Axel A Weber: The euro - opportunities and challenges
Speech by Professor Axel A Weber, President of the Deutsche Bundesbank, at the Ragnar
Nurkse-Lecture, Tallinn, 7 February 2011.
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1. Introduction
Ladies and gentlemen
First, I would like to thank you for giving me the opportunity to speak here today. It is a
pleasure and a privilege to visit Estonia, which not only provides one of the European
Capitals of Culture in 2011 but is also the newest member of the euro area. I am also
honoured to deliver this lecture dedicated to Ragnar Nurkse. Apart from being an outstanding
economist of international renown, he was undoubtedly a true citizen of Europe. Not only is
he said to have spoken seven European languages, including Estonian, Swedish, German,
English and French, he also lived and worked in a number of European countries before
eventually emigrating to the United States.
With that in mind, the obvious topic for today's lecture is Europe and its single currency.
There is little doubt that Estonia has joined the euro area in turbulent times. Not only is
Estonia, as a new member of the club, facing a number of challenges; the euro area itself
has undergone considerable stress over the past months and requires an overhaul of its
foundations. Nevertheless, before reflecting on the existing challenges, we should briefly
take stock of the benefits that arise from our single European currency.
2. The benefits of a single currency and their preconditions
Currencies have always been an important symbol of national identity - the Estonian people
know this all too well. Consequently, the euro has been a key element of European political
integration. Moreover, a single currency also offers plain economic benefits. The most
obvious of these is the absence of exchange rate movements and, hence, of exchange rate
risk. This facilitates international trade and investment, which is especially important for small
open economies. Looking beyond exchange rate movements, the existence of a single
medium of payment also enhances transparency regarding price differentials across
countries. The result is increased competition, a more efficient allocation of resources and,
eventually, stronger economic growth. At the same time, a single currency also facilitates the
integration of financial markets, again promoting an efficient allocation of resources.
However, it has been clear from the beginning that a single currency will not function on its
own. With the introduction of the euro, a gap opened up between monetary policy, which is
conducted for the euro area as a whole, and other areas of economic policy, which lie in the
hands of what are now 17 national governments. Thus, to be efficient in maintaining price
stability, the single monetary policy requires that member states be able cope with
asymmetric shocks to which a common monetary policy cannot respond. This has been
acknowledged right from the outset, and a number of criteria were introduced that countries
had to meet prior to entering the euro area. These convergence criteria comprise low
inflation, adequately moderate interest rates, stable exchange rates and sound fiscal policies.
As the newest member of the euro area, Estonia was no exception to this requirement and
succeeded in fulfilling all the necessary conditions - a remarkable achievement in the face of
a global financial crisis and the severe contraction in output that Estonia experienced in
2009. Public deficits and debt levels were, in fact, outstandingly low, particularly in the light of
developments in most other EU member countries.
In the 1990s, the need to meet the convergence criteria also served as a catalyst for
economic policy reform in what were later to become the member states. However, as the
years following the launch of monetary union have taught us, becoming fit to join a monetary
union is not a one-off task that ends after becoming a member of the club. Rather, fulfilling
the economic requirements that go along with monetary union also has to continue guiding
economic policy afterwards in order to guarantee the functioning of the monetary union.
Unfortunately, this has not always been the case in the first decade of EMU, a fact that has
been ruthlessly revealed by the financial crisis. The deficiencies include misguided policies in
a number of member states, as well as structural shortcomings in the institutional framework
of monetary union.
3. The euro and the financial crisis - discovering deficiencies
The visible outcome of such misguided policies and institutional deficiencies were large
government deficits in some member states as well as persistent current account
divergencies between member states. While some countries, such as Germany or the
Netherlands, had been recording persistent current account surpluses, other countries such
as Greece, Ireland, Spain or Portugal, had been posting persistent deficits. In principle, this
should not have been a cause for concern. It makes economic sense that capital flows from
developed countries to countries that are still catching-up and thus offer ample investment
opportunities.
The problem with this development was that the deficit countries had not always used the
inflowing capital in an efficient way. Instead of financing investments to increase productivity
and to raise potential output, government and private consumption were propped up while, in
some instances, capital imports helped to fuel bubbles on domestic real estate markets. The
surge in demand, combined with inflexible labour and product markets, reduced the price
competitiveness of the countries in question. As a result, current account deficits became
entrenched or widened even more. Although these macroeconomic imbalances are domestic
in origin, the associated problems are not confined to the national level. Given spillover
effects in the closely integrated euro-area financial markets, macroeconomic imbalances in
some member states can easily turn into a problem for the rest of the monetary union,
especially if they are accompanied by a poor state of public finances.
Sustainable public finances are indeed essential for the functioning of a monetary union, both
to be able to react to asymmetric shocks and to safeguard the independence of monetary
policy. The main challenge in the pursuit of sound fiscal policy is that national governments
have an incentive to enjoy the benefits of public debt, while its burden is borne by all
members of the monetary union. A public deficit in one country boosts demand there but, at
the same time, puts pressure on the interest rates in the whole monetary union, reducing
economic growth in all member states. In extreme cases, such a free-rider policy not only
puts pressure on the interest rates but might also affect the credibility and stability of the
monetary union as a whole - as has been demonstrated by the debt crisis.
To ensure that sustainable public finances are regarded not just as an entry requirement for
monetary union but also as an ongoing task, a strong institutional framework is needed; a set
of rules that aligns the interests of national fiscal policymakers with the rest of the monetary
union and bridges the gap between national fiscal policies and a union-wide monetary policy.
This led to the creation of the Stability and Growth Pact (SGP). In essence, the SGP requires
governments to keep their budget deficits within clearly defined limits. However, since its very
inception, the SGP has been subject to political tactics which have greatly reduced its
effectiveness. This problem reached its peak in 2005 when Germany and France insisted on
a reform of the SGP that, all in all, softened the provisions of the Pact.
As a result, many governments did not seize the opportunity to consolidate their budgets
during the ensuing economic upswing. Thus, when the financial crisis hit, a number of
countries already had weak public finances. The subsequent expenditures to support the
financial system and the economy did not improve the situation. And when, in the spring of
2010, sovereign risk came to the fore, it turned into a major downside risk for recovery in
Europe. Within a short period of time, fiscal problems in Greece and other member states
turned into an imminent danger to the stability of the financial system and the monetary union
as a whole. Thus, European institutions decided to implement far-reaching fiscal measures to
support the countries in question. These measures were justifiable given the risks associated
with inaction. Nevertheless, they still placed a serious strain on the foundations of the
monetary union. Consequently, we now have to strengthen these foundations again and
create an institutional framework that supports a stable monetary union.
4. The challenge of creating an adequate institutional framework
As I have just pointed out, the crisis revealed two basic problems within the European
Monetary Union: macroeconomic imbalances and excessive public deficits. Both problems
have their roots within the individual member states. Consequently, it is first and foremost the
responsibility of national governments to act by consolidating their budgets swiftly and
ambitiously and by implementing comprehensive structural reforms.
Nevertheless, reforms also have to be undertaken at the level of the monetary union. As a
first step, the institutional framework has to be enhanced to prevent the occurrence of
harmful macroeconomic imbalances or excessive public deficits. This requires a twofold
approach: first, strengthening the SGP to guarantee sustainable public finances, and,
second, implementing macroeconomic surveillance to detect structural developments within
member states that might be harmful for the rest of the monetary union. Furthermore, as it
will never be possible to prevent crises entirely, a third element should be a mechanism to
solve potential crises in an orderly fashion - but without thwarting the stability-enhancing
incentives set by the SGP and the surveillance mechanism. Let us now take a quick look at
how far we have come in turning this approach into reality.
Given its track record before the crisis, it can no longer be denied that there is an urgent
need to strengthen the SGP: more emphasis should be given to the debt criterion, while
earlier and more consistent sanctions have to be placed on any breach of the rules. The
reform measures that have been agreed so far do indeed entail a number of improvements.
However, the measures lack the ambition to fully redress past failings and to bring about a
fundamental improvement. The major shortcoming of the envisaged reform is that relevant
decisions on sanctions are still to be taken at a political level by the European Council. This
leaves too much room for discretion in interpreting and applying the rules of the SGP.
With regard to macroeconomic imbalances, I have mentioned the need to enhance
macroeconomic surveillance in the euro area. Nevertheless, to make one thing clear from the
outset: the objective of such an endeavour should not be to coordinate or fine-tune
macroeconomic policies - member states have to remain responsible for their national
economic policies. Rather, the objective should be to detect and address macroeconomic
developments that might have serious negative spillovers on other member states or the
euro area as a whole. Against this backdrop, the actual proposals that have been put forward
are a step in the right direction. However, detecting such possibly harmful macroeconomic
developments ex ante is notoriously difficult and some details still have to be discussed.
Thus, even though enhanced macroeconomic surveillance is indispensable, its actual
implementation might prove difficult and could easily lend itself to discussions that distract
from the real challenges - past demands on Germany to implement a more expansionary
wage policy and to set more fiscal stimuli being a case in point.
Having an eye on macroeconomic developments and placing limits on budget deficits and
public debt by means of an enhanced SGP will certainly help to make the euro area more
stable. Nevertheless, the occurrence of crises can never be ruled out. For that reason, it is
necessary to have a crisis-resolution mechanism in place. As the current European Financial
Stabilisation Facility (ESFS) and the European Financial Stabilisation Mechanism (EFSM)
will expire in 2013, the European Council has decided on the main features of a European
Stability Mechanism (ESM), which will then replace the EFSF and the EFSM. The "no bail
out" clause has been affirmed as an essential element of the ESM: no member state is
responsible for the debt of other member states. This certainly helps to maintain incentives
for sound fiscal policy. Incentives are further strengthened by provisions that allow for a
restructuring of private sector debt in case of insolvency. Faced with the prospect of losing
money, financial markets should penalise unsound fiscal policies at an early stage and thus
prevent the build-up of excessive deficits. In the further negotiations, it will be important that
these basic features of the ESM are maintained.
5. Conclusion
Ladies and gentlemen
The euro is probably the single most important European project from an economic as well
as a political perspective. And history has shown that the promised benefits were not mere
theoretical concepts but have indeed materialised over the past 12 years. Altogether, the
euro has definitely been a success - and the financial crisis has not proven otherwise. On
the contrary: throughout the crisis, the euro had a stabilising effect and the Eurosystem
demonstrated its ability to conduct an effective crisis management. Nevertheless, it cannot
be denied that the crisis revealed a number of structural deficiencies which require further
reflection.
In my speech, I have outlined the reforms that are necessary to strengthen the institutional
foundation of the euro area. Nevertheless, it is ultimately in the responsibility of the member
states to act in a way that guarantees the stability of the monetary union. Here, it is
indispensable that all member states acknowledge the economic preconditions that were
identified as essential for the functioning of the monetary union and that are embodied in the
convergence criteria applied to prospective members. Estonia has set an example that it is
possible to muster the will to fulfil these criteria even in the midst of a global financial crisis. It
is all the more the case that it should be possible to live up to the requirements of the
monetary union after having joined - and that applies not only to Estonia, but to all its
members.
Thank you for your attention.