these price
gaps are notional - indeed, "speculative". They are often large only because they are not
suitably discounted for risk.
When on 15 September 2008, Lehman Brothers filed for bankruptcy, the turmoil that had
started a year earlier turned into an avalanche. In times of financial panic, banks and other
financial intermediaries shed risky and illiquid investments and rush to liquidity. In the
process, banks' intermediation is reduced, and loans to companies are curtailed. If the
process is allowed to unfold in a disorderly manner, it can create severe damage for
borrowers and for the broader economy.
The ECB was among the first central banks in the world to recognise the severity of the
situation as early as August 2007, when the turmoil began. It took actions well before a
number of other central banks - to be precise: on the very first day the turmoil erupted.
As the failure of Lehman precipitated the acute phase of the crisis, the ECB acted decisively,
taking several measures to protect against a disorderly correction in credit and liquidity
conditions for the euro area. We put banks in a position to maintain their crucial role in the
financing of the real economy. Fears of a "Kreditklemme" have not materialised. At the same
time, we could start to phase out some of these measures and reduce the amount and
duration of liquidity provision.
A few months ago, in May 2010, the ECB decided on bold measures again. It was for similar
reasons. Increasing market concerns about the sustainability of public finances led to a
paralysis in the secondary market for government paper. Once more, private financial
intermediation was threatened.
With the rapid increase in secured interbank lending in the euro area over the past years, the
impact on money markets of developments in government bond markets has grown
substantially. Government bonds have traditionally been an important element in the
transmission process because they serve as a benchmark, or floor, for the pricing of other
financial contracts and fixed-income securities.
In recent years they have also emerged as a prime source of collateral in interbank lending.
As a result abrupt changes in the value or availability of these securities can imply a sharp
deterioration in banks' funding conditions - with adverse effects on both the supply of bank
loans to the real economy and their prices.
Therefore, we had to determine further non-standard measures, including interventions in
debt markets. All our non-standard measures help restoring a more normal monetary policy
transmission mechanism which is necessary to fulfil our primary mandate of accomplishing
price stability in the medium term. It is not to be confused with "quantitative easing" policies
that aim to reduce longer-term interest rates by expanding the monetary base. In fact, all
Eurosystem purchases of debt securities are fully sterilised by conducting liquidity-absorbing
operations. All our non-standard measures are temporary in nature.
That being said we urge all governments to step up consolidation. There is a clear need to
strengthen public confidence in the capacity of governments to return to sustainable public
finances and thus support sustainable growth over the medium term. To this end, it is
essential that countries pursue credible multi-year consolidation plans and fully implement
the planned consolidation measures. Any positive fiscal developments that may emerge,
reflecting factors such as a more favourable than expected economic environment, should be
exploited to make faster progress with fiscal consolidation.
Europe's economy: the current situation and the challenges ahead
Let me come to the third and final part of my remarks and turn to the latest developments in
the euro area economy.
Looking ahead, our quantitative definition of price stability and our medium-term orientation
significantly reduce the likelihood of either deflation or inflation scares. The firm anchoring of
inflation expectations - throughout a time of crisis - meant that we could maintain the rate on
our refinancing operations at positive levels without having any materialisation of a deflationary
risk or inflationary expectations.
Indeed, recent data releases and survey evidence confirm our view that expected price
developments will remain moderate over the policy-relevant medium-term horizon. At the
same time, the positive underlying momentum of the economic recovery in the euro area
remains in place. In line with previous expectations, this implies continuing real GDP growth
in the second half of this year.
The global recovery is expected to proceed, and this should imply a continued positive
impact on the demand for euro area exports. Private sector domestic demand should also
contribute to growth, supported by the accommodative monetary policy stance and the
measures adopted to restore the functioning of the financial system.
But complacency would be inappropriate. The European leaders recognise that our
economic model is in need of a considerable strengthening. At their meeting in October, the
Heads of State or Government agreed on the reform of the system of economic governance.
The proposals put forward by President Van Rompuy represent a strengthening of the
existing framework for fiscal and macroeconomic surveillance. But as I have said before, the
Governing Council of the ECB considers that they do not represent the quantum leap in the
economic governance that is needed to be fully commensurate with the monetary union we
have created.
One key area is surveillance of fiscal policies to prevent excessive deficits and unsustainable
public debt. In our view we need shorter deadlines under excessive deficit procedures so that
corrective policy action is taken in good time. We need quasi-automaticity in the application
of sanctions, based on clearly defined criteria and with less discretion over outcomes. And
we need ambitious targets for the reduction of public debt towards the 60% of GDP ceiling.
The second key area is broader surveillance of macroeconomic policies in the euro area. We
need a new system of mutual surveillance in the euro area, concentrating firmly on euro area
countries experiencing sustained losses of competitiveness and large current account
deficits as these countries face the greatest sustainability challenges. It should be
determined by transparent and effective trigger mechanisms and specify clearly the
sanctions in case of breach. And we need full transparency. The assessments of
macroeconomic imbalances and recommendations for corrective action should be given
broad publicity at all stages of the surveillance process.
The effectiveness of these enhancements to the governance framework will in part be
determined by the quality and independence of the economic analysis that underpins them.
Without reliable statistical data we cannot be certain that the governance framework will
provide the quantum leap forward that is necessary. It is therefore extremely important that
the Commission services charged with conducting macroeconomic and fiscal surveillance for
the euro area be sufficiently independent, ideally supported by a body of "wise persons"
providing external assessments.
Conclusion
Let me conclude. The past 12 years have been very challenging, demanding and eventful
years. The ECB has lived up to its responsibility and delivered what we promised to deliver: a
stable currency, as credible and confidence-inspiring as the best previous currencies. The
euro has also been a force of stability in what is now a more than three year period of
economic and financial instability.
As is the case in all major advanced economies which all, without exception, have to put
under sharp review their previous surveillance framework and economic models, changes
are needed in the euro area framework. Not the kind of changes towards more unilateral
action, with dangers of lack of cooperation, but changes towards greater cooperation, greater
cohesion through a strengthened framework of economic governance. To sum up, more
European unity, more responsible European unity. We must keep our sense of direction.
We are now at a stage where we need to remain bold and enact those reforms that we
envisaged when the crisis was at its deepest. It was then that we witnessed the clearest
manifestation of risks and our judgement was sharpest. It would be a big mistake if, with
gradually improving conditions, we fell back into accepting the status quo. I therefore call on
all parties to remain as bold in their reforms as they were when we were in the eye of the
storm.
Thank you for your attention.