Gertrude Tumpel-Gugerell: Policy challenges facing the euro area
Speech by Ms Gertrude Tumpel-Gugerell, Member of the Executive Board of the European
Central Bank, at the Distinguished Speaker Seminar, European Economic and Financial
Centre, London, 23 July 2010.
* * *
Ladies and Gentlemen,
It is a great honour for me to have been invited to speak here today by the European
Economic and Financial Centre.
My topic today will be the policy challenges facing the euro area, which is a rich topic: in fact,
there is no shortage of challenges for us. What started as financial turmoil in August 2007
turned into a global financial crisis following the failure of Lehman Brothers in September
2008. More recently we have witnessed an exacerbation of sovereign debt concerns. The
economic outlook is still surrounded by a high degree of uncertainty. However, a path out of
the worst financial crisis of our generation seems to be in sight, and there are signs that a
recovery is under way. Yet, the return to normality could be gradual. It requires support.
Therefore, we need to assess all developments carefully.
As Albert Einstein once said, we have to "Learn from yesterday, live for today, hope for
tomorrow. The important thing is not to stop questioning". In fact, we have learnt a lot from
the past few years. Facing the current challenges and addressing them now and in the future
will be key to more sustainable growth, more stable financial markets and an even more
successful euro.
I will start with the achievements of the euro and the single monetary policy, particularly in
recent years. I will then set out some of the main challenges ahead, along with the remedies
and policy priorities.
I. The ECB's actions during the crisis
The euro area has been the focus of a great deal of attention in the last few weeks. But let
me be frank: the euro itself is not the issue. Quite the contrary, the euro is an achievement
that has met with great success.
The introduction of the euro has resulted in deeper financial and economic integration with
great benefits for the economy of the euro area as a whole and beyond. Intra-euro area trade
in goods and services has increased notably. The "home bias" in financial markets has
declined steadily. And, since the launch of the euro, an increasing share of foreign direct
investments are taking place between euro area countries.
Perhaps the most important benefit of the euro has been the success of the monetary policy
framework for the 16 - soon to be 17 - countries participating in the common currency. The
framework has secured price stability for the euro area and inflationary expectations have
remained well anchored, even during the crisis.
Moreover, from the start of the financial turmoil in August 2007 the ECB and the Eurosystem
have proven to be very effective in implementing the policies needed - both conventional
and unconventional policies. In fact, the outcomes could have been far worse - both globally
and across the euro area - without the prompt actions of the ECB and the Eurosystem. I will
briefly discuss what the ECB has done in response to the challenges faced, thereby,
contributing to setting the stage for a sound recovery in Europe.
First, nearly three years ago, amid the initial strong signs of problems in the money markets
around the world on 9 August 2007, the ECB acted quickly to address the severe tensions in
the interbank market.
Second, after the failure of Lehman Brothers on 15 September 2008 the ECB acted
decisively. In terms of conventional monetary policy actions, we reduced our key interest
rates to unprecedented low levels. In addition, we introduced a series of non-standard
measures to support credit provision by banks to the euro area economy. These measures,
which we call "enhanced credit support", essentially comprised five elements: we lengthened
the maximum maturity of refinancing operations, we extended the list of eligible collateral, we
provided liquidity in foreign currencies, we initiated a covered bond purchase programme
and, first and foremost, we provided unlimited liquidity in all refinancing operations at a fixed
rate.
Third, in early May this year renewed market tensions emerged in some segments of the
euro area debt securities markets. As these tensions hampered the monetary policy
transmission mechanism, we launched the Securities Markets Programme (SMP),
intervening in the debt securities markets to support the proper transmission of monetary
policy impulses to the wider economy and, ultimately, to the general price level.
These measures have proven to be extremely important for the euro area economy,
shielding it from far worse outcomes. Let me give you some illustrations of the effectiveness
and the success of our actions.
First, following the reduction in key ECB interest rates and backed by our extraordinary
liquidity support to euro area banks, money market rates decreased considerably from their
peak levels recorded in 2008. Spreads between secured and unsecured money market rates
declined significantly: for example, the spread between the three-month EURIBOR and the
three-month overnight index swap rate decreased by 170 basis points from its peak recorded
in October 2008, falling to about 30 basis points one year later and remaining close to this
level thereafter.
Second, the enhanced credit support measures, including the covered bond purchase
programme, contributed decisively to improving the funding situation of euro area banks. For
instance, issuance and secondary market activity for covered bonds began to revive in
mid2009, and bank bond spreads for unsecured funding have fallen considerably.
Moreover, the improved funding of banks appears to have contributed to a smooth
passthrough of our policy rate decreases to bank lending rates. In parallel to the 325 basis point
reduction in the key ECB interest rates since October 2008, average short-term rates on
loans to households for house purchase and loans to non-financial corporations have
declined by around 310 basis points and 340 basis points respectively. In addition,
improvements in the liquidity situation of banks and their access to market funding have led
to a loosening of credit standards for loans to households and non-financial corporations
since the start of 2009, although credit standards for non-financial corporations have picked
up somewhat recently.
And, third, the inception of our Securities Markets Programme in early May has helped to
ease considerably the tensions in euro area government debt markets. Sovereign bond
spreads and credit default swap (CDS) premia have fallen significantly from the peak levels
that they reached in the first week of May. The dispersion across euro area government bond
yields remains elevated, but it is somewhat below the peak levels recorded in the first week
of May. Together with the commitments made by many euro area governments with respect
to their public finances, the ECB's purchases should contribute to further improvements in
these markets.
Overall, I believe that the bold and decisive measures that we have taken since autumn 2007
have been instrumental in preventing dramatic disruptions in the functioning of specific
financial market segments. We have avoided severe impairments in the provision of credit to
firms and households, and have prepared the ground for a gradual recovery of the euro area
economy from the worst cyclical downturn experienced since the Great Depression. Indeed,
after a period of sharp decline, the outlook for growth is improving. Business and consumer
confidence indicators have trended upwards over the last few quarters and the Eurosystem
staff macroeconomic projections, as well as those of other organisations, foresee a further
rebound in GDP growth in 2010 and 2011.
The outlook for growth is also supported by the improvements that we see in the financial
market. The banking sector appears to be well on the road to recovery. Capital positions
have strengthened, the profit situation has improved, with loan losses peaking last year, and,
notwithstanding the recent renewed tensions, market-based indicators have improved
broadly. Moreover, the redemption of the €440 billion 12-month liquidity operation has only
led to additional demand in the ECB's shorter-term operations of less than half that amount.
The resulting withdrawal of €240 billion of central bank liquidity went very smoothly overall,
without any renewed tensions in the interbank money market.
III. The euro area's main challenges
This positive outlook and the many achievements over the last decade notwithstanding, the
crisis has exposed various challenges facing the euro area. In my view, there are three
challenges that deserve particular attention.
1. The first challenge pertains to cross-country differences in real economic
performance. Over the past few years we have seen moderate growth and productivity
developments in some euro area countries and diverging competitiveness developments
across the euro area. Euro area countries still have to implement further structural reforms -
albeit to varying extents. Such reforms will lead to higher growth and employment and can
contribute to less divergence in developments across countries.
In fact, we have long known that structural reforms pay off. For instance, measures which
increase competition in consumer markets can curtail monopoly rents and lead to higher
employment and output. The introduction of the Single Market has decreased monopoly
rents by a quarter.1 Studies have found that this may also have led to an increase in potential
output in the range of 5%-10%.2 Labour market reforms also have an impact. For instance,
adjusting the unemployment benefit replacement ratio by 5 percentage points has been
estimated to give rise to an increase of 1.5% in output and 1.7% in employment over a period
of five years.
2. The second challenge is posed by public finances in euro area countries. Since the
launch of the euro we have witnessed cross-country differences in the enforcement of fiscal
discipline. While fiscal developments since the launch of the euro have been much better,
overall, than developments in the period prior to the start of economic and monetary union
(EMU), there has only been a limited reduction in the overall level of indebtedness across the
euro area [Euro area aggregate in % of GDP: government budget balance: 1995: -5.0, 2007:
-0.6, 2009: -6.3, 2011: -6.1; government gross debt: 1995: 72.5, 2007: 66.0, 2009: 78.7,
2011: 88.5]. Moreover, some countries did not comply with their commitments under the
Stability and Growth Pact even in good times.
3. The third challenge is posed by the lack of transparency and regulation in financial
markets. In many respects, the recent crisis can be seen as the direct result of vulnerabilities
and imbalances in the financial system. The risks stemming from financial innovations were
compounded by insufficient risk management and adverse incentives. We have all seen the
negative effects on economies around the globe. A key lesson is that systemic risks were
largely misunderstood and thus underestimated.
From a longer-term perspective, concrete efforts will be needed to address all three
challenges and to sustain the recovery, rendering it solid, sustainable and long lasting. I will
now turn to the remedies and policy actions needed to address these challenges.
IV. Addressing the challenges
For the first challenge, improving real economic performance, there are at least three
policy priorities.

First, policies are needed which enhance competition and innovation to speed up
restructuring and investment, thus creating new business opportunities. Increased
labour market flexibility, as well as investment in education and research, are
required to create employment opportunities and enhance competitiveness.
Restructuring of the banking sector to establish solid business models, better risk
management and increased transparency will be essential.

Second, there is a need to safeguard and strengthen the Single Market in
Europe. While the Single Market is at an advanced stage, there is still room for
further progress. A clear example is the energy market, where greater integration
would help to minimise costs and prices, improve energy security and support the
wider use of renewable energy sources.3 Another example is the Single Market for
services. Implementing the internal European services market would undoubtedly
bring great benefits in terms of productivity and employment gains. One specific
example in this respect is the completion of the Single Euro Payments Area (SEPA),
with harmonised retail payment instruments and standards which can bring
tremendous cost savings to companies and consumers.

Third, we need to invest in education and technologies. The global economic
slowdown has had a severe impact on labour markets. Since early 2008 the number
of unemployed people in the euro area has risen by over 41⁄2 million. Policies aimed
at improving labour market flexibility need to be combined with measures to raise
the level of participation and the skill level of the labour force. While some of the
policy measures designed to maintain employment through the crisis have proven
effective, it is important to ensure that these temporary support measures do not
become permanent.
For the second challenge, securing sound national public finances, fiscal discipline is
essential. It is true that the fiscal stimulus measures have made a contribution equivalent to
roughly 2% of GDP in the euro area (not counting off-balance-sheet measures and the
economic support provided by automatic fiscal stabilisers) and, therefore, has helped to
soften the economic impact of the crisis. But with the economic outlook improving, it is now
time to phase out these special measures and to start fiscal consolidation, in line with the
recommendations made in the country-specific excessive deficit procedures. For a number of
countries, this process should start in 2010 and for the remainder it should start in 2011 at
the latest.
Hence, we welcome the fact that a number of euro area governments have now adopted
fiscal consolidation measures and set out ambitious fiscal targets. On 7 June the euro area
finance ministers agreed on the spring 2010 orientations for fiscal policies in euro area
countries. These decisive actions by euro area governments have reassured markets, as
reflected in the fact that all new issuances of government debt have been successfully
concluded and have met with adequate demand.
In this context, coordinated action at the European level is essential. Each country must fulfil
its responsibilities and European governments must work together. This is in line with the
conclusions of the latest G20 meeting in Toronto, where the G20 economies committed to
fiscal plans that will at least halve deficits by 2013 and stabilise or reduce government
debtto-GDP ratios by 2016. This should support a sound and sustainable economic recovery on a
global level.
Budgetary surveillance in Europe also needs to be improved. It is essential that governance
and enforcement structures in the economic policy framework of the euro area be
strengthened. Reinforcing surveillance of national budgetary policies and ensuring rigorous
compliance with the fiscal rules will be key. Furthermore, it is extremely important that close
oversight of relative competitiveness developments be implemented and that a surveillance
mechanism be established to address imbalances in the euro area countries.
For the third challenge, undertaking a comprehensive reform of the financial sector and
of financial regulation with the aim of securing financial stability, the responsible
authorities need to build a safer financial system by enhancing their financial sector
surveillance, both at a micro-prudential and macro-prudential level. Financial institutions also
play a decisive role, as they have to improve their risk management practices. A key
challenge for policy-makers will be to design appropriate measures to enhance the stability of
the financial system without imposing restrictions that would unnecessarily hamper financial
innovation and reduce the efficiency of the system.
At the micro-prudential level, several initiatives are now under way to create more effective
supervisory regulation, taking into account the lessons learnt from the crisis. The proposals
of the Basel Committee - which are known as "Basel III" - aim to enhance capital and
liquidity regulation to improve loss absorption capacity, mitigate pro-cyclicality and increase
resilience to shocks. These measures - when phased in gradually as the economy
recovers - will contribute to long-term economic growth, not least by helping to prevent the
high costs of a crisis such as we are currently experiencing.
An effective macro-prudential framework aims to deliver a thorough analysis of systemic
risks, formulate appropriate policies to address such risks, identify, in a timely fashion, the
emergence and build-up of vulnerabilities, and decide on effective (pre-emptive) intervention.
In this respect, as you are all well aware, the individual results of the stress test exercise for
banks in the EU carried out by the Committee of European Banking Supervisors (CEBS) in
cooperation with the ECB are expected to be published later today. As previously
announced, appropriate action will have to be taken where needed. On the one hand, sound
balance sheets, effective risk management and transparent, robust business models are key
to strengthening banks' resilience to shocks and to ensuring adequate access to finance,
thereby laying the foundations for sustainable growth, job creation and financial stability. On
the other hand, stress tests contribute to the effectiveness of financial intermediation by
providing more information about the condition of financial institutions and of the financial
system as a whole. By combining transparency regarding the results of stress tests with
appropriate measures to deal with potential weaknesses, European authorities will send a
clear message to market participants about the resilience of the financial system. Of course, I
cannot say more about the details of the results until they are published later today.
Concluding remarks
To conclude, looking back, the ECB has been credible in delivering price stability even
throughout the recent crisis and in the current challenging period. The policy measures
implemented by the ECB were indispensable to support the functioning of the euro area's
banking sector. They have supported credit flows to the economy and thus dampened the
effects of the crisis to the extent possible. Even worse outcomes were prevented.
Looking ahead, we now need to learn lessons and focus on what is needed to ensure that
the recovery is sound and sustainable. Price stability is the central contribution that monetary
policy can make to economic growth, job creation, and financial stability.
Several challenges remain. While we have long understood the national costs of failure to
reform, now we know that knock-on effects can occur of neglecting fiscal sustainability and
there are financial stability implications if reforms are deferred for too long. Moreover, the
need to undertake product and labour market reforms to spur economic growth has grown
tremendously.
More generally, financial stability issues will be a major focus for policy-makers. Various
central banks have been given new tasks and responsibilities in this domain. For example,
the ECB will contribute to the European Systemic Risk Board (ESRB) which will conduct
macro-prudential oversight at the European level.
Ultimately, central banks cannot act alone, particularly in a monetary union. Actions are
required to address all issues and challenges, and to spur long-term economic growth. We
all have to work together. National governments, regulators and supervisors, as well as the
private sector and the financial industry have to proceed with the difficult, but vital, measures
required to ensure sustainable and sound economic growth and the stability of our financial
system.
Thank you for your attention.