Mario Draghi: A consistent strategy for a sustained recovery
Lecture by Mr Mario Draghi, President of the European Central Bank, at Sciences Po, Paris,
25 March 2014.
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The euro area has been through a crisis of almost unprecedented drama and severity. Like
the Great Depression of the 1930s, this will most likely provide rich material for economic
historians for decades to come. It will be studied and analysed, its causes and consequences
debated and revised. So it is interesting for us to imagine, when the dust has settled, where
the various accounts of the euro area debt crisis will locate its turning point.
Some historians may locate it in individual policy measures taken during the crisis; others
may place it in a future that we have not yet reached. In my view, the turning point has
passed, and it came in the summer of 2012. What changed at that point was that crisis
management shifted towards the development and execution of a consistent recovery
strategy. It is this strategy that I am going to outline in my remarks today.
I will organise my remarks as follows. First, I will describe the initial development of the crisis,
illustrating how policy choices made under the pressure of events and that were
commendable by themselves, but that were sequenced in the wrong order, made dealing
with the consequences of the debt overhang more difficult. This interacted with features of
the euro area's institutional structure to postpone the recovery.
Thereafter, I will describe how the right sequence of steps after June 2012, when the banking
union project was first agreed, has put the euro area back on a trajectory towards recovery.
The first step was 'rebooting' the financial system, which is a necessary condition of a
sustained recovery, not least because it helps monetary policy to manage aggregate
demand. But it is not a sufficient condition: policies of structural reform that lift the level of
potential growth are an equally important part of the recovery strategy.
In describing this strategy, I am not only talking about the past, but also about the present
and the future. The crisis is not over. To be successful, the recovery strategy is being, and
must continue to be, executed with commitment and perseverance.
Looking back at the crisis
The early phase of the crisis followed roughly the same pattern across advanced economies.
Most had been through a long period of excessive debt accumulation, with private debt levels
in several jurisdictions reaching historical highs. In some countries this fuelled
overinvestment in unproductive sectors, including real estate, which is the sector associated with
most of the severe financial crises in history. The mirror image of this development was a
credit bubble in the banking sector, as banks financed both housing supply, i.e. loans to real
estate developers, and housing demand - that is, mortgages.
When the crisis broke out, this debt build-up quickly became a debt overhang. Many
advanced economies entered a prolonged period of deleveraging as firms, households and
banks attempted to reduce their debt levels. For firms, this meant less investment. For
households, less consumption. And for banks, less credit. Moreover, the collapse of Lehman
Brothers sent shockwaves through the global financial system leading to an unprecedented
rise in uncertainty and risk aversion. This led to a further retrenchment in investment, trade
and hiring and a globalised "Great Recession". Government budgets went deep into deficit to
offset this massive shock to nominal spending.
These events were not only shared across major economies, but they were also largely
consistent with historical experience. There have been several episodes in economic history
of large build-ups followed by periods of debt deleveraging. Serious financial crises tend to
be followed by slow economic recoveries.
Nevertheless, by mid-2010, most advanced economies were showing signs of returning to
growth, albeit at a slow pace. At this point, however, the trajectory of the euro area departed
from others. While the recovery gained ground in the US in particular, the euro area entered
into a second recession that lasted until the second quarter of 2013. Why did this divergence
happen?
For two reasons that were specific to the euro area. First, the sequencing of policy responses
after the first bail-out for Greece aggravated concerns about bank and sovereign debt
sustainability. Second, these concerns interacted with an incomplete institutional framework
in a self-reinforcing way.
In addressing the situation in mid-2010 - and with the benefit of hindsight - one could have
legitimately expected the following sequence of actions. First, agree on a solid backstop for
dealing with sovereign and banking sector problems. Thereafter, conduct a stress test and
recapitalise banks where necessary. Then, with banks in a stronger position to absorb losses
and a sovereign backstop in place, construct a consistent framework for dealing with
sovereigns with excessive debt. Finally, apply that framework to countries that were deemed
to need it. For example, this sequence from backstop to stress test to recapitalisation was
applied in the US, once the lessons from the Lehman Brothers shock had been drawn, and it
accelerated the clean-up of the country's banking system.
However, in 2010 and 2011 it was almost the reverse sequence that took place in the euro
area. The Deauville agreement on private sector involvement in October 2010 and the Greek
debt restructuring in July 2011 were announced while an effective backstop for solvent
governments was still being constructed. And the initial stress testing of banks in 2011 and
the capital raising exercise in October that year were conducted without any clear backstop
for solvent banks. The effect was to cause many banks and some governments to come
uncomfortably close to losing market access, or to lose it altogether. As a consequence,
instead of acting as a shock absorber, both banks and governments began to act
procyclically.
This situation then interacted negatively with two features of the euro area's institutional
structure.
The first was the euro area's incomplete financial integration. While prices had converged in
many asset classes prior to the crisis, it turned out that the euro area had not in fact created
the conditions for deep cross-country financial integration. Integration was largely based on
short-term interbank debt, rather than on equity or direct cross-border lending to firms and
households, and under stress it quickly unravelled. Indeed, the build-up of financial
imbalances in the euro area periphery had in part been financed by short-term lending from
banks in the core. Those banks then quickly reversed their exposures in what amounted to a
"sudden stop", analogous to crises experienced by emerging economies. This contributed to
the fragmentation of the euro area banking sector and economy along national lines, a
phenomenon which had not been visible in the early stages of the crisis.
The second feature was the euro area's fiscal framework, which was not strictly enforced.
That framework was explicitly designed to ensure fiscal responsibility, with two resulting
benefits. First, if strictly applied, it would create fiscal space ex ante for governments to
absorb exceptional shocks, such as the one experienced worldwide. And second, by
anchoring confidence in the medium-term soundness of public finances, it would allow
governments to run those counter-cyclical policies while retaining market access. In such a
situation, there is no need for fiscal risk-sharing or a fiscal backstop.
Yet, as the fiscal framework was not strictly enforced, the two benefits were reversed: a
number of governments either did not have the fiscal space to absorb the shock they faced in
the early stage of the crisis (consider Belgium or Italy); or they were unable to maintain the
trust of the market while doing so (consider Portugal or Ireland). Fiscal policy in these
countries therefore had to switch from providing a counter-cyclical buffer to convincing
investors of debt sustainability.
Under these circumstances, it was unavoidable that fiscal consolidation was front-loaded.
But it also meant that fiscal policy changed from being a tailwind to a headwind, and added
to the drag coming from deleveraging across the private sector. In particular, as the banking
sector had not yet been cleaned up and strengthened, lower growth produced a further
deterioration in balance sheets and added to pro-cyclicality.
In managing the crisis, European policymakers faced an unprecedented set of
circumstances. They were making decisions in real time in the face of political and
institutional constraints. So the aim of my comments is not to criticise. Rather, it is to highlight
the fact that the sequencing and consistency of policy decisions matter. Policymakers dealt
with the immediate situation without simultaneously addressing all its consequences. It was
only when this began to change in June 2012 that we returned to the path of recovery.
The beginnings of a consistent strategy
What happened at this time was that European policymakers acknowledged the need to
complete the euro area's institutional architecture, the initial stage of which was setting up
the banking union. And in doing so, they initiated what I believe was the necessary first step
of a consistent strategy for a sustained recovery.
The banking union had to be the first step of a longer sequence, for two reasons. First,
because it was necessary to consolidate the single currency. Second, because it provided an
opportunity to "reboot" the euro area banking system, which in turn is a pre-condition for the
recovery.
Let us consider the two in sequence.
Restoring 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, which are a liability
of commercial banks. So for there to be a truly single money among sovereign countries,
there has to be fungibility of deposits across borders.
Yet, this fungibility came under threat during the crisis. It was threatened initially by the
fragmentation of financial markets in the euro area, and then exacerbated by the emergence
of redenomination risk in financial prices. Those unfounded fears of redenomination put price
stability at risk, which the ECB had to alleviate through the creation of its Outright Monetary
Transactions (OMT) programme. Our actions underlined the irreversibility of the single
currency and were decisive in restoring confidence.
But the underlying drivers of fragmentation still remained, especially the emergence of credit
risk premia at the national level that mirrored the perceived credit risk of sovereigns, in
particular after the Greek debt restructuring. This link between sovereign and bank risk
reflected, first and foremost, the perception that the ultimate guarantor of deposits in the
banking system is the state. Hence, where perceptions of sovereign creditworthiness
diverged, so did confidence in their respective banking systems.
In essence, what these developments were highlighting was that we did not have a truly
single banking system in the euro area; we had a juxtapositionof national banking systems,
which is why they fragmented so easily. To ensure that the single currency truly is single,
therefore, the only realistic option was to bring together those national systems into one
single system, so that the fungibility of deposits was re-established. 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.
We are now well advanced in the process of unifying the banking system in this way. The
Single Supervisory Mechanism (SSM) will begin operating in November. A deal was reached
last week on a Single Resolution Mechanism and Single Resolution Fund. And a harmonised
approach to the level and funding of deposit guarantee schemes across the euro area has
been agreed, as a first step towards a single deposit guarantee scheme. Deposits of
individuals and small- and medium-sized enterprises (SMEs) will also have seniority in any
future bank resolutions. Together, this goes a long way towards creating a genuine banking
union, although some important details, such as the backstop for European resolution
financing, still need to be clarified.
By reinforcing the singleness of money, the banking union provides the conditions for a
lasting reintegration of the single financial market. It is therefore a pre-requisite for the
recovery. It does not, however, by itself generate a recovery, nor does it put banks in a
position to properly support that recovery. This brings me to the second step in the sequence
of events required to achieve that goal: the role of the SSM in cleaning up the banking
system.
Cleaning up the banking sector
Prior to the crisis, euro area banks had entered a rapid period of balance sheet expansion.
From the start of that expansion in 2005 to its peak in 2012, banks assets increased by more
than 60 percentage points of GDP. This was associated with the development of
unsustainable bank business models. Banks relied too much on debt to finance their lending,
and that debt depended too much on wholesale market funding and too little on deposits.
This model was only able to develop because of the perception of an implicit state guarantee
for bank debt - a perception that reinforced the link between sovereign and bank risks that I
described above. The deterioration of sovereign credit, on the one hand, and the clarification
of the rules regarding bail-in of bank debt, on the other, have both helped to bring to an end a
funding model that was neither desirable nor sustainable.
The euro area banking system is therefore now undergoing a process of restructuring and
deleveraging. As this is a necessary correction, it is not a process that policymakers should
seek to prevent. However, it is a process that needs to be properly managed.
Deleveraging can essentially take two forms: a "good" form and a "bad" form. The "good"
type is where banks quickly carve out non-performing or non-core assets and raise equity,
allowing them to restart lending to new, creditworthy clients. The "bad" type is where they sell
good assets and hold on to non-performing assets in the hope that their value recovers. This
tends to create so-called "zombie banks" and leads to a prolonged period of low credit
growth. And this can be even more damaging if, due to fears about counterparty credit and
liquidity hoarding, liquidity dries up and banks have to sell assets at distressed prices. Such
an interaction of market risk and funding risk can cause a systemic crisis, with an outright
credit crunch as the consequence.
Historical precedents suggest that - all other things being equal - a quick, "good"
deleveraging tends to bring about an earlier recovery.
In the euro area we have largely avoided the worst form of deleveraging, thanks to ECB
interventions to provide liquidity to banks at key moments of the crisis, notably our move to
unlimited liquidity provision in 2008 and our two longer-term refinancing operations (LTROs)
in late 2011 and early 2012. In this environment banks have made progress in deleveraging
and restructuring. However, as late as last year there was still uncertainty as to the true
extent and quality of this deleveraging. This was shown by persistent investor doubts about
bank asset valuations, and low credit growth for the real economy.
It was in this context that the creation of the SSM became critical. The SSM provided a
catalyst for the clean-up of the banking system to take place more quickly and more
comprehensively than would otherwise have been the case.
Why was this? Introducing a joint supervisory framework requires us to conduct a thorough
health check of bank balance sheets, using harmonised methods, so that any legacy issues
are recognised, and that all banks enter the new supervisory regime with sound levels of
capital and liquidity. We are currently conducting this comprehensive assessment in
cooperation with national supervisors. To illustrate its scale, the total amount of risk-weighted
assets (RWA) being reviewed amounts to €3.7 trillion, or just below 60% of total RWA for the
128 participating banks.
The nature of the assessment, which includes an asset quality review, is conducive to
achieving the "good" type of deleveraging. It will shed light on the composition and valuation
of bank assets, which ought in turn to trigger fresh equity raising where appropriate, and a
carving-out of assets where necessary, either by selling to the market or via "bad banks".
Raising equity and strengthening balance sheets is in the long-term interests of bank
shareholders, even if it implies an initial dilution of their claims.
In fact, the cleaning-up of bank balance sheets does not need to wait for the end of this
assessment. The best outcome is one where banks are forward-looking and take any
corrective action before the end of the process. And indeed, we have seen in many cases
that banks have revised asset valuations, raised equity and disposed of assets. Bank
balance sheets declined by around 20 percentage points of GDP in 2013 alone, partly in
anticipation of the assessment. Increasing robustness has been mirrored in banks' share
prices, which increased by around 40% in 2013 relative to average market growth of 20%.
Over time, I expect this process, together with the new regulatory framework which is now
being completed by the Basel Committee, to result in a euro area banking system with a
more streamlined balance sheet structure and higher levels of capital. We should be wary of
situations where bank assets are many multiples of GDP, as we saw in countries like Ireland
and Cyprus before the crisis. Bail-in ability will likely also mean that senior unsecured bank
debt plays a lesser role in the future relative to deposits. In other words, this will be a banking
system that comes closer to its traditional role of taking deposits and making loans. However,
a permanent shrinking of the banking system raises some questions about how finance will
be intermediated in the euro area. If intermediation between savings and investment is taking
place less through banks, then it must take place elsewhere, through capital markets.
Capital markets are already increasingly complementing banks in the euro area: as bank
credit to corporates has fallen, it has been approximately matched by issuance of corporate
bonds. However, the substitution is not perfect, in particular for smaller firms, for which it is
more costly for investors to obtain adequate information. This means that, absent policy
action, SMEs are at risk of losing some access to finance.
If we are to continue with a consistent set of steps to support the recovery, cleaning up the
banking system therefore has to be accompanied by policies to facilitate the development of
capital markets, especially for smaller firms. It is for this reason that we have frequently
highlighted the importance of creating conditions that support capital market deepening,
including by removing regulatory obstacles to the least risky models of securitisation.
Moving towards a sustained recovery
This "rebooting" of the financial system, together with the construction of the banking union,
had to be the first step in a consistent strategy, as a healthy banking system is a necessity
for a sustained recovery. Yet it is still only an enabling factor. What it achieves, essentially, is
to create an environment where "normal" macroeconomic management can resume. It is this
that generates the recovery.
The banking sector supports this process through two channels. First, it facilitates the ability
of monetary policy to maintain price stability and help economic growth return to its potential.
Second, it ensures an adequate supply of financing for investment, and an efficient allocation
of credit between productive and non-productive firms, thus also supporting potential growth.
Let me explain these two points in more detail.
Maintaining price stability and closing the output gap
The task of stabilising output around its potential to maintain price stability falls within the
responsibility of the central bank. This has been especially true in the current crisis as, due to
the unavoidable consolidation of public finances that I described earlier, the contribution of
fiscal policy to economic stabilisation could not be as significant as in normal circumstances.
A larger burden was therefore placed on monetary policy to achieve price stability by
managing aggregate demand.
To illustrate this, we have not only cut interest rates to our lowest level since the creation of
the euro, but we have also introduced forward guidance, whereby we commit to keep our
policy interest rates as low as they are currently or even lower for an extended period of time.
This supports the economy today by steering expectations about the future. In particular, our
forward guidance implies that short-term real rates, which are negative today, will become
even more negative in the foreseeable future. This is because our policy rates will remain low
or lower in nominal terms, while inflation is projected to gradually pick up. In turn,
expectations of lower short-term real rates are reflected in the level of medium-term real
rates, those that are most relevant for investment decisions by entrepreneurs. In this way,
our guidance on the level of rates tomorrow, and the day after tomorrow, supports
investment today.
However, these stimulatory effects have been hindered by impairments in the transmission of
our monetary policy to all parts of the euro area during the crisis, in particular as regards the
bank lending channel. The responsiveness of bank lending rates to cuts in our main interest
rates has been uneven across jurisdictions, with lending rates in some countries falling more
or less in tandem, and in others reacting barely at all. The main explanation for this is the
fragmentation of banking systems and bank deleveraging I described above.
With funds no longer flowing freely within the euro area, banks had to pay higher rates to
attract deposits, pushing up their funding costs. Higher funding costs meant higher lending
rates. Banks in the process of rebuilding their capital also required greater compensation for
loans that carried higher risk weights, such as those to non-financial corporations. And they
needed to rebuild profit margins to cope with a high-risk environment. This again implied that
low ECB interest rates could not be fully passed on to borrowers.
Yet this also implies that as the effects of our OMT announcement feed through, and as
policies to reverse fragmentation accelerate, and bank deleveraging and restructuring
proceeds, monetary policy should become increasingly effective.
In fact, we are already seeing evidence of that process. Deposit rates in the euro area have
been converging towards our policy rate. And banks that are more advanced in their balance
sheet adjustment have been better able to reflect our policy impulse in their lending volumes
and rates. If bank lending rates in the euro area periphery ultimately converge with those in
the core, this would effectively represent a significant additional monetary easing.
As such, I expect monetary policy to regain influence over the economic cycle, and our
accommodative stance to support a gradual closing of the output gap in the coming years.
This is reflected in the current ECB staff projections, which foresee inflation rising to 1.0% in
2014, 1.3% in 2015 and 1.5% in 2016. If any downside risks to this scenario appear, we
stand ready to take additional monetary policy measures that ensure our mandate is fulfilled.
In other words, we will do what is needed to maintain price stability.
Our accommodative monetary policy has an ancillary advantage in the current situation: it
facilitates the ongoing process of deleveraging. It both reduces the numerator of debt ratios,
i.e. the nominal interest rate, and raises the denominator - that is, the nominal growth rate.
And this is again facilitated by the reduction in financial fragmentation, which tends to
increase nominal rates while decreasing growth rates.
Raising the potential
Returning output to its potential is one part of the recovery story; but equally important is the
level and trend of potential itself. In the initial stages of the crisis, the euro area, like most
advanced economies, received a substantial downward shock to potential growth. While
measuring potential growth is complicated, the projections of all the major economic
institutions put the euro area's rate of potential growth lower than before the crisis.
Low potential growth creates several problems. It implies stagnant real incomes, thus limiting
welfare gains and complicating the management of the debt overhang for firms and
households. It is accompanied by high levels of structural unemployment, which is both
socially very costly and creates a drag on aggregate demand. And it reduces the amount of
stimulus that monetary policy can provide to the economy without generating inflation.
For all these reasons, engineering a boost to potential output is the key policy challenge
facing the euro area today - and it is an essential part of a consistent recovery strategy.
However, raising potential growth is not a task for monetary policy. Monetary policy can act
on the output gap, but it is structural policies that act on potential output. And given the euro
area's weak demographics, this has to be principally achieved by policies that raise
productivity, which in turn comes down to raising investment. Investment is crucial because it
is today's demand and tomorrow's supply. Yet, investment in the euro area has fallen by
18% during the crisis, and 35% in stressed countries.
This is where the process of repairing the banking sector can help lift potential growth as
well. Evidence from euro area firms shows that financial constraints have strongly affected
firms' investment decisions during the crisis. This has come both from the supply side -
banks that will not lend to firms - and the demand side, i.e. firms that do not want to borrow
because their balance sheets are too leveraged.
With better capitalised banks, we should see a steady resolution of both these issues.
Financing should resume for firms with profitable investment opportunities, which should
benefit in particular young firms that create most net jobs and are most reactive to changes
in investment opportunities. At the same time, acknowledging losses and raising capital is a
pre-requisite for banks to restructure loans to distressed borrowers, thus facilitating a gradual
workout of private sector debt.
In turn, this will allow the banking sector to support the Schumpeterian process of creative
destruction that is key to productivity growth - that is, allocating and reallocating resources
towards those firms and sectors that most generate innovation. Recent micro-level research
by the Eurosystem's CompNet network has revealed that the distribution between the most
and least productive firms in euro area countries is very large, which implies that reallocation
could provide a significant boost to productivity.
Completing the picture
Yet this is not the end of the story. The rebooting of the financial system is necessary but not
sufficient to achieve higher investment. Investment is also low because demand is low and
there is slack in the economy. This will partially unwind as the economy recovers, but we
cannot exclude that investment will not return to its former level as certain sectors have
permanently downsized as a result of the crisis.
This raises the question of whether policy is doing enough to compensate for these structural
changes - in particular, whether it is creating the framework conditions for new business
models to emerge that require higher levels of productive investment.
For example, is regulation in all countries conducive to investment? 45% of fixed investment
in Europe is estimated to be concentrated in sectors where governments have significant
regulatory influence, implying that regulation could play an important role in boosting
investment demand. Even at the firm level, regulation can influence whether the most
productive firms are allowed to grow. One well-known distortion in this regard is the change
in status and requirements for firms in this country when they have 50 employees or more.
Is the tax code conducive to investment? What matters for investment demand is the
aftertax return that firms receive, meaning tax incentives can improve the risk-return profile of
investment projects, and even more so in a lower growth environment. In this country,
several official reports have suggested that high corporate and labour tax rates hinder
investment. The focus of the current government on this issue is therefore fully justified.
Is the education system conducive to investment? Europe's comparative advantage, like all
advanced economies, is increasingly located at the high-end of the value chain. Yet
investment can only flow there if the workforce has the skills to match. Around half the
countries in the euro area rank below the OECD average for student performance in
mathematics, reading and science, implying standards could still rise. Indeed, educational
attainment is no longer only a factor in income, but also in employment prospects: at the end
of 2012 18% of workers with low education levels were unemployed, compared with only 6%
of highly educated workers.
All this underscores that, when we think about how to restore competitiveness in the euro
area, we should not only think in terms of lowering wages relative to productivity. This may
be a necessary short-run measure in some jurisdictions, but it is a zero-sum game: some
countries benefit at the expense of others. The ultimate source of competitiveness for the
euro area has to be productivity gains built on investment, and this is a positive-sum game. It
raises welfare for the euro area on aggregate.
What I am saying here is not new. The need for a continuous rise in productivity performance
has long been recognised in Europe; it was the context for the launch in 2000 of the Lisbon
Agenda, which aimed to make Europe "the most competitive and dynamic knowledge-based
economy in the world" by 2010. As we know, most of its targets were not reached. But the
objective was, and remains, fundamentally the right one.
What is different today, compared with a decade ago, is that weak productivity can no longer
be hidden by increasing private leverage or rising public sector debt. There are no levers that
can be pulled to raise real growth other than those that address the structural barriers in our
economies. Fiscal policy can support growth by ensuring that consolidation has a better
composition - less focused on raising taxes, more on prioritising expenditure - but it makes
no sense to unwind consolidation now that the hard work has been done. This is why I
reiterate that there is no bigger policy challenge for the euro area than raising potential
growth.
Conclusion
Let me conclude.
The point I have tried to emphasise today is simple: to navigate through a debt crisis such as
the euro area has experienced, the sequencing and above all the consistency of policy
choices is everything.
We need to be consistent across space, and we need to be consistent across time. There
are indeed two inescapable lessons from the account of events that I have presented to you
today.
First, a full recovery will be achieved when - and only when - we complete in full the
sequence of steps I have highlighted. With each step in this sequence, we should not ask
"Have we done enough?". It will be clear when we have done enough: when debts are
reduced, when potential output has been raised and when unemployment has come down -
while all along preserving the integrity of money, meaning price stability.
This means, ultimately, looking hard at whether our economies are fit for