Yves Mersch: Law, money and market - the legal dimension of monetary
policy
Speech by Mr Yves Mersch, Member of the Executive Board of the European Central Bank,
at the Information Club Meeting, Luxembourg, 31 May 2014.
* * *
Ladies and gentlemen,
Thank you very much for inviting me to speak at this event.
What I would like to address in my remarks is what went wrong with the governance of the
euro area and how to fix it. But as this has been much discussed in the past, I want to come
at the question today from a slightly different perspective: that is, to go back to the first
principles of what makes a market economy function, and then to look at the situation in the
euro area from there.
1. Law, money and the market
A well-functioning free market is a socio-economic construct. It is created by a consistent
accord of rules, instruments and institutions.
As economies develop, what this accord entails changes. But at the most fundamental level
there must be a harmony of law, money and freedom. This is because the rule of law
guarantees the freedom of the individual by defining the scope and boundaries of his or her
action. And in turn, it is the freedom of the individual that creates the agency and choice
which is essential to produce a free market to the benefit of the whole society.
The way money fits into this framework was well illustrated by Nicolas Oresme, who was
bishop of Lisieux and adviser to Charles V, the king of France. In 1360 Oresme initiated a
sweeping monetary reform after a period in which the currency was debased many times. A
comment that is attributed to him at this time is that "Money must be as solid as a law, as
stable as a law of nature".1
In essence, what Oresme was saying was that solid law and stable money are two sides of
the same coin (if you will forgive the expression). They both support the ends of the
individual. The law exists to create an environment in which individuals can make free and
safe decisions. Money is the same. And both are pre-conditions for a market economy to
function.
Even one of our most famous Luxembourgeois, John the Blind, implicitly appreciated these
interactions. By experimenting with various currency reforms he sought to ensure that each
coin in his realm would have the same value in trade and commerce, regardless of its
geographic origin or disparities in physical appearance. At the time of course the debate was
about the law of God taking precedence over the law of kings. But fittingly, his motto was "Ich
dien" - German for "I serve". And indeed, this notion of money as "public service" was
exported and lived on: the same phrase appeared on British two pence coins until 2008.
Thus, there is a long intellectual tradition linking rule of law and sound money to functioning
of free markets. But this connection found perhaps its clearest expression in the ordoliberal
school that developed in Germany in the 1930s. Conceived at the University of Freiburg by
Walter Eucken and Franz Boehm, the central understanding of ordoliberalism was that a
stable and well-functioning market economy required a strong legal and institutional
framework. Pure laissez-faire capitalism was unstable and liable to capture by monopolies.
Collectivist central planning, on the other hand, led towards waste and totalitarianism.
Thus, as the ordoliberals saw it, the role of government was to frame markets in such a way
that actual outcomes would approximate the theoretical outcome in a perfectly competitive
market. Achieving such outcomes could imply de-regulation, if government was interfering
too much in market processes, or re-regulation, if market failures were apparent - a feature
that distinguished it from a laissez-faire approach. In other words, the role of government
was both to untie the "invisible hand", and to keep it firmly cuffed to the rule of law.
At the same time, ordoliberalism recognised the crucial importance of monetary and
economic stability to a well-functioning market. This implied an economic framework built
around price stability, competition regulation and budgetary discipline - in Eucken's words,
the perfect "economic constitution".2 This thinking had a strong influence on the design of the
post-war social market economy in Germany, and is seen by some as the foundation for
German economic success in that period.
Interestingly, as many developing countries transitioned from planned to market economies
in the 1980s and 1990s, there was something of a large-scale social experiment of the
ordoliberals' views outside of Germany. Several transition economies followed the
macroeconomic policy recommendations of the so-called Washington Consensus, which
emphasised the laissez-faire side of liberalism - decentralization, deregulation and
privatization - while downplaying the legal and institutional underpinnings of a
wellfunctioning market economy.
The "poster boy" for this approach was Chile in the 1980s under the influence Augusto
Pinochet and German immigrants connected to his regime, together with the so-called
"Chicago Boys."3 While quite striking results were achieved initially, leading Milton Friedman
to refer to "the miracle of Chile", financial speculation and foreign debt quickly built up behind
the scenes. Moreover, privatisation allowed formerly public monopolies to become private
monopolies - precisely what market-oriented reforms were supposed to avoid. The
speculation bubble then burst in 1982, after which economic policy changed track.
A similar pattern was observable in other transition economies. Russia, for example,
privatised and liberalised extensively following the collapse of the U.S.S.R. Without a solid
legal and institutional framework to organise market interactions, however, the country
experienced a series of crises, while resources ended up being concentrated in the hands of
a few powerful individuals.
These experiences led the assumptions of the Washington Consensus to be progressively
revised. Even the IMF acknowledged the flaws in the original list of suggestions, in particular
regarding the importance of institutions.4 Reviewing the available evidence, the economist
Dani Rodrik wrote that the strength of institutions is the most important element of
development economics. The mantra of the so-called "revised" Washington Consensus, he
wrote, should be to "get the institutions right."5
2. The principles of effective economic policy
The aim of this brief review is to underscore that all well-functioning market economies are
based on a consistent accord of rules, instruments and institutions. And what I would like to
turn to now is the state of that accord in the euro area.
The designers of the euro area clearly intended to build a consistent rules-based framework.6
The euro area fitted within a single market centred on a strong competition authority that
could break-up monopolies and remove competitive distortions. The ECB was established
with a mandate to focus solely on price stability. National fiscal policies were expected to be
stability-oriented and conducted within a strict framework, known as the Stability and Growth
Pact (SGP). This would be supplemented, it was believed, by the disciplinary force of
financial markets.
This begs the question: why did the euro area then have a major crisis? The answer, in
short, is that the designers got it wrong. The accord of rules, instruments and institutions in
the euro area was in fact inconsistent.
There were two dimensions to this:
• The first was inconsistency within policy areas, which produced a fragmented and
unstable governance framework.
• The second was inconsistency between policy areas, which caused negative
interactions between them to appear.
Let me address each in turn.
Inconsistency within policy areas
In a highly integrated currency area like the euro area, there are several types of economic
policies that are "of common concern". This may be because they have consequences on
euro area aggregates - for example, excess domestic demand in one large country pushing
up overall euro area inflation - or because they create spillovers for other Member States.
These policies therefore warrant some form of coordination at the euro area level, notably via
common rules. The implementation of these rules, however, can broadly speaking take two
forms.
One form is where rules are agreed centrally but applied decentrally by national authorities.
For this to work, however, there has to be very little room for discretion in how those rules
are applied. Otherwise, political and economic preferences at the national level or industry
lobbies can lead to substantial divergence between member countries. This in turn risks
externalities for others in the currency area.
Another form is where rules are agreed centrally and applied centrally by a European
institution. In this case there can be discretionary decision-making, as the European
institution, provided it has sufficient independence, is not influenced by preferences at the
national level. Moreover, through appropriate accountability arrangements it will be de facto
forced to take a euro area-wide view and apply that discretion evenly.
When EMU was launched, only really monetary policy conformed to one of these forms.
Monetary policy decision-making was fully centralised in a European institution, the ECB,
which had substantial discretion in how it implemented its tasks. This was made possible by
the ECB's clear mandate referenced in terms of the euro area as a whole, for which it was
accountable ex post. This internal consistency explains why monetary policy is the only part
of the EMU framework that has clearly functioned as designed.
Fiscal policies were supposed to conform to the other form of governance, where countries
would decide on and execute their own budgets, but within the strict constraints of the deficit
and debt limits set in the Treaty. Those limits were supposed to be policed by markets, the
Commission and other Member States, but in practice the incentives of the latter to enforce
the rules were weak. This meant that de facto rules could be applied with discretion, while
Member States themselves decided on how to exercise that discretion - in other words, the
worst combination of the two forms.
The result was that fiscal positions diverged significantly, which then created substantial
spillovers for other euro area members. But perhaps more fundamentally, internal
inconsistency meant that fiscal policy itself became ineffective in several jurisdictions. A
number of governments either did not have the fiscal space to absorb the shock they faced in
the early stage of the crisis, or they were unable to maintain the trust of the market when
investors finally reacted - and over-reacted. Fiscal policy therefore had to effectively give up
its stabilisation function - which is vital with a single monetary policy - and switch to
convincing investors of debt sustainability.
Prudential policies were also supposed to fit the decentralised model, although here the
framework was even looser. While a general set of rules for European banks was
progressively established in successive capital requirements directives, substantial flexibility
remained in how those rules was interpreted at the national level. The Lamfalussy process
was launched in an effort to iron out these differences, but the process rested entirely on
cooperation between national supervisors, with no possibilities for binding mediation or
enforcement at the European level - and it was fiercely resisted by countries with financial
centres.
The divergence this permitted in the application of regulatory and supervisory standards
allowed serious financial imbalances to build-up in some jurisdictions, which then of course
created serious blowback for the euro area. But similar to fiscal policies, an inconsistent
framework also undermined the value of prudential policy itself. As, for example, definitions
of forbearance and non-performing exposures differed widely across countries, investors
simply did not trust in banks' stated asset values and provisions. In other words, the
confidence effects that prudential policy is supposed to provide disappeared when they were
most needed.
For structural policies there were no binding European rules at all, as they were seen as
having a primarily national significance.
Inconsistency between policy areas
These governance arrangements were not only internally inconsistent, however; they were
inconsistent with each other. Governance of the euro area can be imagined like a set of
interlocking cogs wheels: they do not all need to be of similar size - that is, we do not
necessarily need the same degree of centralisation in each area - but they need to all move
in the same direction. If one cog moves in the other direction, the whole machine grinds to a
halt.
There were several inconsistencies between policy areas in the euro area that had such a
countervailing effect.
To begin with, the frameworks for economic and financial policies pulled in different
directions. Increasing financial integration encouraged capital to flow from core to periphery,
but this was not accompanied by increasing integration of product and services markets to
ensure that this capital was allocated efficiently. In fact, as competitive pressures remained
weak, in particular in the non-tradable/services sector, certain industries were able to
maintain excessive rents and distort price signals. This meant that the low marginal product
of capital in these industries was offset by rising profit margins, leading capital to become
misallocated.
The fiscal and financial frameworks also interacted negatively with one another. In particular,
policy-makers underestimated the extent to which financial integration depended on the false
perception of relatively homogenous sovereign credit risk. As euro area banks were heavily
exposed to own governments' debt, when perceptions of sovereign creditworthiness
diverged, so did confidence in their respective banking systems. The resulting market
fragmentation further increased sovereign risk, entrenched domestic banks as the marginal
buyer of their sovereigns' debt, and thus deepened this bank-sovereign nexus.
Finally, the interaction between bank and sovereign risk jarred with the single monetary
policy. A fragmented banking system not only impaired monetary policy transmission. But
more fundamentally, it called into question the singleness of money. Money, it has to be
remembered, is a liability of the banking system. Banknotes represent only a fraction of the
money we use daily; the bulk of money is deposits. Thus, for there to be a truly single
money, there has to be full fungibility of deposits across borders. If confidence in national
banking systems diverges, such that a deposit in one jurisdiction is seen to worth less than a
deposit in another, then money within the euro area is no longer unquestionably single.
3. Bringing consistency back
To sum up, the problems the euro area has faced derive from the fact that it did not learn its
own lesson. The stability of European countries in the second half of the 20th century was
based on providing their national economies with the right accord of rules, institutions and
instruments to produce desirable market outcomes. Yet when it came to the euro area
economy, these tried and tested principles were somehow overlooked. Several policy areas
were governed inconsistently, with little reflection given to how the different cogs wheels
would fit together.
The main aim of the euro area today is therefore to bring consistency back: that is, to make
governance of different policy areas mutually consistent and internally consistent. Let me
briefly review how this is being addressed in the banking, fiscal and economic domains.
Banking union
Since 2012, the priority has been to restore consistency between the single monetary policy
and other policies - that is, to guarantee the singleness of money irrespective of the fiscal
health of sovereigns. Essentially, this had to involve removing the fault lines between
national banking systems that called into question the fungibility of deposits, and that meant
bringing those national systems together into a single system. This is where the banking
union comes in.
Banking union means three things: it means a single supervisory framework that minimises
equally the risk that a euro area bank takes excessive risk and runs into failure. It means a
single resolution framework, so that if a bank does still fail, it can be resolved in the same
way, with limited use of taxpayer money, irrespective of where the bank is located or the
fiscal strength of its government. And it means a system of deposit protection that provides
depositors with equal confidence that their deposits are safe, regardless of jurisdiction.
In terms of implementing these three elements, the euro area has made considerable
progress. And importantly, the governance reforms that have been agreed are much more
internally consistent. They come close to the two ideal forms that I mentioned earlier: in
some areas there will be centralisation and discretion; in others decentralisation and no
discretion.
From November this year banking supervision will be centralised in the Single Supervisory
Mechanism (SSM). Bank resolution will also be centralised in the Single Resolution
Mechanism (SRM). The latter is particularly important as the legal framework it will
implement - the Bank Recovery and Resolution Directive (BRRD) - contains quite some
discretionary exemptions, in particular from the new bail-in provisions.
For deposit guarantee, there is no centralisation yet. But under the recently adopted directive
national schemes will have to meet the same minimum standards for levels and funding,
meaning that there is also little discretion. Implementation, therefore, will be key.
Fiscal union
Banking Union will certainly help reduce the impact of sovereign risk on the banking system.
But still, there is little that can be done if sovereigns pursue manifestly unsound fiscal
policies. Domestic banks remain heavily exposed to their sovereigns. And any regulatory
initiatives to address this issue - e.g. large exposure limits or doing away with the risk-free
treatment of sovereign debt - can only be introduced very gradually in order to avoid market
turmoil, and most likely only in the context of other governance reforms. Thus, to be
consistent, a single banking system and a single currency require a fiscal framework that
guarantees budgetary solidity.
The euro area has done a lot since the start of the crisis to strengthen fiscal rules. In
particular, Member States have sought to move away from the unstable middle ground of the
first SGP by anchoring fiscal rules more firmly in national law. The Fiscal Compact - which
requires countries to run balanced budgets over the cycle and reduce their debt levels
progressively towards 60% of GDP - has to be written into national constitutions or
equivalent, and is overseen by national fiscal councils. This comes closer to the model of
having decentralised implementation of rules, but with very little discretion.
But will this be enough? I see two possible outcomes.
The first is a stable equilibrium between centralised banking governance and decentralised
fiscal governance. That is, banking union better insulates national budgets from financial
shocks, meaning budget deficits are generally milder. And in this context, the Fiscal Compact
provides sufficient medium-term credibility to allow fiscal policy to operate counter-cyclically
without threatening market access.
The second possibility is some form of deeper fiscal union at the euro area level.
Economic union
Clearly, the political economy of deeper fiscal integration is difficult, especially given the
preferences expressed at the recent European Parliament elections in some reform-resistant
countries. Thus, we should focus our efforts for now on making the new equilibrium work. But
here again we need consistency. If the current fiscal rules are to be credible, we need higher
growth, and that means looking deeply at how we coordinate structural policies across
Europe.
On our current reform-resistant course, I see a distant but distinct probability that growth in
the euro area begins a secular downward drift. With inflexible markets, downswings are likely
to deeper, as adjustment has to happen slowly through quantities - i.e. unemployment -
rather than quickly prices. And with low productivity and investment, upswings might be
shallower as growth is driven only by cyclical rather than structural factors. Indeed, most
estimates find that potential growth in the euro area has diminished during the crisis.
This is why moving ahead with structural reform is essential. The best way to raise real
growth in the euro area is to open up product and services markets and to reallocate
resources to the most productive industries. When I see that most countries in the euro area
periphery have a revealed comparative advantage in services,7 and yet these markets are
the least integrated in Europe, it strikes me as a missed opportunity.
Implementing structural reforms is of course mainly a national responsibility. But so far we
have not done enough at the European level to help gather momentum behind them. Some
might argue that the European elections will make this harder still, but I would tend to
disagree. First, the reasons for extremism in some countries have more to do with national
governments than with Europe. Second, what is causing some people to turn against the EU,
in my view, is not a dislike of European governance per se; it is a lack of delivery on jobs and
growth. If European policy-makers can find better ways to get the most out the European
project, I strongly doubt the voters as a whole would be against that.
4. Conclusion
Let me conclude.
What I have tried to underline today is that a well-functioning market depends on getting the
rules, institutions and instruments that govern it right. And the source of the euro area's
difficulties, in my view, is that policy-makers failed to do so.
For this reason, it would be wrong to conclude that Europe, or the euro, has failed. It was
policy that failed. But importantly, policy can also be fixed. What we need now, therefore, is
to finish what we started in 1999 and make the euro area work.
We have done much to stabilise the euro area with Banking Union and other reforms; but
now we need to find ways to make the euro area sustainably grow. Voters in Europe have
overall given policy-makers a mandate to do this; we have a pro-European majority in
Parliament. If we do not seize this mandate, however, they may not provide another one.