Yves Mersch: The euro and the ECB - perspectives and challenges
ahead
Keynote address by Mr Yves Mersch, Member of the Executive Board of the European
Central Bank, Journée Boursière, Luxembourg, 6 May 2013.
* * *
Ladies and Gentlemen, dear friends and guests,
It was fifteen years ago, in May 1998, that the first Executive Board of the European Central
Bank was constituted and commenced its work in Frankfurt. This anniversary is passing
almost unnoticed. Some may say this is not a good moment for cheerful celebration. Indeed
we have little room to pause as we are confronting new challenges every day. Nonetheless, I
would like to take a step back and start off my remarks with a tribute to the founding fathers -
and founding mother - on the Executive Board of the ECB. They have set us on the right
course. The ECB, for its part, has delivered on what it has been asked to do.
The same cannot be said for other policy areas. Partly because of its success in establishing
itself as a credible institution, the ECB has been in a position to step into the breach during
the crisis as a guarantor of stability and is now being asked to shoulder additional
responsibilities. As back then, when the first Board prepared for the launch of the euro, today
the ECB is steering a course into uncharted territory. As it was back then, today we need to
be guided by firm principles and a clear compass to serve as an anchor of stability.
Once again we are engaging in a process of institution building, like the pioneers fifteen
years ago - including, in our own modest perimeter, the setting up of the Banque Central du
Luxembourg.
Once again the Executive Board and the Governing Council need to be mindful about the
limits of what can be asked of monetary policy, what can be asked of central banks and what
must not be asked. This will be a main theme of my remarks tonight on the perspectives and
challenges that lie ahead for the ECB and the euro. Equally though, other policy areas need
to be mindful - and be reminded - of their respective responsibilities for the stewardship of
the euro.
A sound institutional framework for the euro
Let me be perfectly clear: the Euro, the promise of a single and stable currency for Europe -
from its inception - has been both a political and economic project. With the establishment of
the ECB fifteen years ago and the creation of the euro on 1 January 1999 monetary policy
was centralised and safeguarding the euro's stability was delegated to a strong and
independent central bank. The ECB has delivered on its primary objective of price stability
and will continue to do so. By contrast, responsibilities for fiscal policy, economic policies and
supervision remained located at national level, while being subject to common rules and
procedures. In the end this arrangement has proved insufficient in preventing the build-up of
financial and economic imbalances in the euro area, associated with divergence in
competitiveness as well as unsustainable trends in public and private debt and associated
banking crises.
For this reason last year the Van Rompuy report by the four presidents put forward the case
for complementing and completing monetary union with further "four unions" to ensure that
all relevant policy areas fully live up to the common responsibility that sharing a common
currency implies. These are important steps towards overcoming the "institutional solitude" of
the ECB, in the words of the late Tommaso Padoa-Schioppa.
First, banking union was a missing element in the original Maastricht design. It is essential to
provide a durable foundation for monetary and financial stability and to ensure a level playing
field. Counterparties remaining under different national regulatory regimes can be a
significant source of financial fragmentation and an impediment to the transmission of the
single monetary policy.
Second, we need further steps towards fiscal union as well as a strengthening of the
governance of economic union. Ultimately, this should also be reflected more broadly by
elements of political union. Much progress has been made, namely in the first two domains
to provide a sound basis for financial integration and financial stability as well as to ensure
fiscal sustainability.
Further efforts are clearly needed on structural reforms to restore competitiveness and
promote lasting economic growth and employment creation. In the end, well-functioning
institutions at both national and European levels - including, in particular, forceful application
of the macro-economic imbalances procedure and credible enforcement of the fiscal rules -
are essential, alongside the ECB as the guarantor of a single and stable currency. Together
they provide the appropriate foundation ("Ordnungsrahmen") for a genuine monetary and
economic union underpinning durable wealth creation in the euro area, based on a sound
financial system, sustainable public finances and a competitive market economy.
Essential elements of banking union
Progress on the four unions set out by the four presidents is necessary, first and foremost,
for crisis prevention, i.e. they will help to avoid the build-up of economic imbalances and
financial vulnerabilities that have led to the present crisis. Setting out a strong commitment
and a clear framework for improved future governance also facilitates crisis resolution and
crisis management. At the same time we should not put the cart before the horse in the
transition period and responsibilities must be clearly defined.
This applies in particular to the main elements needed for a banking union.
A single supervisory mechanism (SSM) ensures effective supervision and a level playing
field across the euro area, underpinning financial integration and safeguarding financial
stability. The SSM regulation is nearing adoption subject to the necessary parliamentary
approvals in a number of jurisdictions.
A single resolution mechanism (SRM) is essential to break the link between banks and their
respective sovereigns and to ensure that non-viable banks can be wound down in an orderly
manner. A draft regulation for the SRM is expected from the Commission by the summer.
SSM and SRM are like Siamese twins, on cannot survive without the other. A supervisor can
only credibly do his job if liquidation is possible without undue risks to financial stability.
Conversely, the resolution mechanism must be able to rely on the well-founded and impartial
judgement of the supervisor before putting any funds at his disposal.
While a common fiscal backstop is needed for the SRM, resolution funds could come from
the private sector, namely the financial industry and the banks eligible for the SRM. To
achieve fiscal neutrality this could be done via private sector pre-funding or via a mechanism
that would re-reimburse any loans from the SRM ex post via a bank levy. In this way
recourse to taxpayer funds could be limited and remain temporary for the SRM.
The European Council has decided to entrust the SSM to the ECB. This has been seen by
some as a testimony to the credibility that the ECB has built up as an institution. Others
regard it as a poisoned chalice, which might put into doubt the very credibility and
independence that the ECB has earned itself in the monetary domain.
With the ECB set to assume supervisory responsibilities, indeed much has been made of
possible conflicts of interest between monetary policy and financial stability, and supervisory
tasks in particular. To my mind, such conflicts are pertinent and should not be ignored.
Hence it is essential that the SSM and all reporting lines for supervisory functions to the
Governing Council are clearly separated from other ECB tasks. The Governing Council's
commitment to deliver on its primary mandate must not be put in doubt.
At the same time, a successful banking union in the euro area will help crisis prevention in
future. It will also be helpful for crisis resolution at present. On both counts swift
implementation of SSM and SRM would reduce, not increase, the risks of overburdening
monetary policy. Over the medium term, and in most circumstances, monetary and financial
stability are complementary. This also applies to the task of supervision to maintain sound
financial institutions. Conflicts arise once one or the other objective is put in jeopardy and if
appropriate instruments are not in place to achieve the respective objectives. Today, most
countries have adopted arrangements where possible conflicts are appropriately managed
and internalized inside the central banks.
What monetary policy can do and cannot do
This brings me to the role of monetary policy in times of financial crisis.
We need, again, to distinguish three aspects: crisis prevention, crisis management and crisis
resolution.
crisis
On prevention, maintaining an environment of price stability is the best contribution that
monetary policy can make to supporting financial stability. The attention paid to money and
credit variables in the ECB's monetary policy strategy also helps to take into consideration
the build-up of financial imbalances and associated development in asset markets. These in
turn can imply risks to both financial stability and price stability over the medium term.1
On crisis management, in a financial panic there is a legitimate and well-established case for
central banks to step in to provide liquidity as a lender of last resort. The well-known
principles established by Bagehot in the 19th century remain a valuable guidepost: "lend
freely, to illiquid but solvent institutions, against adequate collateral, at a penalty rate". While
this is easier said than done in practice, these principles remain a salutary reminder of the
need to guard against moral hazard in central bank crisis measures.
Responsibility for crisis resolution lies outside the domain of monetary policy and is up to
supervisory and fiscal authorities. More precisely, while the SSM is to be entrusted with the
analytical role performed inside the central bank, the SRM needs to take the financial and
redistributive decisions that belong to the political sphere, when it comes to winding down
non-viable banks. More broadly, addressing the root causes of the crisis, both economic and
financial, is up to other policy domains, it namely lies in the hands of governments and
regulators.
Against this background, monetary policy measures in a crisis can serve a critical role in
guarding against disorderly self-fulfilling disruptions. They can buy time for other policy
domains to undertake the necessary adjustments and reforms. But they cannot substitute for
such actions. They must also be mindful of adverse longer-term consequences of short-term
support provided.
Here is my "to do" and "not to do" list on monetary policy in crisis times, expanding a little on
Bagehot.
• Provide liquidity, not solvency support. Recapitalization is the task of shareholders
and governments.
•
Prevent disorderly deleveraging and fire sales of assets, do not delay unduly
necessary balance sheet adjustments.
•
Provide temporary backstop to markets under stress, do not replace market
functioning for too long.
•
Provide short-term liquidity support, do not enter long-term credit allocation to be left
to financial intermediaries.
•
Act as lender of last resort to the banking system based on the traditional role of
central bank refinancing, do not confuse this with LOLR to governments or
inappropriate fine-tuning of financial markets.
•
Support functioning monetary transmission mechanism (via banks and markets), do
not guarantee uniform financing conditions or suppress fundamentally justified risk
premia.
•
Preserve singleness of monetary policy, do not compensate need for political
commitment to keep composition of currency area intact.
•
Buy time and pre-empt self-fulfilling dynamics (tail risks), do not distract from need
by other policy domains to undertake structural reforms and address underlying
fundamentals, avoiding wrong incentives and moral hazard.
•
Fulfil the duty of fire-fighting in crisis to preserve financial and ultimately price
stability, but keep a medium-term perspective and do not neglect unintended
consequences and adverse side-effects from protracted non-standard measures on
financial institutions and functioning.
•
Take responsibility and credit for averting Armageddon, but do not overstate what
monetary policy can and cannot do.
The ECB's non-standard measures
In living up to these "ten commandments" sketched out before it is well understood that in
practice central banks need to perform a balancing act when carefully assessing the costs
and benefits of unconventional measures.
Against this background let me briefly review the main characteristics of the non-standard
measures adopted by the ECB in the wake of the financial crisis. Most measures are
mirrored in the size and composition of the Eurostem balance sheets, reflecting its role as
liquidity provider of last resort in the crisis: to monetary counterparties, to markets and
ultimately to the real economy.
•
The bulk of liquidity support has been via lending operations (against collateral),
rather than via outright purchases. This practice is closer in line with the ECBs
operational framework, limits balance sheet exposure and facilitates endogenous
exit. At the same time, both modalities are in principle also part of the toolkit of
traditional instruments for monetary policy operations.
•
With the adoption of fixed-rate full allotment in liquidity provision, lending is almost
done freely against collateral to deal with impaired money markets, while quantities
respond endogenously to the degree of stress in interbank markets.
•
Extension of LTROS maturities up to 1 year in 2009 and to 3 years in 2011/12. This
lengthening of the maturities still remained broadly within the realm of short-term
liquidity provision while addressing uncertainty on bank funding.
•
Covered bond purchase programmes were limited in size and duration. They were
targeted to malfunctioning markets and are important bank funding instruments. This
was done with a view to act as catalyst for market activity (notably in 2009) rather
than replacing private market activity.
• The securities market programme in place from 2009-2012 again aimed at specific
dysfunctional government bond markets, where volatility had increased and liquidity
diminished. Purchases were not aimed at targeting specific yields and were fully
sterilized to offset impact on the size of the Eurosystem balance sheet.
•
The Outright Monetary Transactions announced last September to address
unwarranted tail risks, allow for ex ante unlimited interventions, but are subject to
strict conditionality (IMF/EU programme) to address concerns over moral hazard.
They are also restricted to maturities up to three years.
All of the ECB's non-standard measures seek to balance the benefits and possible adverse
side effects of what monetary policy can and cannot do. This pertains, for example, to the
maturity of operations, the duration of liquidity support, the role of conditionality.
Scope and limits of non-standard measures
Most of the ECB's non-standard measures have been motivated by impairments in the
transmission of monetary policy, in particular with respect to impaired interbank markets,
bank funding and bank lending channels as well as financial market segments with particular
relevance as benchmarks (governments bonds) or as a bank funding instrument (covered
bonds).
Additional obstacles to the smooth transmission of the ECB' monetary policy stance across
the euro area arise from financial fragmentation that exacerbates heterogeneity across
countries that may exist in part for fundamentally justified reasons.
The objective of restoring a better or more uniform transmission of a given stance of the
single monetary policy is conceptually distinct from the objective of using unconventional
monetary policy to impart additional monetary policy stimulus when standard policy rates are
constrained by the zero lower bound. In practice this distinction is the more difficult to draw,
the more widespread transmission impairments become and the closer policy rates are to the
lower bound.
In both dimensions, it is nonetheless useful to recall again the limits of monetary policy.
Monetary policy transmission may be hampered at times where banks, in particular, but also
non-financial sectors need to repair their balance sheets. At times of uncertainty and lack of
confidence liquidity may be hoarded rather than be put to use for investment. These are
cases where standard monetary policy may be "pushing on a string" (in the words of John
Maynard Keynes). These are also impediments that need to be fundamentally addressed by
regulators and government entities, via the strengthening financial balance sheets and via
confidence-enhancing economic and structural policies.
One example of the need for action in the respective domains to help unclog specific
transmission and funding channels concerns impediments to SME funding and possible
measures to re-activate securitisation markets. The latter may be impaired by a combination
of unwarranted stigma due to the fall-out form the US subprime crisis, by stringent regulatory
requirements and by a range of structural and practical factors. These have to be addressed
primarily outside the realm of monetary policy, even if the latter could potentially perform a
catalytical role in some circumstances.
Regulatory impact on financial markets and monetary policy: the financial transaction tax
Finally, let me turn briefly to the financial transaction tax (FTT), as an example where
government regulation may have adverse consequences on financial markets and monetary
policy transmission. I would not like to enter into the case for or against the FTT.
Reservations are well known, while it is appropriate for us to take a neutral view on the
objectives of this measure.
Looking at the specific FTT proposal published by the EU Commission on 14 February,
nonetheless attention needs to be drawn to possible negative implications for the
implementation of monetary policy and financial stability:
• Incentives to replace secured market funding (subject to FTT) with central bank
liquidity (exempt from FTT), which may hamper market liquidity and increase banks'
recourse to the Eurosystem funding.
•
The possible distortion will be largest on the shortest maturities in the secured
money markets, i.e. repo market (given FTT does not take into account maturity).
•
Reduced liquidity in secondary fixed income markets (including government bonds)
which may hamper smooth monetary policy transmission and worsen market
fragmentation at a time when many of these markets remain fragile.
For these reasons a careful impact assessment warranted in these respects and some
modifications in the current proposals merit consideration.
Some decades back, long before the financial crisis, James Tobin gave us four definitions of
financial market (in)efficiency (in his Fred Hirsch Memorial lecture 1984)2:
1. information arbitrage efficiency - accepted by Tobin in its weak form.
2. fundamental valuation efficiency: do financial asset prices reflect rational
expectations of future payment flows? - very much doubted by Tobin.
3. full insurance efficiency: do financial markets support Pareto efficient, complete
markets Arrow-Debreu allocations? - very much questioned by Tobin, since
incomplete financial markets interact with inefficient goods and labour markets.
4. Finally, Tobin proposed a notion of "functional efficiency", i.e. do financial markets
and intermediaries provide value to society at large? Do they channel savings to the
most productive investments, by pooling risk and allocating it to those best placed to
bear it?
It is this fourth notion (not much found in our finance textbooks) that we need to revert to
assess the financial system in the wake of the crisis and its service for the real economy.
While he was critical of the considerable resources that tended to be devoted to "churning",
to "gambling" and endogenous, self-referential activities in financial market, he was a lifelong
critic of the Tobin tax named after him.
Concluding remarks
Fifteen years after the setting up of the ECB, we need to press on with the ongoing relaunch
of the institutional underpinning to put the euro on a sounder footing. Such a relaunch should
not put into question the achievement of the single monetary policy, the ECB's clear and
unequivocal mandate and the clear division of roles and responsibilities among different
policy areas. In particular, a fully-fledged banking union, as complement to monetary union
supports financial integration and monetary policy transmission and hence ultimately reduces
the burden on monetary policy.
At fifteen, the ECB, and the euro, are approaching adolescence. In the crisis the euro area
had to grow up very quickly amidst daunting challenges to its identity, even its very
existence. Further turbulence cannot be ruled out. But I am confident that we, at the ECB,
will do all that is needed for the euro to have a long and prosperous life. After very difficult
years of adjustment and renewed institution building, the euro will stand on solid feet and
emerge stronger, provided that all in the family of stakeholders live up to their respective
responsibilities.