Patrick Honohan: A view from Ireland - the crisis and the euro
Address by Mr Patrick Honohan, Governor of the Central Bank of Ireland, to the David Hume
Institute and the Scottish Institute for Research in Economics, Edinburgh, 13 November
2012.
* * *
Insulating the euro from both scepticism and complacency
How is it that the euro, having confounded its critics by displaying resilience and tranquillity
for a decade, is suddenly plunged by the global financial crisis into a severe structural crisis?
The view from Ireland, one of the economies most damaged in the crisis, allows us to see
just how release 1.0 of the euro was under-designed, and robust only to moderate shocks.
Also evident from Ireland is how the plausibility and credibility gained from the outset by the
system resulted in market and official complacency that allowed imbalances of indebtedness
to grow too large. The debts reached such a point that, when a crisis of confidence hit, it was
likely to have consequences too large to be coped with by conventional tools. Now
nonstandard measures of monetary policy and intergovernmental lending have been put in
place, while the institutional architecture of the euro area is being rapidly overhauled towards
a fairly early release date for euro 2.0
Although it is said that Celts are prone to analysing and re-analysing the historical
antecedents of present woes; and although I cannot claim to be free of this vice, if vice it be, I
will try not to rake over at any length the sorry story of how Ireland's macroeconomic
performance became bogged-down in the first years of the new millennium. Instead I want to
speak more about how the euro is involved in this story, and how a way forward is being
mapped.
Scotland and Ireland in the crisis
I know I will be understood in using a bog as a metaphor when speaking to a Scottish
audience. Indeed, I am aware that, although Ireland prides itself on the extent and richness
of its bogs, raised and blanket, Scottish naturalists claim that you have to go to Caithness
and Sutherland to find "arguably the finest blanket bogs on the planet". In the 1990s, Ireland
had stuck to the arduous but dry uplands of growth through competitiveness and fiscal
discipline that alone lead safely to sustainably higher income, full employment and steady
prosperity. But sometime around the turn of the century, lured by a Will O' the wisp, or tine
ghealáin, or teine biorach, in the form of a property and construction bubble financed by easy
access to foreign borrowing, Ireland stumbled into a morass of over-indebtedness from which
it is now extricating itself.
It is the international context in which the extrication is being engineered on which I want to
focus today and in particular to the European context. We, Irish and Scots, live in Europe and
depend on our European connections for much of our prosperity. If I may be permitted to
consider the economy of Scotland in isolation, I might say that in some respects it depends
on European connections even more so than Ireland. Even excluding intra-UK trade, it
seems that European countries represent nine of Scotland's top ten export customers. (For
Ireland, the same applies with one difference: China is a bigger customer of Ireland than
Norway). Of course the rest of the world matters, and will do increasingly, but proximity
counts too, and Europe is the context.
This is even more so given the recent stresses which have been felt by the euro area, and
which have had their effect worldwide, but more particularly throughout Europe. Scotland is
not in the euro, of course, but like Ireland, the economy of Scotland too uses a common
currency managed in the context of a larger economic entity.
Actually, were it not overshadowed by that of Ireland, the recent economic performance of
Scotland, might be characterised in much the same language, if I am to look at the latest
GDP figures which show Scotland's economy to be still 3 per cent below its 2007 peak, with
construction - 15 per cent below peak - the weakest sector. The difference is in amplitude:
Irish GNP is about 10 per cent below peak and building and construction is down almost
twothirds from the peak. The legacy in terms of over-indebtedness is likewise much more acute
in Ireland. I do not ignore the fact that Edinburgh, long a world centre of banking, has
experienced some hard knocks in that sphere, but the extraordinary loan-losses experienced
by the Irish banking system, whose shareholders lost essentially all of their investment and
still left a heavy burden, are in a class of their own, exceeded perhaps only by Iceland.
Weighed-down by what may (relatively speaking) be the largest ever banking tab picked-up
by a Government, Ireland, after years of apparent fiscal discipline, has recently been
somewhat precariously, but nevertheless rather effectively, fighting to restore international
confidence in its creditworthiness.
Why has the poison of the crisis become concentrated in the euro area?
Latvia and Iceland, non-euro countries both, had equally severe economic collapses
resulting from credit-fuelled bubbles in the 2000s. Some aspects of euro area membership
are helpful in the recovery phase. Thus, while the siren seduction of a devaluation fix for
restoring competitiveness is tied down, inflation remains under control and extensive liquidity
provision by the central bank met the outflows of Government-guaranteed funds. Yet the
crisis has seemed more deep-rooted and intractable in the euro area than elsewhere.
Far-reaching corrective action needs to take account of the underlying reasons. I was beaten
to the label euro 2.0 by the Vice President of the European Commission, and I think it is
undeniable that the transformation of the institutional, legal and policy architecture of the
euro area that is under way - and needs to be under way - definitely amounts to a new
release, and could not be merely labelled - shall we say - euro 1.2.
After all, current data for existing members does not shape up to the prerequisites for
admission to the euro in 1998. It is not only Ireland, Greece and Portugal that need to tackle
public debt ratios in excess of 60 per cent of GDP and rising; fully two-thirds of the
membership, including Germany, has debt levels in excess of that famous, albeit somewhat
arbitrary, threshold [Chart 1]. The same with the deficit [Chart 2] and, of course, and most
shockingly, long-term interest rates [Chart 3]. Only the spread of inflation rates remains close
to being within the Maastricht range [Chart 4] - a tribute of course to it being the target of
ECB policy. In a way, that last slide is quite instructive in showing the capacity of the
monetary union to achieve what was, after all, set by Treaty as its over-arching goal, namely
price stability.
As of 2012, then, what were thought of as prerequisites for a successful operation of the euro
in its initial guise are hardly present. But why has it come to this? We can answer this from a
close-in, blow-by-blow perspective, or, standing back from consideration of the system in the
round. Adopting the first perspective, it is by now well understood, at least by close
observers, this situation has arisen because of the interaction between financial market
sentiment and the behaviour of public and private sector borrowers. Complacent regulatory
and fiscal policy design meant that the entire euro area became increasingly vulnerable to a
turn in sentiment that would make the servicing of vastly increased debt ratios problematic.
Some countries with high public debt at the start of EMU did not bring their debt ratios down:
with the newly lowered interest rates, the situation looked manageable. Public debt even in
countries with relatively low credit ratings traded during the early 2000s at tight spreads
allowing these governments to roll over their debt easily, and to rely on insecure revenue
sources. Then, when the global financial crisis hit in 2008, all governments naturally and
rightly allowed automatic fiscal stabilisers full rein and many added discretionary stimulus in
accordance with most textbooks to help offset the collapse of global demand.
Accumulation of private debt was the other dimension of creeping vulnerability which was
exposed when the global crisis hit. Liberalised finance generated balance of payments flows
on current and private capital account resulting in large cross-border claims and liabilities to
an extent which was scarcely monitored, especially within the euro area: indeed it was, for a
time, considered politically incorrect in some quarters to think of national balance of
payments and other macroeconomic data for individual euro area member states as worthy
of analysis. After all, how much attention does Scotland pay to its balance of regional
payments within the United Kingdom? Largely unnoticed against a background of huge
international flows in the rest of the world, the intra-euro area flows were large. Some of the
private international flows within the euro area were, no doubt, eased by the removal of
exchange rate risk; but it was a time of vast flows anyway, and not all of these flows were
well-used by the under-regulated intermediaries and, in turn, by their borrowers.
Banking losses in turn were socialised, adding to the pressure on the public finances in some
countries, but especially in Ireland. Perhaps it is too much to ask of my audience tonight to
picture themselves in an economy where all of the banks had failed and required
recapitalisation in the tens of billions; but then again, perhaps it's not so hard for you to
imagine this.
In effect, public and private sectors both largely discounted the risk of a crisis of
creditworthiness in the euro area until mid-2010. Since then, though, the reaction of financial
markets has been to tighten a vicious feedback loop adding to the pressures both on those
countries that had become over-indebted even at the old interest spreads, and on those
whose debt had seemed manageable at lower interest rates but now looked less so at the
higher rates demanded by the market. [Chart 1 again] Far from trading at spreads that were
insensitive to ratings (as had been the case just a few years before), euro area government
bond yields became super-sensitive to ratings and other risk factors. Nothing alerted
governments to the sharp widening of yield spreads for highly indebted countries from 2010
on: suddenly levels of debt and of public spending that seemed perfectly sustainable at the
old levels of risk appetite and the old assessments of credit risk in the euro area, were no
longer secure [Chart 5].
The risk of debt restructuring, reinforced by the case of Greece, where sizable losses have
been incurred by investors in government bonds, has caused yields on government debt in
many parts of the euro area - and as a result most other forms of debt in those countries - to
soar. Debt levels that seemed quite manageable at lower yields now look potentially
unsustainable to some market participants. In addition, the volatility of market perceptions of
credit risks has been contributing to the level of yields. Short-term investors in what are now
relatively high-yield bonds face considerable uncertainty about the price of those bonds in
the market if they want to sell before maturity. It may very well be that they are caught
needing to sell just when the market happens to be in a pessimistic frame: through this
mechanism yield volatility translates into high average yields.
All in all, the market's reassessment of the degree to which things can go wrong has
generated a potentially lethal combination of high yields and high debt, to the point where the
concept of redenomination risk, previously all but unimaginable to most analysts, became
factored into market considerations.
The commitment device bites back
This blow-by-blow account fails, however, to explain why these mechanisms have been so
uniquely pernicious in the euro area: after all, all of the world's economies have been hit by
the crisis to some extent or another. In order to understand why the euro has been at the
epicentre of the global crisis the key concept to keep in mind is the concept of a commitment
device. The euro is a commitment device whereby member countries increased the cost of
policy laxity with the intention of obtaining the benefits of enhanced credibility that policy
would be disciplined. Unfortunately, the discipline was nevertheless not maintained, and the
commitment penalty has been correspondingly severe.
Let us recall that the euro was set up after 30 years of debate on how to reduce the
disruptive impact of divergent monetary and exchange rate developments, including
numerous devaluations, on real trade and investment integration in Europe.
It also reflected the chequered experience of many European countries in the 1970s and
1980s with surges of inflation in response to monetary and fiscal indiscipline. The lack of
fiscal and monetary credibility resulted in high nominal and real interest rates and recurrent
relapses. Was there a way for these countries to acquire the credibility of the Bundesbank?
Both of these problems could seem to be solved if a single currency was adopted and put
beyond the reach of politicians with their tendency to succumb to a short-term policy
perspective. In effect, a non-state currency. Granting full independence from government in a
democracy to a central bank meant that its mandate would have to be a focused one.
Central banks through history have occasionally acted beyond a narrow inflation targeting
remit to address acute financial stability crises in the past (as when the Bank of England
famously secured permission in a moment of panic to exceed the limitations of its charter -
first in 1847 in the crisis that coincided with the Great Irish Famine). Indeed, the exception
that proves the rule was the US Federal Reserve's passivity which, it is generally accepted,
lengthened and deepened the Great Depression of the 1930s.
But that experience was not really taken into account in Maastricht Treaty planning. By the
time of that planning, deep systemic crises were probably seen as a thing of the past for the
advanced economy in part because of improved legal and financial infrastructures and also
because, since the time of Keynes, fiscal policy was seen as having the tools to stem and
reverse any aggregate demand declines that might occur.
Against this background, designing a mechanism which could cope with the moderate
fluctuations of the normal business cycle and sporadic fiscal pressures and was sure to
eliminate inflationary surges and exchange rate changes seemed safe and even prudent.
For the mechanism to work, however, sovereign states had to go beyond declarations of
intent. They had to design and adopt a commitment device. As a commitment device (think
of Ulysses and the sirens, Alexander or Cortez burning their boats, or medieval rulers
exchanging hostages as an earnest of peace), the EMU should have functioned very well
indeed. Debt, competitiveness and balance of payments problems were always going to be
harder to fix if they emerged in a euro area country. Perhaps that was not fully and constantly
brought home to decision-makers. Instead, they seem to have assumed that all problems of
macroeconomic imbalance would automatically be self-correcting in the new environment.
For example, by removing the possibility of devaluation, membership of the euro ensures
that any country which allows its competitiveness to get out of line will ultimately suffer a
costly period of adjustment likely associated with unemployment. It was always going to be
much more difficult and more painful to readjust aggregate competitiveness. Did that stop
countries from losing competitiveness: no! [Chart 6]. Indeed, wide discrepancies in
competitiveness quickly opened-up and became progressively worse until 2007.
Where one might have expected the financial markets to enforce discipline, they did not
always do so. In particular, a market understanding that there really was going to be no
bailing-out from the rest of the union of national governments that got into trouble, no transfer
union, should have implied that market investors would penalise countries heavily for
accumulating debt at an excessive rate. Some market participants did recognise the
existence of differential credit risks. Let me return to the chart which I showed on ratings and
yields [Chart 5]. The much maligned credit rating agencies did distinguish between euro area
sovereigns - albeit only in a relatively narrow range that extended down to A (for Greece).
But the range of market yields on government debt did not reflect even this range of credit
assessments: in effect real money must have assumed that governments would be bailed
out, despite the "no transfer union" dogma. Accordingly some governments were able to
spend and borrow without seeing the cost of funds move up against them (though admittedly,
the accumulation of excessive debt before the crisis was not as large as is sometimes
carelessly asserted.) (Note that the markets were wrong: they did eventually lose significantly
on Greek debt).
The rapid expansion in cross-border borrowing and lending in the euro area unrelated to
Governments was a phenomenon driven as much by global financial liberalisation as by the
existence of the euro. It led to a huge accumulation of banking claims. The threat this
accumulation presented to the public finances (given the likelihood that Governments would
step in to cover at least a part of the losses generated by bank failures, were they to occur),
which should have acted as a reason for national Governments to exercise some restraining
hand on the exposure, was greatly underestimated and Governments did little or nothing
about it. Indeed, by failing to include any significant system-wide banking surveillance in the
euro area, the governance structures of the euro area left open a wide gap presenting huge
risks. In addition the euro area authorities largely neglected to analyse national balance of
payments trends on the mistaken assumption that only euro-area wide aggregates needed to
be considered for central banking policy, and indeed the view was that focusing on national
macroeconomic aggregates could be a damaging distraction to the formulation of the correct
policies for achieving the price stability objectives for the euro area as a whole.
So although competitiveness, indebtedness and banking failures were going to be much
more difficult to resolve for a country in the euro area, this commitment device did not in
practice discipline countries. They continued to operate as if occasional devaluations could
be adopted to restore competitiveness, rebalance external payments and reduce the real
value of debt. With the low interest rate environment that prevailed due to the removal of
market discipline, the imbalances had the potential to grow much larger than they had when
markets had feared devaluation. Only when they got into trouble did countries realise how
costly fixing the imbalances was now going to be: they had adopted a commitment device
and were paying the penalty for ignoring it in their behaviour.
The ECB response
The deep crisis of the euro area (at first just an aspect of the global financial crisis) clearly
required exceptional measures to bring things back onto a stable path and restore efficient
market functioning with high levels of employment. The ECB was well-equipped to take some
of the necessary steps, even though some of them pushed the frontier of conventional
monetary policy. Thus, having already been the first of the major central banks to provide
unlimited financing to banks (initially on a one-off basis in August 2007) it made this
openended provision continuous from October 2008, liberalised its collateral rules and then
provided opportunities for extended duration lending at first of 12 months duration (July
2009) and then of 36 months (December 2011).
However, as the fiscal response to the initial stages of the crisis expanded deficits and debts,
and as the market's heightened sensitivity to credit risk started to impose high spreads on
borrowers across a wide swathe of the euro area the needed policy response became more
difficult to implement, especially given the implicit and explicit constraints of the ECB's
mandate. In addition, the distributional impact (for example between countries) of monetary
policy actions was beginning to become evident.
A regime which had been set up to deal with problems of moderate scale was now being
required to deal with a financial and balance sheet crisis of severity unmatched since the
1930s. For some analysts, no attempt should have been made to use central banking tools
to address problems not conceived of in the Maastricht Treaty. But for most it was clear that
central banking tools did have to be used even if this was not explicitly envisaged in the
Treaty. Although the Treaty did wish to preclude certain types of destructive action that some
misguided central banks had fallen prey to historically, its drafters did not envisage that the
euro area would have less of a capacity to resolve emergent problems of macroeconomic
stability. The ECB had to act, but without trespassing on matters that are properly the domain
of national governments. This was especially challenging given the potential, as Greece
faced the need for a debt restructuring, of central banks' actions resulting in very evident and
indisputable redistributions as between member states.
Getting the design of those actions right now presents an acute problem for the central bank.
Entirely new issues have presented themselves. Previously there was no great difficulty in
ensuring that the desired interest rate levels would be transmitted by market forces more or
less uniformly throughout the euro area: that can no longer be taken for granted. The
emergence of redenomination risk in market perceptions and its disruptive influence have
generated undesired and damaging yield volatility. Additional corrective action, as recently
announced, is clearly necessary.
In considering and taking such corrective action, the ECB has not only to ensure no
compromise with its Treaty mandate and obligation to maintain price stability, but must also
avoid the appearance of partiality, and retain the confidence and respect of the body politic.
It has been argued by some that the ECB could have moved further sooner; history is of
course littered with at least as many unhappy episodes consequential on hyperactive central
banks and those which were destructively compliant with the desires of spendthrift
governments and imprudent bankers as with those resulting from excessive central bank
caution, and it is history that will be the judge of all this.
And now...
Managing the transition from the emergent bad equilibrium of high debt, high perceived credit
risk and risk aversion, and high and volatile yield spreads to a position where confidence has
been sufficiently restored is the task of the policy and institutional innovations that form the
"what's new" of euro 2.0. To some extent the new institutions, policies and instruments are
designed for a transitional period and to some extent as the framework in which the system
is to settle down. Consistent with the analysis that I have proposed, it could be argued that
only the transition matters, and that euro 1.0 had a sufficient structure, but was simply not
well enough managed in terms of fiscal and especially financial regulation. That is a
defensible position, but market and indeed general public confidence in the system has taken
such a knock that to insist on it would surely be to tie one's hands behind one's back also
during the transition. For this reason alone the task must be seen as the creation of a much
more robust regime for the long haul. The four main dimensions of reform - relating to
banking, budgetary framework, economic efficiency and competitiveness for growth and
democratic legitimacy - have been conveniently set out in the report of the four presidents,
(of the European Council, the Commission, the Eurogroup and the ECB) which was prepared
in advance of the June 2012 Summit.
Some of these are well understood, some well advanced, but there is a lot of work to be
done and quite a bit of potential for misunderstandings as we go along.
As far as the proposals now being fleshed out for a banking union are concerned, it is true
that there are subtly different expectations concerning what can and will be achieved, and
how. Three components are now envisaged in the banking union, namely a single
supervisory mechanism, a common deposit guarantee regime and a common resolution
agency. The first of these is in full active preparation; draft legislation is expected to be
complete by the end of 2012 with an implementation phase during 2013. The other two
would come later. Much is expected from these, and I believe that they are very important
elements of euro 2.0.
For the single supervisory mechanism, there is both the potential for an operational
improvement and - even if there were to be no operational improvement - the potential for
greater cross-border confidence in banks to an extent that could improve the access of
banks in stressed countries to private and perhaps public debt and equity funding. My work
on developing countries long ago convinced me that cross-border involvement of supervisors
can help local supervisors achieve the distance and scepticism that can often be needed to
detect under-assessed risks in a banking business, especially in the midst of an
unsustainable boom. Moving to a single supervisory mechanism will tend to achieve this, the
main challenges being how to do so without losing what is equally essential, the nose for
local detail, rumour and feel of the market. Achieving the balance, which will require a subtle
balance between national and central supervisors, will not be easy but can be developed
over time. After all, the euro area is not the only entity covering thousands of banks in which
centrally controlled supervision is in place.
To what extent is this likely to represent an intrusion into what should properly belong to a
national policy arena? I am doubtful that there is any intrusion at all. Safety and soundness of
banking is a common goal of bank supervision: non-market goals of public banking policy
can be effected through taxation or other means. Assessing creditworthiness and balance
sheet risks is not really something that I believe has much room for national exceptionalism.
Expectations with regard to the likely roles of a common deposit insurance scheme and of a
common bank resolution agency are still diffuse, I feel. Deposit insurance of the first
€100,000, currently provided at national level, offers peace of mind to retail users of banking
services, and a strengthening of the perceived backstop by pooling the responsibility and
resources for payouts could help this, especially at a time when the creditworthiness of some
national governments has been called into question. But it is well to understand what a
common deposit insurance scheme can and cannot deliver. Deposit insurance does not fully
protect banks and banking systems against wholesale bank runs, which are typically much
faster and larger than anything generated by retail holders.
There is also the danger of divergent expectations with regard to the intended operation of a
resolution agency. If greater private sector involvement in burden-sharing of future banking
failures is envisaged, and if the single supervisory mechanism is sufficiently proactive and
prompt in identifying the need for and taking corrective action, then it will not require or use
substantial public funds. But that is not how the recent wave of failures has been dealt with.
Can we be sure that enough will have changed in this respect for the future, or will the public
purse be called upon again?
Perhaps I have ventured enough into the uncertainties of the design and implementation of
euro 2.0 to convince you that this makeover is indeed a large and ambitious venture. This is
what we are working on. Its accomplishment over the coming years is the sine qua non to
re-establishing smooth and effective operation of finance and banking in the euro area, and
that in turn is of course a prerequisite of a return to sustained growth, employment and
prosperity in all of the regions of Europe.