Philipp M Hildebrand: Europe's fiscal challenges
Speech by Mr Philipp M Hildebrand, Chairman of the Governing Board of the Swiss National
Bank, at the Annual General Meeting of the Swiss-American Chamber of Commerce,
Rüschlikon, Switzerland, 21 June 2010.
* * *
I would like to thank Rita Kobel Rohr for her valuable support in drafting this speech. I also want to thank Matthias
Lutz for helpful comments.
I want to thank the Swiss American Chamber of Commerce for the kind invitation. It is a
privilege to speak to you this evening at your Annual General Meeting.
The last time I was with you - it is now nearly two years ago -, I paid homage to Albert
Gallatin, the legendary Swiss-American Secretary of the Treasury of the United States at the
beginning of the 19th century. On that occasion, I chose to honour Gallatin because I felt he
incorporates fundamental values long shared by Swiss and Americans alike. As it turns out,
recent developments in Europe and elsewhere demonstrate compellingly that one of the
important lessons of Gallatin's outstanding career remains particularly relevant today. He
teaches us that public debt reduction requires unwavering political commitment to fiscal
discipline.
In my remarks this evening, I will attempt to put the fiscal challenges Europe is currently
facing in a broader context. The handling of these challenges by Europe's governments and
its citizens will have implications for Switzerland, but also for the United States and ultimately
for the world.
In an attempt to understand what is currently happening in Europe, we have to go back to the
1950's. European integration as we know it began 60 years ago, and until recently, it has
been a success. The signing of the treaty establishing the European Coal and Steel
Community on 18 April 1951 was the first genuine step towards economic and political
integration. The six signatories - Germany, France, Italy, the Netherlands, Belgium and
Luxembourg -, agreed to run their coal and steel industries under a common management.
The overriding goal was to secure a lasting peace on the European continent. The introduction
of the Euro in 1999 was just one further - albeit major - step in this long-standing integration
process. Throughout these decades, the world benefited from economic prosperity and
peace on the European continent; a continent, that had previously been torn apart by two
world wars within the span of forty years.
From a Swiss perspective, regardless of one's political or ideological leanings, there can be
no doubt that the Swiss economy situated at the very heart of Europe but remaining outside
the European Union (EU) has benefited from the continued process of European integration.
There are a host of examples to illustrate this.
The bilateral agreements Switzerland concluded with the EU in 1999 and 2004 would have
been very difficult to reach with 27 individual nations. Among other things, this has led to
greater immigration from the EU. Despite initial fears here in Switzerland, open and integrated
labor markets between the EU and Switzerland have clearly given the Swiss economy a
welcome boost in recent years.
Indeed, private Swiss firms and even semi-public sectors like health care have reaped
substantial benefits by drawing on the supply of large numbers of highly skilled immigrants
from the EU member states and in particular from Germany. Moreover, this has not come at
the expense of Swiss workers. Recent research actually suggests that the immigration from
the EU during the last couple of years has narrowed the wage differential.1
Immigrants have also been an important source of demand during the financial crisis. They
are clearly one of the reasons why Switzerland's economy has weathered the financial crisis
relatively well. Indeed, Switzerland is one of the very few developed countries where private
consumption remained a steady source of growth virtually throughout the entire financial
crisis.2
A particularly relevant benefit directly linked to the introduction of the Euro pertains to
exchange rate volatility. After the introduction of the Euro and before the peak of the financial
crisis in 2008, the average Euro - Swiss franc volatility was roughly 30% lower than the
prevailing Deutsche Mark - Swiss franc volatility in the 1990. The compression in exchange
rate volatility is significantly larger if one takes the Lira or the Peseta or any of the other
peripheral European currencies as a reference point.
With the mounting concerns in financial markets over the ability of several, mainly peripheral
European countries to handle their public debt level, the situation has evolved significantly.
Exchange rate developments became a challenge for the Swiss National Bank (SNB). With
interest rates at zero and limited means to further expand monetary policy through other
quantitative easing channels, exchange rate interventions were a necessary unconventional
monetary policy tool. The SNB made it clear that it would fight off "safe haven" flows out of
the Euro in accordance with its objective to prevent deflationary risks from materializing by
way of an excessive appreciation of the Swiss franc.
This strategy of fighting off deflation risks has yielded the intended results. The deflationary
risk in Switzerland has largely disappeared and the Swiss economy has been able to benefit
from the ongoing recovery of the global economy. While the weakening of the Euro with
respect to the Swiss franc is dampening export activity, exports are being supported by
growth in foreign demand. Overall, today the outlook for the Swiss economy remains a
favourable one. Admittedly, the adopted strategy is not without risk which comes primarily in
the form of increased currency and concentration risk in the SNB's balance sheet. This risk
reflects the burden the SNB has assumed in order to protect the Swiss economy from the
threat of deflation. The SNB has sufficient equity capital to withstand even large losses.
When considering the favourable economic outlook for Switzerland, we must not lose sight of
the fact that the latest tensions on the financial markets have increased the downside risks.
Should these downside risks materialise and, via an appreciation of the Swiss franc, lead to
a renewed threat of deflation, the SNB would take all the measures necessary to ensure
price stability. In other words, the SNB would do whatever it takes to fight deflation and
safeguard price stability in the medium- and longer-term.
Switzerland has an obvious and enormous interest in Europe's ability to manage through this
public debt crisis decisively and ultimately successfully. Europe's ability to navigate out of the
current crisis is also very much in the interest of the United States and indeed the world.
When I say this, I don't mean to refer solely to the potential economic strains as a result of
Europe's public debt concerns.
What is ultimately at stake is the vision of the founding fathers of the EU; the vision of a
continent living in peace and prosperity and thereby contributing to a stable world order.
Merely upholding this vision will not, however, resolve the debt situation. But it explains the
bold and decisive steps taken by European governments, together with the International
Monetary Fund (IMF), to begin to address market concerns. It also explains why after a rapid
deterioration of public finances in Europe, collective monitoring of fiscal discipline and peer
pressure experience a revival. Arguably, more importantly, several countries have embarked
on a path that entails much needed structural reforms.
This public debt crisis is multi-layered. It is clearly a crisis of market confidence and as such
a liquidity crisis. The trigger was a classic fiscal crisis combined with severe competitiveness
problems in the periphery of the EU. However, it is also an institutional crisis. The institutional
mechanism to ensure fiscal discipline inside the Eurosystem was clearly insufficient.
Obviously, part of the fiscal imbalances and the resulting build-up in public debt were directly
related to the financial crisis and its aftermath. One part of the fiscal expansion can be
explained by the direct fiscal effects of the measures taken to stabilize the financial system.
Another part is explained by the drop in revenues and increases in social benefit payments in
response to the post-crisis recession. According to recent IMF calculations, this accounts for
about fifty percent of the increase in debt levels globally since the outbreak of the crisis. The
other roughly fifty percent are unrelated to the financial crisis and its effects on the broader
economy.3 To put it differently, some countries had simply lived beyond their means well
before the financial crisis erupted in 2007.
The reaction of financial markets is a wakeup call to all countries that sooner or later
government finances must be put on a sustainable path.
The main measures implemented so far at the EU level are mainly short-term oriented to
fight of the liquidity crisis and associated contagion risks. A large assistance package has
been established jointly by the EU and the IMF for Greece. To ward off the risk of contagion,
the EU has put in place the European Financial Stabilization Facility (EFSF) while the IMF
has committed to provide significant bilateral funding. Overall, the funding secured amounts
to 750 bn Euros. This significant amount is justified by the high risk of international spillover
effects. Additional support to ward off this contagion risk was given by the European Central
Bank which decided to intervene in the euro area public and private debt market in order to
restore an appropriate monetary policy transmission mechanism.4
These measures provide essential backstops. By adopting them, the governments of the EU
member states and the European authorities have unequivocally stated their intention to
safeguard the Euro. While this was a crucial first step, initial market reactions suggested
persistent scepticism. The uncertainty regarding the health of the balance sheet of European
banks is high and is keeping tensions on financial markets elevated. It is not only the
exposure of European banks towards mainly peripheral EU countries that is a concern to
market participants. Markets are also questioning the overall solidity of bank balance sheets
in the aftermath of the financial crisis.
Therefore, last Thursday the heads of governments of the EU member states agreed that the
results of stress tests on their respective banks will be published in the second half of July.
This decision can play an important role in fostering market confidence. In the event that
these stress tests reveal cases where additional capital is necessary, recapitalization efforts
will have to be undertaken swiftly. Institutional investors appear to be underweight in their
exposure to European banks. This should prove helpful in lending support to potential capital
raising efforts following a credible and transparent stress test exercise. Indeed, one of the
reasons investors currently appear to underweight European banking stocks may very well
be related to the fact that there is insufficient transparency about bank balance sheet
conditions in Europe. Credible stress tests can remedy this problem.
Contrary to what some commentators suggest, financial markets also look beyond the
shortterm. As a result, Europe's authorities had to recognize that decisive and comprehensive
longer-term fiscal programs are needed to put the EU as a whole on a sound fiscal basis.
Equally, individual countries can't forever live beyond their means. Under pressure from the
market, a number of countries have therefore initiated far reaching multi-year programs,
which at least partly address structural problems.
Moreover, the way the EU as an institution deals with public finances will change. As many
European officials have pointed out, in 2004, it was not Greece or Portugal but Germany
- together with France - that undermined fiscal discipline by successfully averting sanctions
foreseen under the Stability and Growth Pact. Now, the EU and in particular the big countries
are openly advocating measures to amend and significantly strengthen the institutional
mechanism in order to enforce fiscal discipline.5
In this context, the member states of the EU are faced with a fundamental issue. The public
debt crisis has shown that interdependence between member states of a monetary union is
strong.6 Going forward in reforming the institutional set up of the EU, the core question is to
what degree EU member states are ready to further relinquish sovereignty. How centralised
or federal should the EU be?
This discussion bears remarkable resemblance to the early years of the United States. At the
time, an intense debate took place around the full assumption of the Revolutionary War debt
of the states by the national government. The debate pitted the Treasury Secretary
Alexander Hamilton against James Madison and Thomas Jefferson. While his opponents
saw the assumption of the states' debt by the national government as a threat to the
republican government, Hamilton saw it as a unique opportunity to pursue his agenda of
creating a more powerful national government. He considered assumption as a way to
assure the new country a solid credit standing at home and abroad. This would allow the
United States to take full advantage of the emerging global commercial and financial
opportunities. In the end, Hamilton prevailed thanks to a classic political compromise
involving the future permanent site of the capital of the United States.7
With history in mind, let me end on an optimistic note:
As more details emerge about the EFSF and as the European authorities proceed with their
stress tests, I am confident that market strains will begin to ease. While the EFSF provides a
financial backstop, the importance of publishing credible bank stress test results cannot be
overemphasized. I am convinced that meaningful transparency about the solidity of
European banks and corresponding swift action to raise capital where necessary will bolster
market confidence significantly.
In a longer term perspective, credible steps are now being examined and will be undertaken
to enhance fiscal discipline in the EU. The EU authorities and governments of the member
states will have no choice but to take decisive steps to address the underlying institutional
flaws that led to the current debt crisis in Europe.
This is decisively not the first time the European integration process arrives at a crossroad.
Since it began in earnest sixty years ago, many severe challenges had to be overcome to
bring Europe to where it is today. As Jean Monnet, the pre-eminent founding father of the EU
wrote in his memoirs in 1976:
"Europe will be forged in crises and it will be the sum of the solutions adopted for
those crises".8
I have no doubt that Europe's authorities will once again rise to the occasion. They will
ultimately adopt the necessary solutions to overcome the current public debt and confidence
crisis. In doing so, they will safeguard the long-standing European integration process that
has proven so valuable to Switzerland and to the rest of the world.