Jens Weidmann: Challenges for the euro area: what progress has been
made - what still needs to be done?
Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, at the Swiss Institute
of International Studies, Zurich, 9 March 2015.
* * *
1. Introduction
Dr Meyer, Thomas, Ladies and Gentlemen
Thank you for inviting me to this event. It gives me great pleasure to be here with you today
in this beautiful city on the River Limmat.
Being a monetary policymaker is rather like trying to swim at a constant speed. If you dive
into the water at the Upper Letten, you will simply be swept along by the current without any
effort - in fact, you may actually have to actively slow yourself down.
If you take a swim in Lake Zurich, on the other hand, you can usually progress at your own
pace in a leisurely breaststroke. But, of course, even there you may encounter more
turbulent waters - waves churned up by a passing boat, for example.
I'm sure you'll agree, Thomas, that we central bankers are currently faced with a fairly strong
countercurrent. Euro-area inflation has been below the target of just under 2% for months
now, with another negative rate of -0.3% recorded in February. And the consensus is that
the inflation outlook will remain subdued for some time to come.
The ECB Governing Council has therefore decided to make extensive government bond
purchases, thus progressing to an even more expansionary monetary policy stance. In terms
of monetary policy, the Eurosystem is undoubtedly facing a difficult situation at the moment.
Failing to meet its inflation target for too long could have negative repercussions, as the
various players in the economy have adapted to this pace of inflation.
As a case in point, both private and public borrowers have based their contracts on the
benchmark of inflation of below, but close to, 2% over the medium term. If inflation remains
below this level for a long time, it will become more difficult for them to service their debt. And
that could have implications for price developments and the credibility of monetary policy.
The dangers associated with inflation staying too low for too long therefore have to be taken
seriously.
But is that really cause for us to loosen our monetary policy? I have my doubts. Despite the
horror scenarios evoked in some quarters, the risk of a self-reinforcing spiral of falling wages
and prices - of deflation, in other words - is very low, a view shared by the vast majority of
the Governing Council members.
There are, at least, no visible signs of especially low wage settlements, either in Germany or
the other large euro-area countries. Negotiated wages are likely to rise by around 3% in
Germany this year; the increase just agreed for Germany's metal-working industry is around
that size. And even in Spain, where inflation rates are negative, the Commission is expecting
wages to rise by 0.7% in 2015.
As for the spectre of debt deflation, there are currently no signs in any of the crisis countries
other than Greece that low inflation is hampering deleveraging in the non-financial sector.
The primary reason why debt ratios in these countries are rising is that increased public
borrowing is overshadowing the partial deleveraging that has occurred in the non-financial
private sector.
When assessing the monetary policy situation, of course, it is also important to look at the
cause of the low inflation rates. Plummeting energy prices are one of the main factors. But
this slump is likely to be fairly short-lived. And although falling energy prices are slowing
down inflation, they are also boosting consumers' purchasing power and cutting enterprises'
costs. Falling oil prices are therefore having the effect of a small stimulus package.
This assessment is also reflected in the ECB staff macroeconomic projections published last
Thursday. While the ECB staff lowered the projection for this year's inflation rate, they made
perceptible upward revisions to the growth outlook for this year and next. Inflation is now
expected to return to the desired range of "below, but close to, 2%" in 2017.
Another point to consider is that purchases of euro-area government bonds are not "just
another" instrument. As the founding fathers of our monetary union were well aware, in a
monetary union with a single monetary policy but continuing national sovereignty over fiscal
policy, the easier it is to pass on the fallout of unsound budgetary policy to other member
states or to the Eurosystem, the stronger the inherent incentive for countries to run up debt.
That is why the EU treaties forbid the Eurosystem from purchasing bonds directly from
member states or giving them loans. Now the Eurosystem is buying government bonds not
on the primary market but on the secondary market. That is not prohibited. Still, these
purchases will make the Eurosystem the member states' largest creditor, thus further blurring
the boundaries between monetary and fiscal policy to a significant extent.
Ultimately, the government bond purchase programme also means that all governments
- regardless of their credit quality - can, in effect, fund a substantial portion of their debt very
cheaply. As the central banks are only purchasing the government bonds of their home
countries, the member states will recoup much of the interest payable on these instruments
at a later date via central bank profits.
That can, of course, ingrain certain habits and ultimately encourage countries to put the
necessary consolidation of their public finances on the back burner. And that, in turn, could
increase pressure on monetary policymakers to keep interest rates low for longer than
necessary - even if monetary policy considerations would call for a rise in key interest rates.
The mere impression that monetary policy is no longer centred around the goal of price
stability could erode its credibility, and central banks would have to make great efforts to
combat this.
Ultimately, deciding whether to make bond purchases is about weighing up which risks are
more pressing. On the one hand, we have the risk associated with blurring the boundaries
between monetary and fiscal policy, combined with possible financial stability risks caused by
very loose monetary policy. On the other, we have the risks to credibility caused by a phase
of low inflation, which could engender the risk of a self-reinforcing deflationary spiral.
Given that the oil price slump - the main cause of the low inflation rates - is temporary and is
also acting as a stimulus for the economy as a whole, I consider the former risks to be more
pressing than the latter at present.
Ladies and gentlemen, the world would be a far simpler place for the Eurosystem's monetary
policymakers if economic growth in the member states were stronger. When potential growth
is low, a central bank will soon start to run out of options - interest rates cannot simply be
lowered ad infinitum into negative territory.
One important reason why monetary policymakers have been forced to take ever riskier
action is the weak growth outlook for the euro area. According to estimates by the European
Commission,1 the euro area's potential growth over the medium term - in other words, over
the next ten years - is a mere 1%. And weak growth prospects mean not only a
comparatively small increase in living standards but also tighter budget constraints in the
future.
What we need is a lasting increase in growth. Yet that can only be achieved if we decisively
tackle our structural barriers.
2. What progress has been made?
It could be argued here that major progress has already been accomplished, especially in the
countries hit hardest by the crisis. I share this view. Indeed, much has been done to correct
the macroeconomic imbalances that were a root cause of the euro-area crisis.
Historian Harold James once likened the behaviour of member states before and after the
start of monetary union to that of couples before and after getting married: "It was like what
happens to couples who, once married, abandon some of their romantic and utopian
intentions in day-to-day married life. At the most trivial level, men now leave unwashed socks
lying around and women drop towels on the floor. In many cases, the situation then spirals
from there ..."2
Before the crisis, prices and productivity in some parts of the euro area had become
increasingly divorced from one another. When the financial crisis hit and investors'
riskawareness grew, they refused to continue to bridge the resulting gap.
But a lot has happened since then. For example, wage bargaining has been decentralised in
many countries and wage indexation abolished or, at the very least, reduced. Consequently,
wages can better reflect the specific circumstances of individual enterprises. This and other
measures have brought prices and wages closer into line with productivity. Member states'
price competitiveness increased significantly, to the point where current account deficits were
completely eliminated in all crisis countries except for Cyprus back in 2013. Cyprus, too, is
expecting to record a current account surplus in 2014.
In addition, progress has been made in the consolidation of government budgets. The
sustainability of public finances in countries such as Italy, Greece, Spain and Portugal has
also been improved by adjusting pensions for demographic factors, with measures including
an increase in the statutory retirement age. As a result, the pension system will be
strengthened financially, much needed expertise will remain in enterprises and the
demographically induced decline in the labour supply will be slowed down to a certain extent.
Germany took this path at an earlier point in time, which makes it all the more regrettable that
it is now back-pedaling a little on these reforms.
3. What remains to be done?
The measures that have been introduced have helped improve the public finance situation
and increase competitiveness. However, competitiveness should not just be the product of
cost cuts. Prosperity ultimately hinges on productivity - and this is where efforts should be
focused in the euro area.
What is now required are structural reforms that unleash innovative power and enhance
productivity. We need these reforms right now not least because they play a part in raising
income expectations. What is more, areas in which higher income is expected in future are
receiving investment today. Supply-side reforms can therefore support demand, too.
Responsibility for some areas in which there is a need for reform lies primarily with the
European Commission and the European Council rather than at the national level.
3.1 The digital single market
Ladies and gentlemen, economic textbooks are in complete agreement on what drives
productivity: technological progress.
In recent years, technological progress has been heavily influenced by IT. As is so often the
case, economists cannot quite agree on the scale of the contribution made by digital
4
technologies. But what they do agree on is that it is considerable.3,
However, the European markets for digital applications remain heavily fragmented,
especially with respect to legal issues such as protection of privacy, contents and copyright.
The liability of online intermediaries, electronic payments and electronic contracts are also
regulated differently. There is still no digital single market in the EU; instead, there are
28 individual digital markets.
If the single market were to enter the digital age with no holds barred, this could significantly
strengthen the forces of growth.
Studies5 show that creating a harmonised and well regulated digital single market has the
same potential as implementing the single market in its original form, which is to say an
upturn in growth of as much as 4%. In Germany alone, as many as 420,000 new jobs could
be created between 2015 and 2020.
3.2 Common market for services
The market for digital applications is not the only one in which integration remains
incomplete.
The single market has proven extremely successful at simplifying trade in goods. As a result,
competition here is intense. Enterprises' market power does not enable them to charge large
mark-ups on top of their costs; levels are similar to those in the USA, for example.
Creating a transatlantic market - the TTIP is a keyword here - could thus provide even more
stimulus in this regard. The USA is the EU's largest export market and its third most
important import partner for trade in goods. As far as trade in services is concerned, the two
regions share even closer connections.
And it is precisely in the area of services that the EU still has some catching up to do in terms
of intensifying competition. Mark-ups on the cost of services are, on average, higher than in
the USA. One could say that the European Commission's Services Directive has failed to live
up to expectations. Thus, achieving a single market for services and ensuring the unhindered
cross-border provision of services promise significant economic benefits.
3.3 Barriers to market entry
Obstacles to growth exist across individual member states in the form of red tape for
business start-ups, to cite one example. Frequent administrative formalities, long approval
periods and high fees make starting a business more complicated and expensive than
necessary.
In the World Bank's Doing Business table, for instance, Germany ranks 114th in the "ease of
starting a business" category. Speaking of which, Switzerland did not fare spectacularly well
in this category either, coming in at 69th place. Other European countries also found
themselves in mid-table positions at best. In other words, there is plenty of room for
improvement.
Even though an enterprise's direct costs may appear to be manageable at first glance, the
economic cost of difficulties entering the market and, as a result, weaker competition should
not be underestimated. For example, studies6 indicate that the differences between the costs
of entering the market in the USA and in the EU, while relatively small, could still account for
10% to 20% of the EU's productivity shortfall. The costs of removing red tape are
comparatively low and could help strengthen growth.
3.4 Labour markets
Ladies and gentlemen, market entry barriers can severely hamper productivity. But
productivity is not only subdued by regulations in the product market. In order for the
economy to flourish, resources must be utilised wherever they promise the highest return. Of
course, this is especially true of the most important resource of all - the labour provided by
each individual.
Studies7 show that innovative European firms are having a considerably tougher time
recruiting the staff they need than their US counterparts.
As a result, allocative efficiency and, ultimately, productivity are reduced. It would appear that
the reason for this is the "lock-in" effect produced by overly strict employment protection,
meaning that it is not so easy for employees to change employers.
That which creates security also creates inertia. But can you have one without wanting the
other? I think so. However, the answer cannot simply be to drastically cut employment
protection. The advice of labour market economist and Nobel Prize winner Chris Pissarides
could serve as a guideline here: "protect workers, not jobs".
In other words, the implementation of less stringent employment protection legislation linked
to adequate financial support in the event of job loss would likely reduce the overall
unemployment rate. But employees would be protected against the vagaries of the market.
The overwhelmingly high unemployment rate in many euro-area countries is reason enough
alone to improve the functioning of the labour markets. Especially dramatic is the high level
of youth unemployment, above all in Spain and Greece. The notion of a "lost generation" is
devastating not only from an economic perspective.
Spain and Greece have already initiated reforms to surmount the divide between protected
and precarious employment. Most recently, Italy has likewise passed reforms that head in
this direction. These steps are encouraging. But it is also clear that reducing unemployment
will not happen overnight - it will take time.
However, in countries where reform has been systematically pursued, such as Spain and
Ireland, the results are already visible. Spain's unemployment rate has fallen by almost three
percentage points from its peak during the financial crisis, while Ireland's unemployment rate
is already down by five percentage points. It is therefore crucial that they not stop halfway.
Flexible labour markets also remain important in the euro area for another reason. Last but
not least, the optimal currency area theory suggests that, in the absence of an exchange rate
as an adjustment variable, the free movement of workers in the labour market is required to
absorb economic shocks. Rendering the European labour markets more flexible would
therefore have a threefold positive effect.
3.5 Capital markets union
Differences in language and culture would suggest, however, that mobility in the European
labour market will not be as high in the foreseeable future as in other currency areas. This
makes it all the more important for other buffers to function effectively.
Even in federal currency areas such as the United States, Canada or Switzerland, this buffer
function is performed primarily by the capital markets. In the USA, for example, the
integrated markets for capital cushion around 40% of total cyclical fluctuations between the
US federal states. If a negative shock hits an industry or a specific region, then this loss is
spread widely beyond the state. But in return, shareholders throughout the country also
receive a share of the profits during the good times.
When compared with the equity capital markets, the significance of the credit markets as a
buffer is lower: around 25% of cyclical fluctuations are evened out via the credit markets.
Fiscal cushioning mechanisms, however, are by far the least significant: only 10% to 15% of
economic shocks are absorbed through public finances.8 This last figure is similar in other
federal systems. Only in Canada is the contribution considerably higher, at approximately
30%.
In terms of their performance, fiscal buffers thus correspond more closely to the traditional
leaf spring; only integrated capital markets are capable of providing the cushioning comfort of
modern air suspension systems. Here, the equity capital markets, in particular, are an
essential component.
4. The fiscal framework
Although the role fiscal adjustment mechanisms play in absorbing asymmetric shocks
appears to be limited, fiscal policy remains at the centre of the debate on the euro area's
future development.
This is related to the incentives for running up debt mentioned earlier, created by the
combination of a single monetary policy and national fiscal policies. As long as fiscal policies
remain in national responsibility, the member states also need to bear the consequences of
their policies themselves. Otherwise, incentives will be created to engage in unsound
practices.
The rescue measures taken during the crisis prevented any further escalation of the crisis
and stabilised the euro area in the short term. However, elements of joint liability have also
increasingly been introduced as part of these measures, while fiscal policy has remained a
matter for national policymakers. Hence, there is a growing divide between liability and
control, which can lead to growth in incentives for government borrowing.
A frequently suggested solution to these euro-area stability problems is the introduction of a
fiscal union with centralised intervention rights at the European level and joint liability. This is
not a fundamentally new idea. Addressing the Bundestag in November 1991, for example,
the then-Chancellor Helmut Kohl remarked that "the idea of sustaining economic and
monetary union over time without political union is a fallacy".
But we ought to remain realistic: there is currently no sign of any willingness - either in
Germany or in our partner countries - to transfer fiscal policy sovereignty to the European
level. Therefore, we will have to make do with the regulatory framework agreed on at the
time by all parties - which places liability and control at the national level.
But the principle of individual national responsibility requires a double safeguard. First, strict
fiscal rules that prevent the development of unsound public finances. Second, a reliable ban
that prohibits countries from providing each other with aid in times of financial distress. Only
a credible no bail-out clause results in risk-appropriate pricing of a country's government debt
by financial markets. The more debt a government takes on, the more expensive it becomes.
The example of Switzerland shows that a combination of fiscal rules and individual financial
responsibility can ensure sound public finances. A crucial element in Switzerland's fiscal
framework is the no bail-out regime for local governments.
But up until ten years ago, no one was quite sure whether a canton really was exempt from
the obligation to bail out a bankrupt municipality within its jurisdiction. The answer to this
question was provided by the Leukerbad case: a court ruled that the canton of Valais was
under no obligation to bail out the highly indebted municipality of Leukerbad. Ever since, the
financial markets have also acknowledged the no bail-out regime as a credible policy, as
indicated, amongst other things, by the fact that yields on bonds issued by cantons which are
home to municipalities facing financial problems have dropped since the court ruling.9
Yet how can the principle of individual fiscal responsibility be reinforced among the member
states of the euro area? A key starting point is to strengthen the financial markets'
disciplinary function. This would require, in particular, an end to the preferential regulatory
treatment of government bonds, which includes banks not needing to hold capital reserves
against investments in government bonds.
This preferential treatment of sovereign debtors is based on the assumption that government
bonds are free of risk, an assumption that contradicts the no bail-out clause and therefore
reduces its credibility. When banks are not required to hold any capital reserves against
government bonds, their solvency is directly threatened by a sovereign default, and a
financial crisis cannot be ruled out. Hence, government bonds should be backed by
adequate capital.
There is also another special treatment that should be ended. To avoid concentration risks,
bank loans to a single private-sector borrower may not exceed 25% of the bank's liable
capital. In future, large exposure limits should also apply to sovereign debtors.
From a financial stability perspective, particular problems are posed by the fact that banks
often only have government bonds issued by a single country in their portfolio - those of their
home country. Not only do the euro-area banks hold more government bonds on their books
than ever before (€1.9 trillion), the home bias has actually become even stronger in the crisis
countries in recent years. In Italy's case, for instance, 97% of the euro-denominated
government bonds held by the country's banks were issued by the Italian government.
So, the banks not only have no capital backing for these government bonds but are also
tying their own fate to that of their country. This will need to change to give credence to the
no bail-out regime.
But even a credible no-bailout regime can only have the intended disciplining effect once
doubts begin to emerge over a country's fiscal soundness. That is why it is also important to
combat the particular incentives inherent in a monetary union to run up debt, so that things
do not get out of hand in the first place.
Hence the need for effective fiscal rules. Switzerland has a wealth of experience in applying
fiscal rules. Its national debt brake has been in force since 2003, since which time debt has
levelled off, and the debt ratio has been on the decline. The debt brake was introduced by
way of referendum, which increases its binding force, as violations explicitly run counter to
the will of the people.
Incidentally, we can gain even more detailed insights from the cantonal fiscal rules, which are
now in place in nearly all the country's cantons. Available research reveals that stricter
cantonal debt brakes also prove to be more effective.10
By revising the Stability and Growth Pact and the fiscal compact, the euro-area member
states have also changed the rules. This served as a counterweight to the introduction of the
substantial rescue packages.
However, it appears that little remains of the original intention to tighten the fiscal rules.
Although it is now much more difficult for finance ministers to turn down the Commission's
recommendations, the Commission's influence has also significantly increased. And that is
not always a positive thing either. The rules, on the whole, have hardly any logic to them, and
the Commission does not always seem to want to apply a narrow interpretation.
But we are learning from the Swiss example that the rules need to be strict. I believe that
flexibility in interpretation should only be applied, if at all, in well-founded exceptional cases.
For this ultimately weakens the structural consolidation requirements and defers them to the
future.
5. Conclusion
Ladies and gentlemen, this brings me to the end of my speech.
With its decision in favour of substantial government bond purchases, the Eurosystem has
once again provided ex ante assistance. Governments and the European Commission must
now use the time to strengthen the long-term conditions for growth in the euro area. Friedrich
Dürrenmatt once said, "The quickest way to clear up a matter is through dialogue".
Therefore, I now look forward to our discussion.