Jens Weidmann: The crisis as a challenge for the euro area
Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, to the Verband der
Familienunternehmer (Association of Family Enterprises), Cologne, 13 September 2011.
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1 Introduction
Ladies and gentlemen
I would like to thank you very much for inviting me to this event in Cologne. As you may
know, I spent a number of years studying at the University of Bonn. It was then that I got to
know and appreciate the Rhineland region, and I'm always very pleased to have the
opportunity to return - even though the subject I'm here to discuss this evening is extremely
challenging.
More than three years after the onset of the banking crisis, and more than a year after the
sovereign debt crisis first came to a head in the spring of 2010, the financial markets and
people across the globe are still scrutinising the situation in the euro area.
As political efforts are being undertaken to solve the urgent problems associated with the
sovereign debt crisis and alleviate its symptoms, there is a danger of many people losing
confidence in decision-makers, agreements and institutions. People in Germany - and
elsewhere - are worried about their currency. And I take these concerns very seriously.
However, we must not forget that the Eurosystem can boast some remarkable successes in
fulfilling its mandate. The euro's record on internal and external value stability is comparable
to that of the Deutsche Mark. Along with the single currency's economic and political
significance, we must not forget this fact when discussing the current crisis.
As President of the Bundesbank and a member of the ECB's Governing Council, my core
task is to safeguard the euro's long-term stability. Credibly fulfilling this mandate not only
provides the justification for central bank independence; it also lies at the very heart of public
confidence in our single currency.
Maintaining confidence in the euro requires, among other steps, the construction of a
sustainable bridge between short-term crisis measures and a credible and stability-oriented
framework for monetary union. There needs to be an institutional framework that offers a
clear, coherent outlook and provides incentives for the individual parties to act reliably and
sustainably. Having this outlook in place will make it easier to allay the short-term difficulties
and ease the current tensions. This is the broad framework that we need for European
Monetary Union; I would now like to look more closely at the details.
The sovereign debt crisis has, without question, been the euro's biggest test to date. The
financial crisis revealed major fiscal and macroeconomic imbalances in some countries. At
the same time, it unearthed weaknesses in the fundamental framework of monetary union
and its actual implementation. The fact that almost everyone - including us - underestimated
the huge challenges created by the increasing complexity and integration of the financial
markets is sure to have played an important role in these developments.
First and foremost, extensive consolidation and reform measures now need to be
implemented in the countries that are experiencing difficulties in order to restore confidence
in the stability of public finances, re-establish competitiveness and ensure a healthy national
financial system. The first steps towards achieving this have already been taken. In some
areas, however, there is a long road ahead.
In addition, comprehensive changes must be made to financial market regulation and
supervision to make the financial system more resilient. The resolutions expected at the G20
summit in Cannes will be another important step towards this objective.
Moreover - and this is the main focus of my speech here today - the institutional framework
for monetary union must be adjusted so as to achieve the right balance between the
responsibility of individual countries, liability and monitoring. My greatest concern is the
current lack of a coherent outlook in this area. The steps announced, and those already
taken, have shifted the balance of the framework in a direction that is not sustainable in the
long term. This threatens to substantially harm the public standing of the euro.
In principle, I think that there are two economically sustainable approaches to designing a
stability-oriented monetary union for the future. The first would be a return to the founding
principles of the system agreed in the treaties, which still essentially applies; this would entail
having European rules for national fiscal policy, countries retaining their fundamental fiscal
policy independence, applying the no bail-out principle and financial markets disciplining
fiscal policy. Despite all the comments to the contrary, I still believe that it is possible to
successfully stabilise and consolidate this framework. The other approach would be to
embark upon a major shift entailing a fundamental change in the federal structure of the EU.
This would involve a transfer of national responsibilities, particularly for borrowing and
incurring debt, to the EU.
I believe that political leaders need to take a prompt decision on which of these two routes to
take. The middle road of communitising liability whilst retaining independent national fiscal
policies threatens to be derailed by its own inconsistency. It would endanger the survival of a
stability-oriented monetary union, and thus also the European integration achieved thus far.
2 Sound public finances as a crucial precondition for a stability-oriented
monetary union
The current crisis in Europe was caused in no small part by the imbalances in fiscal and
economic policy in some member states, which, in combination with the financial market
crisis, triggered the current sovereign debt crisis. The combination of a single monetary
policy and decentralised fiscal and economic policies - an issue which had already been
central to the debate when monetary union was founded - thus proved to be a flaw in
European Monetary Union. The coordinating mechanisms designed to address this
weakness were clearly inadequate.
Sound public finances have always been of paramount importance to the internal and
external stability of a currency - all the more so in a monetary union where national
governments retain sovereignty over fiscal policy. The incentive for individual member states
to incur debt is even higher in such a union; if sovereign debt rises in one country, some of
the negative repercussions are passed on to the other member states. The risks that this
entails were already clearly identified when European Monetary Union was established, and
that is why rules for fiscal and monetary policy were laid down in the Maastricht Treaty.
These rules aim to shield monetary policy from unsound fiscal policy.
However, one factor was underestimated when monetary union was founded: the risk of
contagion means that it is difficult for the other member states to deny assistance to the
country at fault and thus force it to bear more of the costs and risks resulting from its
misguided fiscal policy. This can therefore lead to a conflict between fully applying the
nobail-out principle and safeguarding financial market stability in the short term. Indeed, the
more successful a monetary union, ie the more integrated its real economies and financial
markets, the greater the possible contagion effects.
3 The existing legal framework for monetary union
The founders of monetary union were essentially aware of the importance of sound public
finances. They therefore imposed a set of rules on the euro area that aimed to prevent these
kinds of imbalances from emerging where possible and to correct them where necessary.
Because of the temptation I have already outlined for decision-makers to to misuse monetary
policy , it was stipulated that monetary policy would be independent and charged with
safeguarding price stability in the euro area as a whole. In the euro area's single monetary
policy, financing government deficits in the individual member states was prohibited. As well
as the inflation risks arising from the overly expansionary monetary policy that this would
entail, there is another important reason for prohibiting such financing in a monetary union
where the individual member states retain fiscal policy sovereignty. By supporting individual
member states via the central bank balance sheet, monetary policy would redistribute
financial burdens between the taxpayers of the different countries. If assistance for individual
countries is considered essential for exceptional and overriding reasons, such as a threat to
financial stability, it must generally be provided through fiscal policy, which is the
responsibility of national governments and parliaments. The most recent ruling by Germany's
Federal Constitutional Count was probably based on this reasoning. Monetary policy in a
monetary union therefore differs crucially from a purely national monetary policy, such as in
the United States or the United Kingdom, where there is no danger of having to shunt risks
resulting from unsound public finances between the taxpayers of different countries in order
to avoid jeopardising financial stability.
There is still a large degree of national fiscal autonomy within European Monetary Union.
The principle of subsidiarity is firmly enshrined in the current legal framework and the
national parliaments have the last word in fiscal and budgetary policy decisions. This is true
of revenue and expenditure and, in particular, borrowing. The Maastricht Treaty and the
Stability and Growth Pact were designed to impose effective limits on government borrowing
by restricting sovereign debt to non-critical levels and avoiding lasting deficits. However, the
public often have little awareness of these fiscal rules beyond the two threshold figures of
3% for the annual deficit and 60% for the debt level (both in relation to gross domestic
product). In fact, the rules are more comprehensive than this - including, for example, the
objective of achieving a close-to-balance budget in the medium term.
4 The run-up to the crisis
Despite the existence of this framework and the substantial successes achieved in
consolidating public finances in the convergence phase before the euro was introduced,
sovereign debt was not effectively contained in the subsequent phase - quite the opposite, in
fact. Looking at the run-up to the crisis reveals, above all, a lack of political will to implement
the rules, which were circumvented or even actively bent if there was no other way of
avoiding sanctions.
One major back door for getting around the rules was the fact that a majority vote among all
member states was required at key points in the excessive deficit procedure in order for it to
progress. Otmar Issing described this scenario rather colourfully as "sinners sitting in
judgement over fellow sinners", and it does indeed encourage strategic voting. In many
cases, the member states consequently failed to achieve the fundamental budgetary
objectives and pre-crisis borrowing was far higher than it would have been had the rules
been applied consistently. Another aggravating factor was the weakness of the Commission,
as the guardian of the treaties, in its confrontations with the member states.
In some countries, a number of failures - many of which can be summarised as "a loss of
competitiveness", "asset price bubbles" and "excessive lending" - played a crucial role in the
run-up to the crisis. It would take too long for me to discuss these issues in detail in this
speech. However, we should remember that initially neither the national decision-makers, nor
the European bodies, nor the financial market participants appear to have recognised the
extent of these escalating problems. The preventative mechanisms and risk provisioning
were insufficient. When these imbalances were corrected, this placed substantial additional
pressure on some countries' government budgets and financial systems. We must draw
lessons for the future from these experiences, too.
5 Routes to a sustainable institutional framework for monetary union
As a complement to short-term crisis measures, it is crucial to structure the institutional
framework for European Monetary Union so that it is stable, inspires confidence and
ultimately lends credibility to short-term crisis management.
I would now like to look at the two possible routes for achieving this in more detail.
5.1 Strengthening the existing legal framework
The current debt crisis in several euro-area countries has revealed the inadequacy of the
existing procedures for preventing and resolving such crises. In response, numerous
adjustments have since been made to the framework for monetary union. Some of these
adjustments have yet to be specified in detail or approved by national parliaments. They do
not aim to change the fundamental principles of monetary union. In particular, they expressly
reaffirm the no bail-out principle, thus making it clear that individual member states are to
bear responsibility for their fiscal policy decisions and investors for their investment
decisions.
As a short-term crisis measure, the European Financial Stability Facility (or EFSF) and the
European Financial Stability Mechanism (or EFSM) were created in the summer of 2010
after Greece had been granted bilateral assistance loans. Recent decisions specify that the
EFSF is to be expanded substantially. Assistance was granted to Ireland and Portugal via
the EFSF, and it has recently been signalled that Greece may be granted additional aid.
Another package of reforms aims to prevent future crises by amending the Stability and
Growth Pact (or SGP), introducing a procedure for preventing and correcting macroeconomic
imbalances and adopting a Euro Plus Pact (or EPP).
Furthermore, for emergency situations in which the preventative mechanisms do not suffice,
a permanent crisis resolution mechanism (called the European Stability Mechanism, or ESM)
is to be set up to avert dangers to the stability of the euro area as a whole. This mechanism
is scheduled to replace the EFSF and the EFSM in mid-2013.
In principle, this was the right decision. It reflects the dimension of increasing financial market
integration, which was underestimated by the founders of monetary union and which was
facilitated to a considerable degree by having a single currency. Nonetheless, it is crucial to
ensure that the specific design of the support mechanisms does not discard key basic
principles - such as subsidiarity, independent national responsibility for fiscal policy and the
no bail-out principle, and thus also the disciplining function of the capital markets - under the
smokescreen of financial stability. This would risk further increasing the euro-area countries'
propensity to incur debt and heightening the pressure on the single monetary policy to adopt
an accommodative stance.
I am therefore rather critical of some elements of the decisions taken by the euro area's
heads of state and government on 21 July. However, I must emphasise that I do not share
the all-too common view that the existing framework is unsuitable for a monetary union. I am
convinced that its founding principles remain appropriate for a stability-oriented monetary
union, too. However, certain adjustments undoubtedly need to be made to this framework to
reflect recent experiences. And I certainly do support many of the announced reforms.
Before I discuss the specific points on which I take a critical view, I would like to outline the
core elements that a strengthened framework would need. Specifically, I believe that we
need to give renewed force to the no bail-out principle, which is still enshrined in the relevant
treaties, and to the disciplining of national fiscal policies via the capital markets that this
principle entails. There are four key elements in this context:
1. Prevention: The planned strengthening of preventative procedures is key to
ensuring that crisis prevention is more reliable in the future. However, to ensure that
it actually works and avoids the build-up of unsustainable sovereign debt, there
needs to be a much greater automatism, particularly in the Stability and Growth
Pact, for imposing sanctions when the deficit and debt limits are breached. The
procedure for preventing and correcting macroeconomic imbalances and the Euro
Plus Pact (EPP) can only act as supplementary tools for avoiding obvious and
serious imbalances. In their use, we should nevertheless avoid attempts at
macroeconomic fine-tuning.
2. Financial market stability: In addition, further suitable measures should be taken
in the fields of financial market regulation and supervision to strengthen financial
market stability, thus reducing the potential conflict between the objectives of
safeguarding financial market stability and ensuring that private creditors remain
liable (including in the event of a euro-area country defaulting).
3. Crisis management mechanism: There needs to be a crisis management
mechanism as a last resort for averting financial crises that threaten the existence of
the euro area. It should contain three key elements: attaching strict economic and
fiscal policy conditions to assistance, ensuring appropriate interest rate premiums
and a credible involvement of private investors in the event of a default.
Having a strict macroeconomic and fiscal adjustment programme and, above all,
significant interest rate premiums over the rates paid by countries with high credit
ratings can maintain the incentive for member states to return to the capital market
as soon as possible.
Regarding the disciplining of national fiscal policy through the capital markets, the
rules for monetary union should be adjusted so that, when a euro-area country looks
likely to experience difficulties, private creditors cannot rapidly shift their liability to
the taxpayers of the countries providing assistance. The introduction of collective
action clauses (CACs) alone, scheduled to start in 2013 within the framework of the
ESM, is highly unlikely to be sufficient to achieve this objective. The approach of
adding a trigger clause to the terms and conditions of bonds stipulating that
maturities will be automatically extended for a fixed period of time (such as three
years) in the event of the ESM granting assistance to the country in question, as
proposed by the Bundesbank, should therefore be supported.
I have already stressed that I am critical of key elements of the recent EU decisions
concerning the design of the crisis resolution mechanism. In my view, they
undermine some of the key basic requirements for an assistance mechanism in the
existing legal framework, which is based on countries bearing responsibility for their
own finances. One serious cause for concern is the fact that the new, looser credit
conditions considerably reduce the incentives for countries receiving assistance to
make fiscal and economic reforms to enable as rapid a return as possible to
sounder public finances. Adopting these conditions in future assistance programmes
(or even in the ESM) would perpetuate such problems and encourage countries to
apply for assistance.
The planned secondary market purchases would also further weaken the incentives
for countries to conduct an appropriate fiscal policy. If the bonds of countries that
are not receiving assistance are purchased on the secondary market, it is unclear
how these countries can be strictly obliged to fulfil conditions governing
consolidation and reforms. It is also unclear how this can be brought into line with
the requirement of granting assistance only as a measure of last resort to avert a
risk to the stability of the euro area as a whole.
These decisions mean that member states with an unsound budgetary policy can
count on receiving assistance, while countries with sound finances will increasingly
be called on to provide funds. In addition, if the impression arises that the conditions
attached to the assistance are open to negotiation if targets are missed, there is a
danger that the countries receiving assistance will not make sufficient efforts
themselves.
This inconsistency can be illustrated through the following example: How can an
improved sanction mechanism in the Stability and Growth Pact prevent unsound
national fiscal policies if sanctions are threatened but, where rules continue to be
breached, protection from the capital market is ultimately granted at extremely
favourable conditions - indeed, far better conditions than those for some of the
countries providing assistance?
4. Consistent implementation: The effectiveness of any set of rules hinges on its
implementation - if the principle "pacta sunt servanda" ceases to apply, reliable
economic relationships are no longer possible. Ultimately, it is up to the sovereign
countries receiving assistance to decide whether or not to fulfil the conditions
attached to receiving assistance. To avoid making a mockery of national
responsibility, this framework must also clearly establish that no further assistance
can be granted if the conditions are not met.
All in all, I believe that strengthening the existing legal framework essentially remains a viable
and promising means of stabilising monetary union. However, this framework must ensure
that conducting a sound fiscal policy is in the best interests of each individual country - even
more so than before the crisis. And, when taking this route, we must not allow the design of
the crisis resolution mechanisms to open the door to misguided incentives.
5.2 Core elements of a fiscal union with a substantial transfer of competences
from national to EU level
The fundamental alternative to strengthening the existing framework would be to undertake a
major shift to a fiscal union, involving a partial transfer of fiscal policy competences to the EU.
Establishing a European fiscal union would not by any means require a complete
centralisation of fiscal policy (including policies governing revenue and expenditure). In
particular, the principle of subsidiarity implies that wide-ranging competences should remain
at national level in order to ensure that the arrangements reflect the preferences of the
individual countries' citizens as closely as possible.
In my view, enshrining strict deficit and debt limits for national budgets in EU legislation is
pivotal to achieving a stable fiscal union and reliably shielding the Eurosystem's single
monetary policy from unsound public finances. These limits would then apply to all levels of
national government, including central, state and local government and the social security
systems; the EU would need to be granted ultimate powers of intervention to ensure that the
limits are effectively implemented in practice. In a fiscal union, these powers of intervention
would have to be extensive enough to ensure that national governments lose their
sovereignty over fiscal policy when deficit and borrowing limits are breached, if not
beforehand. Consequently, the national parliaments would no longer have ultimate
decisionmaking authority over government budgets; their decisions would be subject to approval by a
central body.
I must emphasise that, contrary to public opinion, such a fiscal union would not necessarily
have to entail joint liability. In principle, this kind of centralised solution could function
successfully without joint liability. This would allow room for somewhat greater flexibility in
national borrowing. Existing national deficit and debt limits could, in principle, be set and
monitored by a democratically legitimised central body, such as the European Parliament. It
should then be ensured that decisions exclusively affecting euro-area countries are only
taken by representatives of these countries. However, the system for setting deficit and debt
limits would need to follow consistent rules; it would have to be rule-based, much stricter
than in the existing framework - reflecting recent experience - and should be made difficult
to change, for example by requiring large majorities. Within the bounds of this framework,
national fiscal policy could then essentially remain autonomous and, if permitted by the rules,
could, for example, allow automatic stabilisers for cyclical smoothing to take effect and take
out temporary own loans. The EU limits should constitute ceilings; there should, of course,
be no obligation to fully exhaust them.
Provided that stringent rules are implemented, this approach could make a crucial
contribution to ensuring sound euro-area public finances in the medium term and overcoming
the sovereign debt crisis. This kind of framework would shield the Eurosystem's single
monetary policy from unsound fiscal policy.
As I have said: introducing joint new borrowing or communitising existing debt by issuing
Eurobonds, which are currently being so widely discussed, would not be at all necessary in
this context. However, it would be possible to do so as a second step (but certainly only once
fiscal policy sovereignty over deficits and debt had been transferred to the EU) without
undermining the consistency of the legal framework, although this framework would have to
be tightened even further.
At all events, even in a fiscal union, joint liability would raise the incentives for member states
to incur debt. These incentives would therefore have to be restricted, for example through a
strict ban on new borrowing at national and EU level. Otherwise, I believe that the fiscal
union would be a long way from ensuring an adequate balance between liability and control.
A communitisation of debt would be sure to result in a substantial redistribution from sound to
unsound countries. In addition, Eurobonds, in and of themselves, would actually be rather
counterproductive to solving the fundamental problem that led to the outbreak and spread of
the sovereign debt crisis. In short, I believe that the risks associated with Eurobonds far
outweigh their potential benefits.
Alongside reforms to restore competitiveness, such a fiscal union would provide a consistent
legal framework. This would be a major step in the process of European integration - a
significant move on the part of the EU, or at least the euro area, in the direction of a federal
state. However, its implementation would require extensive treaty amendments and probably
also amendments to national constitutions - doubtless including the German Constitution, as
the German Federal Constitutional Court's ruling has shown. We should be under no
illusions: The route to fiscal union would be long and arduous. Without broad support from
the people of the euro-area countries, this kind of shift would be almost inconceivable, and it
is unclear whether this support actually exists. It is vital not to make the mistake of taking the
steps in the wrong order.
6 The increasing misuse of monetary policy
In principle, it is possible for monetary policy to safeguard price stability in either a
decentralised or a centralised legal framework for monetary union, provided that the chosen
system is adequate. However, substantial problems are likely to arise in future if an
inconsistent framework is enshrined in law or - perhaps even worse - an inconsistent
framework is not re-enshrined in law but is applied in practice regardless of the legal
provisions.
The momentum of the crisis shows a worrying pattern in this respect, particularly from the
point of view of a central bank.
 Insufficient economic and fiscal policy measures in the member states lead to a loss
of confidence on the markets, which focus on the new weaknesses.
 Sooner or later the situation escalates, the country in question sees its bond yields
rise and has difficulty accessing the capital market. The interest rate rise is all too
hastily classified as unsustainable. Crisis meetings are then arranged, at which ad
hoc measures are adopted and calls are made for monetary policy - which is
supposedly the only institution directly able to intervene - to step into the breach to
stabilise the situation in the short term. The situation becomes yet more problematic
if neither the countries concerned take measures to remedy the situation nor the
countries potentially providing assistance wish to take on risks.

Monetary policy certainly does have tools that can calm the financial markets in the
short term. However, taking such measures can blur the boundaries between the
responsibilities of monetary and fiscal policy and overstretch the mandate of an
independent central bank. In addition, they threaten to perceptibly weaken
incentives for fiscal policymakers to take action themselves.

This in particular can subsequently lead to a delayed or inadequate implementation
of fiscal policy measures, bringing us full circle and triggering a downward spiral in
which monetary policy is left "holding the baby".
It is certainly true that central banks, too, have to learn lessons from the crisis and rethink
fundamental positions. I believe that one key lesson is, as I have mentioned already, the
primary importance of efficient financial market regulation and supervision for an efficient
framework for monetary union and, in particular, for a stability-oriented monetary policy and
its interplay with the financial markets.
I am also aware that the real world is not black and white and that rules and actions can be
interpreted differently. Nonetheless, following the Bundesbank's tradition, I believe that it is
particularly important for monetary policy to remain true to its principles - all the more so in a
monetary union. But there is no place for dogmatism. Certain situations not only allow room
for a certain degree of flexibility, they also require it.
Financial market stability is, without question, of great importance for monetary policy. Even
so, this fact must not lead us to systematically overturn fundamental commitments and
responsibilities. This would cast doubt over the legitimacy of an independent monetary
policy, jeopardise its primary objective - safeguarding price stability - and compromise the
confidence of the general public in monetary policy, which is of vital importance.
Central banks have currently relieved fiscal policy of part of its burden of supporting
individual member states or distressed banks. However, this has brought substantial risks
onto the Eurosystem's balance sheet. I firmly believe that these risks must now be reduced
and on no account increased. It is therefore high time for fiscal policymakers to decide what
risks they are willing to take on, both in combating the crisis and going forward. That is not
the responsibility of monetary policy.
7 Closing remarks
Ladies and gentlemen, I mentioned at the beginning of this speech that this is a complex and
challenging subject. I would like to thank you for giving me the opportunity to discuss this
issue in detail here today.
I believe that the current developments are of vital importance for the future of the euro. The
democratically elected parliaments must decide on the future fundamental design of
European Monetary Union. This could mean maintaining the agreed framework and
correcting the incentives so that they are conducive to stability. Alternatively, it could involve
undertaking a major shift to a fiscal union, including a fundamental transfer of key areas of
responsibility from national parliaments to democratically legitimised European bodies.
However, I believe that the middle road embarked upon through some recent decisions is
leading us in a direction that is not stable in the long term.
Thank you for your attention.