Peter Praet: The crisis response in the euro area
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the afternoon session "The challenges ahead" at Pioneer Investments' Colloquia Series
"Redrawing the map: new risk, new reward", organised by Unicredit S.p.A., Beijing,
17 April 2013.
* * *
I would like to thank P. Hess, L. Stracca, R. Beck, A. Mehl and R. Straub for their contribution.
A pdf of clearly detailed accompanying slides to this speech can be found on the European Central Bank website.
Ladies and Gentlemen,
It is a great honour and pleasure for me to speak to this esteemed audience at this esteemed
place.
Introduction
Today, I will provide you with a central banker's view on the role of monetary policy in
overcoming the current crisis in the euro area, but I will also touch on other, equally essential
elements of policy-making in the euro area. I will structure my observations around four
points:
•
First, the factors that have led to the crisis and in particular how the euro area
became engulfed first in the global financial crisis and then in the sovereign debt
crisis;
•
Second, the crisis response in the euro area, including both monetary policy as well
as other policies;
•
Third, the key lessons we have learned from the global financial crisis in the euro
area and in particular the institutional weaknesses that were uncovered during the
crisis;
•
Finally, I will touch on institutional reforms at the level of the euro area and the
European Union at large, which have also contributed, in my view, to an
improvement of the foundation of our monetary union which is, we hope at least, the
harbinger for a better performance in future. Work in this area is still in progress, and
for that reason I will then conclude by sketching the challenges that still lie ahead of
us.
1. The factors leading to the crisis
As I have argued on previous occasions, it might be useful to think about the development of
the global financial crisis and subsequently the euro debt crisis in the last five and a half
years as the gradual discovery of an iceberg. As you probably already know, because the
density of ice is lower than the density of sea water, normally only one-ninth of the volume of
an iceberg is above water. Moreover, the shape of the underwater part can be difficult to
judge by looking at the section which is visible above the surface. This is in my view a useful
metaphor, because as the crisis gradually unfolded, a chain of unexpected problems came to
the surface and vulnerabilities that were previously underestimated became apparent.
Let us consider first the tip of the iceberg, namely the liquidity crisis. Tensions in money
markets erupted in August 2007 when the US mortgage market, which was at the epicentre
of a complex network of financial derivative products held globally, started to un-ravel.
Liquidity in interbank markets worldwide dried up as market participants became paralysed
by uncertainty. The key problem was that counterparty risk - which had hitherto remained
limited - suddenly increased in great proportions because the distribution of risk exposures
to US subprime mortgage markets was markedly opaque. This led some market segments to
partially freeze and others to close completely.
This is where the second layer of the iceberg comes onto the stage. The collapse of Lehman
Brothers in the autumn of 2008 triggered an exceptionally abrupt re-pricing of risks globally. It
led to a very significant intensification of the financial crisis; to a temporary freeze in trade
financing and a global trade decline; to a curtailment of credit and domestic demand; and,
ultimately, to a severe decline in global demand and output.
The main channels through which the crisis was transmitted internationally are now relatively
well understood, although the extent and strength of the interconnectedness was quite
surprising in real time. Activity corrected most in countries where credit was booming prior to
the crisis, with large current account deficits, high external debt and highly leveraged
financial sectors, in particular.1
In the euro area, a channel of particular importance was the fact that some banks had tapped
US wholesale funding markets in large amounts to finance their activities.2 Some of these
banks were in addition as heavily involved as US banks in the production of allegedly
riskfree securities, such as asset-backed commercial paper, that aimed to meet the needs of US
money markets funds.3 They were severely hit when these markets froze. Moreover,
although the euro area's current account was broadly balanced, it still had significant gross
external assets and liabilities vis-à-vis the US, which acted as a powerful conduit of the crisis.
Challenges became more intricate still when the third layer of the iceberg - the sovereign
debt crisis - surfaced towards the end of 2009. Risk re-pricing intensified, spreading from
banks to sovereigns and back to banks in an adverse feedback loop, and interacted with
existing - but previously hidden - vulnerabilities in several euro area countries. This
feedback loop included three separate ingredients. First, the solvency of some banks was
strained by significant exposures to domestic sovereign debt and write-offs or declines in the
market value of government bonds that eroded their capital. Second, declines in the market
value of government bonds led to liquidity strains, insofar as these bonds are widely used as
collateral in interbank markets. And third, in some instances, governments had to step in to
recapitalise vulnerable domestic banks, thereby increasing their own debt in turn.
This "tale of two debt overhangs", as some have called this twin crisis of banks and
sovereigns, had uneven effects across euro area countries.4 Some countries were markedly
more affected than others, which contributed to increased financial fragmentation in the euro
area. This also laid bare further fragilities that had been accumulated in the past, including
the fact that some euro area countries had neglected structural reforms and as a result faced
competitiveness losses and the built-up of external deficits. While these fragilities had not
gone completely unnoticed, and had been pointed out early on by the ECB, they had not
received the attention they deserved until the crisis struck. This bears similarities with the
Asian financial crisis, which is well remembered in this part of the world. Some experts saw it
coming and warned at an early stage against the causes that led to it, such as short-term
financing in foreign currency of long-term investments (maturity mismatch) and insufficient
prudential standards leading to excessive risk taking and rent seeking behaviour.
Unfortunately the warnings were not taken seriously until the issues and risks materialised
first with the depreciation of the Thai baht in July 1997. Perhaps we have not learnt enough
from the past!
As growing financial market tensions made the financing of these deficits ever more difficult,
the last and most unexpected layer of the iceberg - namely the so-called "redenomination
risk", the possibility of a break-up of the euro area - came to the surface in the middle of last
year. By that time, the sovereign spread of high-yield euro area countries relative to other
euro area countries had widened to an exceptional extent, hardly justified by fundamentals
and fundamentally incompatible with a well-functioning monetary union. This led to the
announcement by the ECB of the modalities for Outright Monetary Transactions (OMT),
which helped to remove redenomination risk.
2. The monetary policy response to the crisis
Let me now outline in more detail how the ECB has responded to this multi-layered crisis.
Before I delve into this, however, let me also first emphasise upfront that monetary policy can
buy time for reforms that become effective with some time lag, but ultimately cannot
substitute for reforms and decisions in the political sphere. Monetary policy is therefore only
a crisis mitigation tool, and it is important to keep this fact in mind and not to expect too much
from the central bank in terms of crisis resolution. In addition, monetary policy is surrounded
by two goalposts: the overarching objective of price stability and the independence of the
central bank.
The ECB's response included two types of measures, standard and non-standard measures.
The standard reaction of monetary policy was to adjust our key interest rates downwards
owing to a less benign macroeconomic outlook and downward risks to price stability. Short
term interest rates are now close to zero in the euro area, and overall financing conditions
are very favourable in the euro area as a whole.
At the same time, the standard monetary policy action was judged as insufficient because,
during the crisis and especially from 2010 the interest rate channel of the monetary policy
transmission mechanism was impaired, initially because the interbank market was
dysfunctional, then because the banking sector in some countries became itself
dysfunctional and was unwilling or unable to perform its normal intermediation role. In
response to this challenge, the ECB engaged in a sequence of non-standard measures to
restore a proper transmission of the monetary policy impulses, including lending operations
through a fixed rate tender procedure with full allotment, the provision of liquidity with longer
maturity and an expansion of the set of assets that could serve as collateral for receiving
central bank liquidity. As financial integration in the euro area was being severely eroded and
banks largely retrenched within their national borders, the Eurosystem remained ready to
provide liquidity at consistent and uniform conditions over the entire euro area, as it should
be in any monetary union.
As a further step to address the banks' funding problems and financial fragmentation within
the euro area, the Eurosystem started intervening directly in securities markets in order to
correct severe mal-functioning of certain segments. The first action of this type was the
Securities Markets Programme (SMP) launched in May 2010, followed by a purchase
programme for bank-issued covered bonds started in October 2011, and finally the Outright
Monetary Transactions (OMT) programme announced in September 2012 but so far not
activated. Let me now spend a few words on the OMT programme in particular.
It is important to emphasise that the design of the Outright Monetary Transactions
programme creates the right incentives for governments to improve their performance with
respect to fiscal prudence and structural reforms. In fact, OMTs will only be activated in
cases where the beneficiary country has signed up to strict and effective conditionality
attached to an appropriate EU/IMF lending programme. They can also be considered for
Member States currently under a macroeconomic adjustment programme, but only once they
have regained bond market access. Moreover, the design of OMTs entails interventions only
in the relatively short end of the government bond market - up to three years' time to
maturity - and they will be fully sterilised, meaning that the Eurosystem would absorb all
amounts of liquidity injected by OMTs.
Since the announcement of the OMT programme, financial market conditions in the euro
area have improved significantly, sovereign spreads have declined substantially and there
are some signs that the process of financial fragmentation in the euro area is being reversed.
It is important to recognise that the role of policies other than monetary policy being
implemented in the meanwhile, at both national and euro area or EU level, have also
materially contributed to restoring confidence in the euro area.
3. How the crisis revealed institutional weaknesses in the euro area
As I already noted, the monetary policy response to the crisis has been mainly aimed to buy
time for reforms that become effective with some time lag, but it cannot substitute for reforms
as time goes by. In this respect, the crisis has unveiled the incompleteness of the euro area's
institutional design which currently policy makers are addressing both at the national level
and at the euro area/EU level. Let me first outline these main weaknesses and then go
through the progress that has been made so far and the road ahead.
The euro area was missing an effective framework for (i) crisis prevention (ii) and crisis
management and resolution, which are, as I will argue, essential ingredients for effective
policy-making in a monetary union. Let me elaborate.
The lack of effective crisis prevention framework before the crisis was indeed evident.
First, too complacent regulatory policies in the financial sector still allowed excessive risk to
build up. The establishment of the monetary union made is easier for deficit countries to
finance macroeconomic imbalances through cross-border capital inflows for too long,
resulting in the accumulation of risk. When these flows turned into outflows as the economic
environment deteriorated after 2008, these imbalances not only led to problems for the
countries concerned but also produced contagion to other parts of the euro area. These
externalities led to the emergence of a twin crisis, where private sector debt (often by
financial intermediaries) was rapidly converted into public liabilities, resulting into the
self-reinforcing negative feedback loop between sovereigns and banks I alluded to before.
A single mechanism for banking supervision and a common authority with strong tools for
bank resolution could have mitigated the emergence of these negative externalities. The
crisis clearly highlighted that financial stability is a common good and as such requires
shared responsibility for its preservation. We have learned the hard way that high financial
integration without a commensurate deeper integration of financial stability policies is
intrinsically unstable.
Second, sustained divergences in competitiveness and macroeconomic imbalances were
largely ignored. Persistent current account imbalances within the euro area, signalling
vulnerabilities of some Member States, were long considered as irrelevant in a monetary
union. Besides fiscal surveillance, the working assumption was that there is no need to
closely monitor macroeconomic imbalances. Disequilibria originating from the private sector
were supposed to be only short-lived and eliminated by market forces. The crisis has taught
us that imbalances in individual countries may have powerful negative externalities on other
countries within a monetary union. This recognition led to the belief that the governance of
economic policies at the EU level has to be reformed: more effective macroeconomic policy
coordination at euro area level is an essential building block of a monetary union.
Third, the euro area availed of a fiscal policy coordination and surveillance framework. The
existence of fiscal rules at the EU level, codified in the Stability and Growth Pact and in the
Treaty Excessive Deficit Procedure, was motivated by the need to ensure fiscal discipline,
preserve fiscal space and hence allow automatic stabilisers to play out in full during
downturns. More fundamentally, the fiscal rules were supposed to prevent countries from
pursuing irresponsible fiscal policies with negative externalities on the rest of the monetary
union. However, the previously existing framework did not have sufficient "teeth" and its
implementation by Member States within the Eurogroup remain insufficiently strict. As a
result, EU fiscal rules did not constrain budgetary policies sufficiently.5
At the beginning of the crisis, it became painfully evident that the euro area was also lacking
effective crisis management tools.
First, the design of the euro area assumed that stabilisation would take place at the national
level and to a large extent automatically. The crisis has shown us, however, that shock
absorbers at the national level are insufficient in case of a major financial and economic
crisis. Indeed, the scale of the shock after the 2008 financial crisis was unprecedented in a
number of countries and it far exceeded their national shock absorption capacity. The euro
area had no mechanisms to provide financial support for countries in difficulty, ensure
efficient risk sharing and prevent cross-border contagion; notably, there were no area-level
institutions to prevent fiscal sustainability from being jeopardised by severe problems in their
domestic banking systems. This underscored the pitfalls of a design that relied too much on
the national level to fulfil the stabilisation function.
Second, the financial crisis demonstrated that financial contagion is the unintended
consequence of financial market integration. The euro area, however, was lacking effective
instruments to mitigate contagion. Policy instruments that can act as circuit breaker, limiting
thereby negative feedback loops, are an essential crisis management tool in a monetary
union.
To summarize, one of the key lessons that we have learned from the crisis is that the design
of the euro area was incomplete. Indeed, the euro area lacked certain institutional elements
which are associated with federations and which act as crisis prevention mechanisms
ex ante as well as shock absorbers ex post. The logical corollary is that we need to
compensate for these "missing institutions" by establishing a much stronger financial and
economic union. I will now outline the main elements of that endeavour. I will first discuss
reforms implemented at the national level - though sometimes also decided in the context of
EU-IMF lending programs - and then move to the reforms at the EU or euro area level.
4. The road ahead towards deepening the union
4.1 Reforms at the national level
Almost six years down the road since the start of the financial turmoil that turned into a crisis,
many euro area countries have experienced a significant, although to date still partial,
correction of external and domestic imbalances. This is positive news, before reform action
at the national level is ultimately the most important for getting the crisis behind us.
Substantial progress can be seen most clearly in the development of current account
balances. Much of this was driven by an inevitable drop in domestic demand, but we have
also seen strengthening exports in a global environment that is not really buoyant. This
indicates that the countries' efforts to rebalance their economies are starting to bear fruits.
Part of this picture is also the partial reversal of previous losses of competitiveness, but here
the pace of progress varies across countries.
Fiscal balances have also shown strong improvements. For example, Greece's structural
primary balance has improved considerably, though the fiscal situation is still facing big
challenges. At the same time it is positive to see that the general upward trend in private
sector indebtedness has been halted in most countries, both in the household and the
corporate sector, including the financial sector.
Last but not least, structural reforms have gathered pace. The countries under an adjustment
programme have taken many initiatives to make their economies more flexible and
marketoriented, thus sowing the seeds for better performance and increased competitiveness in the
future.
All of these developments give reasons to be cautiously optimistic about the prospect for
crisis-ridden countries' return to a path of sustainable growth, productive investments and
creation of new jobs.
However, historical experience suggests that the combination of an economic downturn and
a financial crisis is usually associated with a prolonged recession and losses of jobs and
welfare. Most structural reforms take time to generate positive effects, and some of the
countries in distress are still saddled with rigidities in the markets for goods, services and
labour.
In order to prevent - and indeed reverse - job losses, the downward adjustment of both
prices and wages need to be stronger in those areas where unemployment is still high, and
where this adjustment has not taken place to a full extent due to structural or institutional
factors. If this goes hand in hand with a continued consolidation of public sector budgets,
then the cautious optimists will see their views confirmed through a chain of reduced
uncertainty, renewed investor and consumer confidence, better access to funding and a
return to robust and sustainable growth.
4.2 Reforms at the European level
Let me now turn to the last and arguably most important topic of my intervention today,
namely the reforms which have been introduced in order to make the euro area and the EU
stronger in the long haul. To an external observer, especially from Asia, the reform process
may seem slow and haphazard, but one has to keep in mind that institutional evolution is
almost never a formal optimization exercise starting from a "clean slate", but rather
something that builds on the existing institutional setting and adds additional layers and
structures, and the institutional evolution of EMU is no exception, as pointed out in recent
ECB research.6 The need to agree on reforms at both the domestic and the European level
also introduces an additional element of complexity, which is perhaps difficult to understand
from the outside. But it is important to point out that if one looks back it is impressive how
much has been achieved in a matter of a couple of years. Let me just briefly describe what
has changed in the institutional setting of EMU - and indeed also in the EU more generally -
in just a few years. I will start with innovations in the crisis prevention toolkit, and will then
move to crisis resolution tools.
Fiscal governance reforms. As I mentioned earlier, one of the major weaknesses of the
original institutional setting of EMU was that EU fiscal rules were not sufficiently binding and
in particular that sanctions were not credible. This has been addressed in a series of reforms,
starting with what we call "six pack", a group of six Regulations which entered into force in
December 2011. Without going into the details of the Regulations, let me only mention that
their effect is to strengthen the Stability and Growth Pact and to make sanctions a more
credible threat.
Another important innovation has been the Treaty on Stability, Coordination and Governance
in the Economic and Monetary Union, known as "fiscal compact", which entered into force in
January 2013. This is an intergovernmental treaty which establishes, among other things,
that Member States must enact laws (preferably at Constitutional level) requiring their
national budgets to be in balance or in surplus within the treaty's definition. The laws must
also contain a self-correcting mechanism to prevent any breach. The treaty defines a
balanced budget as a general budget deficit less than 3.0% of the gross domestic product
(GDP), and a structural deficit of less than 1.0% of GDP if the debt level is below 60% -
otherwise it shall be below 0.5% of GDP.
Finally, the so-called "two-pack" Regulations entered only very recently into force, subject
euro area countries to the obligation of ex ante notification of budgetary plans to the
European Commission. Should countries be subject to an excessive deficit procedure (EDP)
or be involved in a financial assistance program by the European Stabilisation Mechanism
(on which I will touch on shortly), they will also be subject to an enhanced monitoring by the
European Commission.
Overall, the cumulative effect of these reforms will be a significant enhancement of fiscal
governance in the euro area and it is important that the reforms are now implemented fully.
Macroeconomic Imbalances Procedure. Another important innovation of the "six pack"
Regulations is the introduction of the Macroeconomic Imbalances Procedure (MIP), which is
designed to prevent and correct phenomena such as high current account deficits,
unsustainable external indebtedness, abrupt or prolonged loss of competitiveness and
housing and credit booms and busts. Unlike reforms in fiscal governance, which were mainly
aimed at strengthening what was already in place, the Macroeconomic Imbalances
Procedure is something which was completely absent in the initial design of the founding
fathers of EMU. The procedure starts from a scoreboard of indicators, whereby the European
Commission identifies the countries and issues which require in-depth reviews. Based on
these in-depth reviews and depending on the severity of the imbalances the Commission
proposes a policy recommendation under either the "preventive arm" or the "corrective arm"
of the MIP. In particular, if the Commission identifies an excessive imbalance that may
jeopardise the proper functioning of EMU, it will propose a follow-up under the corrective arm
of the MIP, the Excessive Imbalance Procedure. The Member State concerned will have to
prepare a corrective action plan with a roadmap and the deadlines for implementing
adequate measures. Note that this process may end up in sanctions up to 0.1% of GDP, in
case of non-compliance by the affected Member State.
The procedure for identifying and correcting macroeconomic imbalances is very important
and addresses a concern that the ECB has voiced repeatedly in the European context. Also
in this case it will be important to implement it fully, while being aware of the unavoidable
difficulties, also of an analytical nature, of identifying relevant imbalances ex ante.
Macro-prudential policies. Turning to macro-prudential policies, in line with other jurisdictions
the EU has equipped itself with a body whose task is to recommend actions to reduce
systemic risk in the EU financial sector, the European Systemic Risk Board (ESRB), which is
closely associated with the ECB. While the ESRB cannot take direct action, its advice and
recommendations carry great weight. In addition, the Single Supervisory Mechanism (SSM)
- which I am about to describe in a moment - will assign micro-prudential powers to the ECB
for the banking sector of those countries which adhere to the SSM. The ESRB will remain
responsible for macro-prudential issues in the EU as a whole and for the whole financial
sector (i.e. beyond banks).
Financial market union. Let me now turn to plans to establish a financial market union in the
euro area. The nexus between banks and sovereigns and financial fragmentation in the euro
area are phenomena that contradict the very essence of a monetary union, where monetary
and financial conditions should in principle be uniform in the whole union. Plans to establish
a financial market union in the euro area are very important, I would say decisive, in breaking
the link between financial conditions and countries. An important and very well advanced
element of the financial market union is the Single Supervisory Mechanism (SSM), whereby
the ECB shall assume ultimate responsibility for specific supervisory tasks related to the
financial stability of all euro area banks as foreseen in the EU Treaty. While I will not go into
the details of the proposals currently on the table, which establish direct ECB supervision of
the largest euro area banks and delegate the supervision of the other banks to the national
authorities (with the possibility for the ECB to claim direct supervisory powers also for these
banks if necessary), let me mention that the ECB considers them an appropriate basis for
taking on supervisory responsibilities, while being aware of the many practical challenges
associated to them.
It is important that the SSM does not remain the only staple of the financial market union. It is
essential that the SSM is accompanied by a euro area (and even better EU) Single
Resolution Mechanism.
Economic union. In concluding my remarks on reforms aimed at making future crises less
likely, let me also mention proposals currently on the table for the establishment of a
Convergence and Competitiveness Instrument, also known as "reform contracts", within the
EU budget. The proposal is essentially to create a special EU budget account supporting
timely implementation of needed (and possibly unpopular) structural reforms following
contractual arrangements between Member States and the Commission. A review of the
compatibility of product and labour market structures in euro area countries with the
requirements of EMU is also underway, which might provide further impetus to structural
reforms in the euro area and make countries less vulnerable to future shocks.
After describing reforms aimed at crisis prevention, let me now turn to crisis resolution
mechanisms. Like fire safety restrictions and fire-fighters, the two elements are individually
imperfect but should reinforce each other and work in symbiosis.
The European Stability Mechanism (ESM) was created in order to provide financial
assistance to euro area countries in financial difficulty. The ESM will function as a permanent
firewall for the euro area with a maximum lending capacity of €500 billion. Euro area Member
States can apply for ESM financing if they are in financial difficulty or their financial sector is
a stability threat in need of recapitalization. ESM interventions are conditional on Member
States first signing a Memorandum of Understanding containing a programme for the needed
reforms or fiscal consolidation to be implemented in order to restore the financial stability.
Note that a precondition for receiving financing from the ESM is to have fully ratified the fiscal
compact, which creates a link between crisis prevention and resolution schemes. The
involvement of the IMF in the financing schemes is not strictly required but is still highly
desirable, also in view of the Fund's analytical expertise in crisis resolution.
I would also like to emphasise that the range of tools available to the ESM compares
favourably with those available to the International Monetary Fund (IMF). Hence with the
ESM the euro area has equipped itself with a state of the art and permanent crisis resolution
scheme, a key missing piece in the initial design of EMU.
Conclusions
As Asia knows very well from its own crisis in 1997/1998, a crisis can be an opportunity for
reform and renewed growth. This is embodied by the character ji, which in Classical Chinese
means at the same time "danger/crisis" (weiji in today's language), as well as
"chance/opportunity" (jihui to use today's term). In this sense the Asian crisis experience is a
useful lesson for the euro area, which - I am convinced - will emerge more integrated and
stronger from the current challenge.
Perhaps the greatest challenge at this point in time is to keep up the reform momentum even
if hopefully the most severe manifestations of the crisis abate and financial market
conditions, including financial integration within the euro area, come back to more normal
conditions. While the ECB will continue to play its part and maintain price stability in the euro
area, as noted the role of the central bank is limited. Keeping up reforms at the national level
is particularly important, as is providing a better foundation for a stronger monetary union and
hence fully implement the institutional changes that have been agreed or are currently on the
table. Among the latter, I would single out an ambitious and full realisation of a financial
market union comprising three legs (single supervisory mechanism, single resolution
mechanism and possibly common deposit insurance as decisive for the long term viability of
the euro area. Also in this case, the ECB will play its part in full.
Thank you very much for your attention!

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