Lars Rohde: The European crisis and the development of the European
Union
Speech by Mr Lars Rohde, Governor of the National Bank of Denmark, at the European
Affairs Committee's consultation: "The European crisis and the development of the European
Union", former Upper Chamber of the Danish Parliament, Copenhagen, 26 February 2013.
* * *
Thank you for inviting me to speak here today.
The EU member states have been severely affected by the financial crisis and then the
sovereign debt crisis. The recession is now in its fifth year. Many measures have been taken
to contain the crisis, and more are in the pipeline.
Being a small, open economy, Denmark is highly vulnerable to developments in the EU. We
participate in many community efforts, but not in the monetary union. We have opted out, but
at the same time the krone is tied closely to the euro. The purpose of keeping the krone
stable against the euro is to avoid exchange-rate uncertainty - which is very important to an
economy such as the Danish one, with exports accounting for almost half of the gross
domestic product. At the same time, inflation and inflation expectations are anchored to an
area pursuing stability-oriented economic policies with low and stable inflation. The
fixedexchange-rate policy means that fiscal policy is the instrument at our disposal to stabilise the
economy. This arrangement has served us well for 30 years.
Denmark's economic policy enjoys considerable credibility - also in the financial markets.
This is why we have for some time been - and indeed, we are still - seen as a safe haven for
international investors. This has resulted in historically low interest rates. Despite the most
recent increase, Danmarks Nationalbank's deposit rate is still negative. The low level of
interest rates has mitigated the real economic consequences of the financial crisis. But at
some point interest rates will normalise.
The stability of the anchor currency - i.e. of the euro area - is important to the Danish
economy. The political system in a non-euro area EU member state such as Denmark must
perform a balancing act - how far should we go in terms of participation? This question was
topical in relation to the issue of closer fiscal cooperation, as it is in the current process
towards a banking union.
In the early 1990s, the European foreign-exchange market came under strong speculative
pressure and one currency after the other came under attack. The crisis culminated in 1993
with speculation against the Exchange-Rate Mechanism, ERM, existing at the time. Some
20 years down the line, the financial crisis and sovereign debt crisis in certain European
countries have once again put the European economic cooperation under pressure. The
most recent crisis has differed from the situation in the early 1990s when each EU member
state had its own currency. If national currencies had not been replaced by the euro in 1999,
we could very well have seen an extensive currency crisis on top of the financial crisis and
the sovereign debt crisis. For the euro area, the euro has prevented this. The Danish krone,
on the other hand, was hit by short-term currency unrest in the autumn of 2008, as were
other small currencies. Subsequently, the sovereign debt crisis has, from time to time, led to
pressure on the krone, but this has been upward pressure due to large capital inflows.
A fixed-exchange-rate system is not in itself an effective bulwark against irresponsible
policies. The euro area sovereign debt crisis could very well have taken a far more dramatic
path, leading to disorderly sovereign defaults, without the variety of pan-European initiatives
to solve the sovereign debt crisis that were the result of the economic-political cooperation
between the euro area member states.
The introduction of the euro back at the turn of the millennium caused interest rates to drop
markedly in many euro area member states, and yield spreads within the euro area were all
but eliminated. But the interest-rate gains were not used for consolidation. Instead, they
boosted domestic demand. As a result, competitiveness was eroded, and these member
states saw increasing current- account imbalances. At the same time, housing bubbles
emerged in several member states, and this later caused distress for the banks that had
helped to fund property projects at inflated prices. The euro area systems for monitoring and
addressing government deficits and other macroeconomic imbalances proved to be
completely inadequate. This was one of the reasons why the imbalances were allowed to
develop - and to become much more serious than they had been ahead of the crisis in the
early 1990s. Furthermore, risk premiums on the government bonds of these member states
were unsustainably low for a long period after the introduction of the euro. Hence market
pressures for political action were correspondingly low. This changed abruptly when the
financial crisis and sovereign debt crisis set in.
Since many countries had failed to take advantage of the favourable economic climate in the
early years of this century to consolidate public finances, their position was weak when the
crisis struck. Still, most countries eased fiscal policy in 2009 as part of concerted European
efforts to offset the negative impact of the crisis on growth and employment. This caused
further deterioration of public finances, and for several euro area member states it led to an
outright sovereign debt crisis. One reason was that the banks' non- performing loans
eventually became a problem for the public sector, thereby weighing down on government
finances. In many countries, fiscal expansion during the boom immediately before the crisis
has now made way for extensive consolidation. In other words, fiscal policy has amplified
cyclical fluctuations instead of dampening them.
Therefore, the lesson to us all - from the ERM crisis in the early 1990s and recent years'
financial crisis and sovereign debt crisis - is that it is important to address macroeconomic
imbalances in time to prevent systemic risk. The financial crisis and the sovereign debt crisis
revealed a clear need to strengthen political cooperation between euro area member states.
The most recent crisis has exposed at least two fundamental weaknesses in the EU's
economic cooperation. Firstly, the pressure for budgetary discipline was not strong enough.
Secondly, the one-sided focus on fiscal policy was too narrow. A comprehensive view of the
member states' economic situation is required. It is also evident that price stability alone is
not sufficient to ensure financial stability.
In recent years, the EU member states have adopted a series of new rules aimed at
addressing these weaknesses, including the Fiscal Compact, which tightens the
requirements for fiscal discipline. In addition, the EU member states have adopted rules for
surveillance of macroeconomic imbalances, under which the European Commission is to
monitor whether a member state is building up excessive imbalances. There is now more
focus on systemic risk, and a European Systemic Risk Board, ESRB, has been set up. In
Denmark, we have introduced the Systemic Risk Council, whose members were appointed
last Thursday.
Although Denmark has, in many ways, navigated the financial crisis better than many other
countries, we have generally had to learn the same economic policy lessons as others. In
Denmark, too, fiscal policy in the pre-crisis years reinforced the boom rather than dampening
it. Among other things, this led to higher wage inflation and weaker competitiveness. As a
result of the procyclical fiscal policy, the downturn was more severe than it would otherwise
have been.
But the underlying fiscal policy was sounder than in the member states now experiencing
problems. This is true both in terms of cyclical stabilisation and long-term fiscal sustainability,
although we lost focus in the pre-crisis years. The conclusion to be drawn from
developments in the 2000s, not only in Denmark but throughout the EU, is that if fiscal policy
is procyclical in a boom, it will have to be procyclical also in the subsequent downturn.
Obviously, this is not expedient.
Denmark has chosen to adopt the Fiscal Compact as a framework for future fiscal policy.
This has been reflected in a Budget Act with a more stringent sanctions regime vis-à-vis local
and regional government - the levels at which it has, historically, been most difficult to
observe budgets and agreements.
Major steps have already been taken to strengthen economic cooperation in the EU with
stronger budgetary discipline and increased macroeconomic surveillance, but all the same it
is essential that there is still political will to ensure that the policies pursued have a strong
medium-term orientation while also dampening, not amplifying cyclical fluctuations. It is
important to observe the spirit as well as the letter of the common rules. This also applies in
the event of a future banking union.
***
The financial crisis was succeeded by a sovereign debt crisis in the EU. This has revealed
close negative interaction between the economy and bank finances in a number of member
states.
To prevent the credit lending from collapsing, governments have had to use public funds to
support the banking sector. At the same time, the sovereign debt crisis has made these
governments more dependent on the banks, which buy up a large share of the domestic
government bonds.
Fiscal developments have raised concerns about these member states' ability to continue to
support the banking sector. This has had a negative impact on the banks' access to funding
and reinforced the tendency for banks to reduce their lending. Since lower lending volumes
may further curb economic activity, the economic challenges become even greater.
In the short term, the banking union represents an attempt to break the negative interaction
between governments and banks. The vision behind the banking union is to prevent crises
like the one seen in recent years and to mitigate the impact if a crisis should, nevertheless,
arise. The aim is to shield developments in the financial sector from developments in public
finances in individual member states - and vice versa - and increase financial stability. In the
longer term, a banking union is to help support financial integration in the EU, and hence the
single financial market.
Vulnerable euro area member states are facing major challenges in relation to both public
finances and the financial sector. A banking union does not necessarily address these
challenges. The reforms required in these member states will undoubtedly be costly and
have real economic implications. It is imperative to find a solution to existing challenges in
vulnerable states and banks so as to bring them back on the right track without undue delay.
Danmarks Nationalbank supports the overall vision for a banking union. A banking union
makes good sense in an integrated financial market, where financial institutions are free to
operate across national borders.
The single market for financial services has contributed to strengthening competition and the
supply of credit, to the benefit of both the Danish financial sector and its customers.
Integration within the European financial sector increased until 2007, but has since the onset
of the financial crisis been decreasing. Like the other EU member states, Denmark has an
interest in a well-functioning single financial market. I see merit in the current discussions on
the establishment of a banking union as a mechanism for supporting financial integration in
the EU.
Developing the individual elements of a banking union will be a huge task. If the vision is to
be realised, the banking union must comprise at least three elements: (1) a single
supervisory mechanism, (2) a single resolution mechanism for failing banks, and (3) a single
deposit guarantee scheme.
Initially, focus has been on establishing a single supervisory mechanism under the auspices
of the European Central Bank in order to solve some of the problems currently faced by
some European banks. The single supervisory mechanism is primarily aimed at euro area
banks, but non-euro area member states may opt in. The framework conditions will differ,
depending on whether the member state in question has adopted the euro. At present it
looks as if non- euro area member states will be able to participate in the single supervisory
mechanism on an equal footing with euro area member states. This is positive.
The set-up with a single supervisory mechanism can enhance the credibility of financial
supervision in the EU, especially in the euro area, and will contribute to financial stability,
which will also be an advantage for the Danish economy - whether or not we decide to join.
The Commission is expected to table proposals for the remaining elements of the banking
union later this year. The content is as yet unknown, and it is difficult to predict the final
set-up.
The distribution of costs is a politically sensitive issue, not least in terms of whether legacy
assets are to be included in the equation.
The establishment of a strong single deposit guarantee scheme, and not least a credible
single resolution mechanism with bail-in for failing banks, is essential if the EU is to succeed
in containing the negative contagion from banks to governments in a future banking union. In
Denmark we already have a credible resolution mechanism, and we have retained our AAA
rating throughout the crisis. Both have served us well. All the same, it cannot be ruled out
that Denmark's independent resolution approach has increased the banks' funding costs in
the short term, so it is important to establish a single European framework for resolution of
banks.
The Danish banking sector is characterised by substantial cross-border activities among the
largest banks. The consolidated assets of Danish banks amount to almost four times
Denmark's GDP. In addition, the ratio of the largest Danish bank's consolidated assets to
GDP is among the highest in the EU. Due to the size of the banking sector and the high
degree of concentration, a single European insurance scheme, as provided for by a banking
union, will, other things being equal, be attractive from a Danish point of view. After all,
insurance schemes work best when many equal policyholders share the burden.
***
Overall, I believe that it would be an advantage for Denmark to participate in the banking
union once the remaining two legs - the deposit guarantee scheme and the resolution
mechanism - are in place. Therefore it is important to remain firmly seated at the negotiation
table and contribute to ensuring a robust and effective set-up which Denmark may join if we
choose to do so.
If a credible framework is established for a banking union, and tax payers will not have to foot
the bill when banks fail in the future, this will have a stabilising effect, not only within the euro
area but also in other member states. As I see it, that is in itself a strong argument in favour
of Danish participation in a banking union.
Thank you for your attention.