Yves Mersch: On European unity - economic and institutional
challenges facing Europe
Speech by Mr Yves Mersch, Member of the Executive Board of the European Central Bank,
discussant Prof. Hannah Scobie, Chairman, European Economics & Financial Centre,
European Economics & Financial Centre, London, 25 June 2015.
* * *
Ladies and gentlemen,
David Laidler, the English economist and one of the foremost scholars of monetarism, once
stated that "transparency is an asset that depreciates very rapidly, so communication has to
be ongoing, and if it is to enhance accountability, it must be a two-way process as well".
As a central banker, I fully concur with this assessment. To explain our monetary policy
measures - and to defend them when challenged - has become the state of the art in
contemporary central banking communication.
The exchange with academia, financial market participants and the general public is the litmus
test for how we succeed in managing expectations. This holds in particular for times of
heightened uncertainty and complexity.
That is why I consider seminars like this one an important part of my professional duty - it
provides an opportunity to explain the actions of the European Central Bank (ECB), to answer
your questions and also to ask some questions of you, in order to benefit from your wealth of
experience.
The euro area in particular has faced many questions since its inception and - as one of the
foremost euro area institutions - the ECB has increasingly been drawn into debates that go
beyond a very narrow definition of monetary policy. As a result, a criticism that is sometimes
levelled at us is that we spend too much time talking about policies which are outside our
mandate - namely structural reforms and euro area governance - and too little time focusing
on actually delivering that mandate, i.e. returning inflation from its current low levels back
towards below, but close to 2%.
You will not be surprised that I do not share this view. But the fact that it persists in some
quarters suggests that there is a need to explain our position more clearly. Namely, to underline
why the ECB has acted in the way it has in response to low inflation, and why we have insisted
on others acting in their domains of responsibility as well, both at national level and European
levels.
This is what I would like to do in my remarks today. There are three points in particular that I
would like to address.
Implementing large-scale asset purchases
The first point relates to our monetary policy and our decision to enter into our APP in January.
While in some quarters this was seen as excessive activism, in others - often on this side of
the Channel - it was seen as excessively hesitant. The argument was that as a price
stabilityoriented central bank with a symmetric mandate, we should have followed other major central
banks and deployed asset purchases sooner to push inflation back to our objective.
If one looks at the steps we have taken based on the data available in each period, it becomes
clear that we acted based on an evolving medium-term outlook and taking into account the
balance of risks at each moment - as any responsible policymaker should. The process in
2014 that led to the launch of our APP illustrates well this point.
At the start of 2014 we were confronted, on the one hand, with a consistent and broad-based
downward trend in past inflation, falling from 3% at the end of 2011 to less than 1% at the
beginning of 2014. But on the other, sentiment on the economic outlook was relatively positive
for the year, with nearly all forecasters expecting the recovery to strengthen as the year
progressed. In this context, we felt relatively comfortable that the medium-term inflation outlook
was secure. While we were very alert to the risks to that outlook, there was no clear justification
for a strong expansion of the monetary policy stance at that time.
Moreover, the use of large-scale asset purchases was unprecedented in the euro area and
came with concerns that do not exist in other advanced economies. There was more
uncertainty about the strength of the relative transmission channels given the euro area's
financial structures; and there was more concern about the possible side-effects and
redistributive effects of holding large amounts of government bonds in a monetary union that
is not a fiscal union. All this created a further reason to be patient. In my view, deploying asset
purchases had to be an ultima ratio decision. We had to see clear evidence of heightened
deflationary risks either in the realised inflation data or in the movements of inflation
expectations.
That evidence started to appear in the summer of 2014 as the macroeconomic situation
worsened unexpectedly and the underlying impetus that we saw earlier in the year faded. This
removed an important driver behind the reflation scenario we had expected. The sharp fall-off
in oil prices that began in the late summer added then further disinflationary pressures, feeding
also into core inflation. The result was that, by January 2015, the euro area was experiencing
negative headline inflation rates. Crucially, there were also material signs that inflation
expectations were becoming unanchored, which increased the likelihood that inflation would
stay below our objective even when the oil price effect faded.
These data, especially measures of inflation expectations, were sufficiently decisive to warrant
our shift to large-scale asset purchases in January this year. The prevailing macroeconomic
outlook meant that the benefits of deploying that instrument in terms of delivering our mandate
now clearly outweighed the costs in terms of potential side effects. But by waiting for adequate
evidence, had we ended up "behind the curve" in counteracting the disinflationary trend? In
my view the answer is clearly no.
First, we had taken a series of expansionary measures throughout 2014 in response to the
incoming data, including cutting our main refinancing rate to its effective lower bound;
introducing a negative rate on our deposit facility; launching our targeted long-term refinancing
operations (TLTROs); and, importantly, in September 2014, with our decision to begin
purchases of ABS and covered bonds.
Second, by communicating clearly the conditions under which we would use large-scale asset
purchases - our so-called reaction function - we had already initiated a gradual easing of
financial conditions as markets anticipated our measures. Long-term nominal interest rates fell
by around 100 bps from mid-2014 to January 2015. Because we were predictable and credible,
our policy was taking effect before it was actually announced in January.
Third, even though our measures were partly priced-in, when they were launched the initial
impact was stronger than many expected and the response of macroeconomic indicators was
quicker. We have seen strong signalling effects, reflected in rising inflation expectations, a
rebound in consumer and business confidence and higher equity prices. And we have also
seen evidence of significant portfolio rebalancing effects, both across assets classes (i.e.
towards more risky assets) and across jurisdictions, producing a fall in the effective exchange
rate.
As a result, the economic recovery has broadened and the June ECB staff projections now
envisage inflation to average at 0.3% in 2015, 1.5% in 2016 and 1.8% in 2017. Our actions
have proven timely and provide us, so far, with comfort that the medium-term inflation outlook
is secure. Both output and inflation forecasts are broadly balanced.
These forecasts are however contingent upon a full implementation of our programme. We
intend to carry out our public sector purchases until end-September 2016 and, in any case,
until we see a sustained adjustment in the path of inflation. Only once we see convincing
evidence that inflation has returned sustainably to levels in line with our objective will we be
able to declare success.
Monetary policy and structural reforms
But this begs the question: if our measures are working well, why do we put so much focus on
other policies? This is the second point that I would like to address - why structural reforms
are relevant for monetary policy and why it is legitimate that, as a central bank, we take a view
on them. In a nutshell, in the euro area, the more divergent economies become in terms of
their structural conditions, the harder it ultimately becomes to achieve price stability at the euro
area level.
First, structural reforms have a direct link to inflation, inflation expectations and real interest
rates through their effect on the adjustment process.
When a country is hit by a shock, output will be less affected if relative prices can adjust quickly,
and the recovery in output will be faster if the economy is able to reallocate resources in a
more efficient way. This depends critically on structural features of the economy - for example,
how labour markets adjust (i.e. the relative contributions of wage and employment adjustment),
whether product markets are competitive and allow the entry and growth of new firms, and how
quickly labour and capital can redeploy to more productive uses. This is related to issues such
as the strength of insolvency regimes and effectiveness of active labour market policies.
How adjustment takes place in turn has implications for euro area price stability. A fast price
adjustment will cause inflation to fall steeply initially, but then agents will expect it to rise again.
This ensures a firm anchoring of medium-term inflation expectations and does not affect
perceptions of real interest rates going forward. A slow employment adjustment, by contrast,
will create more prolonged downward pressure on inflation, which is more likely to weigh on
inflation expectations. This in turn can lead to higher expected real interest rates and
exacerbates the effect of the shock, thus complicating the achievement of price stability at the
euro area level.
Second, structural factors can compound adjustment difficulties by affecting the transmission
and effectiveness of monetary policy across different countries.
That is because if economies recover very slowly from shocks, it is more likely to produce
financial fragmentation and impair the transmission of monetary policy to those areas. For
example, a prolonged downturn with higher unemployment will tend to create higher
loanlosses for banks, which impairs the bank lending channel of transmission as banks are forced
to rebuild their capital. Such an economic slump is also likely to worsen the fiscal position for
the government, which can further exacerbate fragmentation via the bank-sovereign nexus.
Moreover, even if transmission works smoothly on the supply side, structural reforms also
affect the demand side: the willingness of entrepreneurs to take on credit for new investment.
Insofar as structural factors create an unattractive investment environment, they can impede
credit demand and thereby hamper the effectiveness of monetary policy. By the same token,
structural reforms and accommodative monetary policy can be complementary in boosting
investment.
That would include, at the micro level, opening up protected sectors where there is pent-up
investment demand or reducing administrative burdens on entrepreneurship; and at the macro
level, lifting expectations of future growth and hence "animal spirits", especially where firms
are constrained by a debt overhang. This psychological dimension of reforms is particularly
important for the euro area given that 5 years ahead growth expectations among forecasters
have been falling continuously since 2001, from around 2.7% then to 1.4% today.
Third, if due to structural factors shocks leave deep scars on some economies, it can affect
the long-term cohesion of the Union.
Divergence in structural unemployment is more likely to become entrenched across the Union,
which of course cannot be offset, like in other federations, by fiscal transfers between the
constituent members. And to the extent that this weakens the political rationale for monetary
union - that all members are better off over time inside the Union than they would be outside
- it also weakens its long-term cohesion. This undermines the integrity of the currency union.
The ECB's interest in structural reforms therefore has two dimensions: achieving an efficient
implementation of monetary policy in the short-term, and maintaining the integrity of the
currency over the longer-term. Both of these feed into euro area price stability. However, our
interest is not in how countries implement reforms. This is a national question and there are
different models that can work in a monetary union. Our interest is in whether they succeed in
doing so, as it is this that has implications for the whole euro area. It is in this context that we
at the ECB have recently called for stronger common governance in this area.
This call reflects the fact that some of the original expectations on how monetary union would
function have, I think, now clearly been shown as over-optimistic. In particular, when the
Maastricht Treaty was signed, it was evident to most policymakers that monetary union would
ultimately need to be accompanied by integration in other policy areas too. But it was widely
expected that, following the functionalist logic, sharing a single currency would automatically
trigger that integration. We know this did not happen. And while the role of common institutions,
rules and procedures has increased, the institutional equilibrium in the euro area is still fragile.
Institutional responses to our economic challenges
So my third point is that we need to reflect seriously on the key features of a well-functioning
monetary union, and how we can progress towards establishing them. A lot of progress has
already been made in strengthening our rules and institutional architecture. We have
reinforced our fiscal rules and improved the coordination of our economic policies. And we
have made a huge institutional leap with Banking Union, establishing the Single Supervisory
Mechanism (SSM) within the ECB and a Single Resolution Mechanism (SRM). But we know
that the architecture of EMU is not yet complete, and the 5 Presidents' Report published this
Monday describes how to take this process to the next level.
Though like Rome a complete EMU cannot be built in a day, I believe we have to be ambitious
both in the short and longer term. We have to show that we are building a bridge towards a
more stable and prosperous union. This is what the report does. It fleshes out a number of
quick-wins that can be implemented in a first stage without Treaty change. The Commission
will come forward with concrete proposals on these still this year. And it sets the priorities for
more fundamental changes to how monetary union operates in the future. The ECB fully
supports this process and will continue to actively contribute to it. Let me highlight what we see
as two crucial aspects of the report.
First, the report makes a strong case for completing Banking Union. It calls for finding a swift
agreement on bridge financing and a permanent backstop for the Single Resolution
Mechanism (SRF), with the ESM identified as the natural institution to act as a backstop for
the SRF, while remaining fiscally neutral. These measures would help further sever the
banksovereign nexus, which would in turn complement the functioning of monetary union - by
reinforcing the singleness of money within the euro area, and by supporting the even monetary
policy transmission across jurisdictions.
Second, the report advocates a long-term sovereignty shift in both economic and fiscal policies
- a 'move from rules to institutions'. Most importantly, the report calls for a new economic
convergence process to make the euro area more resilient against shocks, which would in turn
make further sharing of sovereignty in the fiscal domain possible. It also proposes eventually
establishing a euro-area treasury to take decisions jointly on certain elements of national
budgets. This is certainly not for tomorrow, but this is the direction our Economic and Monetary
Union ultimately needs to move in. In order to maintain the momentum, this process needs to
start now.
It is now up to the European leaders to reflect on these proposals and carry them forward. As
a matter of fact, they are discussing the report at the European Council in their meeting tonight
and tomorrow. I trust that the wider context will not be lost in those discussions.
Conclusion
Let me conclude.
Our forceful monetary policy measures were first, necessary, second, timely, and, third,
effective. The economic recovery is now proceeding at a moderate pace. And we see
encouraging signs that it is broadening.
Monetary policy accommodation is a necessary condition for the recovery to keep on track.
This implies that we will deliver what we announced. But it is not a sufficient condition. Member
states have to do their part. Structural reforms are needed to strengthen the supply side and
help economies regain a competitive edge in a globalized economy. And only with such an
increased growth potential will the cyclical recovery become a sustained, structural recovery.
Neither monetary policy nor economic policy takes place in an institutional vacuum. The
institutional refurbishment of the European house has so far achieved a lot. But the ambition
to do so was often driven by the urgency of crisis. And now that the worst may lie behind us,
we have to keep the momentum of further integration. The 5 Presidents' report is a useful
roadmap for the way ahead.
A strong commitment to completing Banking Union will ease financing conditions for
enterprises sustainably, and increase the resilience of Europe's financial landscape with a view
also to hemming in contagion. Likewise, a long-term sovereignty shift in both economic and
fiscal policies will stimulate convergence towards similarly resilient economic structures, based
on common standards. Not everything can be achieved today, but all countries agreeing on
the same way forward is a key element for higher confidence and a lasting end to this crisis.