Patrick Honohan: The European Union - financial, fiscal, economic and
political challenges ahead
Address by Mr Patrick Honohan, Governor of the Central Bank of Ireland, to the National
Bank of Poland Bi-annual EU Presidency Lecture, Warsaw, 19 March 2013.
* * *
Let me begin by thanking Marek Belka, President of the National Bank of Poland, for inviting
me to give this inaugural lecture in the National Bank's bi-annual series during Ireland's
Presidency of the European Union.
It is not, to be sure, my first visit to Poland: I have come here for both business and leisure,
and most recently had the most interesting pleasure of visiting Wroclaw during the Polish
Presidency at the Informal Ecofin meeting hosted by Marek and by Jacek Rostowski.
Ireland and Poland have many cultural ties, and as you know we have welcomed a large
population of Poles in Ireland over the past decade. They came during the boom years, but
many have put down roots and are staying with us even in these more difficult economic
times; over 21⁄2% of Ireland's population have Polish nationality.
I was interested to discover that, thanks to this migration flow and the associated two-way
travel that follows from it, there are no fewer than 66 weekly nonstop flights between Ireland
and Poland, surely a remarkable instance of European integration considering the distance
involved of as much as 2000 kilometres and the relatively small population of my own
country at just 41⁄2 million.
A big part of the explanation - other historical developments aside - is of course the fact that
Ireland and Poland share membership in the European Union; indeed, form the Western and
Eastern borders of the Union at the latitude (52°-53°N) which Dublin and Warsaw share.
Poland took the Presidency of the Union for the first time in 2011; this role has rotated now to
Ireland which performs it for the seventh time in the 40 years of its membership. As you
know, during these semesters, each national government, supported by the national
administrative structures, seeks to progress the Council's role in the strategic and legislative
programme of the Union.
Poland's effective Presidency, in which you steered the turbulent discussions on economic
governance during one of the most pressured episodes of the economic crisis, and secured
agreement on reinforcing fiscal coordination through the so-called "six-pack" of legislative
measures, is recalled as a strikingly successful one.
Eighteen months later, though the systemic financial crisis of the euro area is less acute, and
even if employment growth has resumed in some countries, unemployment at record levels
is but the most conspicuous evidence of the depth and persistence of recessionary times in
Europe.
It would be astonishing if institutional deepening and reform in the economic infrastructures
of the European Union were not still centre stage in the legislative agenda in 2013 and I can
assure you that a large and intensive effort has been mounted by the administrative
resources of the Irish economic and financial authorities to try to progress this agenda.
Before mentioning some of the detailed elements of current legislative debate, let me stand
back a bit, though and ask why it is that the Eurosystem has needed a relaunch. How come
the great expectations for the euro as the single currency of the European Union seem not to
have been fully realized? Why have some commentators been identifying the euro as a
source of weakness rather than strength of the euro area economies, as well of those which,
like that of Poland, are intertwined with the euro area (I see, for example, that well over half
of Poland's exports go to the euro area)? And are the reforms that are currently being
discussed of the correct type and sufficient in scale to set things back on the kind of path
which was not only expected in advance, but up to the current crisis actually had been
achieved in practice, with not only low inflation and anchored inflationary expectations, but
also modest and falling debt ratios, convergence of financial market conditions, reasonably
steady growth and - notably - a considerable reduction in unemployment?
In case there is any doubt that a relaunch is needed, it may be useful to note that the key
entry-requirement indicators of government debt, government deficit and bond yields now
show considerably greater divergence than at entry (even though the entry criteria were
applied in a relatively liberal manner.
But what is needed is not only the kind of fiscal restraint that is clearly a prerequisite for
restoring something closer to what was envisaged for these indicators as threshold levels for
entry - that is the task of the six-pack and the two-pack legislative measures - but a deeper
reform of policy and behaviour to ensure that the divergences do not easily recur, and
construction of institutions that will help rebuild trust and confidence both to market
participants and to partner countries within and outside the euro area.
For this, we need to understand what went wrong. It is easy to point to the global financial
crisis as the culprit, and certainly that crisis, which had its origins in the United States, has
had a devastating impact. But why have the problems been particularly deep and intractable
in the euro area? After all, not all euro area countries have been equally affected. Germany,
to take the largest and most striking example, has emerged from the shocks of the last few
years with lower unemployment than before.
And, as for the most adversely affected countries, the imbalances and excesses which they
have experienced have been quite diverse. Greece's problems have emerged as the result
of large and under-appreciated fiscal deficits, Italy's as a result of high debt and persistent
lack of growth dynamism, Ireland from a banking-driven boom-and-bust cycle. What is the
common feature of these and other syndromes?
This is important for us in understanding what needs deepening in a relaunch of the system,
and it also, of course, is vital for a country contemplating and preparing itself for a future euro
membership.
I believe that the key to this mystery lies in the fact that the euro represents a commitment
device, a policy straitjacket which, if accompanied by the behaviour to which the country
implicitly and explicitly commits when it joins the currency union, will lead to an improved
economic performance relative to what can otherwise be achieved.
The commitment is of course to policies that retain macroeconomic balance, which requires
fiscal discipline, and international competitiveness in both price and non-price dimensions.
For decades, many European Union countries have had a chequered history of
macroeconomic imbalances, generally resolved through devaluations at the cost of relatively
high inflation, and high nominal and real interest rates, all of which contributed to
growthdamaging uncertainty.
In addition to the considerable microeconomic benefits of eliminating currency conversion
costs and all of the exchange rate risk for intra-euro area transactions, the main advantage of
the currency union was seen to be lower inflation and interest rates, contributing to a stable
growth platform.
Yet it was as if policymakers and market participants believed that the results would happen
semi-automatically.
Governments would adopt restrained fiscal policies for fear of market reaction, and if they
didn't markets would quickly penalize them with interest penalties that would incentivize them
to get back on track.
Likewise any loss of competitiveness due to wage rates increasing faster than the currency
area would result in such quick damage to employment that such divergences would be
short-lived. Above all, private capital flows could be relied upon to be stabilizing and
sustainable.
With such strong forces for macroeconomic stability, what need for anyone to pay attention
to fiscal and cost competitiveness?
But markets were not as effective task-masters, and they allowed the old pattern of
imbalances to persist. Indeed, the very fluidity of large-scale international capital flows (partly
attributable to the currency union itself, but even more - as can be seen by the parallel
experiences of countries such as Iceland and Latvia - by technology-driven liberalization of
finance) allowed the imbalances to become larger than ever.
The difference now was that the old adjustment device - devaluation and inflation - had
been eschewed. Imbalances, allowed to emerge, had even more costly consequences when
those safety valves - imperfect and corrosive though they are - were not available. High
debt ratios had to be sweated down or, when this was impossible in Greece, in effect written
down.
The needed fiscal contraction removed demand and triggered the double-dip of the
recession in several of the most affected countries, and unemployment soared, especially to
the extent that the inflexibility of nominal wage rates inhibited needed restoration of
costcompetitiveness.
The solvency of banks, both those in the countries suffering the adjustment, and those which
had extended large advances across borders within the currency union, came under
suspicion.
On top of this, the severity of the needed adjustment made markets question the ability of
some member states to stick with the single currency - a doubt whose elimination required
the invention of the ECB's Outright Monetary Transactions (OMT) programme.
In sum, the continued failure to maintain fiscal, cost and financial discipline in some
countries, despite the implicit commitment to do so embodied in euro area membership, had
much more severe consequences than they had had in the previous decades of autonomous
and often weak currencies.
How can Poland ensure that life in the euro (whenever that comes about) could be
accomplished without the mishaps and imbalances that have characterized several euro
area countries in the financial crisis?
I believe that Ireland's experience suggests that this can be done, and that the errors that
were made could be avoided without too much difficulty, as long as the commitment required
of membership is widely appreciated.
Thus one would envisage a more decisive response - with macro prudential and fiscal
tools - to the big property price and construction boom that made Ireland such a
recordbreaker in mid-decade; the degree to which fiscal balance was becoming dependent on
boom-time revenues could have been better recognized, and public expenditure kept in
check accordingly; finally, if and when things had got to the point of wide scale bank failure,
crisis management could have allowed for a lower socialization of the losses.
In avoiding such pitfalls for the future, the new euro-area institutional arrangements will help,
but in fact a well-managed economy has nothing to fear from the euro.
The consequences of misbehaviour in policy by those who failed to respect the commitment,
have not only been for economic performance in stressed countries, but have also
spilledover into wider concerns about the functioning of the Economic and Monetary Union.
Cross-border interbank lending dried-up, introducing sizable divergences between the cost of
credit in different member states which, though not as wide as they were at one point, have
remained substantial and represent a departure from what had come to be expected from the
single currency area.
Credit no longer seems to flow seamlessly across borders without incurring what is de facto
a country premium for the stressed countries.
It is often remarked that this is nothing more than a wholly justified risk-premium that should
have been present from the start. That could be true for interest charged by the market for
lending to Governments. But I am not so sure that it holds for non-Government borrowers: it
seems to me that this is largely a spillover from fiscal and macro-prudential risks which
cannot easily be avoided by firms in stressed countries even if their own firm-specific
conditions would not warrant a high risk premium.
This is not, of course, the only country-specific national source of competitive advantage and
disadvantage. Tax rates, social benefits, infrastructure, to name just a few. So the
emergence of interest differentials on lending is not unique. But it is a departure from what
was envisaged at the outset of the single currency and held out as an important integrating
function of the euro.
And the sudden awakening of market to credit risk on lending to Governments is much more
damaging now, when Governments have accumulated so much debt, than if it had been a
constant from the outset.
Stressed countries have naturally turned, not only to the IMF, but also to their partners in the
European Union for assistance in these circumstances. The countries that have avoided
these errors have been called upon to provide financial assistance on a rather large scale to
five stressed countries.
The assistance being granted is in the form of loans, but even so some taxpayers and
electorates may fear that their savings are being threatened by being lent where markets
have been reluctant to go. The fear seems to be that the system is having the effect of
spreading the cost of policy errors in some countries to the taxpayers of countries that
maintained discipline. This fear has been influencing the design of crisis management
measures.
Thus, as is so often the case when it comes to the finances of stressed borrowers; neither
the borrower nor the lender is content.
Herein lies the most fundamental rationale for a relaunch of the euro: the need to ensure
collaborative arrangements that command the confidence of both the stressed and the
strong. That confidence can underpin quicker and more comprehensive crisis management
based on a stronger sense of trust, solidarity and common purpose among member states
than has yet been fully in evidence.
The fiscal aspect of the crisis was the first to receive attention from the point of view of
reforming and strengthening institutional structures. As the successive financial assistance
packages to Greece, Ireland, Portugal and now Cyprus have been put in place in conjunction
with the IMF to deal with the loss of market access by those countries in the crisis,
institutional deepening has also been in the works. The initial funding vehicle, the EFSF, has
been succeeded by a permanent successor, the ESM, incorporating risk-sharing
mechanisms based on mutual national guarantees proportional to the share of ECB capital.
But that is just one dimension of the fiscal institutional reforms.
I have already mentioned in passing the progress towards strengthening the surveillance of
national policies and economic policy coordination through the adoption of legislative
measures: the six-pack under your Presidency and the two-pack under our own, thereby
building the fiscal dimension to this concept of closer collaborative arrangements. The six -
pack greatly reinforces the preventive arm of the Stability and Growth Pact with the
possibility of sanctions and stronger powers for the Commission and the two - pack
introduces the procedures to allow for meaningful and timely action. The Intergovernmental
Fiscal Stability Treaty has incorporated the core principles of the Stability and Growth Pact
into binding national legislation. It was passed by Referendum in Ireland in May 2012 with
60% of the vote. As for Poland, I understand that the President of Poland last month gave his
assent also to this Treaty.
But the crisis has above all had at its root, failures in banking and finance, and in the
regulation and supervision of banks. Faced with the crisis, the ECB has stepped up to the
plate with a succession of policy innovations (difficult to design in a multi-country
environment) including the open-ended liquidity provision, the long-term refinancing
operations, the securities market programme and its successor the OMT, specifically
designed to remove redenomination risk. These have been non-standard measures
designed to improve the transmission of monetary policy and thereby serving to remove
obstacles to the accommodating low interest rate policy being effective throughout the euro
area.
Here too (in banking and finance) structural reforms are needed alongside these conjunctural
measures, and an institutional strengthening agenda is also being fleshed-out. The most
immediate part of this agenda at present is the creation of a Single Supervisory Mechanism
for banking based in the ECB. Securing agreement on the legal texts that will form the basis
of the SSM is high on the action list of the Irish Presidency.
Would the SSM, had it been in place, have prevented the banking collapse? This is a tough
question. While there is a lot to hope for from centralization of bank supervision - removal of
the perception of national political pressures, emotional detachment from the waves of
euphoria that occasionally sweep national financial systems, a cross-fertilization of
supervisory perspectives from different parts of the Union to name a few aspects - it has to
be acknowledged that supervisory failures across the world in the lead-up to the great
financial crisis were very widespread.
Still, not creating a single supervisor was a missed opportunity at the start of the EMU and
one which will yield benefits, I am convinced, down the road. In the more immediate future, I
think its creation is one of the essential ingredients for building confidence in the strong
countries that banking weaknesses that have been exposed in the stressed countries are not
going to recur or persist because of supervisory inadequacies.
To be sure, a single resolution authority and a common deposit guarantee system will also
be needed in the Banking Union when it is complete. The former will build on the current
draft legislation on national resolution systems, which is being actively negotiated in this
Presidency, and the latter's importance has been underlined, I believe, by some very recent
developments.
Let me describe in a little more detail the progress of discussions in our Presidency.
As an over-riding theme for this Presidency, Ireland seeks to be seen as "a recovery country
driving recovery in Europe". Thus, we are trying to build on our national experience through
considerable domestic efforts for recovery to help consolidate fiscal and economic stability
across the European scene. Ireland has long entered such endeavours inspired by certain
core values:
•
Ireland has always upheld the Community method rather than intergovernmentalism
•
Ireland is strongly commited to working constructively with the European Parliament
• Ireland is a long standing advocate of global institutions and of trade. (Recent
examples: it is a member of the UN Human Rights Council and chaired the
Organisation for Security and Cooperation in Europe in 2012).
Apart from the financial agenda, among the specific objectives of the current Presidency - on
a number of which good progress has already been made - are:
•
Support to President Van Rompuy in getting agreement on the budget for
2014-2020 and finalising negotiations with the European Parliament.
•
Finalising agreement on the "two-pack" of measures to enhance coordination of the
budgetary process for the Euro area.
•
Promoting the Digital Single Market Agenda, tackling issues such as e-signatures,
intellectual property rights and cyber security.
•
Agreement on opening a comprehensive EU-US trade deal.
•
A Youth Unemployment package including a Youth Guarantee, a fund to help young
people into a job, apprenticeship or further education or training within 4 months of
leaving school.
On the Financial Services front the Irish Presidency has, in the interests of getting results for
the Union as a whole, made some tactical decisions and prioritised efforts on six files for the
first half of our mandate. In the coming days, we will review progress and decide priorities for
the second half. This approach partly reflects a pragmatic approach from a relatively small
administration but is primarily based on a realistic assessment of the decision-taking capacity
of the Union's institutions.
Absolute priority has been given to all files relating to the promotion of a Banking Union as
set out in the December 2012 European Council conclusions. As I have already suggested, a
Banking Union, shifting supervision of banks to the European level, combined with a
common system for deposit protection and integrated bank crisis management will reassure
citizens and markets that a common, high level of prudential regulation is being consistently
applied. It will help build the necessary trust between member states which is a pre-condition
for the introduction of common financial arrangements. This will pave the way towards the
use of the ESM as a public backstop to directly recapitalise banks and help break the
negative feedback loop between banks and their sovereigns.
I will say a little about progress on the Banking Union files:
CRD IV
Agreement on CRD IV (when it is confirmed) will mean that Europe can fulfil the
requirements of Basel III and its G20 commitments to greatly strengthen the prudential
requirements for banks, and improve governance and remuneration practices. It will also be
a large step forward in the completion of the single rulebook.
A huge effort has been put into getting final agreement on CRD IV. This has been a massive
undertaking which has absorbed the energies of many Presidencies including the Polish. In
the first 8 weeks our Presidency held 7 Council Working Party meetings, 5 Political Trilogues
and a large number of technical Trilogues before reaching outline overall agreement with the
Parliament on 28 February and in the Council on 5th March. Final formal agreement
(including clarification of a number of technical drafting points) is in sight.
Single supervisory mechanism
The SSM, the transfer to the European level of key supervisory tasks for banks, is designed
to provide strong and consistent supervision across the Euro Area. As I mentioned, it holds
the promise of removing local politics from the enforcement of bank supervision and will lever
a diversity of supervisory experience - best practice across Europe. Most importantly it will
help to break the link between sovereigns and banks.
There have been 10 Political Trilogues and 8 meetings of the Ad Hoc Working Party. Good
progress has been made on the ECB Regulation and examination of the EBA Regulation is
under way. The contours of an agreement are emerging. Intensive negotiations and technical
work is scheduled to continue for the coming weeks and Parliament is geared to conclude by
the end of the month. A particular pressure is the need to allow sufficient time for the German
parliamentary process of ratification to conclude before Bundestag dissolution on 5 July.
Extensive preparations are well under way in the ECB to take responsibility for supervision
within 12 months of final agreement on the Regulations.
Crisis management: bank recovery and resolution
Even if the European Commission's estimate that banking collapses have led to over
€4.5 trillion (or 37% EU GDP) of state aid going to distressed financial institutions between
October 2008 and October 2011 adopts the most expansive possible definition (and is far
greater than the likely ultimate fiscal cost of the crisis), it is clear that crisis management and
resolution has entailed extremely high budgetary costs, and even higher overall economic
costs - crippling in the case of some countries. The Recovery and Resolution proposal
(relating to national crisis resolution, and not specifically to a Union-wide, or euro area-wide
mechanism) would ensure that in future national authorities will have the means to intervene
decisively before problems occur and early on in the process if they do. They could also
ensure that the cost of restructuring and resolving failing banks falls on the owners and
creditors and not on taxpayers.
The December Summit asked the Council to agree this dossier by end March and for
Trilogies to be completed before June. This is a very tight schedule indeed. The Commission
proposal dates from June 2012. The Presidency has conducted intensive work teasing out
and clarifying the issues. Principally they are:
•
the balance of power between home and host authorities in group scenarios and the
role of the EBA in mediation
•
financing and funding arrangements
•
bail-in; its scope and possible exclusions
•
the use of Deposit Guarantee Schemes in bail-in
•
the transposition date for the bail-in tool
•
possible inclusion of public intervention tools in the Directive
Discussions to date within the Council have been technical and slow moving and it is only
recently that a compromise text covering all the elements has been tabled. We now have a
tool box which is understood and which can work but Member States have not addressed the
cost of the compromise needed to achieve a workable regime.
Now that the issues have been clarified it is time for the member states to begin to take
decisions.
Related to this is the Deposit Guarantee Scheme Directive which aims to significantly
enhance depositors' confidence by introducing a higher level of coverage, faster payout and
more credible funding of the schemes. However, Member States are unwilling to restart
negotiations of this proposal until the Bank Resolution package is nearer conclusion - in
particular its treatment of funding. The European Council asked for work on this dossier to be
accelerated so that it can be adopted in line with Bank Recovery and Resolution.
Clearly the Recovery and Resolution proposal and the Deposit Guarantee Scheme will be
pressure points for the remainder of the Irish Presidency.
Outside of the Banking Union priority we are focusing on certain Markets and Consumer files
and I will deal briefly with them.
MiFID II/MiFIR
This proposal aims to make financial markets more efficient, resilient and transparent and to
respond to the challenges of new trading venues, products and technological developments.
Following an intensive round of bilaterals the Presidency has issued 3 compromise texts in
the hope of getting agreement on a General Council approach by April so as to allow
engagement with an impatient Parliament to begin.
There are important differences between key member states on three main issues
•
transparency for equity trading venues
•
rules for the Organised Trading Facility category
• non-discriminatory clearing access.
Having said that, discussions are beginning to go in the right direction as Member States
realise they have to finalise their positions soon.
Market abuse regulation
The issue of market abuse has risen up the agenda especially for the Parliament who are
linking it to public concern about the manipulation of benchmarks including LIBOR.
Steady progress is being made and depending on resources the file may be taken forward in
a drive for agreement in the second half of the Presidency. The main issue to get right is the
interaction within the Regulation between criminal and administrative regimes.
Central securities depositories regulation.
This regulation aims to bring more safety and efficiency to security settlement in Europe. It is
also linked to the introduction of T2S on schedule in 2015. The Presidency is carrying out a
technical review and may allocate additional resources to advance this file in the latter half of
the Presidency. There are a number of issues on which it will be quite difficult to achieve
compromise including whether banking services should be separated from core CSD
services and on whether to include provisions on conflict of laws
Consumers
Within the broad consumer agenda the Irish Presidency is concentrating its resources on
getting agreement on the Mortgage Credit Directive.
The Directive would facilitate cross border activity, enhance consumer protection and ensure
more responsible mortgage lending.
There have been a large number of Council Working Party meetings and Trilogues. Good
progress is being made but there are a considerable number of outstanding issues. These
include FX lending, tying practices, conduct of business requirements, the treatment of
variable interest and loan rates and early repayment.
The Presidency is intent on reaching agreement. It hopes that the willingness to negotiate
and compromise which was earlier expressed by all institutions - Council, Parliament and
Commission - begins to be translated into concrete results.
ECOFIN
The next major event for the Presidency will be the informal ECOFIN meeting in Dublin
12-13 April. Among the topics for discussion I expect that Ministers and Governors will be
wanting to take a strategic view in their discussions on Banking Union; there is also the
opportunity to have a discussion on Long Term Financing of the European Economy, an
issue which may have been a bit neglected in the crisis, but is to be the subject of a
forthcoming Commission Green Paper (which is expected mid-March).
In these difficult times, Jean Monnet's famous remark - true not only for our continent and
the great endeavour that he and others launched so effectively - "Europe will be forged in
crises, and will be the sum of the solutions adopted for those crises" should be a leitmotiv for
our thinking now. This is not a time for stop-gaps, but for ensuring that each policy choice
that is made is guided, not only by short-term expediency, but by a clear vision of where
Europe is going. Europe is far more than an economic, budgetary and financial entity, but it is
in these fields that current challenges inevitably dominate official decision-making now.
I hope not to sound sycophantic, but I have to say that I think that the proposals for a new
architecture - for Union in the financial, fiscal, economic and political domains - which have
been made by the four Presidents of the European Council, the European Commission, the
Eurogroup and the ECB last Summer, hit the nail on the head, and sketched the way in
which a new European framework must emerge, heralding a greater sharing of sovereignty
combined with risk sharing and financial backstops. This is a viable path which, if we follow it
to its conclusion, will help replace the somewhat fraught and crisis-prone regime in which we
have been living for the past half-decade. To recall, this vision incorporates
•
an integrated financial framework - Banking Union - to ensure financial stability
•
an integrated budgetary framework - Fiscal Union - ensuring coordination and
solidarity
•
an integrated economic policy framework - Economic Union - to promote growth,
employment and competitiveness
•
the necessary democratic legitimacy and accountability - Political Union
What is needed, therefore, is a staged process, a mutually reinforcing series of carefully
sequenced steps which will combine substantial ambition with careful balancing in each
phase. Moves towards more responsibility and economic discipline should be combined with
more solidarity and financial support. Deeper integration of regulation and policy must be
accompanied by political integration to ensure democratic legitimacy and accountability.
Fine words, you will say, but who can doubt the need for this - including the Political
Integration dimension which really is well beyond my mandate, not to say my competence.
After all, Jean Claude Juncker (drawing on his long-term experience as President of the
Eurogroup) put it succinctly: "Ministers know what measures need to be taken but do not
know how they can be subsequently re-elected."
It will not be enough to provide in the future for a greater involvement of the European
Parliament, however essential that may be. Decisions on national budgets traditionally have
been at the heart of Member States' parliamentary democracies; a stronger European
dimension and mechanisms will have to be found by which national parliaments can be
brought further into the European decision making process.
The crisis, its resolution and the long term development of the EMU have both a European
and a domestic dimension. Onto the national political system level falls the challenge of
striking a new social contract, reorienting expenditure, modernising tax systems, promoting
flexibility, strengthening competitiveness.
In Ireland we believe that if we are to stay on the path to a successful consolidation and
adjustment continued efforts are needed at both national and European levels. Other
countries are facing or may face the same challenges.
The coming years will test the ability of all our leaders to manage successfully in the
interaction between the national and the European.

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