Joachim Nagel: Current challenges facing the European Monetary
Union
Speech by Dr Joachim Nagel, President of the Deutsche Bundesbank, at King's
College, London, 22 March 2023.
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1. Introduction
Ladies and gentlemen,
I am very pleased to be with you today and to speak in these beautiful and history-filled
surroundings.
We are living in turbulent times - once again . I guess almost everyone can name
factors currently adding to overall uncertainty : the Russian war of aggression against
Ukraine, the comeback of high inflation, high public debt levels and, most recently,
financial market tensions as well. In such times, it is especially difficult to prioritise
actions that need to be taken.
In my speech today, I will focus on a number of issues that I deem important right now . I
will shed some light on current economic developments. Then I will of course, comment
on inflation and monetary policy. And I will focus especially on fiscal developments and
the discussion surrounding fiscal rules which - as you may know, is a particular
obsession of central bankers.
One topic that is probably of particular interest to you is the most recent developments in
financial markets. Whenever banks get in distress or fail , questions inevitably pop up:
about proper risk management, about sufficient regulation, about contagion risks. And
rightly so. It is our duty as central banks to probe the stability of our corners of the
global financial system.
As far as I can see, the majority of risk managers in banks have done a decent job of
coping with today's challenges. Regulation in the euro area is far stricter now than it
was 15 years ago. The euro area banking sector is resilient , with strong capital and
liquidity positions. And despite the events that we have witnessed in the past 15 days,
contagion risks to euro area banks appear to be low. We will continue to monitor closely
the developments in financial markets. And we are ready to act, if need be.
With that, I would like to move to issues more important in the long run . In my speech
today, I will elaborate on some of the current challenges facing the European Monetary
Union, with special focus on the two public sector agents influencing the
macroeconomy - monetary and fiscal policies. I will draw particular attention to the
ongoing debate about reforming European fiscal rules.
But every speech on general issues is naturally held in specific times and cir
cumstances. So, let me begin with a few words about the economic and inflation
outlook in Europe as well as about our latest monetary policy decisions.
2. The macroeconomic environment
Last year, the euro are saw an expansion of 3.5% in economic activity. The main factor
behind the economic expansion in Europe was the lifting of COVID-related restrictions.
However, high inflation dampened private consumption. This was, to some extent, due
to the energy crisis caused by the Russian war of aggression against Ukraine.
Initially, during the late summer, there were deep concerns that a cut in the Russian
energy supply would cause a severe recession, at least in some euro area countries.
Fortunately, European countries and Germany in particular made considerable
progress in finding alternative gas suppliers and in filling gas storage facilities before
the winter. Thus, the most negative scenario was avoided.
Nevertheless, the energy crisis provoked not only surging energy retail prices and
higher production costs for firms. It also created considerable uncertainty and made
production planning for firms more difficult, especially for those with high energy
consumption. These dampening factors had an effect in the second half of the year
especially, while the growth effects of the lifting of COVID restrictions petered out.
For this winter, we expect economic activity in the euro area to increase marginally.
According to the ECB's economic projections published last week, GDP in the euro
area will grow only by 1% this year. It should be taken into account though, that the
current financial market tensions imply greater uncertainty around projected figures.
One of the most striking economic features of the recent past is the comeback of high
inflation. To be fair, the high inflation did not emerge only because of the energy crisis
caused by the war in Ukraine. The inflation rate had already accelerated in the summer
of 2021.
As the world recovered from the unprecedented economic slump caused by the
pandemic, supply chains were under stress. Together with expansive monetary and
fiscal policies, the rapid recovery pushed up energy prices. Moreover, demand for
certain goods and services increased strongly. Supply bottlenecks and price increases
were the result.
With the Russian invasion of Ukraine in February 2022, energy prices skyrocketed.
Furthermore, the war and its consequences disrupted some other supply chains. In
particular, the energy price shock heated up inflation even more.
The figures clearly demonstrate how exceptional last year was. According to the IMF,
2022 consumer prices in advanced economies rose by 7.3%. That was the highest
increase in almost four decades. In the UK, the consumer price index even rose by
more than 9%. In the euro area, the Harmonised Index of Consumer Prices rose by
8.4% on an annual average for 2022.
Initially, high inflation rates were driven mainly by energy and food prices. Energy prices
recently decreased , and with them headline inflation rates. However, inflation keeps
becoming more broad-based . We can see this from core inflation, which excludes
energy and food prices. Core inflation keeps rising in the euro area. In February, it
stood at 5.6%.
Overall, inflation rates will remain high in the near term. According to the ECB's
economic projections, the inflation rate will average 5.3% this year. This is more than
double our medium-term inflation target of 2%. According to the projection, we will have
to wait until 2025 to see inflation approach our target by decreasing to 2.1%.
Moreover, the projection still contains significant uncertainty, and in particular upside
risks. For example, high commodity and production prices could be passed on to
consumers to a greater extent than previously expected. Wages may increase even
more strongly than assumed in the projections.
3. Current monetary policy issues
Given this outlook, the Governing Council of the ECB could not simply assume that high
inflation will return to the target level of 2% on its own . On the contrary, monetary policy
has to act decisively. That's why the Governing Council of the ECB delivered six
interest rate increases over the last eight months. Monetary policy rates increased by
350 basis points - the largest hike sequence ever in the euro area.
However, increasing the policy rates is not the only instrument we have at our disposal.
In the first half of 2022, we discontinued net purchases under our PEPP and APP asset
purchase programmes. This meant that security holdings under these programmes
remained largely constant. From this month on until June, we are reinvesting only about
50% of maturing assets under the APP . So our balance sheet is starting to shrink
gradually, phasing out one additional component of the previous expansive monetary
policy. From July onwards, reinvestments in the APP could be further reduced. This
would support the tight monetary policy needed to rein in inflation.
With our monetary policy actions, we are dampening economic activity. This is not an
unwanted side effect, but an important link in the causal chain of our monetary policy
tightening. We have to tame inflation, and to do so, we have to be bold and decisive. In
my view, our job is not done yet. If inflation develops as projected, further interest rate
hikes have to follow in upcoming meetings.
In the event that financial market tensions continue or spread to the euro area, we are
prepared to respond to preserve financial stability in the euro area. The monetary policy
of the Eurosystem will do what is necessary to ensure a timely return to price stability.
But it is not monetary policy alone that influences the inflation outcome. The former
Governor of the Bank of England Mervyn King once said: "If central bankers are the only
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game in town, I'm getting out of town!". So let's have a look at the other important
player of the public sector - fiscal policy.
4. Current fiscal policies
Before touching on some general aspects of the discussion on fiscal rules, let us take a
quick look at the current policy mix in the euro area. Last year, we went through tough
times. Fiscal policy action was needed . Huge increases in energy prices and high
inflation severely affected households and businesses. It was right to use fiscal policies
to help those people who were hit hardest and could not help themselves. It was right to
support viable businesses that otherwise would not have made it through the
particularly difficult times.
Fiscal policy has delivered quite forcefully . Sizeable temporary measures were taken,
and the fiscal support was, for the most part, relatively broad and untargeted. And the
measures were mainly financed through additional deficits .
However, while expansionary fiscal measures are appropriate to restore stability in the
case of a demand shock, this is not so much the case in today's cir cumstances. The
current situation is characterised to a large extent by supply-side effects and, of
particular relevance for monetary policy, by high inflationary pressures.
In such a situation, expansionary fiscal measures risk fuelling inflation further. There is
a risk that monetary and fiscal policies will work against each other. Therefore, looking
ahead, it is important that in the euro area, the size of fiscal policy support is reduced as
soon as possible. Any further support should be well-targeted.
The easing of tension in the energy market will assist in the reduction of fiscal support.
And some measures, such as the German gas and electricity price brakes, will be less
costly than initially planned. It would be highly advisable not to use this kind of fiscal
relief for other purposes like other expenditure or tax cuts. They should instead
contribute to lowering the high deficits. In this way, fiscal policy in the euro area can
support the Eurosystem's monetary policy by reducing the fiscal stimulus and by putting
public finances on a more sustainable path.
5. Fiscal rules in the euro area
In general, and not just in today's specific cir cumstances, fiscal policy is a major factor
influencing how effectively the Eurosystem fulfils its mandate of price stability. Monetary
and fiscal policy have their interdependencies . Their policy stances can more or less be
in harmony.
In the best case, sound fiscal policy provides the necessary bedrock for monetary policy
also in a broader and longer-term perspective. In the worst case, persistently unsound
fiscal policy creates significant risks that make it more difficult for central banks to fulfil
their mandate. Here, we speak of the risk of fiscal dominance. What does fiscal
dominance mean exactly?
The higher the level of public debt becomes, the greater the pressure on central banks
to maintain favourable financing conditions in order to prevent the state from
experiencing a solvency crisis. If the central bank gives in to that pressure, it is no
longer primarily following the goal of price stability. In an extreme case, the roles of
fiscal and monetary policy are reversed : the central bank stabilises government debt,
and the level of inflation is determined by fiscal priorities. Or, as the American
Economist Michael Woodford puts it: "Fiscal dominance manifests itself through
pressure on the central bank to use monetary policy to maintain the market value of
government debt".2
In the euro area, fiscal soundness is all the more important because a single monetary
authority operates amid many sovereign fiscal authorities. Therefore, the architects of
Economic and Monetary Union not only relied on market discipline by emphasising the
no-bail-out principle. In addition, fiscal rules were established as an important feature of
the monetary union to preserve sound public finances and to prevent fiscal pressures
on monetary policy.
The fiscal rules are enshrined in the European treaties. They were regularly the subject
of controversy and have been repeatedly adapted and reformed over time. A frequent
criticism was that the fiscal rules might be an impediment to public investment . Others
criticised the rules as being overly complex and opaque.
In my view, the fiscal rules were better than their reputation - at least when we look at
their substance. The quantitative budget ceilings were suited to ensuring that high debt
ratios fall swiftly. However, they were insufficiently binding and their application was
often the result of political negotiations. The results were not convincing either. Highly
indebted countries failed to reduce their debt levels even in good economic times.
Currently the rules are still suspended until the end of the year. During the pandemic,
general escape clause from the Stability and Growth Pact was activated. In parallel,
athe reform process was launched. For that purpose, the Commission initiated a
consultation process in 2021. The Bundesbank also contributed its proposals to this
process.
Our main recommendations were to make the quantitative targets more binding , with
less discretionary exemptions and more stringent implementation. Moreover, we
suggested allowing for more deficit-financed investment expenditure when debt ratios
are sufficiently low, and national rainy-day funds to enhance flexibility for fiscal
authorities. In addition, we proposed making fiscal rules more binding, for example by
transferring fiscal surveillance to an independent institution with an exclusive focus on
debt sustainability - such as the European Stability Mechanism.
Last year, the Commission presented its first reform proposal, which saw contentious
debate among Member States. Last week, the Economic and Financial Affairs Council -
ECOFIN - agreed on basic reform principles. I very much welcome its commitment to
sustainable public finances and reduction of high debt levels. However, the current
agreement appears to be largely based on the Commission's proposals of last
November . I have not been convinced by the initial Commission proposals. I have
expressed doubts that such an approach will lead to an improvement in fiscal rules, but
instead, I believe it will do the opposite .
The Commission proposes multiannual fiscal adjustment paths. Those paths would
have to be agreed by the Commission and every Member State. Individual public debt
challenges as well as reform and investment plans would have to be taken into account.
In my view, such an approach is hardly compatible with the goal of a common clear,
transparent, and binding fiscal framework for all Member States. It implies leeway for
Member States as well as a high degree of discretionary judgement by the
Commission. Monitoring compliance with fiscal rules would be highly complex, and
results of sustainability analyses will crucially depend on initially defined assumptions.
These challenges will be aggravated if the rules take reforms and investment plans into
account. Fiscal targets would be mixed with other policy goals. In combination with the
multiannual set up, this raises concerns about whether back-loading might become the
new standard of fiscal efforts. I am concerned that such a fiscal framework would fail to
contribute to a reliable reduction of high sovereign debt levels. And this would be a
burden for our monetary policy and would leave us feeling exposed when it comes to
dealing with future economic shocks .
However, the discussion on reforming the common fiscal framework is still ongoing
between the Commission and the Member States. And similar concerns have been
raised, not least by the German Finance Minister Christian Lindner . So we have to wait
for the final agreement. In the end, the specific design of the rules and, equally
importantly, their implementation, will determine the outcome.
6. Perspectives of the European Monetary Union
Now you may ask: what's next for the euro area? Well, unless there is democratic
legitimacy for a European political union, the future of the European monetary union
relies on strengthening the existing governance framework.
In general, progress has been made in resolving the well-known drawbacks . The
European Stability Mechanism - ESM - was established to provide financial assistance
if necessary. A macroeconomic imbalance procedure has been introduced, and reforms
have been implemented to mitigate the mutual reinforcement of problems in the
financial sector and public finances. In particular, the Single Supervisory Mechanism
and the Single Resolution Mechanism are designed to forestall financial distress in the
banking system. However, further reform progress is needed to contain any detrimental
impact of distortions from the government to the banking system.
Ultimately, however, each Member State remains responsible for its fiscal and
economic policy. As regards the fiscal governance framework, fiscal rules should
become less complex , less discretionary and more binding.
In my view, however, fiscal rules alone cannot ensure, together with monetary policy,
price stability. That means financial markets have to play their part by pricing sovereign
risks adequately and thereby support fiscal discipline. Borrowing at European Union
level to finance current expenditure, such as with Next Generation European Union
transfers, should remain an exception . This guarantees that potentially rising risk
premia for government debt constitute a significant incentive for sound fiscal policy.
Capital market disciplining would be helpful in this respect.
The debt ratio in the euro area increased rapidly during the pandemic.
Politicians have to find a proper way to bring it down. Sustainable public finances
secure capital market access and avoid potential conflicts with monetary policy. I hope
the current reform of the governance framework will not culminate in a rules-free
setting. Sustainable public finances are in the interest of taxpayers as well as fiscal
authorities and central banks.
7. Closing remarks
Ladies and gentlemen,
let me conclude.
From a central banker's perspective, fiscal rules are indeed very important . The
economist Karl Brunner expressed this with the following words:
"The crucial conclusion from [-] stability analysis suggests that a stable, non-inflationary
monetary regime is unlikely to persist in the absence of a fiscal regime effectively
3
containing the average deficit."
In this context, the direction of the current reform process causes me concern . We will
see whether the answers to questions still under discussion will improve the outcome.
And we will see how any new rules will actually be implemented .
In my view, the European Union weathered the crises of the last few years fairly well .
The EU countries reacted responsibly and successfully to the economic shocks caused
by the pandemic and energy crisis. Certainly, we would not have been better off during
the crisis had we been dealing with twenty different European currencies. Working
together to find a common European response is worth the effort. I am firmly convinced
that monetary union is beneficial to all members.
Thank you.
1
Tucker, P. (2018), Unelected power: the quest for legitimacy in central banking and
the regulatory state, Princeton, p. 525.
2
Woodford, M. (2001), Fiscal Requirements for Price Stability, Journal of Money, Credit
and Banking, Vol. 33, No. 3, pp. 669-728
3
Brunner, K., Fiscal Policy in Macro Theory: A Survey and Evaluation. In The Monetary
versus Fiscal Policy Debate, edited by R. W. Hafer and N.J.Totowa: Rowman and
Allanheld,1986.