Boris Vujčić: Challenges for policy responses within the European Union
in the context of post-crisis reconstruction
Keynote speech by Mr Boris Vujčić, Governor of the Croatian National Bank, at the
international conference "Economic and Financial Cycle Spillovers: Reconsidering Domestic
and Cross Border Channels and Policy Responses", organized by the National Bank of the
Republic of Macedonia, Skopje, 7-8 April 2016.
* * *
I would like to thank Saša Cerovac and Ivana Herceg for their help in preparing these remarks.
Dear Ladies and Gentlemen,
I am truly honoured to be invited as a keynote speaker at this conference that gathers central
bankers and policy makers in the region to discuss issues raised by the heightened levels of
distress and volatility in financial markets. With two episodes of severe distress behind us,
the global financial crisis, followed by the euro-area crisis, many observers share a
conviction that today we might be observing the seeds of a new similar incident waiting to
happen. Some point to possible bubbles in asset markets, some to distorted business
models in (parts of) the financial industry, and quite a few of them see a new crisis lurking
behind emerging market developments, which may start the latest episode of a " crisis
trilogy", as recently pointed out by Andrew Haldane from the Bank of England1. To
circumvent the reoccurrence of a lengthy and costly crisis, we need to improve our
understanding of the processes underlying crisis episodes and adjust our policies
accordingly. This is a great challenge for our trade, even more so amid the current
deconstruction of overarching paradigms and a slow, if any, emergence of new central
banking principles. Such principles need fundamental research as a foundation to help
redesign the policy frameworks of central banks and to guide our corrective actions.
This is an exceptional opportunity to address the challenges of shaping policy responses in
an increasingly integrated and changing world, particularly from a perspective of countries
that are or aspire to become members of the European Union and the euro area. I hope I can
raise a few relevant issues with the potential to provoke a constructive discussion and obtain
much needed research insights.
Allow me to briefly summarize the main points for my discussion, structured here in three
interrelated topics. First, real and financial cycles exhibit some regular patterns relevant for
designing policy responses in open economies exposed to frequent shocks. Second, it is of
major importance for the future of the euro area to advance the institutional design in order to
make all of the envisaged protective mechanisms operational and enhance setting the right
policy mix, which encompasses both EU and national policies. Finally, such a policy mix
should pay a particular attention to careful coordination, given the interdependences among
different national and supranational policies and immense potential for cross border policy
leakages. I will elaborate briefly on each of the mentioned topics.
1. Economic and financial cycles: five important patterns
The financial crisis in 2007-08 has induced a change in the hierarchy of central bank goals.
The concern of central banks for business cycles and economic growth has moved far
beyond the extent to which those did, or did not, generate inflationary (or deflationary)
pressures. Price stability has proven insufficient to deliver financial stability and the lack of
the latter has once again disclosed the overwhelming economic and social costs generated
by the episodes of financial instability2. This has altered our view of financial stability issues,
inaugurated the notion of systemic risks, and subsequently led to the broadening of our
policy mandate. The establishment of the dual mandate for central banks implied that the
traditional monetary policy function was "supplemented" by macroprudential policy as a
response to the interplay of financial cycles and systemic risk.
The broadening of the central bank mandate and the need to add new measures and
instruments to the policy toolkit have opened several avenues for central banks to expand on
their knowledge. We need to re-examine the phenomena of regular disturbances, or cyclical
processes taking place with different frequencies, as well as their inherent structures. While
the nature of shocks and propagation mechanisms still largely remain on the battlefield of
economic theory, empirically observed patterns and the consequences of the materialisation
of risks necessitate our reaction, which should be based on our best knowledge and abilities.
Allow me to get into more detail here.
Optimal policy responses in a multi-country setting require a careful examination of real and
financial cycles, both domestic and international. For that purpose, let us look at five
important patterns that seem to characterise them. First, financial cycles seem to have a
lower frequency and higher amplitudes compared to standard business (real) cycles. Credit
and asset price cycles may take long to develop their potential to destabilize the financial
system. Further on, such a potential may emerge regardless of watchful micro-prudential
supervision or stable inflation. The resulting notion of systemic risk may be identified as the
interplay of macroeconomic shocks that make financial sector vulnerable, the contagion
resulting from financial interconnectedness and endogenous financial imbalances associated
with credit booms, credit leverage and risk taking behaviour of financial institutions3.
Second, there are still no mechanisms in place to engineer sustainable synchronisation of
cyclical movements across Europe. The question of cyclical synchronisation arises as
particularly important within the international setting. This is the factor that makes policy
responses even more complex, especially within a currency union such as the euro area,
where the damage of suboptimal policy responses might exceed mere fiscal costs and output
losses - they may threaten the future of the euro itself. Due to the recent events, therefore,
researchers have focused their attention on testing for the endogeneity of optimal currency
areas, further enriching the vast literature on the synchronisation of business cycles4. This
literature substantiates the conclusion of diverging real and financial cycles across member
states, both during the pre-EMU and post-EMU regimes. The single monetary policy has not
2
D. Miles, Monetary Policy and Forward Guidance in the UK, speech given at the Northumbria University,
Newcastle, 2013, D. Kapp, M. Vega, Real Output Costs of Financial Crises: A Loss Distribution Approach,
MPRA Paper No. 38988., 2012, A. G. Haldane, The $100 Billion Question, comment by Andrew G. Haldane,
Financial Stability, Bank of England, Institute of Regulation & Risk, Hong Kong, BIS Review 40/2010.
3
Constâncio, V. (2015): Financial stability risks, monetary policy and the need for macro-prudential policy;
speech at the Warwick Economics Summit, 13 February 2015 (https://www.ecb.europa.eu/press/key/
date/2015/html/sp150213.en.html).
4
Grigora, V., Stanciu, I.E. (2015): New Evidence on the Synchronization of Business Cycles: Is there an
European Business Cycle?, National Bank of Romania, Macroeconomic Modelling and Forecasting
Department, Bucharest University of Economic Studies; Basten, C. (2006): Business cycle synchronisation in
the euro area: Developments, determinants and implications, Working Paper Series, Research Notes 22,
Deutsche Bank research; Stremmel, H. (2015): Capturing the financial cycle in Europe, Working Paper Series,
No.1811/June 2015, European Central Bank; Sybille, L. (2012): Has the Euro Changed Business Cycle
Synchronization? Evidence from the Core and the Periphery, Ifo Working Paper No. 122
(www.cesifogroup.de); Gouveia, S. and Correia, L. (***):Some facts about business cycles synchronisation across the euro
area countries: the case of small countries, Centre for Transdisciplinary Development Studies (CETRAD),
Department of Economics, Sociology and Management (DESG), University of Trás-os-Montes and Alto Douro
(UTAD), Portugal.
brought cycles together, although a few efficient and credible shock absorbers were devised
at the eve of the euro.
Further on, there is some evidence on the increasing correlation between real cycles and
financial cycles across different groups of EU member states, as provided by Meller and
Metiu (2015)5. Such a pattern emerges regardless of different sources and well-documented
differences in frequencies and amplitudes between real and financial cycles. Moreover,
researchers from the Bank for International Settlements have shown that the correlation
between real and financial cycles gets stronger over time as the duration and amplitude of
financial cycles increases. The main explanation for the increasing correlation between the
real and financial cycle is the so-called "unfinished recession" phenomenon, according to
which globalization and a more activist monetary policy, which fails to take into account the
state of the financial cycle, eventually cause a bigger recession down the road6.
We are left with two more interesting features of cyclical (co)movements. The degree to
which real and financial cycles converge across groups of member states is neither constant,
nor does it increase in linear fashion over time. All the previously described processes might
deliver the periods of high synchronisation, followed by rapidly collapsing convergence.
Finally, the (in)famous duality between the core and the peripheral countries emerges as a
theme here as well, as country groups tend to cluster in terms of real and financial cycles. All
of these notions call for further research and better understanding, but they are nevertheless
useful information for shaping policy responses.
The expectations of convergence in real and financial cycles due to increased trade and
financial integration, pursued strongly within Europe (the euro zone) during the last few
decades, have far from materialized. In addition to some old suspects, theoretical and
empirical literature have identified some new channels at work to explain for such a
phenomenon7. The traditional view that increasing trade integration may, or may not be,
supportive for the synchronisation of business cycles, depending on the specific trade
pattern, has certainly been warranted (Krugman vs. Frankel-Rose hypothesis). Further on,
stronger financial linkages have also proven to be an elusive channel for engineering
sustainable convergence of real and financial cycles. While debt flows remain a theoretical
channel that might increase the extent of international risk sharing, the actual effect depends
on what happens during the crises. For example, an increased risk premium and depressed
collateral prices in a country hit by an asymmetric shock may reverse capital flows exactly
during the period when higher inflows are most needed. Such effect is usually known as a
sudden-stop in capital inflows and the mechanics of the process is not too different from the
disrupting effect of the financial accelerator on the credit channel of monetary policy in
developed countries.8
Finally, even an analysis of trade and financial integration, while improving our understanding
of complex open economic systems, may fall short of explaining the synchronisation of real
and financial cycles. Since cyclical patterns are largely attributable to different cost structures
and profitability profiles that affect investment decisions and output volatilities, another
potential explanation should be sought on the production side, which operates in conjunction
with trade and finance. What is often left out of the euro area storyline is the fact that the
monetary union came on top of diverging trends in total factor productivity (TFP) as the
catching-up process in the EU came to a stall during the early 1990s9. A reversal in the
catching-up process came regardless of high investments in some peripheral countries and
high capital output ratios - rather than a sign of success, high investments were an indication
of deeper-rooted problems.10 Many peripheral countries did not need more investments per
se to restart convergence - what they needed was a more efficient allocation of investments.
The efficiency of investments fell victim to poor economic governance, rigid labour and
product markets, low investments in information and communication technologies, defunct
educational systems and the poor quality of corporate management. What the monetary
union accomplished against such a background was to create an illusion of continuing
convergence on the back of increasing foreign borrowing and investment in non-tradables,
rather than to enact discipline in the economic governance of peripheral countries. The
adoption of the single currency, followed by the consistent private sector interest spread,
elimination of exchange rate risk and implied fiscal bail-out clause, cemented the duality in
the quality of economic governance and boosted the suboptimal reallocation of resources in
the periphery. So, we have observed financing low-productivity sectors (via real estate or
government spending) with debt inflows, instead of capital flows fuelling further "catching-up".
This has produced asset bubbles and large exposures of banks from core euro area
countries, as well as world-wide creditors, towards the euro area periphery, and created
strong contagion channels that have increased the amplitude of swings in comparison to
historical business cycles. Such a phenomenon has in quite a few instances also been
observed outside of the euro-area, regardless of the exchange rate regime implemented,
which brings me to the discussion of challenges in finding an optimal policy mix in a small
open economy.
2. Mutations of the traditional monetary trilemma: policy responses in open
economies or "Ray in European clothing"
According to the newly emerging set of principles, this dual central banks' mandate is
supposed to function via two independent sets of policies. As real and financial cycles
diverge, central banks need a set of two independent policies.11 Monetary policy should
target the real cycle in order to stabilize inflation, while macroprudential policy should be
used to tame the financial cycle. The task of maintaining price stability and financial stability
should be even easier if central banks adopt a flexible approach to inflation targeting, the one
that allows for temporary deviations and the gradual convergence towards the inflation
target, as pointed out by Stanley Fischer (2010)12.
Such a simple story of two independent policies - monetary and macroprudential - aiming at
two separate goals, has some weaknesses. Such a framework is underlined by the
traditional monetary trilemma theorem launched by the Mundell-Fleming model. The
traditional monetary trilemma limits policy choice to only two among the three dimensions:
independent monetary policy, free capital mobility and exchange rate stability. However, the
usefulness of exchange rate flexibility as the shock absorber has been increasingly
questioned over time. A more sceptical view on the usefulness of flexible exchange rates has
changed the trilemma into an "irreconcilable duo: independent monetary policies are possible
if and only if the capital account is managed" (Ray, 2013)13. Those who believe that
exchange rate flexibility should not be abandoned, even in the cases of small open
economies, have largely deflated their expectations of flexible exchange rates to act as
shock absorbers14. Therefore, the notion that "the global financial cycle constrains national
monetary policies regardless of the exchange rate regime" has now become part of common
knowledge.
With supranational "one-size-fits-all" monetary policy, the role of national fiscal policy in
stabilizing real activity and inflation has, accordingly, increased in euro-area member states.
However, the configuration of single monetary policy, coupled with national fiscal sovereignty
and the no bail-out clause, has generated suboptimal policies and frictions that threaten the
monetary union. With single monetary policy, commitment not to bail-out heavily indebted
member states is necessary to eliminate potential for moral hazard. However, the actual
euro-area experience demonstrates strong incentives for sovereign fiscal policies to
"trespass" on the prudent fiscal stance, either in the expectations of non-enforcement of the
no bail-out clause, with the implicit assumption that sovereign default will be politically
unacceptable, or through a direct support of common monetary authority through special
monetary operations. This uneasy triangle is usually referred to as the fiscal trilemma of the
monetary union. Such a "holy trinity" makes impossible the cohabitation of the independent
monetary policy of a supranational central bank, national fiscal sovereignty and the no
bailout clause15. In order to ease the frictions stemming from national fiscal policies, the
monetary framework of the euro area was reconstructed by implementing the elements of the
banking union (the Single Supervisory Mechanism and the Single Resolution Mechanism),
setting up the European Stability Mechanism (ESM, previously the European Financial
Stability Fund (EFSF)) as well as by starting the ECB's quantitative easing program (QE). All
these mechanisms should help to decouple bank distress and sovereign debt pressures.16
The described trilemmas in the European economic and monetary framework, with the still
absent synchronisation of real and financial cycles, have given birth to a specific
quadrilemma that demonstrates difficulties faced by policy makers in the euro area. With
supranational monetary policy concerned primarily with the overall price stability objective,
symmetric (global) shocks transmitted through financial linkages and domestic (national)
divergent cycles, the burden of adjustment has to be borne by national macroprudential
policy. The absence of other adjustments mechanisms, such as a perfect labour mobility or a
transfer mechanism in the form of unemployment insurance17, adds to the burden on fiscal
policy, which is already suffering from moral hazard issues. The Vice-President of the ECB,
Vitor Constancio, is right to emphasize that "macroprudential policy is therefore essential in
any economy as the business and financial cycles are not synchronised. Even more so in a
monetary union where vulnerabilities identified in each country can be addressed with
macroprudential policy, allowing for the appropriate heterogeneity, while countries remain
subject to a single monetary policy"18.
13
Ray, H. (2013): Dilemma Not Trilemma: The Global Financial Cycle And Monetary Policy Independence,
Working Paper 21162, NBER Working Paper Series.
14
Couré, B. (2015): Paradigm lost: Rethinking international adjustments, speech atEgon and Joan von Kashnitz
Lecture, Clausen Center for International Business and Policy, Berkeley, 21 November 2015.
15
Beck, H., Prinz, A. (2012): The trilemma of a Monetary Union: Another Impossible Trinity, Leibniz Information
Centre for Economics.
16
Pisani-Ferry, J. (2012): The Euro Crisis and the New Impossible Trinity.
17
Bernoth, K., Engler, P. (2013): A Transfer Mechanism as a Stabilization Tool in the EMU, DIW Economic
Bulletin, 1.2013.
18
Constâncio, V. ibid.
There are a couple of other difficulties related to the use of national policies. The shock
absorbing capacity of fiscal policy is in too many instances limited by the narrow fiscal space
existing before the crises. The recession has further eroded fiscal positions and fiscal rules
have failed to tame unsustainable fiscal paths so that the ability of fiscal policies in the EU to
deal with another blow of crises is quite limited. Also, a need for national macroprudential
policy immediately opens the issues of harmonisation and coordination on the international
level in order to avoid unintended consequences, which I will comment in more detail later
on. Additionally, for macroprudential policy to be effective it must be intrusive, affecting the
"normal behaviour" of agents and markets19, yielding benefits in reducing long-term costs
generated by the systemic risk that makes it hard to attenuate public interest thus creating a
central bank's legitimacy paradox20.
Unconventional expansionary monetary policy, which was pursued after reaching the zero
lower bound, and out of the fear of "the risk of doing nothing"21, may be risk-inducing by
fuelling search for yield behaviour. Abundant liquidity and low borrowing costs have the
capacity to generate bubbles, confirming a notion that rational individual decisions may lead
to irrational social outcomes - albeit as a reaction to highly non-conventional policies. When
inflationary impulses eventually pick up, the present monetary support will dry up and trigger
a renewed divergence of national real and financial cycles, the phenomenon termed
"unfinished recession".
The reconstruction of the euro area is clearly the work in progress. We need to get the policy
framework right in order to pursue optimal policies. But given the magnitude of challenges, a
good policy framework will not be enough to set the right policies - a lot of talent and
ingenuity will be needed as well, making our job an art much more than before.
3. Critical moments in the post-crisis reconstruction of the European Union and
specificities of macroprudential policy
The experience of the global financial crisis and more recent euro area debt crisis has
motivated the reconstruction of the European economic and monetary framework along the
pillars presented in the Fiscal Compact and Five President's Report22 on completing the
monetary union. These issues need to be put into the described perspective in order to value
the potential of the new framework to reduce the chance of catastrophic scenarios and
provide us with adequate instruments should such a scenario take place.
First, the rebalancing of the euro area has often been associated with reducing labour costs
in order to improve competitiveness. Coeuré (2016)23 vocally reinforces the view that
productivity growth is central to competitiveness and to growing out of debt, as opposed to
benefits of wage moderation. Seeing rebalancing as being all about cutting costs is
misguided as benefits diminish with more countries engaging in such activities. However,
pursuing structural reforms to raise productivity, in contrast to wage moderation, benefits
substantially and uniformly all countries. "We do not need all euro area countries to adopt
identical structural reforms. What we need is a framework that takes into account both how
countries differ based on their national conditions, and how they are similar by virtue of being
in a monetary union. Within those parameters there are various combinations of
countryspecific institutions that can produce smooth adjustment." (Praet, 2015)24.
These notions should, of course, be the key ingredients of the Macroeconomic Imbalance
Procedure and the Structural Reform Support Programme (as of 2017). If these conditions
are met through institutional reform plans (until 2025), relying on deeper convergence,
entailing, for example, Competitiveness Authorities and further financial and fiscal reforms,
including the Deposit Insurance Scheme, Capital Markets Union and European Fiscal Board,
should help resolve the quadrilemma. In the words of the Report: "...the Macroeconomic
Imbalance procedure (MIP) could be utilised as a tool not only to prevent and correct
imbalances but also to foster reforms and monitor progress in each euro area Member State
towards these common standards. Significant and sustained convergence towards similarly
resilient economies should be a condition for access to a shock absorption mechanism to be
set up...".
As central bankers we need to be aware of the role and importance of structural reforms.
And we also need to communicate this to the general public. However, even if convergence
in TFP as a source of sustainable catching up gets kick-started and risks arising from it
eventually get ironed-out, fiscal and macroprudential policies will still be needed to take care
of residual idiosyncratic shocks. Moreover, we are directly responsible for getting
macroprudential policy right, and in order to be able to do that, we need a profound
understanding of all the issues relevant for its smooth and efficient implementation. Some of
the critical issues for macroprudential policy at this point in time encompass (i) cross-border
spillovers, (ii) the coordination of macroprudential and monetary policy and (iii) devising an
internally consistent structure of macroprudential instruments.
International policy coordination, harmonisation and the consistent application of
implemented instruments are vital to ensure effectiveness and limit the possibility and impact
of adverse cross-border spillover effects25. The potential spillover of nationally implemented
macroprudential policies largely depend on the degree of financial cycle synchronisation,
especially within the highly integrated (economically and financially) states, as in the case of
the European Union, or even more so within the currency union members with a single
monetary policy. Several aspects of the potential spillover should be considered when
formulating the policy stance in a highly integrated environment that challenges us in
pursuing financial stability. Outward cross-border spillovers of systemic risk create a need for
countervailing macroprudential measures, clearly emphasising the need for policy
coordination and measure reciprocation. In contrast, inward spillover effect is a direct
consequence of the regulatory arbitrage that motivates internationally operating financial
institutions to seek organisational restructuring that minimizes regulatory costs. The issue of
converting subsidiaries into branches has recently attracted a lot of attention, as some
member states are actively trying to reduce this risk,26 alongside international efforts directed
towards formulating a framework for voluntary cross-border reciprocity27. Some countries, for
example, try to internalize the costs of registering subsidiaries as branches by increasing
depositor and retail consumer legal protection through an option for retail clients to cancel
liability/claim without penalty, extraordinary contributions to deposit guarantee systems, etc.
The potential for intra-banking-group arbitrage could also be diminished if a macroprudential
measure is applied at the appropriate level of consolidation and/or exposure location, making
reciprocity arrangements a necessary condition for mitigating these effects.
Since it may be difficult to simultaneously hit macroprudential and monetary objectives due to
the general low degree of synchronisation between real and financial cycles, the policy
coordination of the two is an essential prerequisite for simultaneously stabilizing the general
price level and financial movements as there are "important synergies and interactions
between the two policy functions" (Constancio, 2015). This is especially evident today in the
environment of the anaemic growth and low inflation that require pursuing the expansionary
stance of monetary policy, yet at a price of jeopardizing financial stability through the search
for yield behaviour that might create new asset bubbles. To tame these risks, the tight stance
of macroprudential policy is needed. Still, it remains to be seen how effective
macroprudential policy can be in taming the risks that emanate from a long period of
ultraloose monetary policy.
The macroprudential ammunition at the disposal of central banks is another potential source
of concern. The CRR/CRDIV has provided us with various tools: supply-side (such as capital
and liquidity buffers) and demand-side instruments (such as LTV, LTI or DSTI ratios).
However, one should be very careful not to err in calibration of those instrument, whether on
the side that leaves insufficient coverage (effectively producing policy inaction) or on the side
that creates too much of a burden (exceeding the net benefit of macroprudential policy in the
medium term).
Conclusion
I hope this overview comes as a stimulus for further theoretical ad empirical research,
regardless of the degree of agreement on the specific issues outlined in this speech.
Therefore, I am looking forward to this conference. Hopefully, we will leave with answers to
at least some of the questions raised and with a strengthened sense of obligation to continue
with demanding work.
Thank you.