Jürgen Stark: The economic crisis and the response of fiscal and
monetary policy
Speech by Mr Jürgen Stark, Member of the Executive Board of the European Central Bank,
at the Austrian Industrial Organisation, Linz, 8 June 2009.
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Introduction
Following the default of Lehman Brothers in mid-September last year, the turmoil in financial
markets which had started in August 2007 turned into a major financial crisis. Liquidity dried
up, and credit flows to the economy slowed down. Problems in the financial system quickly
spilled over to the real economy, and an adverse feedback loop between the real economy
and the financial sector emerged. This has led to the most severe and synchronised global
economic downturn for 80 years. The euro area has not been spared. Economic activity has
declined sharply, and inflation is at its lowest level since the launch of the euro.
Monetary and fiscal authorities across the globe have responded quickly and decisively to
these extraordinary developments. In particular, against the background of rapidly receding
inflationary pressures and risks, the Eurosystem has taken monetary policy and liquidity
management measures that were unprecedented in nature, scope and timing. Since October
last year we have reduced the interest rate on the main refinancing operations by 325 basis
points. We have also provided unlimited liquidity support to the banking system in the euro
area to maintain the flow of credit. Likewise, governments in the euro area have reacted
swiftly to stabilise the financial system and to counteract the adverse impact of the financial
crisis on the real economy.
Looking ahead, both monetary and fiscal authorities will need to remain credible and
effective, and to fulfil their respective responsibilities. In so doing, they will lay solid
foundations for future economic recovery and long-term economic growth and job creation.
The crisis has shown how important it is to have an independent central bank firmly
committed to the objective of price stability. At the same time, governments must make a
strong and credible commitment to a path of fiscal consolidation and thus comply with the
Stability and Growth Pact. But they must also resist the temptation to further increase the
size of the stimulus measures, as this could erode trust in the sustainability of public finances
and undermine the effectiveness of the measures already adopted.
In my presentation today, I would like first to analyse the economic outlook and then discuss
in more detail the policy measures taken in response to the crisis. I will then consider their
implications and the lessons to be drawn from the crisis for central banks and monetary
policy.
Economic outlook
a. Global economic situation
Let me begin with the assessment of the global economic situation. The turmoil in financial
markets, which was triggered by a systematic under-pricing of risk, particularly in the US
subprime mortgage market, has now developed into a fully-fledged financial and economic crisis
at global level.
While the world economy continues to face a severe and synchronised downturn, recent
international business confidence indicators suggest that the pace of the decline in economic
activity is slowing down somewhat. Most forecasters expect that the global economy is likely
to recover in 2010, albeit at a gradual pace. The June 2009 Eurosystem staff
macroeconomic projections for the euro area, which have just been published, are in line
with this overall assessment. They are based on the assumption that the global economy
outside the euro area will contract by 1.6% this year grow and by 2.1% in 2010.
Nonetheless, the economic prospects remain fraught with uncertainty. Compared with a few
months ago, overall risks to global economic growth have become more balanced. A
stronger positive confidence effect than expected triggered by the monetary and fiscal policy
measures could lead to a more sustained recovery in global demand and in global trade, and
a quicker normalisation of financial market and credit conditions. Of course, if global policy
actions fail to strike an appropriate balance between economic stimulus and longer-term
sustainability, financial market conditions could turn unfavourable again.
Global inflation rates have continued to diminish rapidly. This is mainly due to lower
commodity prices, weaker labour market conditions and greater global economic slack. Risks
to global inflation seem to be broadly balanced in the short to medium term. Beyond that
horizon, however, inflation risks depend on how efficiently the authorities withdraw the policy
stimulus.
b. Euro area activity
In line with global developments, economic activity in the euro area has also contracted
sharply since the second half of 2008. The euro area economy has shrunk by about 4% over
the past two quarters, the worst decline since the start of Economic and Monetary Union.
For the current quarter, there is evidence that the economy has shrunk further, though at a
slower pace. The economy is no longer in free fall; we are seeing the first signs of
stabilisation. Indicators of consumer confidence and business sentiment have continued to
improve somewhat. We are also seeing some encouraging signs of normalisation in financial
markets.
Looking ahead, the euro area economy is likely to be very weak for the remainder of this
year, before gradually recovering in the course of 2010. The Eurosystem staff projections for
real GDP growth are broadly in line with the most recent forecasts from the IMF and the
European Commission. Both institutions expect the euro area economy to contract by 4% or
more in 2009, followed by a gradual recovery in 2010. Quarterly growth rates are expected to
return to positive levels by mid-2010. The projected gradual recovery reflects the significant
macroeconomic stimulus under way and the measures taken to make the financial system
function normally both inside and outside the euro area.
c. Euro area price developments
Inflation in the euro area has declined rapidly since it reached its highest level, 4%, last
summer. In May, euro area HICP inflation was down to 0.0%, according to the preliminary
estimate from Eurostat. This is the lowest number registered since the launch of the euro.
The rapid decline over this period is primarily due to the marked fall in global commodity
prices, and particularly oil prices. If we exclude food and energy, however, HICP inflation
over the past year has moderated only marginally. In April, the most recent month for which
we have data, HICP inflation excluding food and energy was 1.8%.
Inflation rates are likely to enter negative territory during the summer, but we expect them to
turn positive by the end of 2009. This can largely be explained by base effects from energy
prices. These effects are of no concern to the ECB, which aims to maintain price stability in
the medium term. In other words, its monetary policy strategy aims to ensure that short-term
volatility in inflation rates does not lead to volatility in long-term inflation expectations.
It is important not to confuse the temporarily negative inflation rates we are likely to
experience this summer with outright deflation. Let me remind you of the difference: a
deflationary process is a persistent, broad-based and self-sustaining fall in the overall price
level. It is reinforced by the anticipation that prices will decline further in the future. As a
consequence, inflation expectations become disanchored and negative, and firms and
households may decide to postpone investments and major purchases.
In fact, what we are experiencing at the moment can be described as a period of rapid
disinflation. This is linked to transitory movements in relative prices and is in principle a
welcome development. Provided that medium-term inflation expectations remain well
anchored at levels consistent with price stability, low or negative inflation rates for a short
period of time may help to sustain real income and may therefore stimulate spending.
But even if we expect inflation rates to turn positive again by the end of this year, the weak
economic outlook for the euro area is expected to keep domestic price pressures contained
for some time. According to the Eurosystem staff macroeconomic projections, HICP inflation
in the euro area is likely to be very moderate, but above zero, on average this year. Inflation
is expected to pick up, but remain at a moderate level in 2010. Forecasts produced by the
European Commission and other international organisations paint a similar picture. The risks
to this outlook are viewed as broadly balanced. However, in the longer term, it is important
that the current policy stimulus is withdrawn in due course.
d. Monetary and financing conditions
Let me now turn to the monetary analysis, which is particularly useful for assessing risks to
price stability in the medium to long term. The latest money and credit data support the
assessment of diminishing inflationary pressures in the medium term. The deceleration of
broad money growth observed in 2008 increased towards the turn of the year and continues
at a rapid pace. Developments in money and credit aggregates have been volatile over the
past few months. This may be explained partly by the sharp reduction in the key ECB interest
rates, which may have encouraged shifts in the allocation of funds. If we disregard this
volatility, the continued deceleration in the pace of underlying monetary expansion and in
credit growth seems to reflect the sharp deterioration in economic activity.
As regards financing conditions in the euro area, external financing costs have been
declining since October last year, and particularly sharply since the start of this year.
Following policy interest rate cuts, bank lending rates have fallen significantly. This indicates
that the pass-through mechanism from policy rates to the real economy has continued to
function in recent months, even though there is evidence that banks' margins have widened.
With credit spreads across all rating classes decreasing from their record highs and with
stock prices rising, the overall cost of financing for euro area non-financial corporations is
diminishing. In general, the recent positive signs from financial markets point to a gradual
improvement in confidence among investors.
Policy measures
I will now turn to the policy measures taken in response to the current crisis. Both monetary
and fiscal policy-makers have reacted in a forceful and timely manner, aiming to restore
confidence. And indeed, as regards the Eurosystem's monetary policy and liquidity
management measures, it seems that our responses are bearing fruit. Confidence has
returned to financial markets, and business surveys are picking up. I expect global and
domestic demand to increasingly benefit from the significant economic stimulus and the
measures taken so far to bring the financial system back to normal functioning.
Monetary policy
The ECB has acted in a timely, decisive and appropriate manner since the start of the
financial market turmoil. We have cut our key policy rate by 325 basis points since last
October, when the escalating financial crisis led to a rapid decline of inflationary pressures.
The interest rate on the main refinancing operations now stands at 1.0%, its lowest level
since the launch of the euro. This level is appropriate taking into account all information and
analyses. Money market rates have fallen even further to record lows, and the loan interest
rates charged by banks have declined. Our substantive monetary policy easing is already
being felt in the real economy.
In addition to lowering the policy interest rate quickly and sharply, we have resorted to highly
non-standard liquidity operations in order to provide the financial system with the liquidity that
was so urgently needed. Last October, we adopted a "fixed-rate full allotment" procedure in
all our open market operations. This gives banks as much central bank liquidity as they want
at our key policy interest rate, against an expanded list of eligible collateral. Coupled with the
fact that essentially all financially sound euro area credit institutions can participate in the
Eurosystem's refinancing operations, these measures have significantly eased the banks'
balance sheet constraints, thereby avoiding a sudden stop in the supply of credit and the
emergence of a systemic crisis.
At the Governing Council meeting in early May, we decided to extend the maturity range of
these liquidity-providing operations from six to 12 months. Furthermore, we decided that the
Eurosystem will purchase euro-denominated covered bonds issued in the euro area. Last
week we announced the details of this purchase programme. These decisions were taken to
enhance credit support to the economy through banks. More specifically, all these measures
aim to promote the ongoing decline in money market term rates, to encourage banks to
maintain and expand their lending to clients, to improve market liquidity in important
segments of the private debt security market, and to ease funding conditions for banks and
enterprises. These measures take into account the central role played by the euro area
banking system in financing the economy. This contrasts with the financial structure of other
economic regions.
The above-mentioned measures led to a significant increase in the Eurosystem's balance
sheet: it reached a peak of 19% of GDP in December 2008 from 10% of GDP in mid-2007,
up by €850 billion. This increase in the size of the balance sheet corresponds to a higher
level of outstanding refinancing operations, and has consequently increased the amount of
risk borne by the Eurosystem. Since its peak in December, the size of the Eurosystem's
balance sheet has declined by around €300 billion to 15% of GDP in May 2009. This decline
suggests a gradual increase in money market activity, at least for very short maturities. The
fact that we have taken on additional risk is no coincidence. Whenever liquidity dries up
because market participants are reluctant to lend to each other, the central bank has to step
in, but at the same time not put its reputation at risk.
To summarise, we have employed a wide range of measures to counter the effect of the
financial and economic crisis. The approach we have followed has been tailored to the needs
of the euro area, where the banking system plays a more important role in financing than in
other major economies. These differences are important for the implementation and
transmission of monetary policy, and therefore the Eurosystem's reactions to the crisis
cannot be compared directly with those of other leading central banks.
Fiscal policy measures
Let me now turn to the fiscal policy reaction to the economic crisis. Fiscal authorities in the
euro area have demonstrated their willingness and capacity to act rapidly and in a
coordinated manner in exceptional circumstances. It is important to distinguish between
measures intended to support the banking sector and fiscal policy measures aimed at
stimulating demand.
Support for the banking sector
Government support for the banking sector was necessary; it has safeguarded the stability of
the financial system. The price of this success, however, is that governments have incurred
substantial fiscal costs and credit risks that are ultimately borne by taxpayers. Following the
adoption of a concerted European action plan on 12 October 2008, euro area governments
announced national measures to support the banking sector. These measures consist of
government guarantees for interbank lending, recapitalisation of financial institutions in
difficulty, increase the coverage of retail deposit insurance and asset relief schemes. Overall,
euro area governments committed about 23% of euro area GDP to financial sector support
measures.
For the euro area, the various support measures adopted so far are expected to have only a
small direct impact on government deficits, whereas the impact on debt is expected to be
about 3% of GDP. Finally, contingent liabilities related to the financial rescue measures are
expected to be about 8% of GDP, excluding government guarantees on retail deposits.
These figures, however, do not reflect the very different developments taking place across
euro area countries.
Between end-September and end-October 2008, concurrent to the announcement of the
broad-based bank rescue packages, an adverse shift in market sentiment towards sovereign
borrowers occurred. It became more expensive to insure against the default of euro area
countries, and this change of mood was reflected in significantly higher sovereign CDS
premia for euro area countries. This would suggest that the bank rescue packages brought
about an increase in public sector credit risk.
At the same time, long-term government bond yield spreads vis-à-vis Germany have
widened substantially for most euro area countries. These spreads mainly reflect perceptions
of differing liquidity and credit risk among countries. The fact that developments in
government bond yield spreads have mirrored higher sovereign CDS premia suggests that
concerns about fiscal sustainability have become an important factor, affecting investors'
perceptions. In particular, government bond yield spreads seem to be higher in those
Member States regarded as particularly vulnerable in the current environment. Among the
relevant factors are current fiscal imbalances, but also external imbalances, and they could
ultimately have repercussions on the general government budget. Past fiscal behaviour may
also play a role.
Rising long-term government bond yields may only have a gradual impact on government
borrowing costs, as changes in interest rates only affect the cost of newly issued debt and
debt at variable interest rates. However, they may signal both a reduced willingness on the
part of investors to provide long-term funding as well as difficulty in accessing capital market
funds. So far, most euro area countries have enjoyed relatively low interest rates on new
government debt issuance, despite facing considerably more difficult market conditions.
Looking ahead, as the economy recovers and competition for financing increases,
governments may face higher bond yields again.
Discretionary use of fiscal policy
In addition to providing financial support to the banking sector, euro area governments
reacted forcefully to counter the negative impact of the financial turmoil on the real economy.
Besides the operation of automatic stabilisers, which provide a significant cushion to the euro
area economy by way of lower tax revenues and higher spending on unemployment benefits,
the discretionary use of fiscal policy helped to mitigate the effects of the global economic
downturn. However, fiscal stimulus measures need to remain temporary and be combined
with measures that ensure fiscal sustainability over the medium run. This will preserve trust
in the sustainability of public finances and support both the recovery and long-term economic
growth.
For 2009 and 2010, the European Commission estimates the overall fiscal impulse to the
euro area economy, as measured by the change in the general government deficit, to be
about 4.6% of GDP, 60% of which is due to the automatic stabilisers.
While the recent coordinated fiscal loosening has been broadly accepted as a legitimate and
necessary step in the short run, given the exceptional economic circumstances, it also entails
a significant fiscal burden. The latest available economic forecasts (EC Spring 2009
Economic Forecasts) point to dramatic developments in euro area public finances. In
addition to a rapidly deteriorating general government deficit, which is expected to be above
6% of euro area GDP in 2010, the euro area debt ratio will increase by about 15 percentage
points to above 80% of GDP by 2010. In both 2009 and 2010 13 out of 16 euro area
countries are expected to have a budget deficit above the 3% of GDP reference value.
These figures are very high, though they compare favourably with other major economic
regions that have also provided a substantial fiscal impulse to their economy. The budget
deficit in both the United Kingdom and the United States is projected to be about 14% of
GDP in 2010, whereas in Japan it is projected to be about 9% of GDP.
Against this backdrop, euro area countries must reject calls for additional fiscal loosening. In
the current environment, any further fiscal stimulus is likely to be counterproductive as it
could hamper the economic recovery in two ways. First of all, even higher fiscal deficits could
fuel market concerns about a country's ability to meet its future debt obligations, thus putting
upward pressure on interest rates. Second, increasing budget deficits would also raise
concerns about a higher tax burden in the future, thus inducing consumers to save rather
than spend any additional income.
Let me now turn to two important questions regarding the fiscal authorities' response to the
economic crisis. First, do the measures have the potential to restore confidence? Second,
are those measures effective?
The financial sector support measures, combined with the Eurosystem's enhanced credit
support measures, were successful in safeguarding the stability of the financial system.
Together, these initiatives have the potential to tackle the crisis of confidence at its root also
by taking into account the fundamental role of the banking sector in the functioning of the
economy. The restructuring of the banking sector is the top policy priority, and progress in
this domain is the key to economic recovery. Given the challenges which lie ahead, banks
should take appropriate measures to strengthen their capital base and, where necessary,
take full advantage of government support and in particular recapitalisation measures.
As regards fiscal policy response, let me first say that the merits of discretionary measures
are less obvious than those safeguarding the functioning of the financial system. In principle,
automatic stabilisers should represent the first line of defence during an economic downturn.
However, under exceptional circumstances and if a country has room for manoeuvre, fiscal
policy can contribute to macroeconomic stability also through discretionary actions. When
assessing the merits of the different measures taken, we should differentiate between
measures such as (1) expenditure increases and (2) tax cuts, and (3) measures like
guarantees and loan subsidies to specific sectors of the economy. In fact, although support
for credit-constrained firms could ease their access to credit and the restructuring of their
balance sheets, it may also lead to an inefficient allocation of capital and the propping up of
companies that would otherwise fail. Moreover, this type of support would be difficult to
reverse and might act as a brake on long-term growth.
Turning to the effectiveness of fiscal measures to stimulate demand (i.e. spending increases
and tax cuts), it crucially depends on the behaviour of economic agents, and that in turn also
affects the size of the fiscal multipliers (i.e. the GDP effect of fiscal stimulus measures). The
expectation that higher government spending today may lead to higher taxation in the future
would induce both households and firms to save rather spend any additional income, thus
reducing the size of the fiscal multiplier. Therefore, the public perception of overall fiscal
sustainability plays an important role in the impact of the respective national fiscal stimuli.
The effectiveness of fiscal stimulus measures also depends on the extent to which private
investors respond positively to tax policy, with their investments likely to be more responsive
in the case of "temporary" tax breaks, as they provide an incentive to bring forward future
investment plans. At the same time, there is a risk that fiscal stimulus measures may crowd
out private investment by putting upward pressure on interest rates.
As regards the size of the fiscal multiplier, empirical studies (e.g. Perotti (2002), Blanchard
and Perotti (2002), IMF WEO (2008)) show that in the short term (i.e. after one quarter)
public spending multipliers are larger than tax multipliers. By contrast, in the long term,
revenue measures are associated with higher growth and faster recoveries. These results
reflect the theoretical Keynesian prediction that some of the higher disposable income from a
tax cut is saved, while government purchases of goods and services directly affect the
aggregate demand. However, the evidence on the relative effectiveness of the different
measures is mixed. For the euro area, the measures adopted by governments are estimated
to have a short-lived impact on real GDP growth, limited to the year in which they are
introduced.
Besides these factors, the effectiveness of any stimulus package will depend to a large
extent on its design and implementation. Fiscal stimulus measures should be "timely,
temporary and targeted". "Timely" means that the measures take effect when they are
needed; any delays in assessing the cyclical situation, in taking decisions and implementing
the measures may fail to prevent a drop in output. "Temporary" implies that the fiscal impulse
should only last as long as the recession in question. "Targeted" relates to the expected size
of the multiplier effect. In addition to these "TTT" criteria, the measures should be consistent
with other policy objectives such as fiscal sustainability, long-term economic growth and the
functioning of the market mechanism.
Implications of policy measures
The current crisis has increased the role of the government in the economy. Some bank
rescue operations have involved outright nationalisations, so governments now have
significant exposure to the financial sector. Similarly, the large fiscal stimuli packages
adopted by many countries have led to a large increase in the size of the public sector in the
economy.
At the same time, the turmoil is being interpreted by some as a crisis of the market economy.
It has encouraged critics of the market economy to speak out and demand a much larger role
in the economy for governments.
The financial system clearly needs a fundamental overhaul. Financial institutions have to
take a different approach and adopt appropriate incentives. Risk-takers should be liable and
not only reap the rewards of their actions but also bear responsibility for their consequences.
We need to strengthen the regulation of the financial system, and in particular, we must
improve the international cooperation between national supervisors of the financial sector.
But let me hasten to add that policy-makers must not get carried away by recent events; they
should act in a measured way, and not throw the baby out with the bathwater. While
governments have had no alternative but to support systemically relevant financial
institutions, they should, as a rule, keep their assistance to specific sectors or firms to a
minimum. And when they do intervene, they should prepare clear and credible exit
strategies. No matter how serious the current crisis is, the market economy remains the best
way to organise our economic affairs. It is only 20 years ago since the breakdown of the
socialist system in eastern Europe, which demonstrated the failures of central planning and
heavy government involvement. Therefore, once we emerge from the current crisis, the role
of government in the economy needs to be scaled back. Its presence in the banking sector
must be gradually reduced as the restructuring of the sector starts to take effect. The
stimulus measures must be reversed in due course. We have seen in the past how so-called
temporary measures ended up being permanent.
An exit strategy is a comprehensive programme to withdraw and neutralise measures taken
during the financial crisis, without causing any harm to the economy. If they have no
welldefined exit strategy, governments may get bogged down and the positive impact of the
measures taken may be undermined. A well thought-out exit strategy is needed to reassure
economic agents that a timely restoration of the level playing field in the different sectors of
the economy is the ultimate objective. As such, an exit strategy needs to contain clear criteria
about the timing of the withdrawal of the financial support and the reversal of the fiscal
stimuli.
In principle, the extra government debt incurred by asset acquisition should be covered by
future sales of these assets. The state guarantees should serve to stabilise the banking
system and would then not need to be called on.
As to the fiscal stimuli, euro area governments did not lay out clear exit strategies when they
announced the stimuli. Some of their measures do not expire automatically or are not
explicitly designed to be temporary. The possible difficulties of reversing the fiscal stimulus
packages may hinder the return to sound fiscal positions in the short run. Under these
circumstances, the peer pressure mechanism, on which the EU fiscal framework is based,
may be weakened thus making more difficult a return to sound fiscal policies. As a matter of
fact, countries with high fiscal deficits may be tempted not to put political pressure on their
peers. Protracted excessive deficits may undermine the credibility of the EU fiscal
framework, thus casting doubts on fiscal sustainability and jeopardising the Stability and
Growth Pact.
In this respect, let me say that the current crisis has taught us an important lesson about the
importance of preserving the public's trust in the soundness of public finances. At the current
juncture, euro area governments must make credible commitments to return to sound fiscal
policies. Doing so in full compliance with the Stability and Growth Pact is the most credible
exit strategy. This requires, first, a full reversal of the fiscal stimulus measures taken so far.
This is necessary to ensure an efficient allocation of resources by minimising distortions in
the incentives of economic agents and by avoiding a permanent increase in the size of the
public sector. Second, governments must live up to their commitment to maintain fiscal
discipline. This means that credible fiscal consolidation plans have to be implemented as
early as possible, including a consolidation effort of at least 1% of GDP per annum where
necessary. If euro area countries do not practise fiscal restraint seriously, the debt dynamics
will be in danger of spiralling out of control.
The current crisis has shown how important it is for countries to consolidate during good
economic times and to build a "fiscal reservoir" from which they can draw in periods of
"drought". Many euro area countries failed to do so. They suddenly found themselves in this
turbulent environment burdened by high fiscal deficits and debt ratios. Their room for fiscal
manoeuvre was very limited, as was their capacity to adopt effective counter-cyclical
measures when they were most needed. In addition, the developments in government bond
yield spreads since last autumn have shown that, in uncertain times, financial markets
increasingly discriminate between countries on the basis of their creditworthiness, including
fiscal fundamentals.
We are seeing the first, timid signs of an economic recovery; investors are regaining their
appetite for risk. It is critical that euro area governments boost confidence in the soundness
of public finances as an element to support both the recovery and long-term economic
growth.
As regards monetary policy, it is equally important to draw up a strategy for withdrawing in
due course the extraordinary measures that have been implemented or announced. The
ECB obviously cannot maintain the current degree of support indefinitely. We are providing
substantial short-term support to the financial system and the real economy, and thereby
ultimately maintaining price stability. But what if macroeconomic conditions warrant a
removal of monetary stimulus?
In fact, we are prepared to take appropriate actions once the macroeconomic environment
improves. We will ensure that the measures taken can be quickly unwound and the liquidity
provided absorbed. This includes, for instance, unwinding the increase in the average
maturity of our refinancing operations. Being prepared to exit from our non-standard
measures - as soon as the macroeconomic conditions justify such a move - helps to
maintain price stability over the medium term and to ensure a firm anchoring of longer-term
inflation expectations.
Any changes in the operational framework will of course be communicated in good time. The
E