José Manuel González-Páramo: What has Europe learnt from the crisis?
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the OMFIF Conference "On the cusp: the world economy at a
turning point. Strengthening stability at a time of challenge and change.", Frankfurt am Main,
15 March 2012.
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The euro area's "missing institutions"
From its conception the euro was and has been a unique and ambitious project. It combined
a centralised monetary policy with decentralised economic policies, and to paraphrase
Tommaso Padoa-Schioppa, created a currency that did not belong to a single nation-state. A
key finding for the euro area, arising from the crisis, is that this construction was not
complete. In particular, the euro area did not have certain institutions we associate with
political federations and that act as shock-absorbers against the negative effects of
imbalances. The key lesson from the crisis, therefore, is that the euro area needs to
compensate for these "missing institutions" by establishing a much stronger economic and
financial union.
A central area where the absence of shock-absorbing institutions has been felt is via
intra-euro area current account imbalances. These imbalances existed for many years prior
to the crisis, but were largely ignored as theory told us that they could always be financed
through cross-border financial flows. However, it is now clear that current account
imbalances - while not being the only proximate causes of the crisis - are not benign and
imply vulnerabilities which can be transmitted to the euro area as a whole.
On the financial side of the current account, persistent intra-area imbalances imply that some
public or private sectors are living beyond their means, year after year. If, as was the case in
some euro area countries, these imbalances are also linked to the large build-up of external
liabilities by an over-leveraged domestic banking system that engages in excessive risk
taking, this may also create the conditions for the kind of twin sovereign-bank crises which
we have witnessed over the recent period. Private liabilities can quickly become sovereign
ones when governments are required to recapitalise banks or guarantee bank funding,
leading to sovereign debt crises. At the same time, sovereign liabilities can undermine
domestic banking sectors given the high exposure of euro area banks to their own
governments' debt and the link made by markets of the cost of funding of banks with that of
their respective sovereign.
Such negative effects may potentially be better mitigated in political federations given their
stronger shock-absorbing institutions. For example, if a particular state in the U.S. were to
experience a build-up in private sector liabilities that threatened its local banks, the
responsibility for recapitalisation and deposit insurance would fall on the federal government
- through institutions like the U.S. Treasury and the Federal Deposit Insurance Corporation.
This means that a U.S. state cannot be brought into financial difficulties by a mismatch
between the size of its banking sector and that of its local economy, whereas a euro area
country can - as we saw in Ireland.
On the real side of the current account, persistent trade imbalances within the euro area also
reflect accumulated competitiveness losses in deficit countries. The problem may be masked
while growth is driven by credit and consumption, as was the case in some euro area
countries before 2008. But when there is a reversal in financial flows and foreigners are no
longer willing to finance the further accumulation of external debt, accrued competitiveness
losses come to the fore. This can result in particular regions suffering sustained low growth
and unemployment.
Again, these negative effects may be more manageable with the shock-absorbing institutions
of a political federation. A homogenous language and culture may facilitate labour mobility,
providing one channel for adjustment - although recent evidence suggests this effect is not
as significant in the U.S. as previously thought. At the same time, having a large federal
budget creates a natural stabiliser as federal spending on "big ticket" items like social
security, healthcare and defence redistributes incomes between rich and struggling regions.
Constructing a sui generis response
It is clear that the way ahead for the euro area cannot involve trying to construct the
institutions of a political federation overnight. This implies that the euro area needs a different
approach to ensure the smooth functioning of monetary union that can compensate for some
of these "missing institutions". This approach has two main pillars.
The first pillar is to strengthen fundamentally the governance procedures which prevent
imbalances from arising. With fewer shock-absorbing institutions to mitigate crises when they
arise, the euro area has learned that it must become more effective at preventing
imbalances. This process has involved tightening the rules for fiscal policies and creating a
much needed framework to monitor broader macroeconomic imbalances and
competitiveness.
On the fiscal side, the reform of the Stability and Growth Pact and the new Fiscal Compact
are specifically designed to catch imbalances earlier. A key focus of the SGP reform was to
strengthen the so-called "preventive arm" - for example, sanctions are now possible for
noncompliance with medium-term budgetary objectives. The Fiscal Compact supports this focus
on prevention by creating a new "first line of defence": balanced budget rules with a
constitutional status. Importantly, this shifts the onus for enforcement away from Brussels
and onto national institutions, encouraging greater ownership. Indeed, if applied properly, this
Fiscal Compact would correct imbalances before the EU level rules ever need to be
activated.
On the broader macroeconomic side, the new Macroeconomic Imbalances Procedure allows
for early monitoring of - amongst other things - competitiveness trends, private sector credit
flows and house prices. If excessive imbalances show up in these areas, sanctions1 can be
applied to euro area countries that do not follow recommendations to correct them. Under
this framework, the kinds of credit booms and competitiveness losses we witnessed in the
first years of the euro would be "flashing red" much earlier.
I am aware that some criticise this process as asymmetric. While it is clear that the
vulnerabilities created by large current account deficits are greater than those of surpluses
- and therefore require more urgent remedies - the structural drivers of current account
imbalances in surplus countries are also partly being addressed, even if not to the same
extent as those in deficit countries. In parallel to the Macroeconomic Imbalances Procedure,
for example, the Commission intends to undertake further analysis on the drivers and
possible policy implications of large sustained current account surpluses, including trade and
financial linkages between surplus and deficit countries. It will also examine ways for further
rebalancing current account imbalances, particularly at the level of the euro area, and within
the global context. A key theme of the crisis response has also been a renewed focus on
structural reforms as embedded in the Euro Plus Pact and Europe 2020 Strategy, which
apply to all participating Member States equally.
It would be naïve, however, to believe that with better governance crises could always be
prevented. The second pillar to compensate for the euro area's "missing institutions",
therefore, is to strengthen the way in which the euro area as a whole manages crises.
Having witnessed how imbalances in one euro area country - no matter how small - can
become systemic and create financial obligations for other taxpayers, the EU institutions,
national governments and national parliaments are now playing a much stronger role in
demanding and monitoring economic reforms.
This shift is visible in much more active role of the euro area Heads of State or Government
in the economic management of the euro area - now institutionalised in the form of the Euro
Summit. It is also visible in the greater scrutiny applied by national parliaments to the
economic policies of other Member States: for example, to approve financial assistance
programmes a number of national parliaments now require EU-IMF compliance reports and
debt sustainability analyses. This changing role of national parliaments underscores the
recent observation by Herman Van Rompuy that national parliaments are increasingly EU
institutions.
The Commission is also gaining a much stronger crisis management through the new
"two pack" legislation. The current proposals would allow the Commission to put any Member
State under enhanced surveillance if it is experiencing or threatened with financial difficulties
- regardless of whether it has requested financial assistance. This would imply stress tests of
the banking sector by the EBA, monitoring of macro imbalances and regular review missions
by the Commission in liaison with the ECB. Moreover, the Commission would be able to
send back budgets that did not comply with the SGP before they had been adopted by
national authorities.
In other words, the euro area is responding to the crisis by creating a new and more
comprehensive model of economic governance. This is aimed at preventing imbalances in all
policy areas before they can trigger crises - and managing crises more effectively when they
do arise. In many ways, this response is sui generis and departs from the template we
associate with political federations. For example, the "two pack" gives the Commission the
power to demand the kind of reforms that the U.S. federal government could not demand of a
U.S. state. Moreover, the federal government would not be able to sanction a state if, for
example, its tax code was leading to a local housing bubble. This is now not excluded in the
euro area under the Macroeconomic Imbalances Procedure.
This new model is under development and still needs to be perfected - in particular in the
financial sector, more work still needs to be done. That said, problems of regulatory arbitrage
created by national level banking supervision are being addressed through an increasing
harmonisation of supervisory standards and the establishment of a European System of
Financial Supervisors with new European Supervisory Authorities. Europe is also exceeding
international benchmarks in transposing the new Basel III rules. We may be seeing the
beginning of a euro area framework for banking sector recapitalisation and resolution with
the decision to allow the ESM to recapitalise banks in non-programme countries. Indeed, a
modest first step that will be followed by others in the future.
Conclusion
To conclude, the euro area has learned that the original design of EMU was incomplete, and
is now working hard to complete it. For various reasons, the euro area is not in a position to
adopt in the near term the institutions of a political federation. This means that it has to take a
different road to increase overall stability and - in true European tradition - a sui generis
approach is being developed that focuses on preventing imbalances and improving collective
management of crisis.
It is clear that this approach implies a loss of sovereignty. The crisis has proved that the euro
area is a political entity which is not self-adjusting; it needs to be actively governed, and this
cannot happen without Member States sharing more powers with each other. In other words,
there has been a belated recognition that monetary union entails political union. This shift
has profound implications for the involvement of all levels of governments in the European
project: EU institutions, national governments, national parliaments, and even local
governments are all required to participate in the common governance of the euro area.
Managing this process represents the next great challenge of European integration.