Mario Draghi: The role of monetary policy in addressing the crisis in the
euro area
Speech by Mr Mario Draghi, President of the European Central Bank, at the "Room for
discussion" of the Study Association SEFA and the Faculty of Economics and Business,
Amsterdam,15 April 2013.
* * *
Introduction
There was a time, not too long ago, when central banking was considered to be a rather
boring and unexciting occupation. In the era of the "Great Moderation", mostly seen as the
period between the mid-1980s and the beginning of the global financial crisis, inflation was
tamed and macroeconomic volatility was contained. Some thought that monetary policy
could effectively be placed on auto-pilot. I can confidently say that this time has passed.
The ECB's monetary policy in the crisis
The global financial crisis has put an end to that period in a way that has been very abrupt
and certainly lasting for quite some time to come. In this country, the outbreak of a financial
crisis brings back memories that go quite far into history. In 1763, exactly 250 years ago,
Amsterdam was the centre of a deep financial crisis. Highly leveraged investors were faced
with a situation of falling asset prices. The rolling over of existing obligations became very
difficult and the liquidity crisis became severe. Investors could not refinance themselves
other than through fire sales of distressed assets. Amsterdam bank houses went bankrupt
and merchants suffered significant losses.1
The 1763 crisis has some important resemblances with today's crisis. In the first stage of
today's crisis, liquidity was at the epicentre. Money markets seized up and several market
participants found themselves unable to roll-over funding positions. Concerns regarding bank
solvency rapidly surfaced and the crisis then morphed into a banking crisis. Finally, at the
beginning of 2010 the latest turn: several euro area countries' debt and deficit levels were
found to be unsustainable. It was a sovereign debt crisis.
But differently from the crisis in 1763, the determined actions of central banks prevented the
destructive downward spiral of abrupt deleveraging, fire sales and ultimately deflation. The
ECB, and indeed all major central banks, reduced its policy rates to unprecedented lows. In
addition, the ECB has implemented various non-standard measures to restore monetary
policy transmission, also with a view to supporting credit flows to the real economy. This is a
necessary pre-condition for fulfilling our ultimate objective of lasting price stability.
Our liquidity support gives banks unlimited access to central bank money at a fixed price
against adequate collateral. To make it fully flexible and facilitate banks in their attempt to
liquefy their assets at times of stress, we expanded the set of eligible assets that can be
used as collateral.
Furthermore, in order to give banks sufficient reassurance that access to liquidity will not be
a problem over a relevant planning horizon we have extended the maturity of our lending.
The longest maturity of our long-term refinancing operations (LTROs) has been raised from
the standard 3 months before the crisis to 6 months after the post-Lehman cataclysm, to one
year by mid-2009, and to three years at the end of 2011.
More recently, we have announced the Outright Monetary Transactions (OMTs), in order to
eliminate the pricing of un-warranted tail risks in the bond markets. OMTs entail interventions
in government bonds with a remaining maturity of up to three years. OMTs have a number of
characteristics: they require the government concerned to accept a programme involving
support by the European Stability Mechanism that entails strong and effective conditionality.
Such conditionality is important in particular to preserve monetary policy independence.
Interventions would be ex ante unlimited, which is essential to ensure their effectiveness. All
interventions would be sterilised so as to ensure that there is no impact from these measures
on the overall monetary policy stance. There would be transparency as the stock of
securities acquired under the OMT programme would be published regularly, together with
the average duration.
Like previous non-standard liquidity operations, OMT cope with extraordinary risk premia that
markets require when self-fulfilling expectations of catastrophic events prevail. In 2008, the
dominant fear had originated from the collapse of the payment system following the Lehman
bankruptcy. In the first half of 2012, the prevailing fear had been caused by unfounded
doubts about the continued existence of the euro.
There is another parallel between our early liquidity operations with banks and OMTs. In
providing liquidity to our banking counterparties, we cannot and do not want to subsidise
banks that are failing. Our liquidity support is not and should not be equity support. Likewise,
in pricing out break-up risk in sovereign debt securities, we cannot and do not want to
subsidise governments.
Placing the ECB's monetary policy in the broader context of central bank non-standard
measures
Let me briefly digress to put our monetary policy and its impact on borrowing conditions in
the context of unconventional monetary policies deployed by central banks more generally.
To begin with, the remuneration that investors demand on a long-dated security should be at
least as large as the expected return from a strategy of rolling over short-term instruments
and the risk premia that investors demand over and above the return from the rolling over
strategy. Premia, in turn, are a composite object. They compensate investors for different
risks attached to term investments:
•
The term risk premium for holding on to an asset for a specific period of time;
•
The liquidity risk premium as the compensation for the possibility of incurring losses
when selling the asset back to the market before maturity and at short notice; and
•
Credit risk premia of various types as compensation for the possibility of not
receiving at maturity repayment for the principal because, for instance, borrowers
may renege on their contractual obligations.
At the risk of oversimplifying, one can distinguish the main types of unconventional measures
depending on which component in this decomposition they are aiming to address.
Forward guidance about the intended path of the central bank's monetary policy rate in the
future mainly aims to manage expectations regarding the future evolution of the short-term
interest rates. It thus addresses the expectations component I was referring to before.
Changes in the level of the current policy rate always have an intrinsic signalling content with
respect to possible changes for short-term rates in the future. But during crisis times, when
short-term nominal rates are at zero or close to zero, they cannot be adjusted further down.
The central bank may then engage in active communication reassuring markets that the
future path of policy rates would not deviate from the current low level for a certain period or
until certain observable conditions are verified.
Large-scale asset purchases, or quantitative easing, instead, mainly aim to compress the
term premium.2 This type of policy intervention works through reducing the supply of
securities with long duration and increasing the supply of reserves or liquidity. With less term
risk to hold in the aggregate, the market should require a lower premium to hold that risk.
The ECB's non-standard measures I mentioned earlier are geared towards addressing
primarily two types of premia: the liquidity risk and the redenomination risk. The ECB's
liquidity operations, such as the 3-year Long-Term Refinancing Operations (LTROs), are
intended to relieve banks of liquidity and funding stress. They, therefore mainly aim to reduce
liquidity risk in the money market.
Central banks have adopted different approaches as regards their non-standard measures.
For instance, the Fed, the Bank of England and the Bank of Japan all engage in Large-Scale
Asset Purchases. The Fed also uses forward guidance.
When viewed, however, from the perspective of the framework I just described, most
nonstandard measures employed by the major central banks around the globe seem remarkably
similar. They aim to implement the desired monetary policy stance, in conditions in which the
stance may not be smoothly and homogeneously transmitted to the economy, or where a
further easing of the stance through standard policy rate adjustments is hindered by the
lower bound constraint. The unifying overall goal is to improve the effectiveness of monetary
policy, in ways that can support the attainment of the monetary policy objectives.
Yet, the varying emphasis on instruments and the approaches used by central banks around
the globe are tailor-made to the particular challenges of their economies. The particular
challenge of the ECB is to operate in a multi-country environment: one monetary policy for
17 countries that constitute our currency union.
Unlike economies with a single fiscal authority or with a fully-fledged federal structure, the
euro area comprises multiple sovereign states. The debt of each of these states has different
liquidity and risk characteristics. In such a set-up there is no uncontroversial way to define
the term structure of the risk-free rate. As a matter of fact, this means that there is no
univocal measure of the term premium for the euro area as a whole.
At the same time, during the crisis, normal heterogeneity has turned into detrimental
fragmentation: a landscape with natural diverse scenery has turned into a dangerous surface
with jagged cliffs and stumbling blocks. Liquidity risk, which was a widespread concern for
banks throughout the euro area at the start of the crisis, has become more concentrated as
the crisis has progressed. Fault lines between banking sectors with structural funding
surpluses and banking sectors still suffering from a precarious access to credit run across
national borders.
The banking sector and the financial market of the euro area has become fragmented. This
is harmful as the euro area is a bank-based economy. Around three quarters of firms'
financing comes from banks. So if banks in some countries will not lend at reasonable
interest rates, the consequences for the euro area economy are severe.
Although we see a decrease in fragmentation on the funding side, our very accommodative
monetary policy stance is only partly passed on to the financing conditions faced by firms
and households in some euro area countries. Companies headquartered in stressed
countries face worse borrowing conditions than equally risky competitors in non-stressed
countries. And, within the same stressed economy, Small and Medium-sized Enterprises
(SMEs) suffer relatively more than large companies that have easier access to capital
markets and are less dependent on the banking system. This is especially disconcerting
given that SMEs account for about three quarters of euro area employment.
Our non-standard monetary policy measures have, therefore, the task of removing these
stumbling blocks to ensure that our single monetary policy in fact reaches all parts of the
euro area. This is crucial for fulfilling our mandate.
Beneath the surface: the root causes of the crisis in the euro area
Within the limits of our mandate we have acted with determination. Our balance sheet has
expanded substantially, to almost three times its pre-crisis size. While it has shrunk since its
peak, the expansion is comparable to the increase in the balance sheet of the Fed during the
crisis.3
Tail risks have been largely removed from the pricing of euro area assets. Financial
fragmentation has been receding: banks in stressed countries have seen the deposits placed
with them by euro area residents increasing by about 130 billion euro since August 2012,
TARGET2 balances of the National Central Banks in these countries have declined by more
than 200 billion euro or about 20% since their peak and also banks' dependence on ECB
liquidity intermediation is waning to some extent.
Nevertheless, problems in the euro area economic landscape still loom large. This
understandably triggers calls for more action to be taken by the authorities that shoulder the
responsibility to navigate the economy through these troubled waters.
To address these calls, one needs to take a sober look at the root causes of this crisis.
Most of the stressed euro area economies - and certainly the ones that are finding it most
difficult and painful to adjust - have suffered from a chronic loss of competitiveness while
being members of the monetary union. The erosion of their competitiveness has meant that
these economies started running large current account deficits and some of them have
accumulated large external debt positions.
In some cases the expanding external debt was driven by increasing public sector
indebtedness. Imprudent fiscal policies were masking the private sector's lack of
competitiveness in an effort to shield and even improve living standards.
In other countries it was the banking sector's leverage that increased fast. This in turn
reflected a strong increase in lending to domestic firms and households. In these cases the
lack of competitiveness was triggering a shift of the economies towards domestic
consumption and activities shielded from international competition, such as the housing
sector.
On top of that, banking supervision and regulation did not always mitigate the destabilising
tendencies. There were cases when banks were not induced to develop sufficient capital and
loss buffers in good times.
The way out is to restore competitiveness. And the way to do this in the context of a
monetary union is to pursue with determination an ambitious structural reform agenda. Such
an agenda comprises a number of national measures to make sure that the functioning of
product and labour markets is fully compatible with participation in monetary union. One
specific aspect is to fight vested interests that hamper competition, structural weaknesses of
productivity and to allow, where needed, the nominal adjustments to play out.
And such an agenda also comprises a number of European measures to fully complete the
Single Market especially in the area of services and to allow for higher labour mobility within
the euro area.
Since the crisis started considerable progress has been made in making structural reforms in
euro area countries, particularly those under an EU/IMF programme. And the painful
measures taken are starting to bear fruit.
In Greece, Ireland and Portugal current account balances have improved by more than
7 percentage points (relative to GDP) between 2008 and 2012. In Spain the current account
has improved even more substantially.
Also, we have seen reductions in unit labour costs. Ireland has seen an 18 percentage point
improvement relative to the euro area average. In Greece, Portugal and Spain the
improvement has been about 10 percentage points. As I have recently stressed to the Euro
Area Heads of State and Governments, narrowing the gap between wage and productivity
growth is absolutely essential for improving competitiveness in euro area countries.4
To conclusively address the root causes of the crisis these efforts need to be maintained
and, in some countries, stepped up. In the meantime, however, what I referred to earlier as
the symptoms of the crisis also need to be tackled. Fiscal positions need to be maintained on
a sustainable path and balance sheet weaknesses in the banking sector need to be repaired.
And let me be clear: undertaking structural reforms, budget consolidation and restoring bank
balance sheet health is neither the responsibility nor the mandate of monetary policy.
Monetary policy can only avert an abrupt deleveraging that would have been conducted in an
environment of panic and fire sales. And this is what we have done in order to avoid
deflationary downward spirals that would have prevented us from delivering on our mandate
of preserving price stability in the euro area.
Monetary policy can support the reform progress by safeguarding price stability and
anchoring inflation expectations. But it cannot substitute for actions that other actors,
including the private sector itself, must take.
Completing the euro area's institutional architecture
In addition to the role of misguided or imprudent national policies, the narrative of the crisis
that I have just spelled out clearly points to some serious shortcomings in the institutional
architecture of the euro area.
To begin with, the only policy sphere where some form of supra-national surveillance was in
place was fiscal policy. And even in this domain, the mechanisms that were envisaged to
prevent and correct unsustainable fiscal performance by Member States proved to be
lacking. No framework was foreseen for monitoring competitiveness and heterogeneity within
the euro area and for enforcing corrective action when needed. What's more, in
interconnected financial systems an entirely national perspective on bank regulation and
supervision turned out to be insufficient. Finally, no crisis management framework had been
set up to complement the national shock absorption capacity of euro area countries.
The creation of the EFSF and more recently the ESM has addressed this last shortcoming.
And in our joint work with the Presidents of the European Council, the European Commission
and the Eurogroup, we have set out a vision and a process for building a genuine Economic
and Monetary Union. This is designed to cover the other gaps in the institutional architecture
that I previously referred to.
The genuine Economic and Monetary Union comprises four pillars: a banking union with a
single supervisor; a fiscal union that can effectively prevent and correct unsustainable
budgets; an economic union that can guarantee sufficient competitiveness to sustain high
employment; and a political union that can deeply engage euro area citizens.
Progress is underway in all these directions. As regards the banking union in particular, a
first and important step has been made with the decision to create the Single Supervisory
Mechanism (SSM), the responsibility for which has been assigned to the ECB in the last
Ecofin. I am confident that the SSM's euro area perspective will make a significant
contribution to safeguarding financial stability in the monetary union. In this sense, it will also
support the conduct of monetary policy, as a stable financial system is a prerequisite for the
proper transmission of our policy signals.
But I would like to stress the importance of quickly complementing the SSM with a Single
Resolution Mechanism. This is necessary to guarantee timely and impartial decision-making,
particularly in the cases where cross-border resolution is required. What's more, a Single
Resolution Mechanism is essential to ensure that the SSM's supervisory decisions for
resolution can be followed up with action, without reinforcing the vicious link between banks
and sovereigns. Finally, a Single Resolution Mechanism will credibly pursue the least-cost
resolution strategy from a euro area perspective, also taking into account cross-border
spill-overs.
Conclusion
When considering the challenges that euro area economies are still facing, it is important to
remember the economic hardship that many of our fellow citizens in parts of the euro area
are experiencing, and in particular the massive unemployment, especially among the youth.
But there are also reasons for confidence. Most of the elements needed to address the root
causes of the crisis and to build a genuine Economic and Monetary Union have been set in
motion. The ECB's monetary policy will continue to make its contribution to this endeavour, in
line with its mandate.
The heavy task of implementing the important decisions already taken lies ahead. All parties
involved in this comprehensive reform agenda must persevere. And we must all work with
conviction and determination towards our shared vision. If we do so, I am confident that
restoring stability and ensuring prosperity in the euro area are within our reach.