Mario Draghi: Financial stability and growth - the role of the euro
Speech by Mr Mario Draghi, Governor of the Bank of Italy, at the "Europe and the Euro"
Conference, NBER-Bocconi University, Milan, 17 October 2008.
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To anticipate the thrust of my discussion today, I will concentrate essentially on two themes:
1. First, the euro has proved to be an invaluable asset for our economies. The benefits
of the European single currency are crystal clear at the current juncture, while we
are facing the most dramatic financial crisis of the last several decades. The
common currency has been an essential element of stability. The advantages,
however, are not confined to this role: the euro has also been a catalyst for
fundamental and positive changes in the real economy, some of which are already
very visible.
2. Second, much remains to be done to fully reap the benefits of the single currency.
And in my opinion, what is left to be done goes very much in the direction of more -
rather than less - integration of our economies. There are measures that may be
taken to achieve this goal in many areas and, foremost, in the field of regulation.
1. The euro and the financial crisis
To start with, it is quite easy for me to speak of the benefits of the euro in relation with the
current crisis. There are several aspects I should like to consider.
A first theme relates to the emergency responses to the crisis.
As it has been emphasized, in academic publications and in the press, the current turmoil
presents both similarities and differences with respect to earlier financial crises, in particular
the crisis that led to the Great Depression in the 1930s. As in the past the crisis is marked by
a loss of confidence by investors and the public towards key financial institutions and
markets. Often in the past, the response of policymakers was marked by uncoordinated
actions, and in some case, very serious mistakes, in the provision of liquidity, in the
management of exchange rates and trade policies, in the insufficient scale of the
interventions needed to support banks. Exchange rate volatility and associated
beggar-thyneighbor policies were an important step along the road leading to the Great Depression.
Today the situation is clearly different, and we do have some tangible advantages in dealing
with the crisis.
First, the existence of a common currency in Europe ruled out the possibility of destabilizing
movements of intra euro area exchange rates in response to the financial shocks, which
would have greatly complicated the response to the crisis.
Second, the existence of EMU, by supplying a common currency, a common liquidity policy
across Europe, a forum in which the issue of coordinating economic policies can be more
effectively discussed and solved, is also crucial.
In the immediate aftermath of the crisis, the ECB was quick and flexible to respond to the
challenge posed by the drying-up of market liquidity. The Eurosystem's operational
framework has proved adequate to allow rapid and far-reaching decisions and a timely
management of the initial stages of the crisis, and flexible enough to deal with the evolving
situation, smoothly incorporating any required amendments. We have increased the amount
of liquidity provided, lengthened the maturity of operations, set up a facility to offer liquidity in
dollars in agreement with the Fed. In the last weeks, we stepped up our effort to normalize
the dislocated money market, by deciding some further, and more profound, changes to the
operational system. We have narrowed the corridor of monetary policy, shifted to a fixed rate
tender with full allotment and enlarged the collateral that can be used by participants.
We do not have a counterfactual, but I would argue that some of the pre-EMU national
systems would have been put to a hard test by the recent events. The existence of a
common liquidity policy proved effective in avoiding that uncoordinated national initiatives
open the way to cross-border arbitrage and to undesired spillovers that could have further
amplified the turbulence.
More generally, in the presence of a systemic crisis and with closely integrated financial
markets, the appropriate policy response needed to be coordinated, not only across
European borders, but also beyond the euro area. The unprecedented policy move decided
jointly by the main central banks of the world on 8 October is a case in point. Coordination on
such a scale may have been very hard in the old days.
Finally, the worsening of the turmoil since the beginning of September posed new challenges
to policy makers of the euro area, calling for prompt action. At first, the severity of the crisis
induced some national governments to take autonomous steps to restore confidence, but this
proved insufficient, signaling very strongly the need for a coordinated action at the European
level. The agreement of October 12 on a concerted European plan of action setting the
guidelines for interventions aimed at restoring confidence in financial markets has been a
fundamental step in the management of this crisis, not only at the European level, but also
globally. Our ten year experience in sharing a single currency and monetary policy proved to
be a solid foundation for a common and timely response to the emergency, providing strong
support for a coordinated action of governments and central banks.
A second theme relates to how we should act to limit the credit crunch. In the current
situation the possibility that the tightening of credit conditions and the cyclical downturn
reinforce each other in a vicious spiral represents the main risk for the global economy. In
this respect, restoring the smooth functioning of the interbank markets globally and within
the euro area is a precondition to ensure the stability of credit flows to households and firms,
thereby minimizing the real impact of the financial turmoil. The policies adopted so far,
including the changes in the operational framework I just mentioned, the lowering of
monetary policy interest rates, the efforts of governments to recapitalize distressed
institutions have been all essential to avoid a major financial disruption. However, while some
progress is visible, their effect on interbank interest rates has so far been limited and slow to
build up. Liquidity and counterparty risks continue to be major drivers in money markets,
which remain impaired with abnormally high spreads between secured and unsecured
lending.
In the weeks ahead, an additional support can come from the implementation at the national
levels of the decisions agreed at the European level, including the recapitalization of banks
and the possibility to make available, for an interim period and on appropriate commercial
terms, governments' guarantee, insurance, or other similar arrangements of new bank senior
debt issuance. While some degree of flexibility to adapt to local conditions must be
preserved, it is also of the utmost importance that the actual implementation of the new
measures proceeds in a coordinated manner, so as to avoid creating any segmentation in
markets or uneven conditions for financial institutions across Europe.
At the same time, we cannot rule out that further and even bolder steps may be needed in
the near future to quickly restore confidence, including actions to strengthen interbank
markets.
A final theme relates to the efforts to reshape the rules governing the global financial system,
in a more structural and medium term perspective. In this field, it was immediately clear since
the beginning of the crisis that the structural response had to be internationally coordinated.
This was the task assigned by the G7 to the Financial Stability Forum (FSF). The line
followed by the FSF is that financial intermediaries in the future will need to have more
capital and less debt, be more transparent and be subject to more effective rules. Several
important actions are being undertaken at the international and national level - largely
following the FSF's proposals - to reinforce capital requirements and the management of
credit and liquidity risk, to improve disclosure policies, valuation practices, accounting
standards and the role of rating agencies, and others. Decisive and tangible progress in this
area is an essential part of the cure to come out of the emergency. In Europe, I believe we
must in particular step up our efforts to quickly overcome existing differences in supervisory
practices at the national level, work towards a more harmonized set of rules, make further
progress in the cooperation and exchange of information among authorities. Again, I'm
confident that the EMU and its institutions will act as a powerful catalyst, helping
governments and regulators to redesign the rules for the financial sector, both at the
European and at the global level.
2. The euro and the real economy
2.1. Macroeconomic stability
Besides helping in confronting the financial crisis, there is ample evidence that EMU has also
favoured greater resilience of the euro area economy to adverse real shocks. One crucial
aspect in this respect is the high credibility of monetary policy that the ECB inherited from the
best traditions of the constituent currencies.
A clear cut example is provided by the experience with increases in the prices of energy and
raw materials. Blanchard and Galì, among others, have shown that the adverse effects of oil
price shocks on the economies have become significantly less severe than it used to be in
the past. Recent studies at the Bank of Italy show that after the introduction of the euro the
impact of oil price increases on inflation in Italy may have been reduced by ten times
compared to the seventies. While there have certainly been other structural changes at work
(such as a lower intensity of oil in production and consumption and more flexible labour
markets), there is little doubt that the higher credibility of central banks has played a crucial
role. The case of Germany is illustrative in this respect: the effects of oil price increases on
inflation were very limited already 30 years ago, thanks to the very high credibility the
Bundesbank enjoyed at the time.
2.2. International trade
One of the reasons for adopting the euro was to facilitate market integration and the
completion of the single market, reducing transaction costs connected with the hedging of
exchange risks and the variety of currencies used for commercial invoices. The evidence is
that expectations have been confirmed in full.
Numerous empirical studies concur that monetary union has had a positive effect on the
volume of trade within the euro area, although they disagree as to the extent, which is
estimated between 5 and 15 per cent. A positive effect has also been observed on
commercial flows outside the area; this supports the theory that the adoption of a common
currency, unlike preferential liberalizations, does not have distortionary effects on
international trade.
2.3. The trend in productivity
Is there a visible link between the adoption of the euro and productivity trends in the single
currency area? This is a fundamental question on which no consensus has formed yet. From
the second half of the 1990s, total factor productivity increased much faster in the United
States than in the euro area, where instead its growth slowed sharply. The gap widened with
the start of monetary union and has begun to narrow only recently: during the period it has
averaged about one percentage point a year. The gap reflects diverging trends in the leading
European economies: slower growth in France and Germany and absolute decline in Italy
and Spain, although our estimates indicate it has stabilized in Italy in the last two years.
The poor performance of total factor productivity accounts for much of the growth gap in
labour productivity in the euro area as a whole. The adjustment of capital intensity has also
slowed in the area as a result of heavier reliance on labour in the presence of institutional
reforms making employment more flexible.
To be sure, there are important issues concerning the reliability of statistical measurements.
For example, some studies have shown that productivity growth in the United States might
have been somewhat overestimated due inter alia to the incorrect measurement of gains in
the terms of trade and tariff reductions. In Italy, The Bank of Italy showed that the rate of
increase in the export deflator was overestimated in the official statistics. This led to a
revision of statistics resulting in an increase of more than 0.5 percentage points per year in
productivity growth in manufacturing in the period 1996-2005.
But if the correction for statistical error can make Europe's productivity and growth gap
vis-àvis the United States less alarming than it seems on the basis of the original data, they do
not annul the gaps. The fact that they have existed for a decade forces us to seek their
causes in the structure of our economies.
Answering the question on the effects of the euro on productivity is as difficult as any
counterfactual exercise. It requires to estimate what trend in productivity would have been
without the single currency.
However, I believe an answer emerges quite clearly from this conference, at least in two
mutually consistent analyses. In a presentation tomorrow, Bugamelli, Schivardi and Zizza will
explain how the euro has fostered the restructuring of firms and productive systems,
especially in sectors and countries that had relied most heavily in the past on currency
depreciation in order to recoup price competitiveness in the short term. And Alesina, Ardagna
and Galasso show how the same discipline has pushed governments to carry out significant
reforms in the markets for products and services. The findings point to a substantial positive
contribution of the euro in terms of productivity.
Another case in point is the labor market. Thanks to the reforms of the last ten years, it has
been possible to overcome the old image of an immobile European labour market - reflected
in high rates of unemployment and a low labour force participation rate - for which the term
"Eurosclerosis" was coined. There is empirical evidence of a clear positive association
between adoption of the single currency and the increase in employment and decrease in
equilibrium unemployment.
Finally, Bank of Italy research shows that the reduction of entry barriers in the past decade,
thanks to new, less anti-competitive rules, led to an increase in the share of total employment
of the sectors where reforms were introduced. Sharper competition has increased
incumbents' productivity and decreased their profit margins, fostered the adoption of ICT and
reduced price increases.
3. Conclusions
To conclude, I believe that confronting successfully the challenges posed by the current
crisis requires that we continue on the road of greater integration and market openness
which has been spurred by the adoption of the euro.
In difficult times our economic paradigms may change dramatically and the temptation to go
in isolation to deal with the most pressing problems may be understandable but may prove to
be disruptive. The benefits of having had the euro for the last 10 years speak by themselves.
We want to come out of this crisis able to continue enjoying these benefits.