Jens Weidmann: Global economic outlook - what is the best policy mix?
Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, at the Economic
Club of New York, New York, 23 April 2012.
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1. Introduction
Ladies and Gentlemen
George Bernard Shaw is said to have made an interesting remark about apples - "If you
have an apple and I have an apple and we exchange these apples then you and I will still
each have one apple. But if you have an idea and I have an idea and we exchange these
ideas, then each of us will have two ideas."
I think those words perfectly encapsulate the intention of the Economic Club of New York
and of today's event. Ideas multiply when you share them and they become better when you
discuss them.
I am therefore pleased and honoured to be able to share some ideas with such a
distinguished audience today. And I look forward to discussing them with you.
In a long list of speakers, I am the third Bundesbank President to speak at the Economic
Club. The first was Karl Otto Pöhl in 1991, followed by Hans Tietmeyer in 1996.
Although only a few years have passed since then, the global economic landscape has
completely transformed in the meantime - just think of the spread of globalisation, think of
the introduction of the euro, think of the Asian crisis or the dotcom bubble. All these events
and others have constantly shaped and reshaped our world.
Most recently, we have experienced a crisis that, once again, will change the world as we
know it - economically, politically and intellectually. It is this new unfolding landscape that
provides the backdrop to my speech.
I shall address two questions: "Where do we stand?" and "Where do we go from here?"
Of course, it is the second question that is the tricky one. In answering it, we should be
aware that every small step we take now will determine where we stand in the future.
Specifically, I shall argue that measures to ward off immediate risks to the recovery are
closely interconnected with efforts to overcome the causes of the crisis. They are
interconnected much more closely and vitally than proponents of more forceful stabilisation
efforts usually assume.
But, first, let us see where we stand at the present juncture.
2. Where do we stand?
When we look back from where we are standing right now, we see a crisis that has left deep
scars.
The International Labour Organisation estimates that up to 56 million people lost their jobs in
the wake of the crisis. This number equals the combined populations of California and the
state of New York.
Or look at government debt: Between 2007 and 2011, gross government debt as a share of
GDP increased by more than 20 percentage points in the euro area and by about
35 percentage points in the United States.
I think we all agree that the crisis was unprecedented in scale and scope. And the first thing
to do was to prevent the recession turning into a depression. Thanks to the efforts of
policymakers and central banks across the globe, this has been achieved.
Following a slight setback in 2011, the world economy now seems to be recovering. In its
latest World Economic Outlook, the IMF confirms that global prospects are gradually
strengthening and that the threat of sharp slowdown has receded.
Looking ahead, the IMF projects global growth to reach 3.5% in 2012 and 4.1% in 2013. For
the same years, inflation in advanced economies is expected to reach 1.9% and 1.7%.
Basically, I share the IMF's view. However, we all are aware that these estimates have to be
taken with a grain of salt - probably a large one. Being a central banker, I am not quite as
calm about inflation. Taking into account rising energy prices and robust core inflation, prices
could rise faster than the IMF expects.
We have to be careful that inflation expectations remain well anchored and consistent with
price stability. Expectations getting out of line might very well turn out to be a non-linear
process. If this were to happen, it would be difficult and expensive to rein in expectations
again.
Even though the outlook for growth has improved over the past months, some risks remain -
the European sovereign debt crisis being one of them. And this seems to be the one risk that
is weighing most heavily on peoples' minds - not just in Europe but here in the United
States, too.
The euro-area member states have responded by committing to undertake ambitious reforms
and by substantially enlarging their firewalls. This notwithstanding, the sovereign debt crisis
has not yet been resolved. The renewed tensions over the past two weeks are a case in
point. Thus, we have to keep moving, but each step we take has to be considered very
carefully. As I have already said: each small step we take now will determine where we stand
in the future.
3. Where do we go from here?
Eventually, three things will have to happen in the euro area. First, structural reforms have to
be implemented so that countries such as Greece, Portugal and Spain become more
competitive. Second, public debt has to be reduced - a challenge that is not confined to the
euro area. Third, the institutional framework of monetary union has to be strengthened or
overhauled, and we need more clarity about which direction monetary union is going to take.
I think we all agree on this - including the IMF in its latest World Economic Outlook.
However, there is much less agreement on the correct timing. Since the crisis began, the
imperatives I have just mentioned have tended to be obscured by short-term considerations.
And surprisingly, this tendency seems to be becoming stronger now that the world economy
is getting back on track.
This view is reflected by something Lawrence Summers wrote in the Financial Times about
four weeks ago. Referring to the US, he said that "... the most serious risk to recovery over
the next few years [...] is that policy will shift too quickly away from its emphasis on
maintaining adequate demand, towards a concern with traditional fiscal and monetary
prudence."
It is in this spirit that some observers are pushing for policies that eventually boil down to
"more of the same": firewalls and ex ante risk sharing in the euro area should be extended,
consolidation of public debt should be postponed or, at least, stretched over time, and
monetary policy should play an even bigger role in crisis management.
I explicitly do not wish to deny the necessity of containing the crisis. But all that can be
gained is the time to address the root problems. The proposed measures would buy us time,
but they would not buy us a lasting solution.
And five years after the bursting of the subprime bubble and three years after the turmoil in
the wake of the Lehman insolvency, we have to ask ourselves: Where will it take us if we
apply these measures over and over again - measures which are obviously geared towards
alleviating the symptoms of the crisis but which fail to address its underlying causes?
In my view, this would take us nowhere. There are two reasons for this. First, the longer such
a strategy is applied, the harder it becomes to change track. More and more people will
realise this and they will start to lose confidence. They will lose confidence in policymakers'
ability to bring about a lasting solution to our problems. And we should bear in mind that the
crisis is primarily a crisis of confidence: of confidence in the sustainability of public finances,
in competitiveness and, to some extent, in the workings of EMU.
But there is a second reason why the "more of the same" will not take us anywhere. The
analgesic we administer comes with side effects. And the longer we apply it, the greater
these side effects will be, and they will come back to haunt us in the future.
In the end, it is just not possible to separate the short and the long term. You will be
tomorrow what you do today.
With these two caveats in mind, let us take a closer look at the suggested policy mix. For the
sake of brevity, I shall focus on monetary and fiscal policies.
3.1 An even bigger role for monetary policy?
To contain the crisis, the EMU member states have built a wall of money that recently
reached the staggering height of 700 billion euros. As I have already said, ring-fencing is
certainly necessary, but again: it is not a lasting solution. And it is not the sky that's the limit -
the limits are financial and political.
In the face of such limits, the Eurosystem is now seen as the "last man standing".
Consequently, some observers are demanding that it play an even bigger role in crisis
management. More specifically, such demands include lower interest rates, more liquidity
and larger purchases of assets.
But does the assumption on which these demands are based hold true when we take a
closer look at it? In the end, monetary policy is not a panacea and central bank "firepower" is
not unlimited, especially not in monetary union.
True, this crisis is exceptional in scale and scope, and extraordinary times do call for
extraordinary measures. But the central banks of the Eurosystem have already done a lot to
contain crisis. Now we have to make sure that by solving one crisis, we are not preparing the
ground for the next one.
Take, for example, the side effects of low interest rates. Research has found that risk-taking
becomes more aggressive when central banks apply unconditional monetary
accommodation in order to counter a correction of financial exaggeration, especially if
monetary policy does not react symmetrically to the build-up of financial imbalances. In the
end, putting too much weight on countering immediate risks to financial stability will create
even greater risks to financial stability and price stability in the future.
The Eurosystem has applied a number of unconventional measures to maintain financial
stability. These measures helped to prevent an escalation of the financial turmoil and
constitute a virtually unlimited supply of liquidity to banks. But monetary policy cannot
substitute for other policies and must not compensate for policy inaction in other areas.
If the Eurosystem funds banks that are not financially sound, and does so against inadequate
collateral, it redistributes risks among national taxpayers. Such implicit transfers are beyond
the mandate of the euro area's central banks. Rescuing banks using taxpayers' money is
something that should only be decided by national parliaments.
Otherwise, monetary policy would nurture the deficit bias that is inherent to a monetary union
of sovereign states. In this regard, the situation of the Eurosystem is fundamentally different
from that of the Federal Reserve or that of the Bank of England.
Moreover, extensive and protracted funding of banks by the Eurosystem replaces or
displaces private investors. This breeds the risk that some banks will not reform unviable
business models. So far, progress in this regard has been very limited in a number of
euroarea countries.
And the Eurosystem has also relieved stress in the sovereign bond market. However, we
should not forget that market interest rates are an important signal for governments
regarding the state of their finances and that they are an important incentive for reforms.
Of course, markets do not always get it right. They may have underestimated sovereign risks
for a long time and now they are overestimating it. But past experience taught us that their
signal is still the most powerful incentive we have. At any rate, I would not rely on political
insight or political rules alone.
After all, monetary policy must not lose sight of its primary objective: to maintain price
stability in the euro area as a whole. What does this mean? Let us say that monetary policy
becomes too expansionary for Germany, for instance. If this happens, Germany has to deal
with this using other, national instruments.
But by the same token, we could say this: even if we are concerned about the impact on the
peripheral countries, monetary policymakers must do what is necessary once upside risks for
euro-area inflation increase. Delivering on its primary goal of maintaining price stability is
essential for safeguarding the most precious resource a central bank can command:
credibility.
To sum up: what we do in the short-term has to be consistent with what we are trying to
achieve in the long-term - price stability, financial stability and sound public finances. This
implies a delicate balancing act - a balancing act we shall upset if we overburden monetary
policy with crisis management.
3.2 Rethinking consolidation and structural reforms?
Now, what about consolidation and structural reforms? Here, too, we have to strike the right
balance between the short and the long run.
Those who propose putting off consolidation and reforms argue that embarking on ambitious
consolidation efforts or far-reaching structural reforms at the present moment would place
too great a burden on recovery. They do not deny the necessity of such steps over the
medium term, but in the short-run they consider it more important to maintain adequate
demand, avoid unsettling people and nurture the recovery.
But in the end, the current crisis is, to a large degree, a crisis of confidence. And if
alreadyannounced consolidation and reforms were to be delayed, would people not lose even more
confidence in policymakers' ability to get to the root of the crisis? We can only win back
confidence if we bring down excessive deficits and boost competitiveness. And it is precisely
because these things are unpopular that makes it so tempting for politicians to rely instead
on monetary accommodation.
It is true that consolidation, in particular, might, under normal circumstances, dampen
aggregate demand and economic growth. But the question is: are these normal
circumstances? It is quite obvious that everybody sees public debt as a major threat. The
markets do, politicians do, and people on Main Street do.
A widespread lack of trust in public finances weighs heavily on growth: there is uncertainty
regarding potential future tax increases, while funding costs are rising for private and public
creditors alike. In such a situation, consolidation might inspire confidence and actually help
the economy to grow.
In my view, the risks of frontloading consolidation are being exaggerated. In any case, there
is little alternative. In the end, you cannot borrow your way out of debt; cut your way out is
the only promising approach.
4. Conclusion
Allow me to conclude by going back to the beginning of my speech where I mentioned the
benefits of sharing and discussing ideas.
I have stressed that we have to embark on reforms that make the crisis countries more
competitive; that we have to reduce public debt and that we have to further improve the
institutional framework of monetary union.
But the spirit of my argument was expressed succinctly some 20 years ago by Karl Otto
Pöhl. In his speech at the Economic Club he said: "The true function of a central bank must
be, however, to take a longer-term view."
And after five years of crisis, the long term might catch up with us faster than we expect. We
therefore have to think about the future now - and we have to act accordingly as well.
Thank you for your attention.