Mario Draghi: The euro, monetary policy and the design of a fiscal
compact
Speech by Mr Mario Draghi, President of the European Central Bank, at the Ludwig Erhard
Lecture, Berlin, 15 December 2011.
* * *
Ladies and Gentlemen,
I am honoured to have received the invitation from Professor Hans Tietmeyer to deliver this
year's Ludwig Erhard lecture.
When I was working at the Italian Treasury in the 1990s, Professor Tietmeyer and I had
many opportunities to work together. I vividly remember many of our exchanges over the
course of the two decades since the Maastricht Treaty. And I am very grateful that he
remains in close contact with the European Central Bank (ECB) as adviser to our audit
committee.
Ludwig Erhard's legacy in shaping Germany's post-war recovery stretches far beyond his
own country and far beyond his own times. His conception of the social market economy was
visionary. And he even held cherished views about central bankers, stressing the importance
of price stability: "Die soziale Marktwirtschaft ist ohne eine konsequente Politik der
Preisstabilität nicht denkbar." I think we cannot formulate this idea any better today.
Ludwig Erhard also helped to enshrine the principle of central bank independence. When in
the early 1950s the independence of the German central bank system was not yet settled, he
as minister of the economy argued that the government should not issue instructions to the
central bank. You all know that the statutes of the ECB inherited this important principle and
that central bank independence and the credible pursuit of price stability go hand in hand.
Current circumstances remain demanding, with economic, financial and fiscal issues deeply
intertwined with challenges at the political level in many countries and in the supra-national
European sphere.
Last week two sets of important decisions have been taken, which are going to be the focus
of my remarks today. First, I will elaborate on the motivation for the monetary policy
measures that the ECB announced last Thursday and what we expect from them. Second, I
would also like to share with you some views on last week's European Council summit's
decisions, which brought some very important new elements to our economic and monetary
union.
Monetary policy decisions for the euro area
To explain our recent monetary policy measures, let me recall the particular role of banks in
the euro area economy. The flow of credit to firms and households in the euro area works
largely through banks. During recent years, about three quarters of firms' external financing
have come from that source.
This means that any impairment in the bank lending channel will have stronger
consequences in the euro area than in other economies where firms' external financing
comes largely from corporate bond markets.
Banks in the euro area have recently come under pressure both as regards their capital
bases and their funding conditions.
The plan to strengthen their capital bases is an attempt to reinforce their standing in financial
markets, but this is not an easy process. There are essentially three options for banks to
pursue to raise their capital ratios as demanded by the European Banking Authority: they can
raise their capital levels, sell assets or reduce their provision of credit to the real economy.
The first option is much better than the second, and the second option is much better than
the third. But raising capital levels is expensive in a depressed market and faces resistance
from shareholders. Selling assets is less preferable and curtailing credit to the real economy
is even worse. Therefore, public authorities ought to cushion the impact on the real economy
and banks should consider restraining dividends and ad hoc compensation to strengthen
buffers.
Banks are also facing problems in raising longer-term funding in financial markets. The
resulting shortening of their funding leads in turn to maturity mismatches on balance sheets
of the kind that caused the financial crisis. At the same time, shortages of collateral are
beginning to emerge in some segments of the financial system especially for the small and
medium sized banks.
In addition to identifying these particular strains in the banking sector, our regular economic
and monetary analysis has indicated that the intensified financial market tensions continue to
dampen economic activity in the euro area and the outlook remains subject to high
uncertainty and substantial downside risks. In such an environment, cost, wage and price
pressures in the euro area should remain modest over the policy-relevant horizon. At the
same time, the underlying pace of monetary expansion remains subdued.
In these conditions, and faithful to our mandate to maintain price stability over the medium
term, the ECB's Governing Council has taken a number of far-reaching decisions.
The Council decided to reduce its key interest rates by another 25 basis points to 1%. In
normal financial market conditions, a policy rate reduction is a potent instrument of inflation
control and demand support. The rate cut works its way through a long chain of downward
adjustments in financial returns. At the end of the process, the yield on large spectrum of
securities declines and promotes broad-based policy accommodation.
In the present conditions, this process turns out to be hampered, so that the impact of a rate
cut by itself is weakened. Banks limit their lending to other banks and potentially to the
broader economy, and they hold on to precautionary balances of cash as self-insurance.
Therefore, the Governing Council last week decided on three other measures, each of which
provides additional support in order to bring the necessary monetary policy impulse to the
real economy.
The current package should be felt tangibly in the financial sector and the real economy over
the coming weeks and months. Of course, it comes against strong headwinds generated by
deleveraging.
We established very long-term refinancing operations with a maturity of three years. This
duration is a novelty in ECB monetary policy operations.
The extension of central bank credit provision to very long maturities is meant to give banks
a longer horizon in their liquidity planning. It helps them to avoid rebalancing the maturities of
their assets and liabilities through a downscaling of longer-term lending. Incidentally, we want
to make it absolutely clear that in the present conditions where systemic risk is seriously
hampering the functioning of the economy, we see no stigma attached to the use of central
banking credit provisions: our facilities are there to be used.
Banks will be able to refinance term lending with the Eurosystem and thus preserve their
long-term exposures to the real economy. After the first year, banks will have the option to
terminate the operation. So they can flexibly adapt to changing liquidity conditions and a
normalising market environment.
Our second measure will allow banks to use loans as collateral with the Eurosystem, thereby
unfreezing a large portion of bank assets. It should also provide banks with an incentive to
abstain from curtailing credit to the economy and to avoid fire-sales of other assets on their
balance sheets.
The goal of these measures is to ensure that households and firms - and especially small
and medium-sized enterprises - will receive credit as effectively as possible under the
current circumstances. Of course, we have to screen the collateral carefully so as to protect
our balance sheet.
The third measure we announced last week is to reduce the required reserves ratio from 2%
to 1%. This measure frees up liquidity of the banking sector by about 100 billion euro. Along
with other measures, this reduction in the reserve requirements should, too, help revive
money market activity and lending.
You will notice that I referred repeatedly to small and medium-sized enterprises. The reason
for drawing your attention to these businesses is that they are a significant part of our
economy, accounting for about 70% of employment in the euro area and 60% of the turnover
of all firms. We believe that the measures introduced last Thursday will provide support for
this sector and indirectly also support much-needed investment, growth and employment.
Foundations for a stable economic and monetary union
Let me now shift my attention to last week's European Council summit. For more than 12
years, Europe's economic and monetary union has been haunted by concerns about national
budgets. Within a common currency area during normal times, the fiscal policies of individual
countries typically face less pressure from financial markets. It was for this reason that at the
very beginning of Europe's single currency, the Stability and Growth Pact was established to
provide a control mechanism for fiscal policy.
Next year, the euro area as a whole will have a government primary budget deficit close to
zero. This compares with primary deficits projected at around 5% of GDP in Japan, the UK
and the US.
Yet the implementation of the Stability and Growth Pact has not been good enough. As the
Federal Chancellor of Germany recently remarked, the Pact has been broken 60 times over
the past 12 years. So we clearly have work to do to prevent this happening again.
The new set of rules for economic and fiscal surveillance known as the six-pack - which was
approved by the European Parliament earlier this year - will certainly strengthen the
implementation of the rules. But while these changes were being planned, the entire fiscal
cohesion and credibility of the euro area was weakened.
We have now begun the process of re-designing Europe's fiscal framework on three fronts.
The first lies with the countries concerned: they have to put their policies back on a sound
footing. I believe that they are now on the right track and they are right in implementing
budgetary consolidation resolutely. The unavoidable short-term contraction may be mitigated
by the return of confidence. But in the medium term, sustainable growth can be achieved
only by undertaking deep structural reforms that have been procrastinated for too long.
The second pillar of a response to the crisis consists of a re-design of the fiscal governance
in the euro area, what I called the fiscal compact. The fiscal compact is a fundamental
restatement of the rules to which national budgetary policies ought to be subject so as to
gain credibility beyond doubt.
Last week's summit committed to enshrine these rules in the primary legislation. They will
foresee that the annual structural deficit should not exceed 0.5% of nominal GDP. Euro area
Member States will implement such a rule in their national legal frameworks at a
constitutional level, so that it is possible to avoid excessive deficits before they arise, rather
than trying to control them after they have emerged. Prevention is better than cure.
Rules will also foresee an automatic correction mechanism in case of deviation. Moreover,
the leaders agreed on a numerical benchmark for annual debt reduction to bring down debt
levels. They also agreed to sanctions that will apply automatically to euro area Member
States in breach of the 3% reference value for deficits.
The European Court of Justice may be asked to verify the implementation of these rules at
national level.
Taken together, I believe that these decisions are capable of making public finances in the
euro area credibly robust.
But restoring financial markets' confidence also requires that investors be reassured that
government debt will always be repaid and timely serviced. Greece will remain a unique
case, and a credible stabilisation mechanism, a firewall, will be in place and can be activated
when needed subject to proper conditionality. The leaders unambiguously agreed to assess
the adequacy of the firewall by next March. Its objective is to address the threats to financial
stability, and especially the risk of contagion between different sovereign debt markets.
The leaders decided to deploy the leveraging of the European Financial Stability Facility
(EFSF) at the earliest opportunity. At the same time they agreed that the EFSF's successor,
the European Stability Mechanism, should come into force by July 2012.
It is crucial that the EFSF be fully equipped and be made operational as soon as possible.
With this goal in mind, last Thursday, the Governing Council decided that the ECB would
stand ready to act with its technical infrastructure and know-how as an agent for the EFSF in
carrying out its market operations.
Conclusion
Let me conclude. The decisions of the European Council summit, together with the six-pack
approved recently by the European Parliament, are a breakthrough for clear fiscal rules in
our monetary union.
However, the crisis has not ended yet. It is now important not to lose momentum and to
swiftly implement all those decisions that have been taken to put the euro area economy
back on course.
The monetary policy measures taken last week by the ECB's Governing Council will support
the flow of credit to firms and households in the euro area economy.
Ludwig Erhard faced a situation that was much more difficult than what we face today. Still,
he was able to look through the challenging present and to work hard to build a future that he
never doubted would be brighter. The European policy makers might well be inspired by his
style: "Den Strom der Zeit können wir zwar nicht lenken, aber wir werden unser Schiff sicher
steuern."
Thank you very much for your attention.