Andreas Dombret: Quo vadis euro area? Challenges facing monetary
union
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, to the CDU Economic Council, Berlin, 20 October 2011.
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1 Introduction
Ladies and gentlemen,
Thank you very much for your invitation - I am delighted to be able to speak to you today.
For more than four years now, we have been plagued by a crisis that has changed its
appearance on a number of occasions. It spread from the US property market to the global
financial system, from there to the real economy, leading finally to a sovereign debt crisis in
several euro area countries. A sovereign debt crisis - let me emphasise this explicitly - that
is a severe test for monetary union, but is not a crisis of the euro. The euro is a stable
currency, both internally and externally.
Politicians are at pains to resolve the crisis, yet a consistent approach has been lacking to
date. Meanwhile, we are losing valuable time and, given the rapidly rising levels of sovereign
debt, politicians' scope for action is steadily shrinking. At the same time, uncertainty is
growing on the markets around the globe and the confidence of the general public is at risk
of becoming lost. This makes it all the more important to find a consistent approach to
resolving the crisis in order to restore calm to the markets and to maintain the public's
confidence in the single currency. In looking for such a solution approach, one that will
stabilise monetary union also in the long term, it is worth taking a brief look at the root causes
of the current crisis.
2 The causes of the sovereign debt crisis - a brief overview
It is generally known that there were unsound economic developments in a number of euro
area member countries. Above all, these included excessive lending, asset price bubbles
and a loss of competitiveness. These structural shortcomings were the breeding ground for
the sovereign debt crisis.
However, two fundamental problems are directly responsible for the sovereign debt crisis.
First, the institutional framework of monetary union was obviously too weak to prevent
excessive fiscal deficits. The Stability and Growth Pact lays down rules that are intended to
restrict government deficits and sovereign debt. The political will to enforce these rules was
lacking, however. Instead, they were circumvented and, in some cases, even actively bent.
Sovereign debt in the euro area could not be contained as a result.
Second, there were weaknesses in the financial system. This applies, on the one hand, to
investors' risk awareness. For example, before the crisis, they demanded very low risk
premiums from the euro area countries across the board. Their risk awareness did not
increase until the problems in Greece became apparent. On the other hand, this also applies
to the possible spread of the sovereign debt crisis via vulnerable banking systems. It was this
very problem of contagion that made rescue measures necessary in the first place. Up until
now, aid to Greece has always been justified by the objective of ensuring financial stability
throughout the euro area. The bottom line is that public finances also benefit from stable
financial systems, because they produce fewer crises that might necessitate government
rescue measures.
Thus, in order to get the sovereign debt crisis under control and create a stable monetary
union, the financial system needs to be strengthened and the institutional framework of
European Monetary Union improved.
3 A stable financial system for a stable monetary union
Of course, strengthening the financial system is an important task, irrespective of the
sovereign debt crisis. Since the financial and economic crisis at the latest, creating a stable
and resilient financial system is a matter of global concern. In fact, a number of
improvements have already been made in this context. Basel III has been approved,
entailing extensive new rules for banks. The new capital and liquidity requirements in
particular will make the banking system more stable. What is important now is to implement
these new rules at global and at European level.
Yet even though much has already been achieved with Basel III, a great deal remains to be
done. Problem areas at the moment include special rules for systemically important banks
and the treatment of previously unregulated segments of the financial system, namely the
shadow banking system. Suggestions have been made in the meantime, which will be
discussed at the forthcoming G20 summit at the beginning of November. My impression of
the meeting of the G20 in Paris last weekend is: on the whole, we are on the right path.
And we should not use up our energy on projects that might divert us from that path. In my
opinion, one such project is the financial transaction tax; for in terms of financial stability, the
benefit of such a tax is less clear-cut than assumed, whilst the debate often fails to take the
costs and side-effects into consideration. It is quite possible that a financial transaction tax
may heighten rather than reduce the volatility of the markets. Moreover, two factors cast
doubt on the effectiveness of a financial transaction tax. First, profit expectations and the risk
of loss are so high in times of crisis that not even a tax is likely to curb speculative
transactions very much. Second, such a tax would only really be effective if it were
introduced worldwide. We certainly cannot expect that to happen. Even if such a tax were
introduced at EU level, which is more than unlikely, competition with countries outside the EU
would be distorted as a result. The ensuing costs would then be borne not by the financial
sector but by the real economy.
4 Two paths to a stable monetary union
A stable financial system, then, is a cornerstone of a stable monetary union. Yet to get to the
heart of the problems, European Monetary Union itself needs to be reformed. Essentially,
there are two paths to a stable monetary union: the first is by strengthening the institutional
framework currently in place - a strengthening that must go well beyond what has been
achieved to date; the second path lies in centralising fiscal policy - in other words: fiscal
union.
4.1 Strengthening the existing institutional framework
With regard to the first path, I do not share the frequently expressed fear that the present
framework is unsuitable for a monetary union. Nevertheless, there is, of course, considerable
need for adjustment. This is true of three points in particular.
 First, the no bail-out principle has to be expressly reaffirmed. Investors in the
financial markets will sanction misguided fiscal policy in a timely fashion only if they
stand to lose money if they do not. Of course, this presupposes that the regulation of
the financial markets offers incentives for risk-conscious behaviour.
 Second, the Stability and Growth Pact must be given "teeth". There needs to be a
much greater automatism in the Stability and Growth Pact for imposing sanctions
when the deficit and debt limits are breached. Yet this is precisely what is missing
from the latest resolutions aimed at reforming the Pact. The automatism does not
yet go far enough in my view - there are still too many exceptions and too much
scope for political interference. To paraphrase Otmar Issing, sinners are still passing
judgment on other sinners. In principle, the Pact has been given "more bite", but it
remains questionable whether politicians will let it off the leash when push comes to
shove.
 Third, monetary union needs a permanent crisis mechanism, which could be
brought into play in the event of a crisis that threatens financial stability throughout
the euro area. However, three points are crucial in this context. Financial assistance
for individual countries must be tied to strict economic and fiscal policy conditions;
assistance must be made subject to appropriate interest rate premiums; and private
creditors must be involved should the country in question default. Above all, a crisis
mechanism must not be used to brush aside important principles under the
smokescreen of safeguarding financial stability. These principles include
subsidiarity, individual countries' responsibility for their own fiscal policy and the no
bail-out principle I have just mentioned.
Against this backdrop, a critical view has to be taken of at least some elements of the
decisions taken recently by the euro area's heads of state or government. Allow me to
mention three problems.
 The first problematic aspect is that conditions for granting emergency loans were
loosened. In the meantime, they are more favourable than those borne by some of
the countries providing assistance when they tap the capital market. But the less a
country has to pay for assistance, the smaller, of course, is its incentive to
consolidate its public finances and return to the capital markets. Adopting these
conditions also for future aid programmes or even for the permanent crisis
mechanism would perpetuate the problem. This cannot be our objective.
 A second problem is that government bonds may be purchased on the secondary
market through the crisis mechanism in future. If bonds of countries without an
assistance programme are purchased, it is unclear how consolidation and reform
conditions can be enforced. Nor is it clear how this squares with the requirement
that assistance can only be granted if the stability of the entire euro area is under
threat. Ultimately, therefore, the possibility of secondary market purchases
undermines the incentives to pursue a sound budgetary policy. Moreover, one point
is often overlooked: secondary market purchases are a very crude and, indeed, a
rather ineffective instrument for stabilising the financial markets and influencing
countries' funding conditions. Thus, much larger amounts will be needed to achieve
a particular result. This increases the risk for the taxpayers of the countries providing
assistance.
 A third problem is the topic currently under discussion, that of leveraging the crisis
mechanism - which is to say, first of all, a leveraging of the EFSF. Proposals of this
kind are closely linked to the topic of secondary market purchases; for, since its
recently approved extension, the EFSF has sufficient funds for the classical
instruments of the rescue shield - direct emergency loans to individual member
states. However, all the parties concerned ought to realise one thing. Leverage
constructions increase the risk for the taxpayer - the relationship between leverage
and risk is one of the first lessons from the financial crisis. What in any case must be
rejected is a leveraging by granting the EFSF a banking licence, which would allow
the EFSF to engage in Eurosystem refinancing operations - in other words, to
borrow directly from central banks. For then, the Eurosystem would largely be
unable to shape monetary policy autonomously. Indeed, the EFSF would be able to
generate a virtually unlimited flow of funds to the capital markets and shift risks
around between member states by purchasing large quantities of sovereign bonds.
With that, the ban on monetary state financing set forth in the EU treaties would be
well and truly violated.
Overall, the question that presents itself is: how is a sanction mechanism - no matter how
severe - in the Stability and Growth Pact supposed to prevent unsound fiscal policy if threats
of sanctions are made, yet favourable conditions are lavished on a country that continuously
disregards the rules?
This is a question of fundamental importance to monetary union. Whether the answer proves
convincing will depend on what appear to be purely technical aspects of the solution, since
they can have unexpected implications. One example concerns the choice of a triple-A rating
for the bonds with which the EFSF rescue fund borrows money on the capital market for the
assistance programmes. This top rating ought to remain intact as long as the borrowing by
the EFSF does not exceed the guarantee amount of the liable countries that are triple-A
rated. Thus, the effective lending volume currently amounts to €440 billion. In connection
with the call for additional funds for the EFSF, insistence on this top rating for EFSF bonds
leads, however, to the problematic leverage proposals I mentioned earlier. On the other
hand, abandoning the triple-A rating would also enable the EFSF to lift its lending volume.
With regard to the EFSF in its present form, it was reported that the lending volume of
around €250 billion could have been increased by just over half if an AA rating had been
accepted instead of triple A. In contrast to a leveraging, however, the risk borne by the
taxpayer would be lower if the top rating were dispensed with. If the EFSF bonds had a
somewhat lower rating, the effect would be to raise the EFSF's funding costs somewhat.
However, these costs would be borne by the countries receiving assistance. This would
solve, at least in part, the problem entailed in loosening the conditions for emergency loans
and raise the incentive for countries to return to the capital market under their own steam.
To sum up: in my view, strengthening the existing regulatory framework is a feasible path
towards stabilising monetary union. However, that will work only if the rules are designed in
such a way that they do not leave the door wide open for misguided incentives. This applies
in particular to the crisis mechanism - both at the conceptual level and in terms of the
technical implementation. All too often, the devil is in the detail, and we cannot afford to
make any mistakes there.
4.2 Creating a fiscal union
The alternative, second path towards a stable monetary union is by way of a fiscal union.
This would not automatically lead to a completely centralised fiscal policy. But it would be
important to set, at EU level, strict deficit and debt limits for national budgets. These limits
would then apply at all national levels. In Germany, this means central, state and local
government and the social security systems. The European rules would have to be combined
with appropriate powers of intervention, as only then can the rules be effectively
implemented. If the national levels breach the stipulated deficit and borrowing limits, they
would have to forfeit their fiscal sovereignty. The final decision-making powers over budgets
would then no longer rest with the national parliaments but would be transferred to the
European level.
Ultimately, fiscal union would constitute a consistent framework for the single currency,
although to implement it would necessitate extensive changes to the European treaties and
national constitutions. As you can imagine, this route would be a long one, and there is no
telling whether the people of the euro area would support it.
And to make one point quite clear: a fiscal union of this kind could, in principle, work without
joint liability. Although joint liability could be introduced without much difficulty, it does not
have to be. On no account - this is my firm belief - should joint liability be introduced at this
point in time in mere anticipation of fiscal union. This would be taking the second step before
the first, and inevitably entail the risk of stumbling. Instead of offering a consistent solution,
this would mean pursuing a middle path on which liability would be increasingly
communitised while fiscal policy remains a national responsibility. That path entails obvious
contradictions; for this reason, the Deutsche Bundesbank recommends we shun such an
approach.
5 Conclusion
Ladies and gentlemen, we find ourselves in a situation in which difficult and, perhaps,
uncomfortable decisions are unavoidable. This situation is aggravated by uncertainty in the
markets and among the general public. This uncertainty has to be eliminated if we want to
break free of the present crisis. Yet this uncertainty cannot be eliminated by repeatedly
topping up the rescue fund. Instead, what we need are decisions which address the root
causes of the crisis. Besides a swift and ambitious fiscal consolidation, I would highlight three
main points.
 We need clarity regarding Greece's future. Greece must fulfil the conditions of the
aid programme; if it does not, there is no basis for granting further support. A Greek
default - which most certainly no-one wishes to see - cannot therefore be
categorically ruled out.
 We need clarity regarding the banking sector's resilience. It has to be strengthened
where it is too low in order to prevent contagion effects. This explicitly includes
recapitalisations. This is justified even though the banks are not to blame for the
high level of sovereign debt in several European peripheral countries.
 And we need clarity regarding the future of the monetary union. I have outlined two
different paths in my address. Which of the two paths is chosen is in the hands of
our politicians. It is now up to them to decide quickly. We therefore expect clear and
landmark decisions by the European Council this coming Sunday.