Mario Draghi: A route for Europe
Address by Mr Mario Draghi, President of the European Central Bank, at the day in memory
of Mr Federico Caffè, organised by the Faculty of Economics and the Department of
Economics and Law at the Sapienza University, Rome, 24 May 2012.
* * *
A teacher, says Eco, "teaches that everyone must become individual and different".1
Professor Federico Caffè, albeit with a coherent vision and deeply held convictions, was a
teacher. He taught his students to think for themselves and did not pass on a binding creed.
He helped his students - economists, thinkers, servants of the state and of the institutions,
alert citizens - to discover themselves.
I'll start with the subject which, without a doubt, was the most precious to Caffè, namely
welfare. Probably nothing in his intellectual heritage is more topical than this painful protest
of his: one cannot, he would say, "accept the idea that an entire generation of young people
should consider themselves as having being born at the wrong time and having to suffer job
insecurity as an inevitable fact".2
Work: a European matter
"Full employment is not only a means of increasing production..., it is an end in itself, since it
leads to overcoming the servile attitude of those who find it hard to obtain a job opportunity or
live in constant fear of being deprived of one. In other words, the benefits of full employment
are considered as well, and above all, in terms of human dignity. "These words of Caffè do
not surprise those who knew him and those who have read his works. They express the
fundamental inspiration of his professional and public life: it is a duty of economic policy to
act so that the economy can get as close as possible to full employment.
In 1975, he formulated it more precisely: "The goal of dignified work for all, however, is not
compatible either with situations of privilege, which have now become destabilising, nor with
excessive labour and social security rights, which results in job opportunities evaporating
away". The issue that Caffè raises here is one of fairness. We find it again today: the
international crisis has affected everyone, and young people especially.
In the European Union, between 2007 and 2011 the unemployment rate rose by
5.8 percentage points among the 15-24 year olds, by 3.5 points among the 25-34 year olds
and by 1.8 points in the 35-64 age range. Qualitatively, the profile is similar almost
everywhere; the clear exception is Germany, where the unemployment rate among 15 to
24 year olds in the first quarter of 2012 was 8%; in Italy it was 34.2%, in Spain 50.7% and the
euro area average was 21.9%. These trends reflect a fundamental question: they confirm the
particular vulnerability of this essential part of our workforce. The unequal sharing of the "cost
of flexibility", only affecting young people, an eternal flexibility with no hope of stabilisation,
leads among other things to companies not investing in young people, whose skills and
talents often decline in jobs with low added value. The underuse of their resources reduces
growth in various ways: it makes the creation of start-ups less likely - and they are on
average more innovative than others - it causes a decline in skills in the long run, slowing
down the assimilation of new technology and acting as a brake on efficient production
processes. In addition to undermining society's sense of fairness, it is a waste that we cannot
afford.
I think it's essential to ask how economic policy conducted in various Member States has
done its duty in the way desired by Caffè.
Social progress is one of the key objectives of the European integration process: "The Union
shall work for the sustainable development of Europe based on balanced economic growth
and price stability, a highly competitive social market economy, aiming at full employment
and social progress ... It shall combat social exclusion and discrimination, and shall promote
social justice and protection, equality between women and men, solidarity between
generations and protection of the rights of the child".
(Article I-3 of the draft European Constitution). Welfare is not only a remedy for the failure of
insurance markets, but also a tool to promote inclusion, solidarity and a sense of fairness.
In the three post-war decades (the so-called "Golden Age"), which especially in Europe were
marked by high growth rates, use of advanced technologies, high growth employment, stable
lifetime employment, welfare started to emerge, at different times and on different scales
depending on the country, as an integrated system that protects its citizens from significant
risks.
The European model redistributes many more resources for social purposes than the US and
Japanese systems: on the eve of the crisis, the total expenditure on pensions,
unemployment benefit, for children and families was, in relation to GDP, more than twice that
of the US and Japan. This can take different forms as regards the composition of social
policies and the degree of labour protection. In Italy, with an overall welfare spending ratio of
GDP in line with that of the rest of Europe, spending on support for the unemployed, for
households, particularly those at risk of falling into poverty, is at a level less than half that of
elsewhere in Europe, while spending on pensions is significantly higher. The weakness of
the "social shock absorbers" is that relatively high job protection for those in employment is
accompanied by weaker protection for those out of work, contrary to what happens in the
Nordic models, where the so-called "flexisecurity" combines an extensive social safety net
with less job protection.
In some countries, even if, 40 years on, the assumptions of that model are still valid,
reflections on it began some time ago.
Structural factors have changed the context within which the European social model
operates: the growing competition from emerging countries, the reorganisation of production
processes on a global basis, the speed of innovation, the increasing fragmentation of career
paths with ever looser ties to a "permanent position", the greater instability of families,
declining fertility, the prospective decrease in the workforce, an ageing population. The set of
risks faced by individuals throughout their life has changed significantly.
The social protection systems are therefore constantly evolving; substantial corrections have
taken place in recent years in many countries, including France, the United Kingdom and
Germany, the country where the reform process began a decade ago. In Italy, the recent
pension reform which approves the full transition to a contribution system completes the
necessary correction of the pension spending dynamics which was started years ago. As
Germany shows very well, large and effective welfare systems can be made more efficient
without compromising social goals.
We are living at a critical juncture in the history of the Union. The sovereign debt crisis has
exposed serious weaknesses in the institutional framework; in this context, the difficulties in
finding common solutions are having a negative impact on market valuations. The
extraordinary measures taken by the ECB have gained us time; they have preserved the
functioning of monetary policy.
But we have now reached a point where European integration, in order to survive, needs a
bold leap of political imagination. It is in this sense that I have referred to the need for a
"growth compact" alongside the well-known "fiscal compact".
A growth compact rests on three pillars and the most important one, from a structural
viewpoint, is political: the economic and financial crisis has challenged the myopic belief that
monetary union could remain just that, and not evolve into something closer, more binding,
into an arrangement whereby national sovereignty on economic policy is replaced by the
Community ruling. If the governments of the Member States of the euro define jointly and
irrevocably their vision of what the political and economic construct that supports the single
currency will be and what the conditions to reach that goal together should be. This is the
most effective answer to the question everyone is asking: "Where will the euro be in ten
years' time?".
The second pillar is that of structural reforms, especially, but not only, in the product and
labour markets. The completion of the single market and the strengthening of competition are
crucial for growth and employment. Labour market reforms that combine flexibility and
mobility with a sense of fairness and social inclusion are essential.
Growth and fairness are closely connected: without growth, and the events of recent months
also reflect this, the temptation to "circle our wagons "gains strength, and solidarity weakens.
Without fairness, the economy breaks up into multiple interest groups, no common good
emerges as a result of social and economic interaction, and there are negative effects on the
capacity to grow. Recent Italian history has no shortage of examples.
These reforms have long been indispensable in a global economy very different to the one
which witnessed the creation of the institutions still operating today. In the political structure
that will emerge from the crisis it is likely and desirable that for these reforms a system of
European rules will be introduced similar to that for the fiscal compact, a discipline leading
over time to the European harmonisation of objectives and tools.
The third pillar is the revival of public investment: the use of public resources to push forward
investment in infrastructure and human capital, research and innovation at national and
European levels. (The proposed strengthening of the EIB and the reprogramming of Union
structural funds in favour of less-developed areas go in this direction).
Thus, a growth compact complements the fiscal compact, because there can be no
sustainable growth without orderly public finances. In this regard I have noted on other
occasions the extraordinary progress made by all governments of the euro area in terms of
fiscal consolidation, but, once the emergency is overcome, they need to make improvements
by cutting current spending and taxation.
Let me now consider some issues more directly related to the ECB's monetary policy and
action.
Objectives and instruments
The first issue involves the relationship between objectives and instruments of economic
policy in a macroeconomic reference model that changes over time. For Caffè, one of the
first scholars of Frisch and Tinbergen, the optimal allocation of tools and objectives occurred
in the reference model prevalent in the 1970s, in which the goal of economic policy was to
make best use of the available resources, in particular full employment. In pursuit of this
goal, monetary policy was subordinated to fiscal policy, with an ancillary role for the central
bank vis-à-vis the Treasury. The reference macro-model was based on a static mechanism
of elaborating expectations, which were formed by extrapolating from past observations to
the future. This mechanism amplified the immediate effect of public spending on aggregate
demand. Monetary policy - in charge of credit conditions - was entrusted with the task of
alleviating, through a careful policy of accommodation, the impact that government borrowing
would have exerted on the cost of private debt. The central bank was financing the Treasury
by creating money. Under these conditions, an increase in public spending could "add
demand"- where this would be lacking for the goal of full employment - without taking away
resources from other uses.
Since then, the theory of economic policy has followed two paths that have led it to invert the
ranking of relative potential of tools and to enhance the definition and measurement of the
objective.
As for the instruments, a different theory of the formation of expectations - no longer
extrapolative - has highlighted the strong impact of monetary policy and has weakened the
expected effects of fiscal policy. In the models that we use today, agents, when formulating
their expectations, are attentive to the sustainability conditions of the choices in the long
term. Economic policies deemed unsustainable in the long run are ineffective. For example,
an active deficit-financed fiscal policy is limited by fears about the government's ability to
refinance the debt from which that policy originates. These fears may lead to behaviours that
weaken the private sector - or, at worst, completely neutralise - the impact of public
spending as a means of controlling demand. Monetary policy, by contrast, is strengthened by
this. Acting through the expectations channel, it can have a lasting effect on the expected
flows of financial revenue. Affecting the real rate of intertemporal discount, it can deeply
affect decisions on savings and consumption.
The definition of the objective is now wider. Price stability has become an essential
parameter in defining and measuring prosperity. From taking a relaxed approach to inflation
and considering it secondary, nowadays low and predictable inflation is a pre-eminent
criterion of economic performance. Why? High inflation hits savings - and therefore
investment and future consumption - with a tax on real returns that rewards the risk of
uncertain inflation. Low inflation, however, frees up resources that individual choices can
allocate to increasing the fixed capital. A policy that neglects inflation gradually destabilises
the economy. The costs of uncertainty about the value of the money, initially unimportant,
then overlooked, subsequently become evident, and then are judged intolerable. At that
point, voters express a strong preference for policies that promise rapid disinflation. But such
policies impose high costs in terms of job losses, which have to be included in the dynamic
calculation of the costs of inflation. Also, it should not be forgotten that inflation affects the
poor more than the rich, and is therefore a tax on the weaker members of society.
Under the influence of the neo-classical synthesis of Samuelson and Solow, the long-term
correlation between inflation and growth was perceived as positive in the early 1970s: a
slight increase in inflation would have led - within limits - to an increase in employment and
growth.3 But by the end of that decade, studies by Bob Lucas and Tom Sargent were to show
that long-term inflation and growth are not correlated.4 Monetary policy, while very effective in
the short term, only affects inflation in the medium and long term. It is, in other words,
neutral.
Today, new models and advanced computational techniques allow us to simulate the effects
of inflation on incentives to save and to work, on the formation of physical capital, and
therefore on the prospects for growth. The correlation has become negative: higher inflation
reduces growth and employment. For example, vector autoregressive models with
non-constant parameters allow the identification of a range of values that quantify the cost in
terms of growth failure for every two percentage point increase in steady-state inflation. This
cost implies lower growth of between 3 and 5 percentage points over a period of ten years.
Finally, monetary policy is a powerful tool. When used improperly, it may cause permanent
damage. But it can become an effective, stabilising factor and contribute to collective
prosperity in an independent and active way. The sine qua non for this is to build monetary
policy decisions into a systematic and predictable strategy, based on price stability, which
drives expectations and guides the economy but doesn't shock it. This is perhaps the most
important practical difference to what was studied in the early 1970s.
The ECB's monetary policy strategy
The ECB's monetary policy strategy is based on the new theory of the instruments I have
tried to outline, and takes into account the enrichment of the theory of objectives, which
emphasises the contributions of price stability to the "general prosperity". It also provides
continuity for a monetary tradition in continental Europe that has ensured inflation-free
growth for more than 60 years.
The strategy is based on the objective of "maintaining price stability" that the Treaty has
entrusted to the central bank and the quantitative definition that the Governing Council
subsequently gave the objective. The studies I have mentioned helped to define a range
within which inflation is no longer a factor that distorts economic choices. The ECB pursues,
as an objective of monetary stability in the medium term, an inflation rate below, but close to,
2%, which is the upper limit of this range.
The macroeconomic model on which the ECB's monetary policy strategy rests is imbued with
contemporary macroeconomics, based on dynamic optimisation and on the centrality of
forward-looking expectations.5 At the same time, the model is broader and well structured
and corrects the simplifications of the pre-crisis neo-Keynesian paradigm with its prescriptive
approach to optimal monetary policy.
The weakness of this paradigm was, and is, its inability to recognise the importance of
financial frictions and the role of credit and money. This has to do with the fragility of the
theoretical foundations that formalise the links between the real economy, financial
imbalances and the level of confidence. Ignoring money is tantamount to assuming an
absence of risk and uncertainty. Without risk, Keynes would have said, there would be no
money. The preference for liquidity is not justified in an economy without uncertainty. But the
neo-Keynesian model excludes the possibility of default. In it, risks in the financial sector can
be isolated and therefore have no effect on the real economy.
The financial crisis has clearly highlighted the weaknesses of this system. Macroeconomic
theory has begun to reflect on the neo-Keynesian system and these studies are now one of
the liveliest areas of analysis. These studies - at least their early results - confirm the
farsightedness of some of strategic choices of the ECB. Liquidity, money, credit have always
been - since 1998, when the Bank received its mandate from the founders of the monetary
union - qualifying variables of the ECB's reference model and its strategy. The monetary
analysis requires a constant monitoring of banks' assets and liabilities as sources of
information on the assessment of risk in the markets and the economy as a whole. This
analysis commits the Governing Council to adjust the tenor of monetary policy to ensure the
long-term growth of monetary aggregates and credit consistent with the potential for
economic expansion.
In this sense, the monetary pillar of the strategy can be interpreted as a strategic
reinforcement that helps to prepare correction mechanisms in situations where
macroeconomic imbalances are having difficulty in manifesting themselves in inflationary
pressures.
The monetary analysis gave important warning signals in the years preceding the crisis
regarding the existence of deep macroeconomic and financial imbalances. In the autumn of
2005, in conditions of inflation observed and projected to be "normal", the ECB's monetary
analysis began to record a change in the composition of M3 growth: from a model of growth
explained by money demand factors - that we would define as irrelevant to the evolution of
spending and prices - to a dynamic associated with increased credit creation - that is, to
banks' money supply factors. These changes were accepted as indications that the tenor of
monetary policy, despite the moderation of inflationary pressures observed and projected,
had become too lax. A new cycle of monetary policy tightening was initiated in December of
that year, based on considerations inspired by the monetary pillar, where monetary and
financial stability is an intermediate objective for attaining a more balanced development of
macroeconomic variables and hence price stability over the long term.
In a globalised world, the international financial crisis has not spared the euro area. But today
we know that preventive action by the ECB, implemented mainly by considering monetary
indicators, has mitigated the impact on incomes and inflation.6
The two operations of three-year refinancing (LTROs)
The monetary analysis has also been an essential strategic tool in diagnosing and managing
the crisis. In this regard, the analysis that led to the more recent non-standard monetary
policy measures can illustrate how the systematic monitoring of banks' liabilities - money in
its broadest sense - can provide guidance on the risks faced by the economy as a whole.
Towards the end of 2011, with a decision unprecedented in the history of the euro, the ECB's
Governing Council decided to conduct two three-year refinancing operations. At the end of
February, or when the second three-year operation was completed, the net increase in loans
granted to counterparties was around €520 billion.
The motivation for the two operations can be summarised by the following strategic view. A
central bank is mandated with the crucial task of ensuring the sufficient supply of liquidity to
sound bank counterparties in return for adequate collateral. In normal times, "sufficient
liquidity" means a volume of refinancing in line with the need for banks to meet the obligatory
reserve requirements and the financing of other independent factors which explain the
growth over time in the demand for money. In times of increased financial instability,
"sufficient liquidity" indicates a volume of available central bank money which avoids the risk
that - under such market conditions - the temporary inability of banks to provide refinancing
leads to insolvency and thus to a situation of widespread default.
In neither of the two cases - normal times or crisis periods - can the central bank be
considered responsible for the survival of bank counterparties that are close to bankruptcy.
The two long-term refinancing operations achieved the purpose for which they were
intended. In an environment of a near-shutdown of private credit markets, banks were not
able to refinance their assets and were unable to maintain their level of exposure to
households and businesses. The extensive long-term refinancing allowed for the partial and
temporary substitution of private credit with central bank money and thus avoided a
disorderly process of credit to the economy running dry.
Nevertheless, these operations were not without their criticism. These can be summarised in
three points:
1. The growth in liquidity following the two operations will ultimately lead to inflation;
2. The Eurosystem's balance sheet is exposed to unprecedented and uncontrollable
risks;
3. Such operations have reinforced the perverse link between banks and sovereign
debtors and may be considered a violation of the prohibition of financing public debt
with central bank money, laid down in Article 123 of the Treaty. And, the opposite
- but conceptually equivalent - criticism that these operations did not provide the
economy with finance.
As regards the first point, it is again pertinent to refer to strategy: in the medium to long term,
the inflation dynamic reflects developments in broader monetary aggregates. Conditions that
encourage the creation of inflation or speculative bubbles are generated by strong and
sustained growth in money and credit, not necessarily as a result of an increase in liquidity
granted by the central bank to the banking sector. This liquidity constitutes a precautionary
supply for sight liabilities that the banks have towards households, non-financial corporations
and other banks. The sight liabilities, i.e. deposits, and not the supply of liquidity,
demonstrate a high statistical correlation to the price dynamics of goods and assets.
Today, monetary developments do not allow for the identification of risks of inflation or
pressure on asset prices in the medium term.
As regards the second point, the main criticism related principally to the expansion of
collateral accepted by the national central banks of the Eurosystem as a guarantee in return
for liquidity extended to credit institutions. In particular, doubts were raised regarding credit
claims that became eligible with the decisions taken in December 2011.
These doubts are founded on an incorrect understanding of the guarantees that are
requested by the national central banks to protect against the risk that central bank liquidity is
not repaid. In particular, the discount applied to the nominal value of credit claims provided
as security in refinancing operations is very high. This means that, for credit claims deposited
as collateral with a nominal value of €100, the national central banks accepting the new
collateral provide, on average, the equivalent of around €47 in liquidity. This discounting
represents a powerful method for absorbing the credit risk involved in such operations. It is
also worth highlighting the fact that the main elements of risk control continue to be shared
by the Eurosystem: the criteria for acceptance and measures for controlling risk are
approved by the Governing Council, which is also responsible for the continuous monitoring
of the effectiveness of all of the measures for mitigating risk.
With regard to the third point, it is undeniable that, in some countries in particular (especially
Spain and Italy), banks used some of the liquidity acquired via the three-year long-term
refinancing operations for temporary investments in government bonds.
Today, central banks do not have an instrument for the precise and targeted allocation of
credit to a sector or in favour of a specific financial use. Those who accuse the ECB of an
indirect violation of the prohibition on financing public debt with central bank money are
making the same conceptual mistake as those who accuse the ECB of not having forced the
banks to the use the funds acquired via the LTROs to supply credit to the private sector. In
the first case, banks would have had to have been forced not to purchase government
securities, and in the second case, to give credit to the private sector. Both groups of
accusers forget that the policy of precise allocation of credit was a norm in various countries
until the end of the 1970s. In the 1980s the operational system for monetary policy was
radically redefined, principally on account of the heavily distorting effects of such an
operational framework on economic activity. Moreover, legal arguments relating to the Treaty
and to the current contractual form of repos underlying the LTROs, as well as considerations
relating to feasibility, would make it difficult to reinstate such a framework. Finally, the
behaviour of credit institutions with respect to households and businesses is not uniform
across countries: while some countries saw negative credit developments, others saw growth
in credit, in some cases even significant growth.
In Italy, but also in the vast majority of euro area countries, the fall in loans recorded in
December has come to a halt, avoiding a much more severe risk of credit restriction which
would have had far more serious consequences for growth and monetary stability than the
ones we are seeing currently. The Bank Lending Survey registered a gradual normalisation
of interest rates set by banks and of the criteria for granting loans to companies. The
continued anaemic developments in lending reflect the weakness in demand and the
worsening of creditworthiness resulting from an adverse economic cycle. Furthermore, in the
countries most adversely affected by the crisis, banks are rationing credit on account of
certain prevalent contractual structures.
The large-scale participation in the February operation, in which around 800 banks obtained
funding, and the composition of counterparties in terms of their size and type implies that the
distribution of liquidity has been widespread and could be even more so in the near future.
Furthermore, this widespread distribution of liquidity is also of advantage to small and
medium-sized enterprises with which smaller banks have closer relationships. We would
wish for the liquidity provided to end up as credit to the private sector. This is the motivation
behind the new non-standard monetary policy instrument.
Central bank credit to banks has been a complement to - rather than a substitute
for - private credit: in the first quarter of this year, the amount of bonds issued was equal to
the total issued in 2011 as a whole, which shows that the operations, at least in the first few
months of the year, provided the markets with liquidity, reactivating a number of credit
channels. The two LTROs removed one of the obstacles - the only one over which the ECB
has any influence - to credit, namely a lack of liquidity. The ECB cannot do anything to make
up for a lack of capital, to change intermediaries' risk perceptions, or to remove other
structural obstacles present at national level. More generally, the size and complexity of the
two LTROs is such that it will take time for all of their positive effects on the euro area
economy to be fully felt. However, it is essential for growth and employment that credit
institutions regain their ability to provide refinancing to the economy.