Peter Praet: Adjustment and growth in the euro area
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the European Business Summit, Brussels, 16 May 2013.
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I would like to thank José Marín Arcas for his contribution to the preparation of this speech.
Introduction
Thank you very much for inviting me to speak at this conference of the European Business
Summit.
The theme of my address today is "Adjustment and Growth in the Euro Area". This is a title
that, to some, may sound contradictory. Many of you will have come across commentators
who claim that adjustment is in fact inimical to growth; and that consolidating government
budgets while introducing structural reforms is the main cause of our current difficulties.
Yet, in my view, this is a short-sighted assessment. While it is clear that fiscal consolidation
has affected economic activity in the euro area in the short-term, it does not follow from this
that adjustment and growth are incompatible. Restoring the sustainability of public finances
and implementing well-designed structural reforms are key to restoring confidence.
Measures that are now being undertaken help to lay the foundations for future growth and
bring back a climate of confidence already in the short-term.
First, by prioritising fiscal consolidation, euro area countries can anchor medium-term
expectations about public debt sustainability, which is essential to support confidence among
investors and taxpayers. As many euro area countries already have high public debt levels,
and some have seen their market access threatened, credible fiscal consolidation ensures
that debt can be refinanced at affordable rates in the future, and fiscal crises avoided.
Moreover, if consolidation is focused to the greatest extent possible on unproductive
expenditure items rather than those, like investment, that are conducive to long-term growth,
the negative effects on growth can be contained.
Second, by implementing structural reforms, euro area countries should raise their future
growth potential. Research has shown that a comprehensive package of product and labour
market reforms could significantly increase euro area output - by more than 4.5% over
5 years, according to a recent IMF study. This improved outlook, when incorporated into
medium-term expectations, should encourage forward-looking firms to increase investment,
and could hence lead to higher growth also in the short-term. Such reforms should be
undertaken with due protection of the most vulnerable members of society.
The key point is that for adjustment and growth to be mutually supportive, the commitment to
reform has to be credible. Investors, firms and households have to be convinced beyond
doubt that governments will stay the course. If they fear policy commitments may be delayed
or reversed in the future, they will neither be sufficiently confident in the sustainability of
public finances nor in future growth potential to alter their behaviour today. "Wait-and-see"
will remain the rational response and short-term growth will lag behind potential.
In other words, proposing to reverse course on fiscal and structural reforms does not support
growth. In fact, it only weakens credibility and hence undermines the hard work that has
already been done to put the euro area on a surer footing.
For the remainder of my remarks, I would like to first review the ongoing process of
adjustment across the euro area and what has been done by national authorities, and the
ECB acting within its price stability mandate, to facilitate that process. Thereafter, I will put
forward some suggestions for what remains to be done by euro area governments to ensure
a return to growth as speedily as possible.
1. Restoring growth and employment in the euro area
Let me begin by reviewing the economic situation.
Euro area real GDP still remains about three percentage points below its pre-crisis peak,
although this aggregate figure hides some divergence. For the group of countries which are
still under some financial stress (Greece, Spain, Ireland, Italy, Portugal, Cyprus and
Slovenia), real GDP remains near the trough of the crisis reached in 2009. Other euro area
countries, however, had by 2011 already recovered the previous maximum level of real GDP.
The same is true of labour markets. The employment rate in the euro area as a whole is still
more than two percentage points below its peak, according to OECD figures. However,
Germany has increased its employment rate by more than three percentage points (to
73.1%) while, at the other extreme, Greece has seen its employment rate dropping by more
than ten percentage points (to 50.1%). Youth unemployment rates in a number of stressed
countries also remain unacceptably high.
Looking forward, we expect the euro area economy to resume growth at a modest pace later
in 2013, although it will take more time for this to feed through into higher employment.
Why is growth not rebounding more quickly and evenly across the euro area?
A key explanation is that the adjustment process has been hindered by adverse feedback
loops resulting from the interaction of accumulated fiscal and macroeconomic imbalances,
weak bank balance sheets and the lack of a genuinely European approach to bank resolution
and recapitalisation. To give just one example of such interactions, large fiscal imbalances in
a Member State can lead financial markets to drive up yields on its sovereign debt. This in
turn creates higher funding costs for its domestic banks and reduces their profitability,
thereby hampering credit growth to the real economy. Lower credit growth then contributes to
lower nominal GDP, which not only further weakens banks' balance sheets by increasing
non-performing loans, but also increases concerns about the sustainability of sovereign debt
through the denominator effect; and thus, the feedback loop restarts again. Without a
European approach to banking sector repair, if the sovereign intervenes to break the
feedback loop by recapitalising or resolving banks, it may only heighten market concerns
about its debt sustainability and aggravate the situation.
a. Actions by governments
Addressing such adverse feedback loops between government finances, credit and growth
implies a triple policy response from governments: First, fiscal consolidation and current
account rebalancing to secure public debt sustainability and lower external financing needs.
Second, structural reforms to increase potential growth and offset the potential negative
effects of fiscal consolidation. Third, comprehensive banking sector repair to acknowledge
impaired assets and strengthen bank balance sheets. Fortunately, in all three areas the euro
area is heading in the right direction.
First, fiscal and macroeconomic imbalances have improved significantly: fiscal deficits have
declined from their 2009 peaks throughout the euro area based on sizeable consolidation
efforts and despite strong economic headwinds, while there has been a pronounced
reduction of current account deficits. However, these sizeable flow adjustments have not yet
fully translated into improvements in the accumulated stock of imbalances - public debt
ratios on the fiscal side, net international investment positions on the macroeconomic side -
because of depressed nominal GDP growth.
Most EU countries made significant progress towards further reducing budgetary imbalances
in 2012, in an environment of weaker than expected output growth. The euro area
government deficit has decreased to 3.7% of GDP (3.1% of GDP excluding one-off
government support for financial institutions). In 2013, the Commission expects the euro area
deficit to reach 2.9% of GDP - i.e. below the Maastricht reference value. This level would be
less than half the peak reached in 2009 (6.4% of GDP), and it puts the euro area as a whole
on track to comply with the commitment made by G-20 leaders in Toronto in 2010 to halve
fiscal deficits by 2013. It has to be stressed that correcting for the effects of the weak cycle
the fiscal adjustment has been even larger than suggested by these figures.
Progress with fiscal consolidation has been particularly strong in countries subject to an
economic adjustment programme. The primary structural deficit (cyclically-adjusted deficit
net of interest payments and net of one-off factors and temporary measures) as a ratio of
GDP over the period 2009-2012 has fallen by around 14 percentage points in Greece,
6 percentage points in Portugal and 4 percentage points in Ireland. The true adjustment
effort is likely to have been even larger than these numbers suggest due to significant
revenue shortfalls in a context of rebalancing from (tax-rich) domestic demand towards
(taxpoor) exports. This rebalancing has also been associated with significant improvements in
current account positions. Current account deficits fell on average by 10 percentage points of
GDP in Greece, Ireland and Portugal from 2008-2012, and by 8 percentage points of GDP in
Spain over the same period.
Second, the euro area witnessed a renewed momentum to implement structural
reforms. It
has been well-understood by euro area countries that restoring fiscal sustainability must rest
not only on fiscal adjustment to achieve sizeable primary surpluses, but also on measures to
revive growth to avoid adverse snowball effects undoing the debt-stabilising impact of
primary surpluses. This requires structural reforms that improve labour market and product
market functioning and hence increase potential growth. There are numerous studies, for
instance by the OECD and the IMF, showing the significant benefits in terms of employment
and growth that could accrue to the euro area from such measures - and not only in the
medium-term. A credible commitment by euro area governments to implement structural
reforms could already create a permanent upward shift in expectations of future growth,
improve labour market performance, and as a welcome side-effect, improve the health of
public finances over the medium-term. And to a certain extent, this is what we are seeing in
the euro area today.
As regards labour market reforms, several euro area countries have moved towards a
negotiating framework for wages and working conditions based more on firm-level
agreements. This should enhance competitiveness by promoting a closer link between
wages and productivity and, at the same time, allow firms to rapidly adjust their internal
organisation of labour and production in response to changing economic conditions. In
addition, labour market functioning has been strengthened by addressing distortions related
to the "two-tier" systems that characterise a number of euro area economies - in particular
Spain and Italy. These measures should support social fairness by bringing to an end the
situation where vulnerable temporary workers, mainly young people, de facto bear the full
burden of the adjustment. Moreover, they should increase potential growth by improving the
employment conditions of young workers and their relatively lower opportunities for
on-thejob training, which significantly hampers human capital formation; and by reducing inefficient
labour turnover, since firms would be less reluctant to transform temporary jobs into
permanent ones.
At the same time, to reduce unemployment traps and create incentives for job-seeking,
welfare systems are being reformed so as to shift from a system providing security "on the
job" to one providing income support "in the market", while setting up strict eligibility criteria
and a system of active labour market policies. Together with these labour market measures,
reform efforts have focused on increasing competition in a number of sectors, including retail
and wholesale, transport, energy, and professional services; reducing the administrative
requirements to set up or expand businesses; and improving the efficiency of civil justice and
public administration.
Third, euro area countries have taken a series of measures to address balance sheet
weaknesses in the banking sector. Capital requirements are in the process of being
strengthened following the conclusion of the Capital Requirements IV Directive, which
transposes the Basel III agreement into EU law. At the same time, a number of banks raised
new capital to address balance sheet weaknesses. The greatest progress in financial sector
repair has of course taken place in the countries under EU-IMF programmes, where there
has been a comprehensive restructuring and recapitalisation of the domestic banking
sectors. Spain has also taken decisive measures to address the imbalances of the past via
its ESM indirect bank recapitalisation programme.
b. Actions by the ECB
What is the role of the ECB in this process?
While the ECB has consistently played its part and maintained price stability in the euro area,
it is important to keep in mind that the role that the central bank can play in terms of crisis
resolution is limited. The ECB's monetary policy can only play a crisis mitigation role. Hence,
our monetary policy approach has focused on providing liquidity support, intended to relieve
banks of liquidity and funding stress by giving them unlimited access to central bank money
at a fixed price against adequate collateral. To facilitate this support, we expanded the set of
eligible assets that can be used as collateral and extended the maturity of our lending. It is
widely recognised that these measures have been effective in averting a disorderly spiral of
deleveraging in the banking system, which would have taken place in an environment of
severe liquidity constraints and fire sales. This was necessary in order to avoid deflationary
downward pressures that would have prevented us from delivering on our mandate of
preserving price stability in the euro area.
However, to mitigate the crisis we have also had to go beyond liquidity support, in particular
to counter financial fragmentation in the euro area - created by the adverse feedback loops I
described above - that was disrupting the transmission of monetary policy across the euro
area. Diverging credit conditions by countries, by sectors and by size of companies have
prevented the ECB's very accommodative monetary policy stance from being passed on
evenly in the financing conditions faced by euro area firms and households. As the euro area
economy relies heavily on bank credit, this has serious implications for growth and ultimately
for our ability to maintain price stability.
In particular, in the first half of last year we perceived a situation last year where severe
upward pressure on sovereign yields was being driven by unfounded fears about the future
of the euro area. These fears were causing investors to charge risk premia to lend to some
Member States that could not be justified by economic fundamentals. We therefore decided
to open the possibility of undertaking Outright Monetary Transactions (OMTs), entailing ex
ante unlimited interventions in short- to medium-term securities issued by governments
which have submitted to strict and effective conditionality, in order to eliminate the pricing of
un-warranted tail risks in the bond markets. This has played an important role in reducing
financial market fragmentation, as financial markets understood OMTs as a credible
backstop for countering redenomination risk.
2. What remains to be done
These measures by the ECB, however, can only buy time; they cannot substitute for the
responsibilities of national governments to address the unsound fiscal, economic and
financial policies that are the root causes of the crisis. And while a great deal has already
been done by euro area authorities to address these root causes, there are three areas in
which more progress still needs to be made.
First, the euro area needs to continue to deepen structural reforms aimed at enhancing
competition, flexibility, efficiency, and productivity. The reform process takes time, and so a
medium-term, comprehensive approach is crucial to anchor expectations and maximise the
positive effects of adjustment in the short-term. The greatest challenge today is to maintain
reform momentum and implement fully those changes which have already been announced
or even enacted into law. Concretely, this means, for the labour markets, addressing the
remaining insider-outsider dualities and enhancing labour mobility, including across borders.
For product markets, the key challenge is to open up regulated professions and network
industries that are sheltered from competition by government regulations. This requires a
simplification and streamlining of regulations, a reduction of barriers to entry and limits to
competition, a resolute deepening of the Single Market in Europe. Going forward, structural
reforms also need to go into the government sector itself. In several euro area countries,
modernisation of public administration is essential to increase efficiency in the provision of
public goods, like infrastructure, and essential services, like civil justice. This will also support
fiscal consolidation, by reducing the size of the government sector.
Second, the euro area needs to persevere in fiscal consolidation efforts and reduce steadily
the government debt ratio. Despite the important progress on fiscal consolidation, debt ratios
have yet failed to stabilise in most euro area countries, as improvements in primary balances
were outweighed by the debt-rising impact of unfavourable developments in interest-growth
differentials and deficit-debt adjustments. The euro area government debt ratio is projected
to rise further to above 95% of GDP in 2013 - far above the 60% Maastricht reference value
- with debt ratios displaying large differences across countries. Further adjustment is thus
inevitable, and unfortunately it must take place in an environment of rising consolidation
fatigue. Five years into the crisis this rise in consolidation fatigue is understandable. Going
forward, it will be important for policymakers to communicate effectively both on the need for
further adjustment and how this adjustment will be distributed in an equitable way across
different groups of the population.
In this context, it is necessary to review consolidation strategies that have relied
predominantly on tax rate increases, exacerbating the burden on already compliant
taxpayers, without much broadening of the tax bases. Such an approach has had substantial
negative effects on disposable income and demand, at the same time raising resistance and
negative reactions in the electorate, based on inter-temporal uncertainty and fairness
considerations. Due protection of the most vulnerable is needed here. On the expenditure
side, adjustment has relied disproportionally on cuts in government investment, thereby
weakening the prospects for long-term growth. Going forward, there is a need to focus
adjustment on unproductive expenditure while as far as possible safeguarding government
expenditure that is conducive to long-term growth.
Third, the euro area needs to press ahead with constructing a genuine Banking Union. A first
and important step has been made with the decision to create the Single Supervisory
Mechanism (SSM), the responsibility for which was assigned to the ECB. Political agreement
by the ECOFIN Council and the European Parliament was reached on a legislative package
in March, and technical agreement is expected very soon, so that national parliamentary
proceedings can start, which should be concluded by the summer. The existence of the
SSM, by reducing regulatory capture and increasing supervisory consistency and coherence,
should play an important role in increasing confidence in the overall euro area banking
system, and as a result, reduce fragmentation of interbank and other financial markets.
However, for the Banking Union to be fully effective, a Single Resolution Mechanism (SRM)
to accompany the SSM is essential. This is the case for a number of reasons. First, an SRM
would allow for the euro area to complete the process of banking sector repair without
aggravating market concerns over public debt sustainability, which would help break the
adverse feedback loop I described above and restore the functioning of the credit channel.
Second, this confidence in EU level resolution capacity would ensure that the SSM can be a
credible supervisor, as it would be able to push non-viable banks towards winding down
without endangering financial stability. Third, an SRM would facilitate speedy and effective
resolution of large and complex cross-border banks, removing the need for drawn-out and
inefficient cooperation between multiple national authorities.
To generate these benefits, in our view the SRM must be built around a Single Resolution
Authority and a European Resolution Fund.
Let me now conclude.
The ongoing process of adjustment in the euro area, if persevered with, will create a path out
of the crisis. There is no doubt that this path is a challenging one, as it depends on
deeprooted reforms to the structure of the euro area's economies, and these require courage to
implement and a willingness to confront vested interests. But it is critical that governments
stay the course, as this will allow the confidence effects of a brighter outlook to start being
felt already in the short-term.
For its part, the ECB will continue to fulfil its mandate to maintain price stability, and to use its
standard and non-standard measures to support the flow of credit to the real economy. But
one must also recognise the limits to what we as the central bank can achieve. We cannot
remove barriers to bank lending that stem from insufficient capital or lack of bank repair:
these can only be addressed by governments. This is why establishing a Banking Union with
a strong Single Resolution Mechanism is a priority. I am glad that the elements of a Banking
Union are beginning to fall into place. A swift implementation of the remaining elements is
needed.
Significant progress has been made on fiscal consolidation and structural reform. Looking
ahead, credibility is crucial. Therefore, I welcome the stronger rules for fiscal and
macroeconomic policies like the Fiscal Compact.
All these ongoing important adjustment efforts in the euro area should restore confidence in
the short-term and lead steadily back to sustainable growth.
Thank you for your attention.