Klaas Knot: Germany and the quest for a stable monetary union
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Duitsland Instituut,
Amsterdam, 7 April 2014.
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Introduction
It is sometimes joked that the Netherlands is in fact Germany's 17th Bundesland. The
excellent remarks by Jens Weidmann remind me of this joke, because there are so many
points I agree with. I will not go into them, to avoid that the rest of this afternoon becomes
rather uninspiring. Instead, please allow me to reflect on the future and stability of EMU from
my own perspective.
Even those who don't agree with Jens Weidmann should take the views of the Bundesbank
seriously, for two reasons. First, Germany is the anchor country of the euro. Europe simply
cannot afford to alienate the anchor by moving towards an EMU that would make Germany
very uncomfortable. We also need to take the views of German policymakers and voters into
account. Second, when it comes to economic stability, Germany has one of the best track
records in the world. Most advanced economies made at least three serious policy mistakes
in the past decades: excessive inflation in the 1970s, excessive budget deficits in the 1980s
and excessive credit and house price growth in recent decades. Quite remarkably, Germany
is one of the few countries that succeeded to contain all three problems effectively. Of course
even Germany had difficulties at times, for instance after the reunification, when it was even
called "the sick man of Europe". But the patient recovered after following a tough prescription
of wage moderation, fiscal consolidation and structural reforms.
Ants and grasshoppers
The historian Harold James shows that Germany's stability has led to economic tensions
within Europe for several times in the past few decades. Germany often developed current
account surpluses vis-à-vis other European countries, that led to discussions about the
burden of adjustment. Such was for instance the case in the late 1970s, after the collapse of
the Bretton- Woods system of fixed exchange rates. And it was the case in the late 1980s,
around the time when the Louvre and Plaza-agreements on exchange rates were concluded.
It was also the case in the monetary union, where these tensions gradually built up again
since the start of EMU. Growing current account surpluses in Germany and countries like the
Netherlands matched growing deficits in southern European countries. In retrospect, these
current account imbalances were at the heart of the sovereign debt crisis.
It would be unfair to only look at Germany for this situation, as many serious policy mistakes
were made in southern countries. First, several countries failed to implement the structural
reforms that were needed to function smoothly in a monetary union. Rigidities in product and
labor markets contributed to severe losses of price competitiveness. Second, several
countries experienced booms in domestic demand on the back of unsustainable growth of
credit and house prices. Third, several countries failed to use the windfall of lower interest
rates due to EMU- membership for a lasting improvement of public finances. Between the
mid-nineties and the financial crisis, interest rate expenditure on public debt in the periphery
decreased by 4.5% of GDP on average. Only Spain used this fully to reduce budget deficits.
Unfortunately, in the other countries, on average almost half of this percentage did not
translate into lower deficits. These policy mistakes suggest that the burden of adjustment
mainly lies in southern Europe.
But it would also be unfair to turn the crisis into a moral caricature between the virtuous and
the profligate, between ants and grasshoppers. As Jens mentioned in one of his recent
speeches, several so-called core countries are not in great shape either. Think of low
competitiveness and high public debt in France. Think of low productivity growth in the
German service sector. And think of the painful correction of house prices here in the
Netherlands. This clearly illustrates that all EMU member states need to carry out reforms to
improve their economic growth potential.
Moreover, policymakers in all European countries made misjudgments regarding the
functioning of EMU. Most didn't see these flaws when we celebrated 10 years of EMU, only
months before the collapse of Lehman Brothers. At the time, we all failed to see how the
growing importance of financial factors had fundamentally changed the monetary union. It
wasn't recognized that the euro area was experiencing asymmetric financial cycles rather
than asymmetric business cycles. This is serious omission as recent research shows that
these financial cycles are much larger and longer-lasting than normal business cycles. They
created divergences that EMU was not designed to deal with. In addition, we thought that the
strong increase of financial integration after the introduction of the euro would enhance
risksharing. But we didn't realize that it also spurred contagion and pro-cyclical capital flows. For
example, the financing of southern credit booms also came from banks in France, Germany
and the Netherlands. From this perspective, Europeans are in this together, and can only get
out together.
Situation has improved
The good news is that the Eurozone indeed seems to be emerging from the crisis, if slowly.
The situation has improved significantly since the height of the crisis in the summer of 2012.
At that time, financial fragmentation in the euro area reached alarming levels and several
countries were suffering from a strong outflow of capital. Financial markets probably
responded too pessimistically at times, fuelled in part by fears of the break-up of the euro
area. But less than two years later, markets have calmed down and the crisis entered a new
phase. This change is not only due to the ECB's Long-Term Refinancing Operations and its
Outright Monetary Transactions program, actions that will always to some extent remain
controversial. After all, monetary policy cannot solve the problems of EMU. It can only buy
time that should be used effectively. No, the situation also improved because European
policymakers took measures that seemed unthinkable until recently. And because they did
so in a relatively short time span.
This holds to individual countries in the first place. Many vulnerable member states have
reduced their current account deficits and improved their competitiveness. They have also
made progress with reducing budget deficits and implementing structural reforms. Countries
like Ireland and Spain have therefore successfully ended their financial assistance program.
But it also holds for the European level, where governance has been strengthened.
European policymakers established common supervisory and resolution mechanisms for
banks. This banking union will help to reduce the toxic feedback loops between banks and
sovereigns. Many countries have also introduced macro-prudential policies, with the ability to
co-ordinate these at European level. These recent measures come on top of the enhanced
Stability and Growth Pact and the introduction of the Macroeconomic Imbalances Procedure.
Challenge for the coming years
One crucial challenge is to continue on this course, even now financial markets have calmed
down.
Much remains to be done, and the calm will only be sustainable if vulnerabilities decrease
further. For individual countries, this means more structural reforms. Countries with a support
program implemented reforms, but some of the larger founding fathers are lagging behind.
Moreover, reforms mainly focused on labour markets so far, while much less progress is
made on product and service markets. The gains of further reforms could be significant.
According to the OECD and the Commission, they could raise potential GDP by up to 6% on
average. Another priority is a further reduction of public debt, which now stands at 96% of
GDP in the euro area as a whole. Countries should strive to return below the 60% threshold
of the Maastricht Treaty. This will probably take many years for most countries, but will
significantly improve the stability of EMU. For the European level, many elements needed to
repair the design flaws in the monetary union are now in place. But the effectiveness of these
new governance measures depends crucially on their application in practice. A strict
implementation is absolutely necessary. This not only holds for the Stability and Growth Pact
and the Macroeconomic Imbalances Procedure, but also for macro prudential policies and
the Asset Quality Review of bank balance sheets. Should any problems in the application
arise, European policymakers will need to continue to forcefully tackle them. This enables us
to keep the monetary union stable also in the long run.