Erkki Liikanen: Europe under stress - ways ahead
Speech by Mr Erkki Liikanen, Governor of the Bank of Finland, at the Atlantic Council,
Washington DC, 26 September 2011.
* * *
I have spent the last days at IMF meetings here in Washington. The growth forecasts for the
United States have been revised down. The same was done to Europe mainly due to the
sovereign debt crisis. The US and Lehman were the center of the crisis in 2008, now it is
more about Europe and sovereign debt.
Europe must be seen in a global context. The present problems in Europe are nobody else's
fault, but Europe is dependent on what happens in the rest of the world. That was seen in
2008-2009, and it is visible now. The global economic situation is today a matter of clearly
more serious concern than it was a few months ago.
One need not even refer to the published macroeconomic forecasts to see this. It is visible in
the confidence indicators of businesses and households. It is also demonstrated in the
financial markets, where stock market indices have plummeted and long term interest rates
have decreased since last spring. Significantly, the decrease in yields can also be observed
in the market for inflation-indexed debt, which suggests that it is really a question of
weakening of growth prospects - rather than expectations of deflation, for example.
But it is not the only the forecaster's baseline that has changed. Also the downside risks to
economic performance have increased. This greater uncertainty can be seen in many
places. It shows up in the gold price which has soared, as you know; and much more
importantly, it shows up as flight to (perceived) quality in the financial markets.
The flight to quality is a predictable consequence of current financial conditions: the fragility
of some countries and banks, combined with the heightened uncertainty regarding the future.
Investors react by trying to move funds from more indebted countries to "safe havens". At the
same time, banks are increasingly cautious and selective about lending to their peers - to
the detriment to the operation of the interbank markets. Banks prefer dealing with the Central
Banks instead. In short, liquidity preference has again started to dominate the markets.
As I said, Europe in general and the euro area in particular has become the centre of
attention of the financial markets. This is not so because of the average condition of the
European economy: indeed, judging by several objective criteria, Europe is not worse off
economically than the other comparable economic areas.
In 2011, the public deficit of the euro area should be around 4.5% of GDP, while in the
United States or Japan it will be about 10% of GDP. As we know, the accumulated
government debt is much lower in the euro area than in Japan, and of the same order of
magnitude as in the U.S.
Moreover, the currency is solid. The euro is a credible currency which over the last 12 years
has kept its value in terms of price stability in a remarkable way in comparison with its
preceding national currencies in the previous decades. The stability of the currency itself is
not disputed and there is no evidence of distrust in it, be it in the long-term yields on euro
denominated AAA rated bonds, or in inflation expectation surveys, or in the exchange rate
itself, which is stronger vis-a-vis the dollar now than when the single European currency was
launched in 1999.
But of course, there are urgent problems in the euro area today. But they are not
predominantly aggregate problems; rather, they are problems of divergence within the area,
and structural deficits in several individual member countries. These came to the surface at
the time of eruption of the global crisis in 2008, when the yield differentials on euro area
government bonds started to widen. The problems of divergence and deficits have revealed
serious weaknesses in the economic and fiscal governance of the euro area which are now
in the process of being corrected.
This summer has witnessed renewed problems as markets have worried about the effects of
a possible new global economic slowdown on Europe, at a time when European leaders
were slow to demonstrate their determination to deal with the problems of debt, deficits and
divergence.
In order to restore credibility and to weather even less favorable global economic conditions,
Europe must move forward on three main fronts at the same time. These are the fronts of
1) fiscal correction,
2) bank capitalization, and
3) economic governance.
The necessity of convincing action in these areas has been well recognized in principle and
work is under way.
For instance, in their meeting on July 21, this year, the heads of state or government of the
euro area countries made a number of important decisions which, when implemented, will
take Europe a long way towards dealing with the present problems.
Also, the EU finance ministers reached just over a week ago (in their meeting in Wroclaw,
Poland) an agreement on strengthening the economic governance procedures of the euro
area. The European Parliament votes on the governance package - the so called six pack -
this week and I expect it to be in force as of beginning of 2012.
The political process in Europe is sometimes painfully slow. It is also very complicated and
can be confusing to an outside observer. This is because of the very nature of our Union. EU
is an entity with a lot of jointly legislated and mutually binding norms. But a common
executive is really operative in certain limited areas only, such as trade, competition and
agricultural policies - and in monetary policy, in the form of the ECB. In most areas,
however, EU does not operate by a common executive agency; it operates by common rules.
In these areas, the competence of the EU executive - the commission - works through the
regulation and surveillance of the national governments' actions.
The structure of several national executives, operating under Union treaties and directives,
and the complicated process of making these norms, explains why EU works differently from
the U.S., which has a unitary executive at the federal level, vested in the President. The way
the EU is operates often stretches the patience of the financial markets, who would like to
see quick and clear-cut decisions instead of slow negotiations by large committees and
councils.
A rule-based system of coordination works best if the rules are good, if they are followed and
enforced, and if the world is stable. Under conditions of large and surprising shocks, like the
recent great recession, and soft enforcement of the common rules, the EU's economic
governance has not worked effectively enough, and this is a major underlying reason for the
present problems.
**
I return now to the three fronts on which advance is necessary to restore stability. The first of
the fronts, fiscal correction, means that countries having a fragile fiscal position now must
correct it, as they have indeed committed to do. These countries fall into three categories.
The first is Greece, which is actually deemed a special case now. The new EU/IMF
adjustment program for Greece is crucial to foster sustainable economic growth and stabilize
public finances. Strict and rigorous implementation of this program is absolutely necessary.
Besides fiscal consolidation, the privatization measures and structural reforms agreed in the
program are essential for revitalizing the Greek economy and to create growth over time.
In the summit of July 21, 2011, the heads of state and government made a number of
important decisions which pertain also to the Greek situation and its impact on the European
financial markets. First of all, they agreed to support the new program for Greece. There was
also a decision for enhanced flexibility in the use of the EFSF, including intervention in the
secondary markets, if warranted by exceptional financial market circumstances and risks to
financial stability.
The approach to private sector involvement in the euro area was also clarified. It was
recognized that Greece is in an exceptional situation and that for that reason it requires
exceptional and unique solutions. A part of that is a voluntary bond exchange program for the
private investors. At the same time, all euro area member countries reaffirmed their
determination to honor fully their own individual sovereign signature. The ECB has been
outspoken in this matter. It has made clear that it was advising that any contribution asked of
the private sector should be voluntary, as is the case.
Nevertheless, and despite all financial support, which is given in the form of loans, it is clear
that the task of rebalancing the Greek economy must be carried out by Greece itself.
Besides Greece, we have two other countries which have an adjustment program, i.e. Ireland
and Portugal. These countries are implementing their programs which will restore the public
finances to a sustainable path. Especially Portugal needs also to make structural reforms
which increase the growth potential of the country. I am confident that the programs will
proceed as agreed. One might note that in the case of Ireland at least, the confidence of the
financial markets has recently been improving already. Portugal has taken a positive start.
The adjustment programs of the program countries in Europe are jointly monitored by the
EU, IMF and the ECB, and financed by the temporary European Financial Stability vehicle,
the EFSF. The EFSF is financed through the issuance of bonds guaranteed by the European
states. Because of this reason, rigorous monitoring of the program countries is necessary. It
is important that individual countries are responsible and also feel responsible for their own
fiscal policies. It is also important that the guarantor countries see that the programs are
implemented in a rigorous way.
The third category of countries is constituted by two larger economies, which have not
needed a support program, but have been subject to market suspicions - that is Italy and
Spain. Both of these countries had a serious budgetary consolidation already in their stability
programs approved last spring 2011. Moreover, during the summer both countries enacted
significant additional measures which I think exceeded the expectations of their peers.
Especially Italy, which has larger accumulated debt, has undertaken bold budgetary cuts.
Both countries have speeded up their budgetary consolidation and are implementing
balanced budget rules to their constitutions.
**
Turning now to banking, we can see that the markets and banks themselves are not happy
with the condition of the banking system, as shares have declined and interbank markets are
not working as well as one would hope and expect.
In Europe, the systemic liquidity of the sector is supported by the European Central Bank
which continues to provide liquidity on a full allotment basis, against a broad range of
collateral, both marketable and non-marketable. The ECB has committed itself to continuing
this flexible method of liquidity provision as long as necessary. And the amount of collateral
available in the market is large enough to allow even much greater creation of liquidity than
at present, if demanded.
I think that the main problem with the banking system is that a further recapitalization of
banks is already long overdue. This is the case throughout the world. Perhaps this task is
especially urgent for the euro area, because uncertainty regarding the health of banks
aggravates the negative effects of economic imbalances and divergence in the area.
This should be the task primarily of the shareholders of the weaker banks, who should refrain
from taking dividends or should inject more capital if needed. In some cases, government
investment in bank equity may also be necessary.
Coming from Finland, I can understand very well the political problems involved in cleaning
up the banking system. In the 1990's, after the great Finnish banking crisis, the Finnish
government had to support the asset management company that handled the banks'
problem assets, in amounts that at one point reached about 10 per cent of GDP. Most of this
money was later recovered, but in the meantime taxpayers were furious. The public
frustration with the costs of the banking crisis has not been forgotten in my country.
Despite the short-term discomfort it entails, the resolution of banking problems is necessary
for us to move forward to a lasting recovery. On the one hand, the recapitalization of the
weaker but viable banks is necessary to restore confidence. On the other hand, the
wellmanaged closure of weakest banks is necessary, so that they do not distort the market for
the viable banks.
An important part of the decisions of July 21 by the euro area heads of state or government
was that the use of funds raised by the European Financial Stability Facility was agreed to be
made more flexible. This will make the EFSF a better tool in supporting the present tasks of
crisis management. According to the decisions, loans from the EFSF can be used to
recapitalize banks - not only in the program countries, but in other countries as well.
**
The third front of advance for the EU is the improvement of fiscal and economic governance.
While the fiscal correction front deals with the present imbalances, the governance front will
mainly be directed towards the future, in order to reduce the likelihood of recurrence of deficit
problems. Of course, credible institutions which would ensure future stability should reflect
back on the present situation as well, improving credibility and confidence already now.
When the monetary union was planned in Europe, there was much debate about the degree
of economic convergence between countries that would be necessary for a monetary union.
Some people thought that a high degree of economic convergence was a necessary
precondition, whereas others argued that membership in a monetary union and the necessity
to hold on to it would perforce bring about the necessary adjustments and convergence.
Because of the insistence of Germany and others, emphasis was placed on economic
convergence when the monetary union was established: reasonable entry criteria were set
for membership in the union, and members' fiscal behavior was regulated by the Stability and
Growth Pact.
Now we know that this emphasis on convergence did not carry enough force. In 2005, the
pact was actually made more flexible than originally, despite the resistance of the ECB. That
happened when some big countries faced the prospect of being subjected to the EU's
"excessive deficit procedure." Then, shaken by the steep recession of 2008, several
countries got unexpectedly to the danger zone. The current crisis has demonstrated very
clearly that an ambitious reform of the economic governance framework is in the interest of
the European Union, its members, and the euro area in particular.
Now, we need even tighter economic convergence, and we need better economic
governance within the EMU. We must strengthen economic governance mechanisms in the
euro area to minimize the risk of additional crises in government finances in the future.
The "Euro Plus" pact signed last spring was a step in the right direction. The signatories - all
euro area countries and some other EU countries - committed themselves to several
important reforms, such as to implement the EU's budget guidelines to their national
legislation. These nationally implemented norms could help "internalize" the fiscal discipline
in each country and render the matter less of an issue of EU policing of the countries' current
fiscal actions. The Euro Plus pact also broadened the scope of policy coordination.
Previously, the stress had been on deficits and debt; now, the competiveness issues (such
as relative labor costs) and financial stability were also included.
As I already mentioned, the EU is just now adopting an important legislative package which
will strengthen the stability and growth pact and the macroeconomic surveillance framework
of the EU.
This package includes, among other things, a directive on the budgetary frameworks of the
member countries. This will be important for what is called the "European semester" - the
new annual review of members' budgets BEFORE their adoption nationally. The package will
also make the sanctions enforcing the Stability and Growth Pact more automatic, by the
socalled reverse voting mechanism.
Both the preventive and the corrective arms of the Stability and Growth Pact will be made
stricter. In the preventive arm, policy coordination will extend to the growth rate of public
expenditure of the member countries; in the corrective arm, the debt norm (60 per cent of the
GDP) will be promoted to an equal position to the deficit norm (3 per cent).
Also macroeconomic policy coordination is strengthened by the "six pack" legislative
package. It includes regulation of macroeconomic imbalances which is aimed to prevent the
accumulation of imbalances or loss of competiveness of any member of the euro area. The
imbalances covered include current account deficits and surpluses, among other things. This
policy coordination is underpinned by sanctions which are levied on a country which does not
follow the recommendations of the EU council to address these excessive imbalances.