Jens Weidmann: Exercising responsibility - how monetary union
can be made future-proof
Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank and Chairman of the
Board of Directors of the Bank for International Settlements, at the Austrian Society for European
Politics, Vienna, 6 July 2017.
* * *
1. Welcome
Ewald
Mr Liebscher
Ladies and gentlemen
Thank you for inviting me to Vienna. It gives me great pleasure to talk about Europe with you this
evening.
It's always a delight to pay a visit to Vienna - not just because it's such a remarkably beautiful
city, but also because of the exceptionally good cooperation between the Bundesbank and
Austria's central bank, the Österreichische Nationalbank. It's a relationship that goes back
decades and whose importance we recently underlined by convening a joint board meeting.
Though I've visited Vienna so many times, I've never once managed to visit one of the city's true
landmarks, the giant Ferris wheel in the Prater public park. This attraction, incidentally, is
celebrating its 120th birthday this year.
Yet as an economist, I'd do well to take a ride on Vienna's famous Ferris wheel - after all,
economists are keen to take a bird's eye view of developments - at least that's what I've been
told. That can be a good way of broadening one's horizons and seeing things in the right
perspective. But an aerial vantage point doesn't always make argumentation any easier because
it sometimes means that key details go unnoticed. And one notable such detail, I have found, is
the institutional framework, which I will be returning to later in my speech.
I came here today to share my thoughts on the euro area and on ways in which monetary union
can be made future-proof.
My speech this evening will begin by casting a glance at the economic outlook and the monetary
policy stance, before moving on the responsibility incumbent upon governments to foster
sustained economic growth. And I will conclude by discussing a number of proposals for
changes to the euro area's institutional architecture - changes which I feel are necessary if the
euro area is to be preserved once and for all as a union of stability.
2. The economy
Ladies and gentlemen, the euro-area economy has been expanding for 16 consecutive quarters
now, and anyone looking at the purchasing managers' index of late will even have come across
headings like "Firms barely coping with demand". The upswing, then, is turning out to be
increasingly robust, and it has now spread to pretty much every single euro-area country.
Growth also picked up distinctly in France and Italy recently, so the divergence observed in the
GDP growth rates of the euro area's three largest countries over the past three years has come
to a halt, at least. It's perfectly normal, of course, for economies in the euro area to differ to a
degree, but stubbornly heterogeneous economic paths certainly make life difficult, not least for
monetary policymakers. Monetary policy does, after all, need to be geared to the euro-area
average, and if growth rates are scattered too broadly, we end up tailoring a monetary policy
garment that doesn't really fit any member state.
Consistent with the prospect of a continuing recovery, the ECB staff nudged their June growth
projection a little higher, to 1.9% this year and 1.8% in 2018. And the ECB Governing Council
agrees unanimously that the risks to the economic outlook throughout the forecast horizon are
now largely balanced.
The inflation rate, too, has risen sharply over the past twelve months. Saying that, the rate of
inflation has mainly gained traction because energy prices have climbed substantially on the
year. But with oil prices leaning somewhat to the downside of late, the energy component is
unlikely to add any further inflationary pressure. That is why inflation rates look set to return to a
slightly lower level at year-end.
This is partly because domestic price pressures are still relatively subdued. One measure we
use to gauge domestic price pressures is the inflation rate with energy and food price increases
stripped out. This core rate of inflation, as it is known, is currently just over 1%.
Yet another point on which the Governing Council agrees unanimously is that domestic price
pressures in the euro area will likewise pick up over time - not least as labour market conditions
continue to improve. Unemployment has dropped substantially since the crisis was raging and,
at 9.3%, it's now just one percentage point, more or less, above the pre-crisis average. And as
for employment, more people in the euro area are in work today than before the crisis.
But for all this predominantly good news from the labour markets and the increasing utilisation of
production capacity, wage growth is stubbornly refusing to pick up pace. To some extent, this is
down to the labour market reforms adopted in the past and the rising level of labour force
participation which have been dampening wage growth. Plus there is evidence to suggest that
wage- and price-setting behaviour during the crisis evolved towards a state where the inflation
rate is currently less responsive to shrinking slack than it was in the pre-crisis era. But that most
certainly does not mean that the Phillips curve, as it is known, has flattened out for good - this is
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a point which Mario Draghi also highlighted recently. And incidentally, I share his view that as the
economy continues to pick up and stimulate greater demand, there will also be greater scope for
passing through prices and thus for mounting price pressures as well.
But for now, an accommodative monetary policy stance is the right calibration for bolstering
economic recovery and thus for strengthening inflationary pressures in the euro area - that's
another point we agree upon in the Governing Council. There are, however, different opinions as
to how strongly we need to step on the monetary policy pedal and what instruments we should
use.
It won't come as a shock to you that I'm more sceptical than many of my Governing Council
colleagues, especially when it comes to government bond purchases. In essence, I am
concerned that purchases of government bonds might blur that all-important boundary in a
currency union - the one dividing monetary policy and fiscal policy. Eurosystem central banks
have now become the euro-area countries' biggest creditors. At the end of the day, this can lead
to political pressure being exerted on the Eurosystem to maintain the very accommodative
monetary policy for longer than appropriate from a price stability standpoint. After all, in the
context of asset purchases, changes in monetary policy impact more directly on governments'
funding costs than they do under normal conditions. And that's naturally also problematical in
view of the disciplining effect of the capital markets on government finances because at the end
of the day, sovereigns pay pretty much the same rate of interest on our holdings of assets,
regardless of their credit quality.
Hence my view that government bond purchases are an instrument of last resort - one which
should mainly be used to fend off deflation. But I've said in the past that the fears of deflation are
overblown. They've now become even less of an issue, and the Eurosystem's price projections
reflect as much, of course.
At any rate, the credibility of monetary policy hinges on monetary policy accommodation coming
to an end once the time is right from a price stability perspective.
The ongoing economic recovery is now opening up the prospect of a normalisation of monetary
policy. It's not a question of slamming on the brakes - to stay with the imagery I used earlier on -
but of taking our foot off the accelerator a little. Both the timing and the pace of monetary policy
normalisation depend on the extent to which price pressures are sustainable and self-sustaining.
I'm well aware that savers feel pinched by the accommodative monetary policy and the low
interest rates. But monetary policy isn't the only variable that has a bearing on interest rate levels
- real long-term interest rates over the economic cycle also depend to a large extent on trend
growth. A persistently higher rate of economic growth in the euro area not only helps to ease the
pressure on monetary policy because it drives up equilibrium interest rates and thus widens the
gap to the zero lower bound on interest rates. It would also represent an opportunity for more
people to benefit from rising prosperity and for Europe to once again deliver on its promise of
welfare.
Yet the longer-term outlook for growth in the euro area is looking cloudy, not least because of the
looming burden of demographic change in the euro-area countries, of which Germany looks set
to bear the brunt. That is why adding momentum to the forces of growth must be at the heart of
the euro-area countries' endeavours.
Monetary policy cannot bring about that kind of stronger economic growth - it's an objective that
only smart fiscal and economic policy, such as structural reforms, can achieve. Yet the
willingness to embrace reform has dwindled quite substantially overall since the sovereign debt
crisis came to a head - and the International Monetary Fund is not alone in highlighting this
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issue.
Needless to say, the euro-area countries are each starting out from different positions, with their
own particular economic structures, so it would be wrong to pursue a "one size fits all" approach.
That said, I am convinced that measures that strengthen public finances and help produce
competitive economic systems would also stimulate growth and also enable the benefits to be
more widely shared. For one thing, competition among businesses encourages them to
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innovate, boosting economic growth. For another, studies show that there is a level of
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government debt above which economic growth is stifled.
There's no lack of reform proposals. Recommendations are in abundant supply, not just from the
European Commission, but from other national and international organisations as well.
Germany, too, is facing major challenges. It needs to ready its social security systems to
withstand the challenges posed by demographic trends, push labour force participation higher
still, and step up investment in education so that those in work are more productive and less at
risk of losing their jobs, plus it will have to expand its digital infrastructure.
But aside from these major challenges, IT-related productivity gains can also be harnessed on a
smaller scale, such as in the country's public administration, which is another area which has
some catching up to do in the deployment of digital information and communication technology.
For instance, to apply for a German ID card, you still have to turn up in person at your local
municipal administration office.
Regrettably, very little progress has been made on this score, as a recent European
Commission report on the digital economy and society in the EU member states confirms.
Germany ranks a meagre 20th for its public services, while Austria occupies a far-superior sixth
place.
The European level still has a great deal of unharnessed growth potential of its own, however.
The EU Single Market has been a success story, but the tale isn't over yet. One huge step
forward would be the completion of the single market for services, because unlike the single
market for goods, trade in services is still subject to national barriers.
The forces of growth would also be given a shot in the arm if the Single Market switched
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wholesale to digital goods. Europe's markets for digital goods remain heavily fragmented,
especially where the protection of privacy, copyright, and liability issues are concerned.
Yet businesses would reap rewards not just from a complete single market but also from
broader funding opportunities. This is where the capital markets union comes into play.
European businesses still mainly use bank loans as their chief source of funding. Harmonising
regulation or, for example, boosting investor protection in the venture capital market might make
it easier for businesses to source equity capital on a larger scale. Not only would that broaden
enterprises' funding options; it would also make them more resilient to economic shocks. That's
because equity capital absorbs losses, while debt capital still needs to be serviced in full, even
when times are hard, if a company is to fend off insolvency.
What is more, research for the United States reveals that private risk sharing via integrated
capital markets is far more conducive to cushioning shocks that public risk sharing, which is the
main talking point in Europe. The integrated capital markets in the United States absorb
something like 40% of the overall cyclical fluctuations between the US federal states - fiscal
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policy just between 10% and 20%. If a negative shock hits an industry or a specific region, then
losses are spread widely beyond the region affected if a business's shareholder base is spread
across many different states. And that works in the other direction, too, of course - during
upturns, investors benefit from the investment opportunities in other states.
So there are plenty of ways in which economic growth at the European level can be stimulated
by embracing the right reforms. I do, however, see the risk that the exit negotiations which have
now kicked off between the EU and the UK will absorb so much political attention among
European decision-makers that little scope will remain for other major projects. Which makes it
all the more important for the member states to embrace reform with renewed vigour. On this
score, the announcements made by the new French president are a positive sign.
3. Taking the institutional architecture of monetary union to the next level
Ladies and gentlemen, the economic recovery may be robust, but that shouldn't blind us to the
continued vulnerability of European monetary union.
One fundamental stumbling block existed from day one because of the euro area's asymmetric
design. Member states surrendered their sovereignty in monetary policy matters to the ECB, but
retained ownership of their fiscal and economic policies.
This construction makes the monetary union potentially vulnerable because the crisis showed
that at the end of the day, the euro area as a whole had no option but to cushion unsound
developments in individual member states if it was to prevent the stability of the entire union from
being jeopardised.
In any case, there is less of an incentive to run a sound fiscal policy in a currency union because
the consequences of member states accumulating excessive levels of debt can be passed on in
part to the community.
In a currency union, the interest rate hike for a highly indebted country is smaller than it would be
if it had its own independent currency. By the same token, however, rates also edge a little higher
for all the other member states as well - not to mention the stability-jeopardising situation that
would arise if that country even ended up brushing with insolvency.
This phenomenon is known as the "common pool problem" in economic theory, and overfishing
is often used to explain it. A single fisherman who catches too many fish leaves fewer behind for
others in his profession and ultimately jeopardises the long-term sustainability of fish stocks.
Overfishing, then, is dangerous for the fishing community. But an individual fisherman is out to
net as many fish as possible, ignoring the interests of other fishermen or future generations of
fishermen.
This is arguably one reason why historian and winner of the 2017 Charlemagne Prize Timothy
Gordon Ash described the story of monetary union so far as a "crisis foretold".
Yet that remark isn't really entirely fair to the founding fathers of monetary union, who most
certainly did have their eye on the particular incentive to run up debt. Their idea was that a
combination of market discipline and fiscal policy would keep fiscal policymaking on a sound
basis.
That, of course, is why a no-bailout clause was built into the Maastricht Treaty contains to
prohibit member states from assuming each other's debts. And it also bans monetary financing
of government debt by the Eurosystem. Together, the thinking goes, these safeguards would
ensure that investors themselves - and not other parties such as the taxpayer - would bear the
risks of investing in government bonds.
The Treaty also contains rules which curb government debt and fiscal deficits, not only to ensure
that public finances remain on a sustainable path, but also to pave the way for the automatic
stabilisers to function when the economy experiences a downturn or even, if need be, to provide
sufficient leeway for active fiscal policymaking without raising any doubts over the sustainability
of debt. These rules bolster the principle of individual national ownership of fiscal policy upon
which the Maastricht Treaty is founded.
Walter Eucken, founder of the Freiburg school and a pioneer of the social market economy,
condensed this liability principle, as it is known, into a simple formula: "Whoever reaps the
benefits must also bear the liability." And what goes for the economy goes for countries as well:
decisions will only ever be taken responsibly if those who decide also bear responsibility for the
consequences of their actions.
Thus, the Maastricht Treaty largely assigned the power to act and liability in matters of economic
and fiscal policy to the member states.
Yet the safeguards I have just mentioned were unable to prevent government debt from
ballooning in a number of euro-area countries. This was partly due to repeated breaches of the
fiscal rules - incidentally by Germany too, shortly after the launch of monetary union - which the
capital markets failed to punish by demanding higher risk premiums because the no-bailout
clause lacked credibility. But another reason for the ballooning debt levels was undoubtedly the
financial crisis, which saw a number of euro-area countries being forced to shore up their
banking systems.
This was compounded in the subsequent sovereign debt crisis by emerging doubts over debt
sustainability in some member states. Rescue measures were swiftly rolled out to prevent the
crisis from coming to a head.
These measures, however, did not make monetary union crisis-proof once and for all. Quite the
opposite, in fact. By adding further elements of mutual liability, they softened the principle of
independent responsibility.
Since economic and fiscal policy matters continue to be issues of national ownership, the
relationship between actions and liability has got out of kilter.
The euro area will only ever be crisis-proof once and for all if renewed importance is attached to
the liability principle. There are two ways in which this can be achieved. Either through deeper
integration, ie a situation where every member state surrenders decision-making powers in fiscal
and economic policy matters to the European level, or by returning to an overhauled Maastricht
Treaty, which would mean more national ownership and each member state being liable for the
decisions it takes.
The first solution is the road to a fiscal union with centralised decision-making powers. While a
fiscal union would not guarantee sound fiscal policymaking, it could curb the propensity to run a
deficit I mentioned earlier this evening.
Former German Federal Chancellor Helmut Kohl, who sadly passed away recently, was already
a firm believer that monetary union was merely one step on the path leading to political union.
Addressing the Bundestag in November 1991, he remarked that "the idea of sustaining economic
and monetary union over time without political union is a fallacy".
Genuine political union proved unfeasible back in the early 1990s, however, and it appears to me
that little has changed in this regard since then. Not least because the necessary transfer of
sovereign rights would require comprehensive changes to be made to the EU Treaty and national
constitutions.
It would appear, then, as though option number two stands a more realistic chance of restoring
the balance between actions and liability. That would mean reinforcing the principle of individual
national responsibility.
Only when sound finances are assured in this way and countries are no longer drifting apart
economically will there finally be an ebbing of the pressure on the Eurosystem to intervene
constantly as a firefighter. And only then will the financial markets do their job of taking adequate
account of risks in their lending activity.
But what would have to change for the monetary union's regulatory framework to function better
than it has done in the past?
As long ago the 17th century, Blaise Pascal, the French mathematician, physicist, inventor,
writer and theologian, noted that all good intentions already exist in the world, they only have to be
applied.
In my opinion, the same thing could also be said about the fiscal rules in the euro area. They
have been around for a long time; now they also have to be applied consistently.
The latest reform of the Stability and Growth Pact had the aim of strengthening the binding force
of the rules on debt. In actual fact, it created considerable discretionary scope, mainly for the
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European Commission. We also point this out in our current Monthly Report. And the
Commission has already exploited this scope on several occasions and invariably interpreted the
rules very generously in doing so.
The Commission's dual role as guardian of the EU treaties, on the one hand, and, on the other,
as a political institution concerned with striking a balance between the various policy interests of
the member states, has undoubtedly played a part in comprises having been reached time and
again at the expense of budgetary discipline. Some euro-area countries have been breaching the
rules for nine years now.
Werner Schneyder, the Austrian comedian, once characterised the situation accurately as
Europe consisting of countries that didn't want to be told to do what they had decided to do
themselves.
What is needed to strengthen the fiscal rules is a simple and transparent design and
implementation of the rules. An independent institution taking over responsibility for fiscal
surveillance from the Commission would be a key step towards a less political approach. At
least, that would clearly show where unbiased analysis ends and political concessions begin. For
that reason, the Bundesbank suggests strengthening the role of the European Stability
Mechanism (ESM) in fiscal surveillance, for example.
One thing does seem obvious to me, however. If member states retain their fiscal autonomy, the
sustainability of public finances cannot be safeguarded by rules alone.
It is therefore essential that the binding force of the rules is additionally shored up by the
disciplining effect of the market. In other words, interest rate levels have to be aligned more
strongly again with the risks in government budgets.
The only way to achieve that, however, is if the no bail-out clause in the Maastricht Treaty gains
more credibility again. Investors have to perceive a more credible threat of losing their money if
they buy bonds from governments that have unsound public finances. One proposal put forward
by the Bundesbank thus envisages changing the contractual terms for sovereign bonds in the
euro area by introducing an automatic maturity extension for them as soon as the issuing
government applies for an ESM programme.
Up to now it has been the case that a large part of the assistance loans are being used to pay off
the original creditors. This means that the original creditors, such as banks, are then let off the
hook - at the expense of taxpayers.
Extending maturities, on the other hand, would leave them on the hook, and they could be still
held liable in the event of a later debt restructuring. In an emergency, it can be very difficult to tell
for certain whether a debtor is temporarily illiquid or actually insolvent. An automatic extension of
maturities, however, would allow the ESM significantly more time to give careful consideration to
the question of debt sustainability - and without releasing the original creditors from liability during
this period.
A maturity extension would have the added advantage of substantially reducing the need for
financial aid under an ESM programme. It would also broaden the range and scope of the
existing rescue mechanism. Had an automatic maturity extension had been available to us in
2011, for example, Portugal would have needed only about €43 billion to cover its entire budget
deficit until 2014 rather than the €76 billion in total it received in assistance loans.
However, restructuring sovereign debt would be a realistic option only if the financial system
could also cope with a haircut. That's because not much would be gained by bringing the
financial system to its knees. There would also be an incentive for the community of states to
step in for private creditors.
For that reason, the close link between banks and sovereigns that exists in the euro area has to
be severed. Experience of the crisis years has shown that - especially in times of crisis - banks
have a big appetite for sovereign bonds, preferably bonds issued by their own government.
Banks' appetite for government bonds would indeed be curbed if they had to back sovereign
issues on the books with capital in future like they have to do with private loans. Unlike in the
case of corporate bonds, euro-area financial institutions are not required to hold capital against
government bonds in order to cover potential defaults. And there are also no upper limits on how
many government bonds the banks are allowed to buy. The regulations still treat sovereign bonds
as risk-free, even though the euro-area debt crisis clearly revealed that this assumption is not
accurate.
Banks will be able to cope with the restructuring of sovereign debt only when banks hold
sufficient capital against government bonds and a limit is placed on the size of individual
exposures. And only then is there also likely to exist the political will to take such action.
4. Sovereign bond-backed securities
One advantage of abolishing the preferential treatment of government bonds would be giving
banks incentives to further diversify their sovereign bond portfolio and, thus, their credit risk. That
would represent a major contribution to severing the sovereign-bank nexus that served to fan the
flames of the crisis.
Many fear that abolishing the preferential treatment of sovereign bonds might result in a lack of
safe assets. For that reason, Markus Brunnermeier and his colleagues have proposed the
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creation of what are known as "sovereign bond-backed securities".
The aim of the proposal is to increase the range of AAA-rated bonds in the euro area. To this
end, two tranches of a new type of securities are to be issued. Both tranches are to be
collateralised with sovereign bonds of all the euro-area countries.
Losses from the sovereign bonds would initially occur in the junior tranche. As a result, the senior
tranche is intended to be especially safe. And that is why this tranche is designated in the
proposal as "European Safe Bonds", or ESBies for short.
In principle - and depending on how it is designed - this model could indeed help make it easier
to diversity portfolios. It is highly uncertain, however, whether this would have the hoped-for
impact on the available range of safe forms of investment.
The rating agency Standard and Poors, for example, points out that the risk of defaults on
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sovereign bonds is highly correlated. If a country is struggling to service its bonds, it is probably
not the only one.
That is why the risks of euro-area sovereign bonds cannot be be so easily diversified. At least
Standard and Poors does not anticipate that ESBies would gain the secure AAA rating. Under
such circumstances, the supply of secure assets in the euro area might become scarcer, not
more abundant
Above and beyond that, the proposal leaves a number of further open questions. Only when such
questions have been answered will be it possible to assess what implications the introduction of
sovereign bond-backed securities would have for the functioning of the national sovereign debt
markets.
Furthermore, it would be necessary to rule out the possibility of such securities leading to greater
mutual liability. Such a development would further undermine individual national responsibility in
the euro area - with all the problems I have already discussed.
It would therefore have to be ensured that sovereign bond-backed securities are issued only by
private financial market players - and certainly not by a European debt agency that potentially
possesses a government guarantee.
One simple fact cannot be avoided either. Risks don't disappear just by packaging them; they
simply become concentrated in junior tranches - we learned that much from the subprime crisis.
That is why the banks have to back all tranches of securitisation in a risk-appropriate manner
with capital in future. There should be no preferential treatment of sovereign bond-backed
securities compared with sovereign or private bonds. That is because preferential regulatory
treatment would encourage a mispricing of sovereign default risks and thus harbour a further risk
to financial stability.
Notwithstanding such unanswered questions, if there were a desire to persist in separating
sovereign bonds into safe and less safe components, the obvious thing to do would be for each
government to package its own bonds into different tranches so that especially safe national
securities would then be created.
5. Concluding remarks
Ladies and gentlemen
You can look at it from any angle, and you can't avoid one fact. Sovereign default risks cannot be
eradicated by packaging sovereign bonds or by splitting up bonds into safe and less safe
tranches. Safe opportunities for investment can only be created by the member states
themselves by ensuring sound public budgets. This is best achieved by consistently
implementing the liability principle.
I spoke about that at the beginning of my speech. Like riding on the big wheel, I've therefore
almost come back to the point from where I started. That means it's time for me to get off. And,
as everyone knows, when someone gets off the big wheel, places become available for new
passengers.
Stefan Zweig once remarked that thoughts thrive just as much on affirmation as on contradiction.
That doesn't just apply to the Governing Council of the ECB but also to the discussion on which
we are now embarking.
Thank you for your attention.
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8
Brunnermeier, M, S Langfield, M Pagano, R Reis, S Van Nieuwerburgh, and D Vayanos (2016), " ESBies: Safety
in the tranches", European Systemic Risk Board Working Paper No. 21
9
S&P Global Ratings (2017), How S&P Global Ratings Would Assess European "Safe" Bonds (ESBies).
RatingsDirect.