José Manuel González-Páramo: The European Union and the lessons
from the crisis - the way forward
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the RBC Capital Markets' Central Bank Conference "Impacts and
Implications of Integrated Global Markets", Madrid, 12 May 2011.
* * *
Ladies and gentlemen,
I. Introduction
It is a privilege for me to participate in this conference dedicated to the very important topic of
the "impacts and implications of integrated global markets". As we are all aware, from the
very start of the current crisis, economic and financial distress has been transmitted around
the world through a variety of channels that, together, have formed an unusually rapid and
pervasive cross-border transmission mechanism.
The high degree of integration in today's global financial markets is generally seen as one of
the factors that have contributed to the amplification and spread of the current crisis.
However, the fact that integrated financial markets can contribute to the destabilisation of our
economies is not intuitive. Economists usually believe that more integrated and innovative
financial markets are conducive to sustained economic growth and reinforce economies'
capacity to withstand shocks. The experience of the last four years shows though that, under
certain conditions, financial integration and some types of innovation can increase the scope
for contagion across institutions, markets and borders and contribute to the emergence of
systemic risks.
This is one of the many lessons that we have learnt from the crisis, but certainly not the only
one. There are also important lessons regarding the economic governance of the euro area,
the sustainability of public finances, the regulatory reforms of the financial sector, etc. to be
learned. In my address today, I would like to share with you some reflections on what we
need to do in order to draw such lessons and what, in my view, represents the way forward
for the European Monetary Union.
II. The state we are in
The idea that highly integrated financial markets are always conducive to macroeconomic
and financial stability is not the only economic notion that has been challenged by the crisis.
The current crisis was preceded by the "Great Moderation", a period of reduced
macroeconomic and financial volatility and improved economic performance that began in
the mid-1980s. During this period, the progression of economic history as a succession of
cyclical booms and busts seemed to have come to an end in many advanced economies.
Some economists even referred to specific countries as "Goldilocks" economies, with this
term meaning their supposed ability to grow on a sustained basis at a rate that was neither
too high to generate inflation nor to low to cause unemployment.
The trust in the ability of our financial markets and economies to smoothly overcome any
disturbances came to an end in the summer of 2007, when the financial "turmoil" began.
After the collapse of Lehman Brothers in October 2008, the turmoil mutated into a full-blown
financial "crisis" and many market segments seized up. The "Great Moderation" gave way to
the "Great Recession", characterised by a massive fall in industrial output and trade.
Policy interventions were made by central banks and other public authorities to restore and
secure the orderly functioning of markets and economies. I like to think of the interventions
by public authorities as "lines of defence" against the crisis. They proved successful in
guaranteeing those authorities' ability to continue delivering macroeconomic and financial
stability against the crisis.
Let me recall briefly the three main lines of defence: central banks increased their provision
of liquidity and financial intermediation services; monetary and fiscal authorities adjusted
their policies in order to mitigate the macroeconomic impact of the crisis; and governments
implemented a variety of measures in support of the financial sector.
The government measures adopted in response to the economic crisis - both those related
to fiscal policy and those in support of the banking sector - did not come cheap. This is true
not only in the euro area, but - more generally - in all advanced economies. Together with
the impact on government budgets of the massive economic contraction recorded during the
crisis, they led to a significant deterioration in the public finances of a number of economies
in the euro area.
The deterioration was particularly significant in countries in which: (1) pre-crisis growth had
been of an unsustainable and unbalanced nature - typically as a result of an over-reliance on
the expansion of private credit and the contributions of housing-related sectors (notably
construction and housing finance) - and (2) in which governments had failed to take
advantage of favourable developments in the years of booming growth in order to
consolidate their public finances.
Over time, concerns about the size of government deficits and soaring debt-to-GDP ratios
- combined with uncertainty about the ability of governments to design and implement
consolidation plans in the context of reduced potential growth and massive implicit liabilities
towards the financial sector - developed into uncertainty about the sustainability of
government debt. Although the initial problems primarily concerned the Greek government
debt market, contagion and spillover effects meant that the crisis quickly spread to the
sovereign debt of other so-called "peripheral" countries and other market segments. In
particular, financial markets turned their attention to the solvency of some "peripheral"
economies that were perceived to have been hit particularly hard by the crisis because of
long-standing structural and institutional weaknesses.
The deterioration of public finances in some euro area member States has impacted
negatively on investors' confidence in government bonds issued by these countries, and thus
led to further turbulences in the financial markets. This is also reflected in the sharp increase
in the yields on the government bonds issued by those countries. This additional distortion
has given rise to further instability in the financial system, both directly and through its
interplay with the weaknesses of the public sector.
Given the central role played by sovereign debt in financial markets, its dysfunctional
behaviour threatened both financial stability and the transmission of monetary policy. In this
context, the Eurosystem launched its Securities Markets Programme (SMP), which entails
the outright purchase of debt instruments to address the malfunctioning of securities markets
and to ensure the proper transmission of monetary policy impulses to the wider economy
and, ultimately, the general price level.
In addition, in order to mitigate the impact of the sovereign debt crisis on the banking sector's
ability to refinance its activities, the ECB temporarily reversed the phasing-out of its
nonstandard measures. It also took collateral-related measures to support access to central
bank liquidity by banks located in the countries that were committed to implementing
economic and financial adjustment programmes negotiated with the European Commission,
in liaison with the ECB, and the IMF.
There is no denying that the financial crisis has put the euro and the economy of the euro
area to the test. During the crisis the euro area public authorities have proven their capacity
and willingness to take the necessary emergency steps to maintain financial stability.
However, the crisis has clearly shown the need to undertake a number of reforms in order to
address some institutional and structural weaknesses in our economies. This is essential in
order to map out the way forward for the European Monetary Union, which I will now briefly
sketch.
III. The way forward
The way forward for the euro area and the EU requires a number of initiatives in key areas in
order to guarantee the public authorities' ability to continue delivering macroeconomic and
financial stability. In my view, the building blocks of any comprehensive plan of reform for
Europe are the following:

implementing fiscal consolidation and securing the sustainability of public finances;

promoting sustainable growth and job creation;
 enhancing the crisis management framework;

improving economic governance;

strengthening the financial sector.

Let me briefly elaborate on these points.
III.(a) Implementing fiscal consolidation and securing the sustainability of public
finances
The financial and economic crisis has led to a very considerable deterioration in the fiscal
positions of euro area countries, in terms of both large budget deficits and rising government
debt. However, the economic recession amplified imbalances in fiscal policies that had built
up gradually long before the crisis, reflecting the failure by many countries to implement
sound fiscal policies during past periods of strong economic growth. On the institutional side,
the EU's fiscal framework, which is embedded in the Stability and Growth Pact (and that had
been watered down in 2005), proved to be too weak to enforce fiscal discipline and was not
implemented with sufficient rigour.
As mentioned earlier, reflecting large fiscal imbalances and a loss of confidence on the part
of investors, government bond spreads increased dramatically for some euro area countries
and became very volatile in 2010. The willingness of investors to support governments'
financing needs declined, with the result that the governments of three euro area countries
have since then required financial support by means of joint EU/IMF programmes. These
programmes are subject to strict conditions on fiscal adjustment in order to restore public
finances to health.
However, the need to pursue more ambitious consolidation targets is more general. It is
striking to see that there are currently only two euro area countries that are not subject to an
excessive deficit procedure. Fiscal consolidation is essential to ensuring an environment
conducive to output growth and price stability.
Looking ahead, implementing fiscal consolidation and securing the sustainability of public
finances are among the major challenges faced by policy-makers. The consolidation of public
finances requires a comprehensive policy comprising: (i) the timely correction of excessive
deficits; (ii) the reduction of government debt to more sustainable levels; and (iii) the
reorganisation of banks in order to limit strong links between the balance sheets of
governments and financial sectors, which typically result in the socialisation of banks'
liabilities in times of crisis. These measures need to be complemented by pension and
healthcare reforms to alleviate the fiscal burden arising from population ageing.
Moreover, fiscal governance in the euro area needs to be reinforced by means of the
strengthening of the Stability and Growth Pact. This means establishing stricter and more
binding rules for fiscal policy, backed up by stronger sanctions or mechanisms to ensure
compliance with the rules. At the same time, the effectiveness of budgetary institutions needs
to be improved at the national level. In this context, effective rules on expenditure should be
regarded as a means of promoting fiscal discipline and limiting fiscal vulnerabilities in the
event of adverse economic shocks occurring in the future.
III.(b) Promoting sustainable growth and job creation
Euro area countries also need to increase their efforts to strengthen their growth potential
and their ability to create jobs in a sustainable manner. European countries have made
reasonable progress over the past ten years in the area of employment. Indeed, over
14 million jobs were created in the euro zone since the introduction of the euro, far more than
in the previous ten years (around 8 million). The employment increase in the euro area since
1999 was even significantly larger than in the United States (7.6 million).
This is an important achievement, but it remains insufficient, especially against the
background of the massive employment destruction observed in some euro area countries
during the crisis. Unemployment rates have reached unacceptably high double-digit rates in
some countries and segments of the population (i.e. the young workers), that, as a result,
carry extremely large economic and social costs. This is socially unfair and economically
inefficient.
European countries must made more efforts to resolutely pursue - and with far greater
urgency than in the past - the necessary structural reforms in product markets, labour
markets, pension systems and so on. In this respect, a key contribution to the strengthening
of the euro area's long-term economic prospects will come from the thorough implementation
of the Europe 2020 strategy, with its focus on key areas such as: (i) education, research and
innovation; (ii) resource efficiency; and (iii) high levels of employment and social cohesion.
III.(c) Enhancing the crisis management framework
In response to the sovereign debt crisis, the euro area has recently armed itself with an
important tool to safeguard area-wide financial stability. At the European Council meeting of
24 and 25 March 2011 the Heads of State or Government of the EU agreed to establish a
permanent European Stability Mechanism (ESM) based on the existing temporary European
Financial Stability Facility (which will remain in place until June 2013).
The ESM will grant financial assistance to countries in distress in the form of credit, with the
assistance provided under strict conditionality and on the basis of a strict analysis
- conducted by the European Commission and the IMF, in liaison with the ECB - of the
sustainability of the relevant country's debts. The establishment of the ESM represents an
important addition to the institutional fabric of EMU.
However, the existence of a mechanism to provide financial assistance to countries facing
temporary distress should not be seen as a source of moral hazard. Such risks are
prevented both by the strict conditions under which any assistance would be provided and by
the fact that the mechanism will be activated only if deemed indispensable in order to counter
threats to the financial stability of the euro area as a whole. In addition, the establishment of
this permanent stabilisation mechanism will be accompanied by the strengthening of the
framework for economic governance in the euro area, particularly as regards the framework
for the multilateral vigilance of national policies in the areas of public finances and
competitiveness.
III.(d) Improving economic governance
It is fair to say that the experience of the Economic and Monetary Union (EMU) over its first
twelve years has been a historic success. At the same time, it is also fair to say that the
credit should go, to a very large extent, to the achievements of the monetary pillar of
Monetary Union (the "M" in EMU) rather than of its economic pillar (EMU's "E"). Yet,
monetary policy alone cannot deliver all the benefits of EMU. The economic pillar must also
play its part. Unfortunately, this has not always been the case so far. Indeed, national
governments have not been sufficiently committed to fulfilling their obligation to guarantee
macroeconomic stability and fiscal sustainability in the long term.
Therefore, a key lesson learnt from the crisis is that in order to fully reap the benefits of EMU,
it is essential to strengthen the rules that govern macroeconomic policies in the euro area so
as to ensure their alignment with (1) sound economic principles (such as fiscal discipline and
a commitment to a market-based economic system) that foster macroeconomic and financial
stability, and (2) with the needs of the single currency.
Some concrete legal initiatives in these areas have been proposed by the European
Commission, on the basis of the final report of the task force chaired by the President of the
EU Council Herman Van Rompuy. In a nutshell, the European Commission recommends
strengthening the Stability and Growth Pact, which represents the framework of rules and
procedures preventing countries from accumulating excessive public debts and deficits. In
addition, the European Commission proposes the establishment of a broader
macroeconomic framework for the monitoring of economic policies, which - if not sufficiently
sound - can give rise to imbalances such as a loss of competitiveness, current account
imbalances and excessive private indebtedness.
In addition to these EU-wide proposals at the legislative level, a separate pact (the "Euro
Plus Pact") has been drawn up by the euro area countries and several other EU Member
States in order to further strengthen the economic foundations of EMU.
The ECB is of the opinion that, in both areas, the current reform efforts are not sufficiently
extensive. While the proposals tabled by the European Commission go some way towards
improving macroeconomic and fiscal surveillance in the euro area, they fall short of the
quantum leap forward that is needed in order to guarantee the smooth functioning of EMU.
The legislative acts implementing the reform of economic governance are now being
discussed in the context of the "trialogue" discussions taking place between the European
Parliament, the European Commission and the Hungarian Presidency of the EU Council. The
purpose of these discussions is to produce a common set of proposals that accommodates
the amendments requested by the various authorities involved in the legislative process. The
ECB has called on these authorities to produce a strong and clear set of rules, including
automaticity in the triggering of procedures and sanctions, in line with the ten key elements
for the reform of economic governance published on its website.1
III.(e) Strengthening the financial sector
The financial crisis has also revealed a number of deficiencies and vulnerabilities in the
regulatory and supervisory frameworks in our economies. The massive economic and
financial impact of the crisis has clearly indicated that addressing such deficiencies through
far-reaching reforms is essential in order to prevent similar crises in the future.
There is a relatively broad consensus as regards the nature of the reforms required. Indeed,
following the deterioration of the crisis in the wake of the collapse of Lehman Brothers, the
G20 rapidly identified some of the key areas for reforms and entrusted the task of drawing up
concrete proposals to the Basel Committee on Banking Supervision and the Financial
Stability Board.
Some progress has already been made in the area of financial market regulation, most
notably as regards the "Basel III" capital accord. This calls for strong increases in the capital
requirements of financial institutions and also introduces leverage requirements, as well as
leverage ratios.
In Europe, important steps have been taken with a view to addressing the long-standing
friction between, on the one hand, the international dimension of the operations of
commercial banks and financial institutions, and, on the other hand, the national boundaries
that constrain regulatory and supervisory measures. The Heads of State or Government of
the EU have agreed on a new structure for financial supervision in the European Union - the
European System of Financial Supervision - with a view to improving coordination and
cooperation.

As regards micro-prudential supervision, three newly established European
Supervisory Authorities for banks, insurance companies and financial markets
became operational at the beginning of 2011. These are designed to enhance
coordination between micro prudential supervisors and to ensure the application of
EU wide standards in the area of technical supervision.

In addition, a new authority - the European Systemic Risk Board (ESRB) - has
been established with a mandate to conduct macro prudential supervision within the
EU.
Much has been achieved in the reform of financial market regulation and supervision since
the onset of the financial crisis. But there are still many areas that require the attention of
policy-makers - such as stricter regulation of all systemically relevant financial institutions,
greater transparency as regards the "shadow" banking sector, better regulation of investment
funds and credit rating agencies, and improvements to corporate governance models in the
banking sector. These are just some of the key areas in which greater efforts are needed in
order to strengthen the foundations of our economies.
IV. Concluding remarks
I have described the way forward for the euro area economy. Of course, I have only looked
at what will happen if we take the high road out of the crisis. I haven't even considered some
of the "shortcuts" that, according to some commentators and economists, are supposedly
available to countries unwilling to bear the costs of structural and fiscal reforms. In particular,
it is often argued that Greece would be better off rescheduling or renegotiating some of its
sovereign debt, rather than continuing to implement the adjustment programme negotiated
with the international authorities as part of the financial assistance provided by the European
Commission and the IMF.
The argument is typically presented as follows: "Greece's key problem is not a temporary
lack of access to liquidity, but rather a solvency crisis. The country is too weak to bear the
economic and social costs of implementing the institutional and economic reforms foreseen
by the adjustment package. The country may, therefore, be better off announcing some form
of renegotiation or restructuring of its debts with private creditors. Of course, such a step
should not be taken lightly, since it may be tantamount to a sovereign default, and the
economic literature suggests that the costs of defaults can be both multiple (reputational
loss, exclusion from financial markets, trade sanctions, and so on) and substantial. However,
some empirical studies focusing on emerging economies have fortunately found that the
impact that an inevitable - rather than a strategic - default has on the defaulting country's
economy is typically smaller and less persistent than is commonly believed.2"
Let me stress that I am rather surprised to see the flippancy with which some commentators
recommend that the government of an advanced economy should infringe its legal and
contractual obligations, as though breaching the trust of investors and citizens were the
simplest and least costly solution to the deeply-rooted structural problems in Greece.
Far from being a convenient means of minimising economic losses and dissipating
uncertainty, a default would have extreme adverse consequences, many of an irreversible
nature, for the Greek economy - particularly for its banking sector and for the welfare of its
citizens. Those basing their arguments on past experiences in emerging economies fail to
take into consideration the many differences in the case at hand: Greece is an advanced
economy sharing a single currency with 16 other democracies which has signed up to a
common set of rules, institutions and overriding objectives, notably macroeconomic and
financial stability, together with the other countries of the European Union. Greece's euro
membership rules out debt-devaluation spirals and ensures price stability in the medium
term. Its economy is highly integrated - via a number of channels, such as trade and
financial flows - with other advanced economies both in Europe and around the world that
can potentially act as contagion mechanisms. Greater economic integration has been
accompanied by an increasing degree of institutional cooperation. At the same time, the
country's economy is affected by a number of structural weaknesses and rigidities that have
resulted in the persistent accumulation of public and private sector imbalances.
The thorough implementation of the comprehensive programme of structural reforms and
fiscal consolidation negotiated with the international authorities is the only way forward which
is fully consistent with the long-term interests of the people of Greece. To paraphrase the title
of a study by IMF staff,3 the debate on debt restructuring in a euro area country is
unnecessary, undesirable and unhelpful.
I would also add that this discussion represents a dangerous and unwelcome distraction from
more important debates on issues such as how to enhance the euro area's economic
governance, make our economies more dynamic, ensure the sustainability of public finances
and strengthen the banking sector, which deserve our full attention and to which we must
devote our energies.