Vítor Constâncio: The future of euro governance - how to contain
imbalances and preserve financial stability
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
conference "The ECB and Its Watchers" XII, Frankfurt am Main, 9 July 2010.
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1. Introduction
It is a great pleasure to participate at this conference for the first time in my official capacity
as the ECB's Vice-President. The "ECB and Its Watchers" conference was a pioneering
initiative and the fact that other central banks have chosen to emulate it is surely a powerful
tribute to the usefulness of the event's format.
In my remarks today, I want to address some of the problems that the financial crisis has
created for the governance of the euro area.
The euro area has responded adequately to the challenges that have arisen. Even though
one might occasionally speak of some procrastination, which is understandable in a complex
framework integrating several countries, important and bold decisions have been taken and
new reform processes have been launched.
After the Lehman failure, we responded with the necessary liquidity provision to a financial
sector hampered by clogged monetary and financial markets; fiscal policy implemented the
necessary stimulus programmes; and the banking sector received indispensable and very
extensive government support. Furthermore, Europe participated actively in the international
efforts to design and adopt new regulations for the financial sector and has embarked on a
thorough reform of its own regulatory and supervisory framework. The forthcoming
establishment of the European Systemic Risk Board (ESRB) and three European
Supervisory Authorities will address both the need for truly harmonised European regulation
and the coordination required for a more effective European supervision.
The public sector support for demand and the stabilisation of the banking sector contributed
to the avoidance of a depression and launched an incipient economic recovery that was
gaining strength in the first quarter of the year. That was the moment when financial markets
started to test the cohesiveness of the euro area and whether the setup was more than some
kind of a vast multilateral currency board. This new chapter of the financial crisis, which
threatens to weaken - but not kill - the recovery, has been named the sovereign risk phase.
This has thus far been something of a misnomer, since some important countries with
significant public finance imbalances have not been affected and only a few more vulnerable
members of the euro area merited the attention of the markets.
The European response made clear that our economic and monetary union was more than a
precarious arrangement among nation-states and stands as an important pillar of the
European integration project. Proof of this can be found in the package of loans with
stringent conditionality put together for Greece, in the creation of an European Financial
Stability Facility with 500 billion euro, and in the adoption of further non-standard measures
to defend the monetary transmission mechanism for the whole euro area by buying securities
and providing liquidity. We did this in full consistency with our mandate to deliver price
stability, and with the determination to overcome the unfounded misunderstanding that
purchases of securities could in some inexplicable way be more inflationary than the use of
the same securities in regular repurchase agreements. What counts, of course, are the
overall development of primary liquidity and the management of short-term money market
rates. Incidentally, measured in terms of the monetary base, provision of liquidity has
decreased from €1256.8 billion on 7 May to the current level of €1149.8 billion and Eonia
went up from 0.321 to 0.398 yesterday. At the same time, market inflation expectations are
well anchored bellow 2% up to 10 years.
Apart from the determination shown in taking appropriate measures, Europe has also
recognised that the current episode of the crisis points to the existence of real problems with
respect to public finance imbalances and has even exposed some institutional weaknesses
in our framework for monetary union, which need to be corrected. Consequently, Europe has
now embarked on the preparation of significant reforms of the euro area governance in the
context of the Task Force created under the leadership of President Van Rompuy.
Every good reform starts with a good understanding of the problems. The fundamental point
relates to the issue of imbalances in euro area countries. By imbalances, I do not mean just
fiscal imbalances, but also imbalances stemming from private sector behaviour. I will
concentrate my remarks on the issue of imbalances, starting by analysing their causes and
the necessary policies to correct and, preferably, avoid them in the future. Finally, I will draw
conclusions as to what the experience implies for economic policy and economic
governance.
2. Imbalances and adjustments in a monetary union
There are severe fiscal imbalances in euro area countries. Triggered, in particular, by
developments in Greece, markets have dramatically reassessed their view of fiscal positions
leading to sharp rises in bond yield spreads. This stands in sharp contrast to the markets'
assessment of sovereign risk in euro area countries prior to the financial crisis, which can
reasonably be characterised as one of "benign neglect".
It is indisputable that fiscal imbalances of the kind we have seen in some euro area countries
need to be corrected in a timely and convincing manner. This has been recognised, as fiscal
packages have been introduced in Ireland, Greece, Italy, Spain and Portugal over the last
few months. Moreover, in order to give countries breathing space to carry out fiscal
adjustment, unprecedented support measures have been introduced at the European level.
Fiscal deficits, however, are not the only macroeconomic imbalances we can see when we
look across euro area countries. A number of indicators provide prima facie evidence of
private sector imbalances where high indebtedness and excessive leverage have also
developed over the years. In several countries, it was predominantly the increase in net
private borrowing requirements that was responsible for growing current account deficits,
which are large in some countries and have widened since the start of Monetary Union. In
2008, some 8 of the 16 euro area countries had a current account deficit ratio above 5%. In
1999, only 2 countries exceeded the 5% mark.
In some (but not all) of the countries with current account deficits, there were also sharp
increases in domestic asset prices, particularly house prices. While house prices declined in
Germany between 1999 and 2008, there was an average annual increase of more than 10%
in Spain and Ireland. Other related symptoms include rapid credit growth and a build-up of
private sector debt.
From a methodological point of view, I have to point out that much of the current discussion
is frequently too narrowly focused on a limited and simplistic set of indicators (e. g. relative
prices and current account balances) in a partial equilibrium context. There are also those
who seem to think that the problems are confined only to fiscal policy. A spree of partial
equilibrium analysis has been contaminating the debate.
To give an example of the importance of the general equilibrium approach: in simplistic
accounts, rising current account deficits are often seen as being "caused" by losses in
competitiveness. But it should not be forgotten that the co-movement between the current
account deficit and measures of the "real exchange rate" reflect the joint response of two
endogenous variables to shocks.
In some cases the imbalances could be considered, up to a point, an equilibrium response of
the economy to certain shocks, which does not necessarily warrant a policy reaction. Two
types of shocks that could be associated to such a development, could be, first, the
permanent effect on the cost of financing and capital stemming from entering a new regime
of low inflation and, second, the real convergence expected to happen in catching-up
countries.
In benign scenarios, the apparent imbalances are largely self-correcting. Eventually, the
inter-temporal budget constraints will induce consumers and firms to cut their expenditures,
thereby reducing the current account imbalances. These adjustments will be accompanied
by movements in relative prices, as the economies concerned rebalance domestic and
external demand.
The fact that some episodes of current account deficits and rising relative prices could be
natural economic adjustments to shocks that hit the economy does not, of course, imply that
all such episodes are benign, equilibrium phenomena. Looking at developments in a number
of euro area countries over the past 11 years, we have enough evidence of private sector
imbalances that cannot be explained by reference to benign equilibrium phenomena.
How could such imbalances come about? I think there are three plausible (and not
necessarily mutually exclusive) explanations:
First, expectations about growth seem to have become detached from reality and have
indeed become excessively exuberant. If we are willing to depart from the assumption of
strictly rational expectations and to allow for phenomenon such as learning, it is easy to see
how initial booms - justified by equilibrium phenomena - induce economic agents to expect
that the strong growth will continue indefinitely (or at least for a longer period than was
warranted). In this regard, it is worth noting that most of the bubbles we have observed in
history started in response to changes in fundamentals.
A second factor is the behaviour of the financial system. At the global level, the period was
one in which financial intermediaries around the world were engaging in excessive risk-taking
behaviour. This led to bad credit risk management and very loose credit conditions, which
added fuel to the fire in the case of overheating economies.
Third, the standard adjustment mechanisms implied by theory seem not to have worked
sufficiently well or sufficiently fast. In particular, the real appreciation channel seems to have
been operating very slowly, and inflated animal spirits seems to have put in question the
existence of the fully rational inter-temporal optimisers taken as given in many models.
In addition, the public sector itself may also have been affected by exuberant expectations.
As a result, governments in some countries increased their expenditure and/or reduced
taxes, expecting that the gains in output and increased revenues seen during the boom
years would be permanent. Consequently, when these countries headed into a downturn,
fiscal positions that looked healthy on the surface turned out to be precarious, deficits rose
sharply and debt ratios moved along explosive trajectories. The financial crisis acted as a
trigger to expose the fragilities that had been built up in earlier years and led to rapid
reassessment on the part of economic agents.
Countries that have accumulated imbalances thus now face a long (and painful) process of
adjustment to more warranted levels of spending and debt in both the public and the private
sectors. A process of de-leveraging and balance sheet repair will have to take place in
several cases. These adjustments will inevitably entail a period of low growth in domestic
demand. This, in turn, will necessitate corrective adjustments in relative prices and wages in
order to foster net exports and rebalance the economies in question.
3. Eliminating the imbalances
Even in the absence of explicit policy actions, we can expect a number of standard channels
to start working, leading to a reduction of private sector imbalances and an eventual return of
the economies to a more sustainable equilibrium pattern.
The reassessment of future prospects by households and firms will induce them to adjust
their expenditure plans downwards. The resulting lower level of domestic demand will lead to
lower imports, and thus serve to reduce the current account deficits. This mechanism is a
more or less automatic response by agents to the changed environment. It is likely to be
reinforced by the impact of banks' endeavours to restore their balance sheets by, inter alia,
curtailing lending and by government efforts to rectify fiscal imbalances. In itself, the
contraction of domestic demand brings strong downward pressure to bear on output. In order
to counteract this effect, net exports will need to be pushed for.
In this respect, the so-called competitiveness channel will also play a role. Weaker demand
will lead to lower wage and salary increases (and to reduced domestic prices) via the usual
Phillips-curve mechanism. This will stimulate net exports, offsetting the effects of lower
domestic demand on output. In the long run, the economy will be rebalanced. However,
given evidence of the sluggishness of wage and, to a lesser extent, price adjustments, this
restoration of competitiveness could be a very protracted and painful process.
This implies that policy has a crucial role to play in facilitating and speeding up the
adjustment process. In particular, policy action is needed in four areas:
First, measures should be taken to increase wage flexibility and the adjustment of wages to
appropriate levels. This could be achieved through measures to improve the functioning of
labour markets with a view to enhancing wage flexibility and facilitating the transfer of
workers from the non-traded to the traded sectors. In fact, we have already seen
wagesetting developments in some European countries that many observers would have believed
impossible just a few years ago.
Second, the adoption of measures to increase productivity growth is necessary to facilitate
adjustment. Higher productivity growth will allow the affected countries to improve their gains
in competitiveness for a given level of nominal wage growth. This benefit comes on top of the
improvement in living standards that increases in productivity generate. Achieving higher
productivity growth requires comprehensive structural reforms aimed, in particular, at
sheltered sectors of the economy where there is insufficient competition.
Third, convincing fiscal consolidation to redress the fiscal imbalances is essential. Given the
impairment of the credibility of fiscal policy in many countries, postponing adjustment is
simply no longer an option. Markets need to be convinced right now. This message is now
well understood and, in recent months, we have seen sizeable fiscal adjustments in a
number of euro area countries. This is a very encouraging development, but it is essential to
maintain the momentum and ensure that the new targets are met in the years ahead.
Fourth, repairing the balance sheets of banks and making banks more resilient are crucial
prerequisites for the resumption of growth and for financing the reallocation of resources
from the non-traded to the traded sectors. Many policy initiatives have already been taken in
this respect, ranging from the establishment of "bad banks" to injections of capital and
government guarantees' for bank debt. Of course, the liquidity policy of the Eurosystem has
played a crucial role in supporting the financing of the overall economy since August 2007. At
the same time, viewed from a longer-term perspective, effective regulation has a key role to
play in strengthening the financial system. Currently envisaged changes in the regulation of
banks aim at making banks better internalise the cost of their risk-taking and impose heavier
capital charges on their riskier positions. This will reduce the danger of excessive credit flows
such as those seen in the pre-crisis period, which were - in hindsight - not sustainable. It will
also increase banks' loss absorption capabilities by increasing the level and the quality of
their capital buffers.
The four points I have just mentioned relate to policy action to be taken in "deficit" countries
in the euro area. A natural question to ask at this point is what policy action could be taken to
help eliminate imbalances in "surplus" countries.
There is a debate underway on this issue. Some commentators argue that surplus countries
should pursue policies that are symmetric to those of the deficit countries. If deficit countries
have to restrict their domestic demand through fiscal contraction or wage containment, then
surplus countries should increase their domestic expenditure by engaging in fiscal expansion
or wage increases. This type of arguments can go too far. In some cases, there may be
some room for manoeuvre, but even if it is ignored that the euro area is not a closed
economy, so that all members have other markets to support their growth, it would not be
right to ask countries to compromise unreasonably on their international competitiveness or
to put the sustainability of their public finances at significant risk.
Still, it is true that a reduction of the current account deficits of some countries may, through
the mechanics of the operation of a monetary union, imply a reduction of surpluses in other
countries. From a euro area-wide point of view, wage moderation in the deficit countries is a
negative inflationary shock to the area as whole. The ECB's monetary policy, which focuses
on price stability in the euro area as a whole, would take that development into account. The
resulting stance of monetary policy will affect wage and price developments in the surplus
countries, aiding the adjustment in competitiveness. Similarly, the stance will affect demand
in the surplus countries, again fostering adjustment.
That said, there is scope for some supply side policy measures in surplus countries to
facilitate adjustment. In cases where the current account surpluses reflect structurally low
consumption or limited domestic investment opportunities, structural reforms should be
implemented. The range of possibilities includes structural measures in the non-traded
sectors, such as the deregulation of the services sector, for instance, thereby increasing
productivity and growth, as well as changes in taxation to change incentives to spend.
4. Avoiding imbalances in the future
The experience of imbalances in the euro area in recent years is a convincing reminder that
"prevention is better than cure".
Looking ahead, the key question is what can be done to prevent the emergence of
imbalances in the future. After the current crisis experience, the markets can be expected to
better assess the differences in the risks to Monetary Union members and to increase both
the spreads and the cost of capital when those risks start to rise. Market discipline as a result
of proper credit risk management can be an important mechanism for preventing the
emergence of imbalances.
Policy measures are nevertheless required and are of the same nature of those that I have
already mentioned with respect to the correction of the existing imbalances, in particular
those with regard to fiscal policy and unit labour costs. After all, viewed from a
macroeconomic perspective, the successful participation in a monetary union implies an
anticyclical fiscal policy and an appropriate evolution of wage costs in line with the development
of relative productivity.
I believe that two other policy points also deserve to be mentioned.
First, I think that macro-prudential policy has an important role to play in preventing and/or
mitigating the effects of imbalances in the financial system. The whole panoply of well-known
analytical tools has to be used: sets of financial indicators, early-warning systems, stress
tests, contagion models, macro-models that include the proper feedback between the
financial sector and the real economy. Careful attention in this process must be paid to
leverage indicators of the different types of economic agents: households, firms, banks and
the state. Ensuring financial stability implies avoiding excessive debt and credit growth. The
idea of macro-prudential policy is not new. Rather, what has changed is the institutional
framework in which these policies can be set in place. In Europe, the establishment of the
ESRB will provide the mechanism for identifying imbalances that endanger financial stability
and create systemic risks at the level of the European Union. The ESRB membership reflects
the composition of the 27 members of the General Council of the ECB and, although limited
to issuing warnings and recommendations, the participation in the Board of one
representative of the Commission and the three Chairs of the future European Supervisory
Authorities ensures that proper action will follow the decisions of the ESRB. It is, in fact, the
whole European System of Financial Supervision that will be responsible for guaranteeing
that the functioning of both the financial sector and asset markets is not impaired to an extent
that creates fundamental risks to the financing of the economy.
The second point with respect to policies appropriate for avoiding future imbalances relates
to structural policies that are essential to promote productivity growth and to enhance the
flexibility and competitiveness of the economies in question. In many cases, the restoration
of competitiveness does not depend only on correcting relative costs and prices. In view of
the structural shock of the import penetration emanating from very low-cost producers, what
is necessary is to increase productivity and to change the productive structure.
To ensure a smooth functioning of Monetary Union, the whole set of necessary policies
should be employed in a consistent manner, both across individual policy areas and across
countries. This has clearly not been the case in the past. Hence, there is an urgent need to
improve policy-making at both the national and the area-wide level. With respect to the latter,
there is now a consensus on the need to reinforce economic governance within the euro
area.
In this context, I would like to highlight the very ambitious proposals presented by the ECB, in
the context of the Van Rompuy Task Force, for reinforcing the economic governance
framework in the euro area.
The proposals of the Governing Council of the ECB point towards an overhaul of the
institutional and rules-based framework for the surveillance of fiscal policies. On the
institutional side, the Eurogroup should essentially be recognised as the guardian of fiscal
sustainability, gaining new tasks and powers, including the review of national budgetary
plans and the definition of ex ante fiscal policy guidelines for euro area countries. This
enhanced role of the Eurogroup should be coupled with an increase of the quasi-automaticity
of the Excessive Deficit Procedure, reducing the use of discretion.
Furthermore, one of the most important lessons that can be learned from the experience so
far is that the implementation of the fiscal framework requires an effective regime of
sanctions. This can be achieved by applying the following principles: first, initiating the
imposition of sanctions at an early stage; second, increasing the scale of the sanctions over
time and in relation to the severity of the fiscal imbalance; and, third, applying a broader and
more stringent range of sanctions, including financial, non-financial and procedural
sanctions, which would deepen the degree of EU intervention in national fiscal policies.
The overall framework would also be strengthened at the EU level by creating an
independent fiscal agency within the Commission, which would act as a watchdog for the
Eurogroup and the Council in the monitoring and assessment of national budgetary
developments. At the national level, compliance would also be reinforced through the
introduction in national legislation of fiscal rules and institutions that are consistent with the
EU fiscal framework.
Another area for urgent reform relates to the establishment of an explicit and clear framework
for the surveillance of competitiveness and the correction of economic imbalances. The ECB
advocates in particular the introduction of targeted surveillance. On the basis of a clear and
simple criterion, or a limited set of criteria, on key aspects of competitiveness linked to the
functioning of EMU - based on measures of nominal competitiveness and other supporting
indicators relating to the private and public sectors - countries would be categorised
according to a colour-coded scheme of surveillance, which would be linked to increasing
degrees of intrusiveness.
Finally, the ECB also put forward proposals regarding the establishment of a euro area crisis
management institution, which would have many of the features of the European Financial
Stability Facility. From the ECB's perspective, it is crucial to minimize the risk of moral
hazard, which is always implicit in any ex ante rescue mechanism. Institutional safeguards
would include strong conditionality - reproducing the EU/IMF financial support to Greece -
and graded sanctions in case of non-compliance with conditionality, escalating to a de facto
loss of fiscal autonomy as the extreme form of sanction.
Some of the ideas set out in the Commission's recent Communication on enhancing
economic policy coordination for growth and jobs (30 June) are close to the ECB's proposals.
However, I think that that our proposals are somewhat more ambitious because we feel that
the situation requires a quantum leap forward in strengthening the foundations of EMU and
moving towards a deeper economic union.
5. Conclusion
We are now experiencing the full effects of the imbalances - both public and private sector -
that have accumulated in euro area countries over past years.
The euro area now faces two key challenges. The first is to take the necessary and difficult
measures to restore fiscal positions and eliminate private sector imbalances. So far, this
challenge seems to have been met. This can be seen, for example, in the decisive fiscal
adjustment measures that have been adopted in the countries concerned and in the rapid
adjustment of the private sector to the changed environment. It is essential to maintain the
momentum and to restore sound and sustainable financial positions in both the private and
the public sector.
The second challenge is to make sure that the lessons learned from this experience are well
understood. We should put in place a framework of economic governance and a set of
policies to prevent a recurrence. Here too, there is evidence of significant progress having
been made in recent months.
Some commentators argue that the imbalances that we have seen in the euro area have
seriously weakened Monetary Union, even posing a threat to its survival. I think that the
opposite will turn out to be true. When both challenges are met, the result will be a euro area
that will be far more robust, with a more resilient financial system, and with sounder fiscal
positions and a more balanced development across countries.
Once again, I would like to thank the organisers for their invitation to participate in this event.
I look forward to fruitful interaction with you over the next eight years.