Mario Draghi: The euro area economy - current prospects and
challenges ahead
Speech by Mr Mario Draghi, President of the European Central Bank, at the Economic Club
of New York, New York, 10 October 2013.
* * *
Ladies and Gentlemen,
I am delighted to be here with you today and I would like to take this opportunity to talk about
what is happening in Europe right now.
As you know, the euro area as a whole is undergoing a process of fundamental reform. The
overarching objective is to lay the foundation for recovery and more jobs, foster financial
stability and fiscal sustainability and enhance international competitiveness for the benefit of
all parts of the economy and wider society.
Reform will be a lengthy process but while it is far from complete, perhaps for the first time
we are seeing signs of significant progress.
National policy-makers in Europe are able to focus a little less on short-term difficulties and a
little more on their longer-term responsibilities to strengthen the resilience of their domestic
economies while developing their growth potential.
And the monetary policy that we at the European Central Bank (ECB) are implementing will
accompany the reform process by maintaining the degree of accommodation that is most
appropriate, given our economic outlook and the risks that surround it.
The economic situation and outlook
So let me start with an overview of the current situation and outlook for the euro area
economy.
Recent data releases support our baseline outlook of a nascent economic recovery over the
coming months. Following six quarters of negative output growth, euro area real GDP rose
by 0.3% in the second quarter of this year.
Although more recent data has pointed to a fairly slow start in the third quarter, survey-based
confidence indicators give some comfort that the turning point in economic activity that we
saw earlier in the year is not reversed.
Taken together, incoming information has confirmed the growth outlook from the September
ECB staff projections. While these projections still see real GDP shrinking by 0.4% this year,
a positive growth rate of 1% is expected for 2014.
But the pace of recovery is going to be subdued and uneven across countries for as long as
it is meaningful for us to look into the future. The unemployment rate, currently standing at
12.1%, remains unacceptably high, and the risks around the outlook continue to be tilted to
the downside.
In keeping with the broad-based weakness in aggregate demand, underlying price pressures
remain subdued as well. Annual euro area headline inflation is projected to reach 1.5% this
year, before declining to 1.3% in 2014.
These levels are historically very moderate, and remain in the lower part of the range of
values that the ECB's Governing Council has identified as consistent with the ECB's
quantitative definition of price stability.
That said, inflation expectations continue to be firmly anchored in line with our aim of
maintaining inflation rates below, but close to, 2% over the medium term. And the risks to the
outlook for price developments are expected to be broadly balanced.
Finally, monetary and, in particular, credit dynamics remain weak. The annual growth rate of
loans to the private sector has remained well in negative territory; and the pace of contraction
has actually accelerated over recent period.
Certainly, weak loan dynamics can largely be explained by the current stage of the business
cycle but we have to be attentive to alleviate structural and supply-side factor that may
hamper credit provision. The significant improvement in the funding situation of banks since
the summer of 2012 has partly offset supply-side restrictions. But it will be some time before
the more permissive funding conditions faced by many banks will be turned into an active
spur for credit creation.
The strategy of euro area policy-makers
Against this background, how should policy-makers respond to the still fragile
macroeconomic recovery?
In my view, we need a three-pronged strategy:
First, monetary policy has to remain consistently supportive of the baseline outlook and
mitigate the risks that surround it. Our price stability mandate is sufficiently precise to keep
us concentrated on that mission.
But preserving monetary accommodation is a necessary but not sufficient condition for the
recovery to take hold.
A second essential ingredient is that countries continue the adjustment of their domestic
policies in a way that removes structural impediments to their economic potential and fosters
long-term fiscal sustainability.
Monetary accommodation can accompany and facilitate such regime shift in economic
policy. But we know it can never replace it.
Third and equally important, Europe has to continue the reform process in its banking sector.
Sound finance is part and parcel of a dynamic economy and banks remain a major conduit of
finance in the euro area. Hence, we must establish conditions that align incentives of
individual financial institutions with those of society.
Let me explain the measures that European policy-makers are taking in each of these areas:
monetary policy; fiscal and structural adjustment; and banking reform.
Monetary policy
Let me start with monetary policy.
As you know, the Treaty clearly prioritises price stability as the ECB's primary objective.
Within this disciplining framework, we tailor our policy response to the challenges at hand.
In response to the events of the past six years, we've taken swift and resolute action. We cut
the main policy rates to record lows. We provided funding support to euro area banks over
long time horizons. And we counteracted and removed unwarranted fears of a breakup of the
euro area.
In July this year, we again expanded our toolkit to protect the nascent recovery from the risk
that it could be choked off prematurely by an unwelcome restriction in monetary conditions.
To that effect, the ECB's Governing Council adopted explicit communication on how it
expects its key interest rates to evolve in the future. In particular, we have communicated our
expectation that the key interest rates will remain at present or lower levels for an extended
period of time.
This expectation is based on our assessment that the subdued inflation outlook extends into
the medium term, given the broad-based weakness in the real economy and subdued
monetary dynamics.
What was the rationale for adopting "forward guidance"?
In June and July, we observed substantial volatility in money market rates. The pricing of
term interbank credit in the money market - the first stage of the transmission of monetary
policy to the broader economy - had become increasingly divorced from euro area
fundamentals.
Markets tended to overreact to news that was either not directly relevant to the euro area
macroeconomic outlook or simply confirmed our baseline scenario.
Against this background, our forward guidance aimed at better aligning money market
conditions with our policy intentions.
In interpreting our forward guidance, there are three essential elements.
First, it acknowledges the scope for further cuts in our key interest rates. In other words, the
adoption of forward guidance does not imply that we've reached the effective lower bound.
Indeed, the opposite is the case: the Governing Council has unanimously agreed to
incorporate an easing bias into our forward guidance that explicitly provides for the possibility
of further rate reductions, should the volatility in money market conditions return to the levels
observed in the early summer.
Second, our forward guidance is specifically tailored to the ECB's mandate and monetary
policy strategy: the path of the policy rates remains conditional on the outlook for inflation;
and it will be reviewed over time against the analytical framework underlying the ECB's
monetary policy strategy.
This means that we assess whether the medium-term outlook for inflation remains subdued
against two types of metrics. On the one hand, economic indicators pointing to persistent
slack in the real economy. On the other hand, monetary indicators pointing to persistent
subdued dynamics in money and credit.
The third element of our forward guidance is that, by confirming our policy framework, it
refocuses attention on what matters most for our monetary policy, namely the medium-term
inflation outlook in the euro area. On our side, it induces the sort of prudent language in
communicating about the economy and the type of balanced and steady response to
economic news that is needed in the exceptional circumstances in which we currently have
to steer our monetary policy course.
The observed decline in market uncertainty about future short-term rates indicates that our
forward guidance has helped to anchor market expectations.
Going forward, we will carefully assess developments in money markets and liquidity
conditions. We have to ensure that interest rate expectations remain firmly anchored around
a path that does not add to downside risks to the recovery.
Thus, our monetary policy stance will continue to be geared towards maintaining the degree
of accommodation warranted by the outlook for price stability and promoting stable money
market conditions. It thereby provides support to a gradual recovery in economic activity.
Fiscal consolidation and competitiveness
But preserving monetary policy accommodation is not sufficient in itself for the recovery to
take hold and become self-sustaining.
This leads me to the second element of the policy response: repairing the fiscal and
structural problems that hold back individual euro area economies.
A painful lesson from the last few years is that we all underestimated the destructive potential
that myopic national policies could exert on the euro area's collective body, and on the world
economy as a whole.
It is time to remove the institutional shortcomings that allowed imbalances to build up in the
national economies and escalate into systemic threats in the first place.
In the euro area, two such shortcomings were particularly consequential.
First, the EU fiscal rules were weakly enforced and, as such, incapable of promoting prudent
fiscal policies in times of favourable economic conditions. Second, there was no mechanism
to prevent and correct macroeconomic imbalances within the EU.
This resulted in an incentive vacuum.
Rather than exploiting the advantages of monetary union for a modernisation of domestic
economies, several countries simply delayed necessary adjustments.
And the elimination of exchange rate fluctuations and the levelling-off of spreads in sovereign
borrowing costs that preceded the downturn deactivated the market forces that previously
had disciplined macroeconomic policies at the country level.
European policy-makers are addressing these issues.
Due to a recent strengthening of the EU fiscal rules, Member States now face stronger
incentives to adopt sound budgetary policies.
Moreover, a new "Macroeconomic Imbalances Procedure" has been established at EU level.
It requires governments to adopt competitiveness-enhancing policies and tackle potential
sources of financial instability in their domestic economies.
Reflecting this reform momentum at the European level, governments are tackling
imbalances in their domestic economies. They are implementing reforms to reverse the
misguided policies of the past and to create sustainable long-term growth.
Progress is steady and the data increasingly show that governments are heading in the right
direction.
Euro area countries have cut their fiscal deficit ratios by half since their peak in 2009.
Excluding interest payments, euro area Member States on aggregate are expected to run a
small surplus by the end of this year.
This is clearly in contrast to other industrial economies, such as the US or Japan, which last
year still recorded primary deficits of 6% and 8% of GDP, respectively.
We are also seeing some noteworthy improvements in competitiveness and external
positions.
The countries under full EU-IMF programmes have seen their unit labour costs fall by more
than 10% since 2008, relative to the euro area average. Their current accounts have
improved by around 8% of GDP since then.
In short, there is progress towards more solid economic fundamentals in the euro area.
But maintaining the current momentum of reform is essential for ensuring stability in the euro
area.
Bank balance sheets and banking union
Finally, a sustainable recovery requires healthy financial institutions.
We have seen much progress in the banking sector of the euro area. Since the beginning of
the financial crisis in 2007 euro area banks have raised around €225 billion of fresh capital
and another €275 billion has been injected by governments. All in all, this amounts to more
than 5% of euro area GDP. As a result, the average Core Tier 1 ratio of the largest euro area
banks currently stands well above 11% and the majority of euro area banks already comply
with the minimum capital requirements of the fully implemented Basel III framework.
Furthermore, in countries under financial assistance programmes, problematic legacy assets
have been removed from banks' balance sheets to ensure that they will no longer curb
banks' lending to profitable businesses.
More progress is on its way in terms of the institutional architecture. Europe's Economic and
Monetary Union (EMU) will be complemented by a European banking union.
Last month, the European Parliament cleared the way for the single supervisory mechanism,
which tasks the ECB with overseeing major parts of the European banking system.
By placing this responsibility with an independent institution at European level, the new
supervisory mechanism will allow for more stringent and consistent supervision. This will,
ultimately, afford an earlier identification of financial risk - in both individual institutions and
the financial sector as a whole.
Looking forward, two objectives need to be addressed: First, we need to create full
transparency about the risks on banks' balance sheets. And, second, we need to align
investors' incentives with those of society.
A comprehensive balance sheet assessment will be a crucial preparatory step before we
begin our new supervisory task in autumn 2014. This will serve to strengthen transparency
and to mitigate the risk of the possible emergence of problem banks in the early days of
operation of the new supervisory mechanism. This balance sheet assessment, to be
conducted by the ECB together with national supervisors and an independent third party, will
consist of a supervisory risk assessment and a thorough asset quality review that in turn will
be an input for a stress test to be jointly carried out with the European Banking Authority
(EBA). The three elements combined will ensure a comprehensive assessment, identifying
remaining risks on banks' balance sheets.
To strengthen incentives, the institutional architecture will be augmented by the single
resolution mechanism. As a first step to overcoming the existing problems of incentive
incompatibility, harmonised rules and procedures for bank recovery and resolution are
currently being developed at European level. These harmonised frameworks should be
implemented at national level as soon as possible.
But to ensure a fully consistent and effective application of these rules, their implementation
should be placed within the remit of an independent authority that reinforces the new
supervisory framework at a European level.
To that effect, the EU's institutional architecture should be augmented by a single resolution
mechanism that executes bank resolution in a timely and impartial manner and formulates its
decisions from a clear, encompassing European perspective.
By enhancing transparency and incentive compatibility, the combination of the single
supervisory mechanism and the single resolution mechanism will help Europe return to a
situation in which investment decisions will be based on business prospects, not on
geographical location.
Conclusions
Let me conclude.
The recovery remains in its infancy. Given the prolonged build-up of macroeconomic
imbalances in the past, we have to be prepared for a protracted and anaemic process in the
future.
Yet we should also not exaggerate the euro area's challenges. While the unemployment rate
has increased more in the euro area than in the US during the crisis, the employment rate in
the US has fallen further than in the euro area, which makes the figures difficult to compare.
Moreover, the euro area has a strategy to return to sustainable growth and employment, and
that strategy is being executed. What is essential is that all policy-makers in the euro area
play their part and stay the course. The rewards that will result from the reform of our
economic institutions cannot be overestimated.
Thank you for your attention.