José Manuel González-Páramo: The sovereign debt crisis and the future
of European integration
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the Oxford University European Affairs Society, Oxford,
24 November 2011.
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Introduction
Ladies and gentlemen,
Thank you very much for inviting me to speak here this evening in the "City of Dreaming
Spires". The aims of the Oxford University European Affairs Society - fostering
understanding of political, social and cultural issues across Europe - have never been more
relevant than today. In the sovereign debt crisis, Europe faces one of its greatest ever
challenges. The question is how to confront it. We should learn from the present and the
recent past. And we should look forward, since future prosperity in Europe depends on our
collective success in overcoming the crisis. Citizens in both creditor and debtor countries
have to look beyond national interests. Ultimately, this can only be sustained through deeper
common understanding and stronger sense of what it means to be European.
The sovereign debt crisis will be the theme of my remarks today. I do not want to engage in
the minutiae of the issue or signal any particular policy stance by the ECB. Instead, I would
like to take a step back from the crisis and reflect on what it has taught us so far about
economic and monetary union in Europe. Obviously, I concentrate explicitly on the euro area,
i.e. the seventeen countries sharing the single currency. The status and role of the United
Kingdom, the dynamics of the British domestic debate on Europe, and the cooperation with
the Continent in addressing the crisis are not the focus of my remarks.
I have three main propositions.
First, membership of EMU entails much deeper policy changes than were originally realised.
In 1991, Hans Tietmeyer, the former President of the Bundesbank, remarked that "monetary
union is not just a technical matter. It is in itself, to some extent, a political union". What has
become clear is that countries that adopt the euro as their currency are required to adjust
fundamentally the way in which they conduct their economic and financial policies. At the
same time, ensuring overall stability requires far-reaching coordination in economic and
financial governance. It would be difficult to understand that in the world's second largest
monetary area governance is outsourced solely to the markets and ratings agencies.
Effective governance of an economic area of such importance requires much closer
economic and financial union.
Second, in response to the crisis, a much more radical change in euro area governance has
taken place than many observers seem to acknowledge. Europe tends to reform
incrementally, at times creating frustration at the pace of change. But those increments now
add up to a fundamental overhaul of its economic management. The reasons this has not
been more effective in calming the crisis are complex, but communication stands out among
them: In "selling" their reforms, euro area authorities are forced to walk a tightrope between
the expectations of national electorates and financial markets, and risk satisfying neither. The
only solution to this democracy-market dialectic is, again, much closer economic and
financial union.
Third, and contrary to a strand of current thinking, the Treaty prohibition on monetary
financing is supporting rather than threatening euro area integration. In the euro area, the
central bank is "doubly removed" from the political systems of individual countries: it is not
only constitutionally independent, but also elevated to the supranational level. Euro area
governments cannot expect the ECB to finance public deficits. As a result, they must be
commensurately more ambitious in their economic policies and more disciplined in their
management of public finances to support their debt levels. Moreover, given the prohibition
on monetary financing, having a banking sector which can support growth and provide
adequate financing to the real economy in Europe requires a stronger regulatory and
governance framework, so as to prevent negative feedback loops between banks and
sovereigns. By forcing policymakers to focus their reform efforts on the right priorities the
monetary financing prohibition offers an incentive to closer economic and financial union.
First proposition: The need for radical changes in national economic policy-making
Let me begin with my first proposition, that membership of EMU entails much deeper policy
changes than were previously acknowledged. The crisis has shown very clearly that
countries that adopt the euro have to alter the conduct of their economic policies. These
changes are fundamental. Among them, three are particularly relevant.
First, in a monetary union fiscal and supervisory authorities have to adopt policies that
counteract the emergence of private financial imbalances at the national level. This is a
consequence of the ECB's legal obligation to maintain price stability in the euro area -
defined as an inflation rate of below, but close to, 2% over the medium term. Private debts
denominated in euros cannot be "inflated away".
Second, fiscal and other national macroeconomic policies have to ensure competitiveness by
resisting increases in nominal trends. This is the implication of sharing an exchange rate;
devaluation cannot be used as a tool for any one country to regain competitiveness.
Benchmarking against other euro area countries is unavoidable.
Third, fiscal authorities have to build up sufficient buffers in good times to withstand adverse
conditions. This follows from the prohibition on monetary financing which prevents the central
bank from directly financing governments as well as the so-called "no bail out clause" of the
Treaty which prohibits a Member State to assume the liabilities of another Member State.
The failure to build adequate fiscal buffers during times of economic growth means that
during recessions governments are forced to implement fiscal policies that are more
pro-cyclical than would otherwise be the case.
Some in this audience may respond that these policy requirements were evident to
sharpeyed observers. Indeed, the ECB had been making these points for many years. But they
were not so widely acknowledged as to make a difference. For every economic argument in
favour of policy adjustment, a contrary one could be found justifying the path taken. This
meant many euro area countries did not internalise the policy requirements of monetary
union. In fact, almost the opposite policies were pursued in some countries.
The lack of an adequate regulatory and macro-prudential framework meant that in many
economies the banking sector supported an unbalanced and unsustainable expansion of
credit during the period of low interest rates. The financial sector also became
overleveraged and engaged in excessive risk taking. Although at the time many in the financial
industry justified this with arguments about how financial engineering created possibilities for
sophisticated risk diversification, a posteriori it has become evident that risk was seriously
mispriced in the period before the crisis.
National wage-setting and labour market regulatory frameworks have also proved to be
inadequate. Rather than resisting nominal trends, before the crisis strong wages put
pressure on price competitiveness, often justified by theories of catching-up effects. Fiscal
discipline also proved too lax. Rather than building up buffers during "the good times",
increased tax revenues associated with the pre-crisis housing booms were treated as
structural rather than cyclical, justified by models demonstrating new growth trends.
Taken together, this meant that some of the euro area countries entered the global financial
crisis in an unnecessarily vulnerable position. This explains to a large extent the situation we
are now in.
However, these policy failures were also made possible by a general failure to acknowledge
the new governance responsibilities associated with membership of EMU. Put simply,
"keeping your own house in order" is necessary, but not sufficient, in a highly integrated
monetary union. It is the responsibility of every euro area government to exercise vigorous
and effective mutual surveillance over others' policies. As a crisis in a country like Greece
representing only 2% of euro area GDP can become systemic, disregarding EMU
governance may come at a high cost to taxpayers.
Yet the latter was the attitude prevailing prior to the crisis. The Stability and Growth Pact -
the set of EU level rules for guiding fiscal policies - was never properly implemented.
Member States tended to adopt a principle of "non-interference" over each others' policies.
Peer pressure, on which the framework was predicated, gave way to peer support. By
watering-down of SGP in 2004-05, the largest euro area countries signalled that they had no
stake in the rules. This allowed a certain country to run deficits over 3% of GDP every year it
was in EMU and never face corrective action.
Moreover, the euro area surveillance framework was "blind in one eye", with no formal
framework for monitoring macroeconomic and financial imbalances. The Lisbon Strategy
focused on the structural level, but on policy implementation rather than imbalances.
Eurogroup discussions on imbalances had no enforcement mechanism. The Lamfalussy
framework for financial supervision did not use the concept of systemic risk. Thus a situation
prevailed where countries could be congratulated for strong headline fiscal numbers when
these data in fact reflected substantial imbalances that were building up in the private sector.
To a certain extent, the weakness of these governance procedures was linked to a
misplaced faith in market discipline. The institutional design of EMU gave market discipline a
central role in economic governance. The absence of a transfer mechanism between
Member States was supposed to encourage markets to actively discriminate between euro
area issuers. This was based on the assumption that financial markets would always have
perfect incentives to enforce the "rules of the game".
This assumption, in retrospect, looks somewhat naïve. It is well established in the academic
literature that markets have complex incentives and dynamics. Market psychology tends
towards pro-cyclicality. Perceptions converge around certain information sources, such as
ratings, or certain benchmarks, such as indices, which creates herd behaviour. Structural
features of the financial system, such as the role of ratings in financial regulation and
investment mandates, create an embedded non-linearity in market reactions to news.
What we witnessed in the euro area, therefore, was not a rigorous analysis of sovereign risks
but rather an undershooting followed by a dramatic, and perhaps excessive, correction.
Spreads converged for all euro area countries before 2008, despite high debt levels in some
countries and clear evidence of emerging imbalances. Now we have moved to the opposite
extreme: some euro area countries are confronting phenomena like sudden stops and
buyers' strikes that were in the past associated only with emerging markets.
As we have seen in recent months, market discipline can be a strong and useful force in
encouraging countries to make long-needed reforms. But it is also, clearly, an unstable way
to ensure good policies. Reform decisions have to be made hastily in dramatic meetings.
Politicians lack time to explain the need for reform to their constituencies and build
consensus behind them. It may even be the case that countries have to go "too far, too fast"
to restore market confidence. There is also a serious risk of uncontrollable contagion to other
countries.
In other words, we cannot completely delegate governance to financial markets. The euro
area is the world's second largest monetary area. It cannot depend solely on the opinions of
ratings agencies and markets. It needs economic governance arrangements that are
preventive and linear. This underscores my central point that a much more comprehensive
approach to economic governance is now the priority for the euro area. And this means more
economic and financial integration for the euro area, with a significant transfer of sovereignty
to the EMU level over fiscal, structural and financial policies.
Second proposition: Significant governance reforms have already been taking place
Europe has responded to these policy, governance and market failures by undergoing a
multi-year process of institutional reform. This leads me to my second proposition: that a
much more radical change in euro area governance has taken place than many observers
seem to acknowledge. There is a tendency to see the euro area response to the crisis as
perennially behind-the-curve - as "too little, too late". I concede that national authorities have
not always been effective in stabilising financial conditions. But I also think this assessment
lacks an appropriate benchmark. Observers expect a new "silver bullet" every few months
and when one is not delivered, they are disappointed.
But if we choose a more appropriate benchmark - say, the euro area in 2009 - a quite
different picture emerges. The sum of the incremental steps taken since that date are, in fact,
now a very big step.
Take for example economic governance. The EU Council and European Parliament have
agreed on a legislative package that significantly limits the discretion of national authorities,
even when imposing sanctions on themselves. This includes a framework for monitoring a
wide range of macroeconomic imbalances, also backed by sanctions. Countries are
expected to anchor fiscal prudence in national rules, creating a much more "vertically
integrated" concept of governance. All these measures were unthinkable four years ago.
If we look at the conclusions of Euro Summit on 26 October - dismissed by some observers
as insufficient - we see even more radical steps envisaged for the future. Euro area
countries have committed to adopt balanced budget rules. They have agreed to base their
budgets on independent growth forecasts. They have agreed to stick to the
recommendations of the Commission when implementing the Stability and Growth Pact.
Countries in the Excessive Deficit Procedure - which is currently 14 out of 17 euro area
countries - will allow the Commission to examine draft national budgets and monitor budget
execution.
Although some of the recent governance reforms, like those that formed part of the so-called
"Six-pack" proposed by the European Commission, fall short of the "quantum leap" that the
ECB had long advocated for the euro area, they still represent significant progress relative to
the situation prevailing before the crisis.
The creation of the European Financial Stability Facility and future European Stability
Mechanism could also not have been imagined in 2007. The euro area has institutionalised
the provision of sovereign liquidity and agreed to a Treaty change to ensure its legality. As
the new facilities have developed, they have acquired a range of tools. The current mandate
of the EFSF not only allows it to extend temporary loans to euro area governments in need,
but also to buy bonds in both the secondary and primary markets, to act on the basis of a
precautionary programme and to finance bank recapitalisations through loans to
governments including in non programme countries. The resources committed to the EFSF
are substantial. The ESM, which will have a paid-in capital of €80 billion and callable capital
of €620 billion, has a capital base around three times that of the European Investment Bank.
At the 26 October Euro Summit euro area leaders also agreed on two schemes which will
allow a significant leveraging of existing EFSF resources in order to increase the fund's
ability to act.
But perhaps the most significant development, relative to past expectations, is the
implementation of root-and-branch reform programmes in a number of euro area countries.
One should not underestimate the significance of EU-IMF programmes for structural changes
in some economies. They are dealing with long-needed pension reforms, opening up closed
sectors of the economy, modernising public administration. In terms of collective economic
management, this development goes further than many federations. Can we imagine, for
example, the U.S. federal government requiring a similar depth of reform in California?
Countries outside of EU-IMF programmes have also implemented major reforms. Spain has
recently passed a constitutional balanced budget amendment, disproving the view that major
policy changes are impossible in an election year. Italy has agreed to a technocratic
government to ensure structural reforms are implemented, and invited the IMF to give extra
credibility to this process. All euro area countries, except those under a programme, have
committed themselves to bringing their budget deficits below 3% of GDP by 2013 at the
latest. Overall, the forward commitments of euro area countries to fiscal sustainability go far
beyond what has been agreed in the U.S. or Japan.
Each of these measures, seen individually, may not represent the "shock-and-awe" or "big
bazooka" that some commentators and markets participants call for. But when seen
collectively, they represent a comprehensive broadening and deepening of euro area
economic governance. And relative to a reasonable benchmark - the status quo ante - they
are very significant developments.
It is also worth noting that many steps have been taken to strengthen the financial sector
regulation and supervision. Under the leadership of the G20, a remarkable amount of work
has been done by the Financial Stability Board (FSB) and the Basel Committee in a
demanding timeframe. Profound regulatory reforms need to be implemented to address the
underlying deficiencies that have become apparent in our financial system.
In general, Europe is exceeding international benchmarks in implementing these reforms.
The Commission issued a proposal in July 2011 aimed at transposing the Basel III
framework into EU Law. By doing this, it is among the first to introduce the Basel III
framework and is taking a leading role in delivering on the G20 commitments. In line with
Basel III, the Commission's proposal (so-called CRD IV) provides for higher minimum capital
requirements, a stricter definition of eligible capital and more transparency. It also introduces
also entirely new concepts, such as mandatory liquidity requirements and a non-risk-based
leverage ratio.
Beyond the micro-prudential dimension of regulation, the proposal introduces
macroprudential elements, most prominently the countercyclical capital buffer regime. This
constitutes an important safeguard to protect the banking sector from periods of excessive
aggregate credit growth. And on top of this, the European Council has recently decided that
European banks need to have a 9% core tier one capital ratio by the middle of next year,
instead of by 2018, as agreed by the Basel Committee.
Other important regulatory initiatives are underway. These include the establishment of an
appropriate regulatory framework for over-the-counter derivatives, enhanced oversight of
Credit Rating Agencies, the prevention of systemic risk coming from the "shadow banking
sector" and an EU crisis management framework for bank recovery and resolution. As
regards the supervisory framework, a new system of financial supervision has been
established creating, for the first time, European level macro-prudential supervision through
the European Systemic Risk Board (ESRB).
This discussion raises an obvious question: if so much has been achieved since 2009, why
have euro area authorities not been more effective in halting the crisis?
In my view this is fundamentally a political question, related to making policy between
17 sovereign democracies. Unlike a unitary state, the euro area has 17 Heads of State,
17 Finance Ministers, and countless national parliamentarians. It can only be expected that
their communication on difficult topics may sometimes diverge. As we have seen on many
occasions, this triggers difficult feedback loops between politics and markets which ultimately
undermine the impact of agreed policy measures.
On one level this is a procedural problem: our institutions are not effective enough in
ensuring political leaders speak with one voice. But on a deeper level, it is a problem deriving
from the fundamentally different expectations of domestic populations and financial markets.
Markets expect messages of confidence, of immediacy, of unlimited capacity to act.
Domestic populations want to know the limits of their liability, to ensure that actions are just
and fair, to make sure past mistakes are not repeated.
A classic example of this divergence has been the debate over private sector involvement.
For a domestic audience, banks should internalise the consequences of their lending
decisions and should be punished for their past behaviour. But from a financial market
perspective, such communication is disastrous. It signals to investors that assets that were
previously risk-free are no longer so, that the euro area is a market where their investments
are not guaranteed. And as markets are forward-looking, they sell their assets today. This
immediately undermines the progress I have just described.
A second example is the implementation of crisis response decisions. Markets expect quick,
bold and "shock-and-awe" decisions on highly complex matters. They are exasperated that
something can be agreed by leaders but take months to enter into force. Yet this is a
necessary condition of operating in a system of 17 sovereign democracies. Decisions have
to be explained, approval processes have to be followed, compromises have sometimes to
be made. These dynamics were witnessed even in the US when Congress sent back the
TARP in 2008. The net effect on the euro area, however, is that by the time decisions are
eventually implemented the expectations of market have moved on. The impact of those
decisions is then discounted.
These market-democracy dialectics provide a second reason why a more integrated
economic and financial union is so essential for EMU. The rationale for the original design of
EMU - with centralised monetary policy, but decentralised economic policies - was linked to
principles of subsidiarity and democratic accountability. This was consistent with the
environment that prevailed 20 years ago. But these same principles now imply more Europe,
not less.
Subsidiarity is the principle that the centre should perform only those tasks which cannot be
performed effectively at the national level. Can we really argue, in the current crisis, that the
centre is not the more effective level to exercise, or at least coordinate, certain economic and
financial policies? Democratic accountability is the principle that citizens should be able to
hold their representatives responsible for decisions. If we need a stronger European centre,
then to maintain this principle we also need profound improvements in democracy at the
European level.
The justification for rethinking these principles can be found, I believe, by acknowledging that
membership of EMU entails a significant degree of political union. We have seen that
preventing crises requires that all countries exercise close and effective mutual surveillance
of each others' policies. We have seen that correcting crises requires that decisions are
taken jointly, with a euro area perspective. The need for institutionalised collective
decisionmaking is, fundamentally, what defines a political union. And this is de facto the condition of
all euro area countries.
Third proposition: ECB independence and the prohibition on monetary financing are
essential for euro area integration
This condition of de facto political union raises questions about the proper role of the central
bank in EMU. The ECB is very much in the focus at the moment. Some observers call for it
to play the role of a "national" central bank like the Federal Reserve or the Bank of England,
and emulate their policies. But these viewpoints are partial. They overlook what is my third
proposition: that the Treaty prohibition on monetary financing by the ECB, over the medium
term, is a force in favour of euro area integration and greater stability.
The positive effects of the ECB's policies are fairly obvious in the case of the banking sector.
Our standard and non-standard measures ensure price stability in the euro area. While our
standard measures signal the monetary policy stance, our non-standard measures ensure
the transmission of the desired policy stance to the real economy in those market segments
in which the transmission is impaired. Our non-standard measures ensure that despite
increased liquidity demand, financial institutions are able to continue lending to clients.
However, misconceptions persist related to the Securities Markets Programme, our
programme for intervening in government bond markets. The SMP deliberately addresses
the appropriate transmission of our monetary policy to the real economy in market segments
which are impaired. Government bonds are crucial for the transmission of monetary policy,
via their status as a benchmark for borrowing by banks. Put simply, left unaddressed, the
malfunctioning of sovereign bond markets' could block the bank lending channel. An
important difference with Quantitative Easing programmes is that the liquidity injected into
the banking system via the SMP is sterilised by the ECB through regular liquidity absorbing
operations.
The ECB has been widely recognised as an institution capable of timely, decisive and
convincing action during tumultuous times. We see this as a mark of distinction. However, it
would be erroneous to derive from this that it should be a political institution in charge of
running the euro area economy. It cannot be and should not be. The ECB is a central bank,
committed to its mandate to preserve price stability over the medium term. It is not the fiscal
lender of last resort to sovereigns. Markets participants that call for the ECB to play this role
may care only about the nominal value of their assets and the need to avoid losses. Whether
or not the underlying asset - our currency as store of value - has been depreciated seems
unimportant to them. But survey after survey shows that the people, the citizens of the euro
area, want price stability. They care deeply about their purchasing power and the value of
their savings. The ECB has been established with a clear mandate to meet these
expectations.
Moreover, what these calls for more activism overlook is the positive effects of the ECB's
stance over the medium term. There are some in the academic world that argue that one
way out of the sovereign crisis would be for the central bank to act as a lender of last resort
to the sovereign. These voices suggest that euro area countries are more vulnerable to
liquidity stresses relative to the situation in economies where the central bank is supposedly
prepared to backstop the government bond market.
Certainly the ECB, as the central bank of all EMU countries jointly, cannot act as the central
bank of specific countries. But is this in fact a disadvantage for Europe? In a sense, euro
area countries have given up sovereignty over their national currency. This implies that
maintaining their public debts at reasonable levels requires commensurately more convincing
fiscal and economic policies. It also requires that they "tie their hands" in a credible manner
through stronger and more automatic economic governance. The monetary financing
prohibition, in this way, is a spur towards better policies and better governance - in other
words, a closer economic union.
Similarly, the monetary financing prohibition changes the relationship between sovereigns
and their national banking systems. As sovereigns cannot monetise debt, they can only
backstop large banking sectors at a cost to their own creditworthiness. Insofar as this may
undermine the balance sheets of the banks they are trying to save, it could end up triggering
a self-defeating vicious circle. This implies that the only viable route to support the euro
area's integrated financial sector is through a more integrated system of supervision and
resolution. The monetary financing prohibition, by constraining the resources of individual
sovereigns, pushes the euro area in the direction of collective solutions.
Conclusion
Let me now draw to a close.
The key theme that has run through my remarks today is that, from every perspective, much
closer economic and financial union is essential for the euro area. We have had this
demonstrated in the clearest possible terms by the financial and sovereign debt crises. We
have already taken important steps in this direction. Europe is ahead of others in addressing
its imbalances. The challenge looking forward is to complete the process towards closer
union and not settle for the "quick fix".
The people of Europe want closer cooperation in economic and financial matters.
Eurobarometer surveys find cross-country majorities in favour of closer cooperation to end
the crisis. And this is ultimately unavoidable, given the state of political union between
countries that monetary union de facto creates. It is now a time for politicians to be bold and
courageous, to recognise these trends, and to complete as soon as possible the great
project begun 60 years ago towards "ever closer union".
Thank you for your attention.