Jens Weidmann: Monetary union as a stability union
Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, at the Duitsland
Instituut, Amsterdam, 7 April 2014.
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1. Introduction
Dear Professor Nijhuis,
dear Dr Plecher-Hochstrasser,
dear Dr Ullersma,
dear Klaas,
ladies and gentlemen,
I thank you for the invitation and for the opportunity to speak here today.
The Duitsland Instituut's mission is to increase knowledge of Germany and disseminate this
knowledge to a wide audience in the Netherlands. I am glad to join in this effort today, though
I will confine myself to the Bundesbank's take on matters of the Economic and Monetary
Union. Adding more issues to that would probably constitute an overburdening of the
monetary policymaker you see before you. And overburdening monetary policy is of course
anathema to the Bundesbank.
To me, it seems particularly befitting to talk about the challenges of the intricate construction
that is our monetary union here in Amsterdam.
As you know better than I do, up until the 12th century, the area of what is today known as
the Province of Holland was basically considered uninhabitable. The area consisted mostly
of swampland and morass, and was traversed by many rivers. It took the erection of a dam
to protect a small patch of land from the Amstel River and the tireless effort of pushing
countless wooden piles up to 18 meters deep into the ground to lay a foundation that proved
solid enough. Solid enough to pave some roads and to build the first houses of what would
later become the city of Amsterdam. Nobody would claim now that it was not worth the effort.
Amsterdam is both unique and beautiful.
And this is where the European monetary union comes in. There are surely more obvious
places to build a currency union than in Europe. Without a doubt the euro area lacks some of
the characteristics of an optimal currency area. Labour mobility, for instance, is much lower
than in the US; plus the business cycles are not synchronised, nor is there any central fiscal
stabiliser. At the end of the day, the decision to create the European monetary union was a
political one, not an economic one.
But I am positive that if we learn from the sovereign debt crisis and do not falter in our efforts
to push enough piles into the right parts of that tricky ground, the European monetary union
can be preserved as a place of stability that is worth living in. In the first 15 years since the
euro was launched, people have enjoyed a stable currency. The average euro-area inflation
rate was 2.0%, which is very close to the ECB Governing Council's definition of price stability
("below, but close to, 2%").
In the next 30 minutes, I will present my views on which additional piles are required and how
they will need to be arranged in order to preserve the European monetary union as a stability
union. In doing so, I will first look into what still needs to be done at the country level. From
there, I will go on to address the weaknesses in EMU's institutional foundation.
But before talking about what needs to be done, let us take a step back and consider what
went wrong in the first place.
2. The origins of the crisis
For many euro-area member states, the introduction of the euro ushered in a new era of
abundant capital, due to the elimination of exchange rate risks. And standard economic
reasoning suggests that capital should flow from capital-rich to capital-poor economies,
where returns should be higher.
However, the favourable financing conditions in the euro-area countries with previously
higher interest rates mainly stimulated their domestic consumption, thereby raising prices
and wages in the non-tradable sector. To put it in a nutshell: inflowing capital was not always
put to productive use.
Overinvestment in real estate as well as public and private consumption failed to raise
productivity in some member countries. Unit labour costs soared, competitiveness declined.
And the rigidity of labour and product markets meant that this process gained even more
momentum.
When the financial crisis broke out in 2007, the vulnerabilities became apparent: investor
sentiment began to shift, and interest rates for the countries in question started to rise
sharply, triggering a crisis that is still far from being fully resolved.
How could it go so wrong? Here is where the euro area's unique institutional set-up comes
in.
The euro area teams up one common monetary policy with 18 national fiscal and economic
policies. This approach reflects a currency area composed of sovereign member states. It
grants member states enough room for manoeuvre to preserve their diversity, that is, to
establish their own business models or to tailor institutions and policies to their own national
preferences. Such preferences can differ, for example, with respect to income redistribution
or the role of the state in the economy. At the same time, it leaves the consequences of such
decisions with the respective member state and consistently rules out the option of
mutualising public debt with other euro-area states.
But this set-up also creates vulnerabilities.
First, such a combination gives rise to a deficit bias, as it allows the costs of fiscal
imprudence to be shifted partially on to others. An unsustainable fiscal situation in one
country has repercussions for monetary union as a whole.
And second, each member state issues debt in a currency it cannot create. Thus, a high
level of fiscal discipline is needed to ensure that solvency concerns do not spiral out of
control. This notwithstanding, the central banks' balance sheets can serve as a conduit for
shifting risks among national taxpayers, even if there are no explicit fiscal transfers and
irrespective of the approval of national legislatures - thus undermining countries' individual
national responsibility and hence the very foundations upon which responsible
decisionmaking is built.
However, if central bank independence is used for purposes other than price stability, it is
only a question of time until central bank independence is challenged.
The founding fathers of the euro clearly foresaw the risk of unsustainable public finances for
a stability-oriented monetary policy. Therefore, precautions were put in place to safeguard
sound public finances. They took the form of a prohibition of monetary financing of
government deficits, the no bail out clause and the Stability and Growth Pact.
Barry Eichengreen and Charles Wyplosz wrote in an article in 1998: "The most compelling
rationale for the Stability Pact rests on the need to buttress the no-bailout rule of the
Maastricht Treaty". And having a good sense of what might happen, the two economists
continued: "That need will be most pressing where debt problems place banking systems at
risk and where bond market contagion is pervasive."
At the time, it was assumed that by constraining governments' ability to fiscally stimulate
demand - and by shifting monetary policy to the European level - governments would have
no choice but to implement structural reforms, improve their supply side, and strengthen their
potential for sustainable growth.
It was also thought that the financial markets would enforce fiscal discipline. As we know
now, things did not exactly work out as expected. So, in a sense, the piles on which
monetary union was built turned out to be unsound. The fiscal rules were breached
numerous times, not least by Germany and France.
In addition, investors made hardly any distinction between the bonds of individual member
states. From 1999 to 2007 the average difference between EMU government bonds,
excluding Germany, and German government bonds, for instance, was a mere 14 basis
points. Just for comparison: at the end of March that spread stood at 123 basis points.
I leave it to you to decide whether this was because investors were neglecting the growing
differences in economic fundamentals or because they never really believed that the no bail
out clause would hold when the going got tough. In any case, the strong convergence in
financing conditions set the wrong incentives: governments' purses were loosened, not
tightened, structural reforms were postponed, not pushed.
By the same token, banks and capital markets in many cases failed to allocate the inflowing
capital efficiently. Instead of financing productive investment they shifted money into
ballooning real estate sectors. As a result, banking systems in some euro-area countries
were subsequently hit hard by a severe crisis.
In sum, this is what, to me, largely explains the unsustainable developments in the run-up to
the crisis. Hence, work is needed on three levels.
First of all, the countries have to correct the macroeconomic imbalances and to boost the
potential for sustainable growth by regaining competitiveness, by consolidating public
finances, and by catching up on long-delayed structural reforms.
Second, we need to address the weaknesses in the monetary union's institutional
architecture.
And third, we need a more resilient financial system. Owing to regulatory weaknesses, the
financial system acted as an amplifying transmitter of the crisis.
Due to time constraints, I would like to focus primarily on the first two issues. Let's have a
look at the state of play in the member states.
3. Reforms at the national level
In many countries, structural reforms to remove rigidities in product and labour markets are
now underway. A number of labour market reforms have been introduced to foster
employment and reduce adjustment costs during economic downswings. In addition, the
retirement age has been raised as well. Product market rigidities that weaken competition,
produce regulatory red tape, and inhibit growth, are also being addressed.
And according to the World Bank's Doing Business Report, progress has been made in this
regard as well: Portugal, Italy, and Spain have climbed up the ranking ladder by 17, 13, and
10 positions respectively over the last four years. Greece moved up by 37 positions. Unit
labour costs and current accounts of deficit countries have improved - not only because of
shrinking imports, but also because of expanding exports.
Factors of production are being reallocated to sectors with a strong focus on exports. The
construction sector in Ireland accounted for over half of the decrease in aggregate
employment; in Spain, Italy and Portugal, it accounted for around two-fifths. In industry, by
contrast, either far fewer jobs have been cut or - as in Ireland - new jobs have recently been
created.
Real value added, in particular, far exceeded its pre-crisis level in the export-intensive
information and communications sector in Spain and Ireland as early as in 2012. In Ireland,
other business-related services also showed substantial growth. Compared to its pre-crisis
level, real value added in trade and tourism increased in Portugal and remained virtually
unchanged in Spain.
Progress has been uneven, though, and further reforms are needed to facilitate this shift
from the non-tradable to the tradable sector and, therefore, to strengthen sustainable growth.
Overcoming the crisis is still an uphill struggle; if you don't go forwards, you go backwards.
With regard to reforms, governments therefore have to keep the pedal to the metal. In
footballing terms, I would say "the half-time whistle has blown". However, there is no time for
a break.
Without doubt, adjustment has to happen primarily in the deficit countries, but countries with
a current account surplus, such as the Netherlands and Germany, face challenges as well.
While the Netherlands is still dealing with the aftermath of a housing bust, demographic
trends require Germany to raise its potential for sustainable growth.
Germany's overall investment ratio was 16.7% in 2013, compared with 22.3% in the year
2000. This low level of investment is attributable to numerous factors, many of them cyclical
in nature. However, improving the conditions for investment in energy, transport and
communications networks - like fast and efficient implementation procedures - would raise
Germany's long-term growth potential, as would further investment in research and
education.
In order to counter the demographic challenges, Germany should improve pre-school
education and support educationally disadvantaged young people in order to foster their
employability.
Furthermore, we should reduce, rather than create, incentives for early retirement, and we
need a systematic approach to attract skilled labour from abroad, whose expertise is needed.
And I am not talking about all the world-class footballers from the Netherlands and many
other countries who play in Germany's Bundesliga.
When looking at sectoral developments in Germany, one fact is striking. For the last
20 years, productivity growth in services has lagged markedly behind growth in
manufacturing. In fact, while productivity in manufacturing has grown by more than 30%,
productivity growth in services has barely budged. Why is that?
The data point to a higher degree of competition in the manufacturing sector: Mark-ups, an
indicator of the pricing power of firms, have gone down following the launch of the common
market. By contrast, mark-ups on services have stayed high in Germany, higher even than in
many other European countries. Opening up closed professions, cutting red tape and
improving access to financing for nascent digital firms would serve to improve the functioning
of the services sector.
But while there is room for improvement in Germany especially when it comes to the
efficiency of its services sector, the fact is that European mark-ups are elevated in general,
compared to the US, for example. It is therefore high time to fully harness the forces of the
market for Europe, by making the most of its main catalyst for competition and growth, the
European single market.
In his report to the European Commission, former Commissioner Mario Monti estimated the
potential growth effects of creating a digital single market, which is largely services-based, to
be about 4%, on a par with the gains made since 1993.
Further benefits would ensue from a reduction in the vast number of exemptions in the
Services Directive. Reforms that strengthen competition in the services sector therefore hold
the promise of delivering stronger and more balanced growth. More balanced growth is likely
to translate into a moderation of the current account as well.
This would come without weakening the competitiveness of Germany's export sector. This
would be the case, however, if Germany would accept the economic advice to excessively
boost its wages to stimulate domestic demand. This would harm employment in Germany
and, as a consequence, the economic situation in the entire euro area.
So, while considerable progress has been made at the national level, in the deficit countries
in particular, much remains to be done. And reforms at the national level could be reinforced
by European efforts to strengthen competition, especially in the services sector.
4. Strengthening EMU's institutional architecture
However, when it comes to taking action at the European level, other challenges for
monetary union are probably even more crucial. The safeguards originally put in place for the
stability for the monetary union, the Stability and Growth Pact and the no bail-out clause,
failed to prevent the crisis.
It also turned out that other macroeconomic imbalances likewise pose a threat to the stability
of the euro area: a steady loss of competitiveness, persistent current account deficits, or high
levels of private debt.
Ultimately, the risk of contagion between countries was also underestimated when the
monetary union was established.
In response to the crisis, rescue mechanisms such as the EFSF and ESM were put in place,
and they did manage to contain the fallout somewhat. But at the same time, the rescue
mechanisms have weakened the principle of individual responsibility, as fiscal responsibility
has essentially remained national, while liabilities have been partially mutualised.
In other words: the balance between liability and control has become lopsided. Yet I believe
that this balance is fundamental to the stability of Europe's monetary union. To put it rather
bluntly: you would certainly not want to share your bank account with your neighbour if you
were unable to control his or her spending.
But how do we restore that balance, and put monetary union on a more solid footing? In
principle, there are two ways: first, by creating a genuine fiscal union, or second, by making
the principle of individual responsibility work.
The first option, a genuine fiscal union, would require the member states to relinquish their
fiscal sovereignty and cede it to the European level. In such a setting, the mutualisation of
future liabilities would be consistent.
This step would require a change of the European treaties as well as a change of national
constitutions. But judging by the reluctance of governments and electorates to let Brussels
have a say in fiscal matters, this avenue seems blocked, at least for the foreseeable future.
This leaves us with the second option, making the principle of individual responsibility work
better. In order to do so, the Stability and Growth Pact was stiffened and the fiscal compact
was introduced.
These are steps in the right direction. But the mere existence of these rules will not suffice.
As Erasmus of Rotterdam once said: "A nail is driven out by another nail. Habit is overcome
by habit."
Strict and consistent application of the stiffened rules is therefore important. Here, the
Commission has a special responsibility. In this context I am worried that the fiscal policy
rules have become ever more complex and, in turn, so has monitoring compliance with them.
It has now become almost impossible for experts, let alone the general public, to determine
whether or not countries are complying with these budget rules.
This naturally reduces the binding force of the rules. The binding force of the rules can also
be diminished if there is the impression that they are not being strictly interpreted by the
Commission. And the assessment procedure gives the Commission greater and more
discretionary leeway. Metaphorically speaking, we need to make sure that the Commission
does not go beyond its role as a referee and move the goalposts mid-game.
Based on past experiences it is clear to me that stiffening the rules alone won't suffice to
enforce the principle of individual responsibility. At its core, this principle requires that
sovereigns, banks, and investors bear the consequences of their decisions.
This implies that it is primarily up to the respective government and its citizens to come up
with the revenue required for repaying public debt. This holds, in particular, since high levels
of public debt often go hand in hand with substantial private assets. But it also implies that
the risk of non-repayment ultimately lies with the investors, since they are the ones who reap
the return when things go well. And if the fiscal limit has been reached for real, public debt
needs to be restructured without posing a systemic threat to financial stability.
The introduction of collective action clauses into sovereign bonds was a first step in that
direction. But more steps are needed.
The Bundesbank has put forward a proposal for sovereign bonds to include an automatic
maturity extension of three years in case a sovereign accesses the European rescue
mechanisms. This automatic maturity extension would allow the sovereign in question to
tackle its fiscal challenges while preventing investors from bolting. Liability and control would
be brought better into balance. The amount of official financial support would be reduced,
and time is bought to figure out if the problem is one of temporary illiquidity or insolvency.
But ultimately, all these questions boil down to the quip of American economist Allan Meltzer:
"Capitalism without failure is like religion without sin. It doesn't work." For the above
proposals to work, we need to make sure that the insolvency of both banks and sovereigns is
possible without bringing down the financial system as a whole.
At the moment, the insolvency of a sovereign or of a systemically important bank is
perceived as an unpredictable risk. What do we have to do to make that risk manageable?
At the core of the problem lies what is now known as the sovereign-bank nexus. In the crisis,
this sovereign-bank nexus developed into a vicious circle: Tottering banks and teetering
sovereigns lean towards each other for support, but are in fact pushing each other over.
If a large bank or one which is strongly interconnected with other banks runs into difficulties,
this can pose a threat to the stability of the entire financial system. The state then often has
no other option but to step in if it wants to prevent a meltdown of the real economy. But this
rescue can be a huge burden on government finances. This is what happened in Ireland
where the need to prop up the financial system pushed the public debt ratio up by nearly
30 percentage points.
Conversely, weak government positions can destabilise banks - directly through their
exposure to sovereign bonds, and indirectly through worsening macroeconomic conditions.
This was the case in Greece.
How can we break this "doom loop"? The strengthened Basel III capital rules are a first step
in that direction, as they increase capital buffers and therefore the capacity of banks to
absorb losses.
The banking union, with its Single Supervisory Mechanism, is another such step. Strict and
stringent supervision ensures that tough rules are applied equally to all.
In retrospect, heeding Wim Duisenberg's advice when he argued in favour of a European
banking supervision in the late 1980s would have paid us all a handsome dividend. The
establishment of the SSM 25 years later is testament to his prescience. The SSM is
important for severing the link between banks and sovereigns. But to make sure that banks
cannot pass on the consequences of their actions to the public, more is needed.
As a natural complement to the SSM, an effective restructuring and resolution mechanism
has to establish a bail-in regime that clearly assigns how losses are distributed, making sure
that shareholders and creditors are first in line. In this regard, the agreement on the Directive
establishing a framework for the recovery and resolution of failing banks (BRRD) and the
agreement on the Single Resolution Mechanism three weeks ago constitute progress.
But it would be better still if the bail-in regime were to take effect at the time the SRM starts -
not one year later as is currently envisaged.
The sovereign-bank nexus, however, works both ways. We also have to make sure that
worsening public finances do not infect the financial system. The banking union still has a
sovereign virus, as Daniel Gros from the Centre for European Policy Studies put it. To
strengthen the banking union's immune system, we need to end the preferential treatment
afforded to sovereign debt. At present, sovereign bonds are treated by European regulators
as being risk-free - an assumption that stands in contradiction both to the no bail out clause
and to recent history.
We should therefore put this regulatory fiction to rest. Hence, sovereign bonds should be
adequately risk-weighted, and exposure to individual sovereign debt should be capped, as is
already the case for private debt. An adequate risk-weighting of sovereign bonds would
make banks more resilient if the fiscal position of the respective sovereign were to
deteriorate. And it would bring spreads more into line with the underlying risk, thus sending a
disciplining signal to the sovereign.
But sovereign bonds pose a threat to financial stability not only because of preferential
riskweighting. The most important rule in risk management is diversification.
Yet when it comes to sovereign bonds, banks all too often seem to neglect this principle. In
many cases, European banks hold bonds from one sovereign only - their home country.
During the crisis, many banks, particularly weak ones, used the low refinancing costs to buy
even more sovereign debt; they made a sort of "carry trade". However, a high level of
undiversified sovereign exposure is what makes sovereign default a potentially systemic
event.
Hence, the large exposure regime which caps investments in a single debtor has to be
applied correspondingly to sovereigns as well. This might trigger substantial repercussions,
but these would be manageable if they were phased in over a transitional period - which
would undoubtedly need to be granted.
5. The role of monetary policy
Consistently applying the stiffened rules and ending the preferential treatment afforded to
sovereign debt will be instrumental in strengthening the stability of our monetary union. So
will the banking union.
Currently, much of the support provided to the whole structure hinges on one pillar alone:
monetary policy. But this will work only for so long; monetary policy has already done a lot to
absorb the economic consequences of the crisis, but it cannot solve the crisis. To say it once
again in Wim Duisenberg's words: "Don't ask for monetary policy to perform tricks it cannot
deliver."
Therefore, the best contribution the Eurosystem can make to a lasting resolution of the crisis
is to fulfil its mandate: that of maintaining price stability.
To avoid potential conflicts of interest between the ECB's mandate to safeguard price
stability and its role in banking supervision, changes to the European Treaty will be needed
in the medium term in order to strictly segregate these two functions.
Klaas Knot said recently in an interview with the German daily "Handelsblatt" that it was
sensible to make use of the ECB's credibility to establish the SSM, but that it should be
considered to eventually outsource the SSM from the ECB and to establish a separate
institution. And I can only agree with his view.
6. Conclusion
Ladies and gentlemen, let me conclude.
The crisis has laid bare shortcomings at the national level as well as weaknesses in the
monetary union's institutional architecture. Repairs at the national level have seen
considerable progress, though there is still a long way to go.
Like in a marathon, the second half of the course always feels tougher than the first - and
one major challenge is to not give in to the growing reform fatigue. But at this point, the
weaknesses in EMU's architecture probably pose a more fundamental challenge.
The balance between liability and control has got out of kilter. We need to regain that
balance if we are to put EMU on a more solid footing.
Since a genuine fiscal union is not on the cards - and to me it does not seem to be for the
foreseeable future - we need to make the principle of individual responsibility work.
Therefore, we need to break the sovereign-bank nexus in both directions. The banking union
is an important first step.
But we also need to put an end to the preferential treatment afforded to sovereign debt in
order to immunise the financial system against sovereign default.
To me, these are the piles we still need to push into the ground to provide for a lasting
foundation of our monetary union.
I now look forward to Governor Knot's take on EMU's most pressing challenges. Klaas, the
floor is yours!