Andreas Dombret: Europe's sovereign debt crisis - causes and possible
solutions
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, to the Deutsche Alumni, Frankfurt am Main, 20 December 2011.
* * *
Ladies and Gentlemen
Thank you very much for inviting me to speak to the Deutsche Alumni here today. The
second half of 2011 has certainly not been the best of times for the euro area and for
financial stability.
The financial crisis has now entered into a fourth stage. The first stage was the subprime
crisis which struck the US real estate market. At its heart were those financial products which
spread US housing loans across the world. The second stage was the loss of confidence
within the international financial system following the Lehman Brothers bankruptcy and the
subsequent global economic crisis. The third stage has been the ongoing European
sovereign debt crisis which began in Greece in May 2010. It was initially perceived as a
problem of what was known as the "euro-area periphery". Now, in the fourth stage of the
financial crisis, however, this designation no longer holds.
How things now stand
The sovereign debt crisis has now spread to the core of the euro area. This has affected the
funding conditions for governments and banks alike. The European financial system faces a
serious loss of confidence.
Against this background, the risks to the German financial system have risen perceptibly as
well. And yet, since the beginning of 2009, the German financial system has become much
more resilient. Banks have more - and better-quality - capital. Domestic credit risk is at its
lowest level in three years. Funding vulnerabilities have also been reduced. Customer
deposits, regarded as a stable source of funding for banks, have gone up markedly.
However, the high sovereign debt, part of which is on banks' books, now poses a significant
risk to financial stability - one that not even Germany's financial system can avoid. This is
made particularly clear by the latest Financial Stability Review published on 10 November by
the Bundesbank.
The sovereign debt crisis, though, has not only hit the financial system, but is also
increasingly impacting negatively on the real economy. Although the corporate sector has
still been assessing the economic situation in Germany positively, it expects the situation to
deteriorate in the future. Hard indicators are showing a similar picture: exports, for instance,
went down distinctly in October, which will put a damper on economic output. On the whole,
the Bundesbank, in its current forecast for 2012, is expecting Germany's economy to grow
by 0.6%.
However, since the domestic factors for an upswing remain intact, we expect Germany to
turn onto a recovery path before the end of next year. Supported by an expansionary
monetary policy and a growing global economy, growth in 2013 should then return to 1.8%.
This means that, in the next two years, the German economy's capacity utilisation would
therefore be normal. A probable average increase of 2.5% for this year is likely to be followed
by a return to a much lower cost of living in the coming two years, which the Bundesbank
currently expects to be 1.8% in 2012 and 1.5% in 2013.
This forecast, of course, is based on the assumption that the sovereign debt crisis will be
gradually overcome and will not continue to escalate. This crisis is, and will remain, the
single greatest risk to the financial system and the real economy.
For this reason, I would now like to take a closer look at the sovereign debt crisis, focusing
on three questions. First, what actually caused the crisis? Second, how do we contain the
crisis? Third, where do we want to go with monetary union in the long run?
The causes of the sovereign debt crisis
Unsound economic developments had apparently been brewing in several euro-area
countries for many years. These include, in particular, excessive lending, asset price bubbles
and a loss of competitiveness. These structural deficits were the breeding ground for the
sovereign debt crisis.
The actual weak link at the launch of monetary union, however, was the combination of a
single monetary policy and decentralised fiscal policy. Monetary policy is set at the European
level - by the European Central Bank. By contrast, responsibility for fiscal policy rests with
the individual member states, ie at national level. This severance of responsibilities was
already at the centre of the debate when monetary union was being established. In a
currency area with a decentralised fiscal policy, the member states have an increased
incentive to borrow. Any country that goes deeper into debt does not face the consequences
by itself, as these are spread across the entire currency area - for example, through every
country's interest rates increasing.
The founding fathers of monetary union therefore created a framework of rules to prevent, or
at least correct, such unsound developments: the Stability and Growth Pact. This was
intended to keep national fiscal policies in check. One of its tenets was that annual
government budget deficits should not exceed 3% of gross domestic product. A complex
procedure was performed regularly to monitor member states' compliance with this limit. The
penalties for breaching the deficit limit could be escalated all the way to financial sanctions.
There is one more key building block in the edifice of the euro area alongside the Stability
and Growth Pact: the no-bail-out principle, which forbids member states from assuming
liability for the debts of other member states. The guiding principle of monetary union was
therefore individual responsibility: member states' individual responsibility for the
consequences of their policies and financial market agents' individual responsibility for the
consequences of their investment decisions.
Despite these rules, however, member states' borrowing has not been effectively contained.
Why not? Mainly, because the rules of the Stability and Growth Pact were not only
circumvented but even bent. This was possible thanks to a crucial flaw in the system:
countries that violated the deficit limit were not automatically punished. Instead, the other
member states voted on a sanction. And this - to quote the ECB's former chief economist
Otmar Issing, led to a situation in which sinners passed judgement on fellow sinners. This, of
course, encouraged a "you scratch my back and I'll scratch yours". Put differently: "I won't
punish you today if you don't punish me tomorrow."
Looking back, it must also be noted that the financial markets did not have the desired
disciplining effect on fiscal policy. Investors turned a blind eye to the misbehaviour of some
member states for far too long. By the time the interest rates on government bonds started to
rise, the horse - in this case, the Greek minotaur - had already bolted.
And, once the horse has bolted, the no-bail-out principle is gone with it. As I'm sure you will
remember, no member state is allowed to assume liability for another's debts. This principle
was, at the very least, stretched quite far when assistance was granted to Greece. This,
however, was not entirely unjustified: the euro-area countries are now so closely integrated
that problems in one country can spread quickly to envelop the entire euro area, in a
phenomenon known as contagion. When push came to shove, it was deemed necessary to
help other member states. This is quite understandable in the short term. However, in the
long run it is dangerous if countries with a debt problem can expect to receive help no matter
what. This can raise the spectre of a dangerous spiral of more and more assistance and less
and less confidence in the will of the affected countries to amend their ways.
Routes to a stable monetary union
And such a loss of confidence is just what we are facing right now. The public, and also the
markets, have lost faith - in politics, but also in the architecture of monetary union. The
question is: how do we go about restoring confidence?
Let me begin by stating clearly what won't work. Confidence cannot be sustainably restored
by putting more and more money on the table - for instance, by constantly ramping up the
rescue funds. This strategy ultimately has its limits - be they political or financial. And the
proposal of circumventing financial limits by switching on the printing presses is dangerous.
Of course the resources of a central bank are, in theory, nearly limitless. Using them to
finance sovereign debt, however, does not solve problems but instead creates new ones.
Such an approach would endanger the key foundation of a stable currency: the
independence of a central bank that is dedicated to price stability. This would throw
overboard the very things that need saving.
And, as I said earlier: money can't buy you confidence. The only thing that can be bought is
time. With the EFSF and the forthcoming ESM, instruments to do just that have been
created. However, this bought time must also be used to eliminate the root causes of the
crisis. From this we can derive three main things that, in my opinion, need to be achieved.
Firstly, government budgets need to be put back in order. This goes for all euro-area
countries, but is particularly incumbent on those countries which have time and again put off
the necessary adjustments. Efforts are apparently being made at the political level to step up
pressure from other member states and the European Commission.
Secondly, the countries affected by the crisis need to conduct structural reforms in order to
become more competitive and to promote economic growth. Such reforms are, naturally,
difficult and painful. The Irish case shows, however, that they are possible, and the German
case shows that they pay off in the long run.
And, thirdly, we need a stable architecture for monetary union. Instead of constantly patching
up the results of fiscal policy mistakes and insufficient implementation of the Stability and
Growth Pact, monetary union has to be "reinvented" - such that sound fiscal policy is also
truly guaranteed in future. In my view, there are two options open to the euro area: either we
can return to the founding principles of monetary union agreed at Maastricht, or we should
venture the step towards a deeper European integration which also includes fiscal policy.
Returning to the founding principles of monetary union
Regarding the first option - returning to the founding principles of monetary union - I do not
share the frequently voiced fear that the current framework is unsuited to monetary union.
However, it clearly needs adjustment, of course. There are three key points here.
Firstly, the Stability and Growth Pact must be given "teeth". In particular, a stronger
automatism is needed to punish breaches of the deficit and debt limits.
Secondly, the no-bail-out principle needs to be reinforced: no member state should be
permitted to assume liability for the debt of another member state. Financial market investors
will only punish bad fiscal policy behaviour in a timely manner if they expect to lose their
money.
Thirdly, the euro area needs a permanent crisis mechanism. Recourse could be taken to this
mechanism if a crisis erupts and financial stability throughout the euro area is at risk.
However, there are three important aspects to note: assistance to individual countries must
be tied to strict economic and fiscal policy conditionality; it must be only granted with
appropriate interest rate premiums; and, in the event of a default, private-sector investors
have to bear their losses themselves.
In view of these exigencies, some encouraging decisions were taken at the EU summit on
8 and 9 December. They included the introduction of debt brakes which should be firmly
enshrined in national law. At the same time, the Stability and Growth Pact is likely to be
better protected from political influence in the future. If a country violates the pre-defined
deficit limit, it will, unlike in the past, be automatically punished; it will be much more difficult
to avoid sanctions. That, too, is an improvement. And - depending on the design and
implementation - this could represent a major step towards a "Maastricht Plus" model.
However, it is only a small step towards deeper European integration - I will come back to
this point shortly. By no means, however, is this a fiscal union in the narrow sense of the
term. The important thing now, naturally, is not to allow the agreements made to be watered
down - either in the specific arrangements or their subsequent application.
Deepening European integration
Besides strengthening the existing framework of monetary union, there is an alternative route
to stabilising the euro area. This route would involve deepening European integration.
However, it would not necessarily also mean the wholesale transfer of fiscal policy from
national to European level. National parliaments could retain their independence in deciding
on revenue and spending; European involvement would only affect borrowing and
indebtedness. What kind of involvement could this be?
It would be important to set strict deficit and debt limits at the European level for national
budgets. These limits would apply at all national levels; in Germany, this would encompass
central, regional and local government, as well as the social security systems. The European
rules would have to be combined with appropriately strict powers of intervention, as this is
the only way to make them enforceable. One thing ought to be made clear: member states
that do not comply with the predefined deficit and debt limits would lose their fiscal policy
sovereignty. Ultimate budget-setting authority would therefore no longer rest with national
parliaments but at the European level.
The EU summit decisions, however, still do not give Europe the right to take over national
fiscal policy in the event of persistent fiscal policy misbehaviour. If, for instance, Eurobonds
were to be issued in such a framework, there would be a mismatch between liability and
control: all euro-area countries would be jointly liable for the debts of other euro-area
countries but would not be able to keep them in check. In this framework, mutual assistance
must be granted only as a last resort, must be strictly conditional and must involve
considerable interest rate premiums, in order to give countries an incentive to balance their
government budgets.
Financial market reform as a necessary addition
National fiscal policymakers are ultimately also responsible for convincing market
participants to invest in their sovereign bonds. The recent past has served at a painful
reminder that berths at the "safe haven" of sovereign bonds have to be defended time and
again. This is also true of Germany. The auction of ten-year Bunds at the end of November,
failed to attract sufficient bids despite all-time low interest rates, may very well be interpreted
as a shot across the bow, yet its importance should definitely not be overrated.
In addition, rating agencies have issued warnings, with Germany no longer being left out.
The timing of some of these announcements is certainly debatable - and, in my opinion,
often questionable. However, this should not divert our attention from the responsibilities of
fiscal policymakers. Introducing, through regulatory measures, special rules for developing
sovereign bond ratings does not seem a particularly appropriate solution, at any rate.
Instead, we should reduce references to ratings in regulations wherever possible.
I should also mention that significant progress has already been made in the area of financial
market regulation, too. Given the fact that regulatory flaws were among the main causes of
the financial crisis, this was, in my opinion, of paramount importance. The reform of the
capital framework, which will improve the quantity and quality of banks' capital and thus their
capacity to absorb losses, is certainly a particularly welcome development. Increasing the
amount of losses the banks' investors are able, and required, to bear, reduces the danger of
taxpayers once again having to foot the bill. The phenomenon of systemically important
banks, meanwhile, shows that Basel III is by no means the end of the road. The
internationally agreed rules for dealing with the "too-big-to-fail" issue now have to be rapidly
implemented at national level in an internationally consistent manner. The complex oversight
and, if necessary, regulatory treatment of the shadow banking system remain atop the reform
agenda. Although the current zero weighting of government bonds likewise sets the wrong
incentives, it should only be adjusted going forward, predicated on precise studies.
Looking at the financial markets and their regulation, however, I would like to mention one
more thing. The sovereign debt crisis is shining a new light on a commonly held assumption,
namely, that crises are caused by unfettered markets and can be avoided only by giving the
state more space. However, the sovereign debt crisis has shown quite clearly that even
states are fallible.
Of course, the crisis has opened our eyes to the blind faith in the market that has sometimes
prevailed; however, statism and dirigisme are by no means the right path to take. Instead, we
should return to a founding tenet of the social market economy: individual responsibility.
Those who take risks must also face the consequences. Reviving attaching more importance
to this principle this would represent major progress - including with respect to the sovereign
debt crisis.
Conclusion
Ladies and gentlemen, I have touched upon various aspects which I think are essential for
resolving the sovereign debt crisis. At the EU summit in early December, policymakers
decided to adopt a fiscal pact designed to strengthen, and in some cases go beyond, the
Maastricht Stability and Growth Pact. This is a good first step; however, it must not be
watered down once again during its concrete implementation. The Bundesbank will not
cease to call for this concrete implementation.