Mario Draghi: Stability and prosperity in Monetary Union
Speech by Mr Mario Draghi, President of the European Central Bank, at the University of
Helsinki, Helsinki, 27 November 2014.
* * *
Summary
ECB President Mario Draghi outlined the minimum requirements needed to complete
monetary union in a way that offers stability and prosperity for all its members in a speech to
students of the University of Helsinki.
Acknowledging that, "for all its resilience, our union is still incomplete", Mr Draghi argued
that, ultimately, Member States "have to be better off inside than they would be outside."
"If there are parts of the euro area that are worse off inside the Union, doubts may grow
about whether they might ultimately have to leave".
"The euro is - and has to be - irrevocable in all its member states, not just because the
Treaties say so, but because without this there cannot be a truly single money", he said.
In the absence of permanent fiscal transfers among Member States, there are two minimum
requirements to achieve these objectives: the first is that all euro area countries need to be
able to thrive independently, the second is that euro area countries need to invest more in
other mechanisms to share the cost of shocks.
In a monetary union, the economic performance of any single country cannot be seen as a
purely national concern. "There is a strong case for sovereignty over relevant economic
policies to be exercised jointly. That means above all structural reforms", the President
remarked.
But even so, economic adjustments can have short term costs.
To ensure that countries are better off being in the Union when a shock hits than they would
be outside, "we need other ways to help spread those costs...there is a particular onus on
private risk-sharing to play this role". In this context Mr Draghi said barriers to capital markets
integration needed to be addressed with urgency.
Sovereign debt needs also to act as a safe haven in times of economic stress. It can do so
first of all through a strong fiscal governance framework. Secondly, by having some form of
backstop for sovereign debt in place. "Over the longer-term", the President concluded, "it
would be natural to reflect further on whether we have done enough in the euro area to
preserve at all times the ability to use fiscal policy counter-cyclically. But it is also clear that...
this could only take place in the context of a decisive step towards closer Fiscal Union".
***
Ladies and gentlemen,
A common misconception about the European Union - and the euro area - is that they are
economic unions without an underlying political union. This reflects a deep misunderstanding
of what economic union means: it is by nature political.
The Single Market is itself a political construct that could not operate without adequate
political structures. A strong competition authority requires an executive to enforce
competition policy, a legislative to write the law that it enforces, and a judiciary to resolve
conflicts under the Law. The Commission, EU Council, European Parliament and European
Court of Justice all play these roles.1
Likewise, fiat money is a political construct, and monetary union could not operate without
adequate political structures. In this case, an independent central bank has to ground its
legitimacy in a precisely defined mandate that is embedded in a democratically agreed
constitutional framework - which the ECB finds in the EU Treaties.2
If our union has proved more resilient over the past years than many thought, it is only
because those who doubted it misjudged this political dimension. They underestimated the
political underpinnings of our union, the ties between its members, and the amount of
political capital that has been invested in it.
Yet it is clear that, for all its resilience, our union is still incomplete. This is the diagnosis that
was made two years ago by the Presidents of the European Council, the European
Commission, the Eurogroup and myself, in the so-called "Four Presidents Report". And
though progress has been achieved in some areas, it remains unfinished in others.
So until we have completed EMU, which means achieving the minimum requirements in all
areas for our union to be truly sustainable, doubts about its future will never entirely fade
away. And this is true no matter how much political commitment is voiced.
What I would like to discuss today is what those minimum requirements are to complete our
Union in a way that brings stability and prosperity for all its members.
The minimum requirements for monetary union
When countries join a monetary union, they share monetary policy and no longer have
individual exchange rates. This offers significant benefits, but it also creates costs.
On the one hand, especially for smaller countries, sharing sovereignty over monetary policy
is a way to regain sovereignty. Rather than having their monetary policy effectively
determined by a larger neighbour, they can participate on equal terms in decision-making for
the entire euro area. The removal of exchange rate uncertainty also yields immediate
benefits in terms of reduced risk premia.
On the other hand, sharing monetary policy and in particular an exchange rate deprives
national economies of some adjustment tools in the face of local shocks.
This means that such shocks have to be preempted to the extent possible through sound
economic policies. It also means that when shocks do occur - as they inevitably will -
adjustment has to take place through other channels. And crucially, those channels have to
be at least as effective as if countries were not part of monetary union. Members have to be
better off inside than they would be outside.
The reason for this is as follows: if there are parts of the euro area that are worse off inside
the Union, doubts may grow about whether they might ultimately have to leave. And if one
country can potentially leave the monetary union, then this creates a replicable precedent for
all countries. This in turn would undermine the fungibility of money, as bank deposits and
other financial contracts in any country would bear a redenomination risk.
This is not theory: we all have seen first-hand, and at considerable costs in terms of welfare
and employment, how fears about euro exit and redenomination have fragmented our
economies.
So it should be clear that the success of monetary union anywhere depends on its success
everywhere. The euro is - and has to be - irrevocable in all its member states, not just
because the Treaties say so, but because without this there cannot be a truly single money.
What I am saying of the euro area could apply to most currency areas. But participation in
our monetary union has different characteristics to participation in other political unions. This
is particularly because we operate in an environment where there are no permanent fiscal
transfers between countries.3 And this has important consequences.
In all national economies, permanent transfers take place from richer to poorer regions; from
more densely populated to more sparsely populated areas; and from those better endowed
with natural resources to those less endowed. This is true in the United States, where those
transfers occur through the federal budget. It is true within Germany, within Italy, within
Finland. Fiscal transfers, so long as they remain fair, often help cement social cohesion and
protect against the temptation of secession.
But as such transfers are not foreseen within the euro area, this model does not apply for us.
We need a different approach to ensure that each country is permanently better off within the
Union than outside - and it entails two minimum requirements.
The first is that all euro area countries need to be able to thrive independently. This means
that every economy has to be flexible enough to find and exploit their comparative
advantages, so as to benefit from the Single Market. They have to be able to allocate
resources efficiently and create a dynamic business environment, so that their economies
can attract capital and generate enough jobs.
And they also have to be flexible enough to respond quickly to short-term shocks, including
through adjustment of wages or reallocating resources across sectors.
This is particularly important because, due to cultural barriers, labour mobility offers only a
limited escape valve from high local unemployment in the euro area - at least compared with
more homogenous unions like the US. Certainly, greater cross-country mobility would be
welcome, and we should encourage measures that facilitate it. But research suggests that it
is unlikely that cross-country migration flows will ever become a key driver of labour market
adjustment after large shocks.4 And no country will thrive anyway if its population deserts it.
The second implication that follows from not having fiscal transfers is that EMU countries
need to invest more in other mechanisms to share the cost of shocks.
Many shocks can be preempted by the right policies. But for those that cannot, internal
adjustment will generally be slower than if countries were able to adjust relative prices
instantly through their own exchange rate. In these circumstances, some form of
crosscountry risk-sharing is essential to help reduce adjustment costs for those countries and
prevent recessions from leaving deep and permanent scars.
In our case this means deepening financial integration in ways that improve private
risksharing - that is, through having more diversified financial portfolios that can spread risk and
reward across regions, and more integrated credit markets that can smooth consumption
patterns. And it means ensuring that the conditions are in place so that all countries can
retain full use of national fiscal policy as a counter-cyclical buffer.
Let me explain these various points, and their implications, in some more detail.
Economies that can adjust quickly to shocks and grow
Building economies that are resilient and flexible entails that wages and prices can adjust to
economic conditions, and that resources can reallocate swiftly across firms and sectors.
We know from economic theory that this is crucial in a monetary union to ensure that
adjustment happens through prices, not quantities - that is, unemployment. And we have
also seen this play out in our direct experience: during the crisis countries with more flexible
economies have on the whole adjusted faster and with a lower employment cost. This is
evident, for example, if one compares the experience of Ireland and Latvia with that of Spain,
Portugal and Greece.5
We know as well that economies that are flexible and can allocate resources efficiently
benefit most from the Single Market by exploiting their comparative advantages. And where
populations are ageing, they also have the best chance of raising potential growth. This is
again true in theory, but also visible in practice. To give just one example, the World
Economic Forum ranks Finland fourth in the world in terms of global competitiveness,
whereas Greece is ranked 81st.6
Until now, such differences in the structures and institutions of our economies have largely
been seen as a national concern. Countries that reformed their economies and improved
their business environments were seen as the chief beneficiaries of their efforts. And if some
countries did not reform, it was largely believed that they would be the only ones to suffer as
a consequence.
This understanding was reflected in the fact that, while monetary policy became European,
important parts of economic policy remained at the national level - and with relatively loose
common governance. This seemed natural as many of these policies - such as labour
market institutions or social protection schemes - are deeply rooted in a country's social
model and national traditions.
But with the benefit of experience, I am sceptical as to whether this view is still valid. That
economies can adjust and grow is in fact very much a concern for others.
If some countries in monetary union perpetually adjust more slowly than others, they are
likely to have consistently higher unemployment. And if they also have lower growth
potential, then that unemployment is more likely to become entrenched and structural. In
other words, lack of structural reforms raises the spectre of permanent economic divergence
between members. And insofar as this threatens the essential cohesion of the Union, this
has potentially damaging consequences for all EMU members.
Seen from this perspective, euro area countries cannot be agnostic about whether and how
others address their reform challenges. Their own prosperity ultimately depends on each
country putting itself in a position to thrive within the Union. And for this reason, there is a
strong case for sovereignty over relevant economic policies to be exercised jointly. That
means above all structural reforms.
This was the starting point for the reflection that began with the Four Presidents' Report in
2012 on building a genuine Economic Union for the euro area. And to my mind, deepening
Economic Union would mean two things.
First, in the short-term, using more effectively the rules and procedures we already have,
such as the European Semester. This means making all parties more accountable for
ensuring that recommendations are well-targeted, closely monitored and followed up. And it
means actively using the corrective tools that are there to tackle large imbalances, such as
the Excessive Imbalances Procedure.
Second, over the longer-term, acknowledging the community of interest and the reality of
spillovers in the form of a real sharing of sovereignty in the governance of structural reforms.
That is, shifting from coordination to common decision-making, and from rules to institutions.
Private risk-sharing through integrated financial markets
As I said, however, economies will never be so flexible that adjustment happens as quickly
as if they had their own exchange rate. There will always be short-term costs. And so to
ensure that countries are better off being in the Union when a shock hits than they would be
outside, we need other ways to help spread those costs.
In a monetary union like ours, there is a particular onus on private risk-sharing to play this
role. Indeed, the less public risk-sharing we want, the more private risk-sharing we need.
Private risk-sharing chiefly comes through a well-integrated financial system. Diversified
portfolios make balance sheets more resilient to local shocks and allow the effects of those
shocks to be dispersed across countries. And integrated credit markets allow firms and
households to smooth any negative effects on income by bringing forward future
consumption - which in the euro area essentially means borrowing from countries that are
less affected. In other words, financial union is an integral part of monetary union.
The US provides an example of how effective private risk-sharing can be in a monetary
union. A well-known study found that around two-thirds of economic shocks are absorbed via
integrated financial markets in the US. By contrast, studies on the euro area suggest that
credit and capital markets are much less effective in smoothing income.7
The explanation for the limited degree of risk-sharing in the euro area can be found in the
relatively shallow type of financial integration that evolved before the crisis.
In the banking sector, integration of interbank markets proceeded much faster than
integration of retail markets. Thus, most banks' assets remained concentrated in their local
markets, while their liabilities were mainly comprised of short-term debt. This meant that
when a large local shock hit, they were exposed to heavy and concentrated losses. And
rather than sharing those losses, their creditors were able to "cut and run".8 The resulting
financial fragmentation also meant that cross-border credit markets could not do their job.
In this context, Banking Union represents a vital step forward in creating the conditions for a
higher quality of financial integration. Single supervision and resolution should be catalytic in
lowering the hurdles to cross-border activity and encouraging deeper retail banking
integration. In the process, this will create more private risk-sharing within the sector.9
Banking Union is now well underway: the Single Supervisory Mechanism (SSM) took over
supervision of euro area banks earlier this month. Its founding act, the Comprehensive
Assessment of banks' balance sheets, was successfully completed the month previously.
And the Single Resolution Mechanism will begin on 1 January next year.
But limited risk-sharing within the euro area is not just about banks; it also reflects our
relatively incomplete capital markets, and in particular equity markets. Those markets are the
most effective for absorbing losses. Yet only 44% of equity issued in the euro area is held by
other euro area residents.10
So, if we are to deepen private sector risk-sharing in the euro area, we urgently need to
address the barriers to capital market integration. This is no doubt a complex issue as it
extends into multiple aspects of national law.11 But if we do not want a transfer union, then
we have to be consistent and establish an environment where other mechanisms can work.
This means, first, advancing with the agenda of the new Commission President to establish a
genuine Capital Markets Union in Europe. And second, establishing a genuine Economic
Union in parallel. If countries are to attract capital and benefit from financial risk-sharing, then
it has to be attractive to invest there. And this can only be achieved if, over the medium-term,
all countries have sufficient adjustment capacity and growth prospects.
Yet even with full implementation of these Unions, we could still not call EMU complete. We
also have to acknowledge the crucial role that accrues to fiscal policies in a monetary union.
National fiscal policies that can act counter-cyclically
A single monetary policy focused on achieving euro area price stability cannot react to
shocks that affect only one country or one region. And we do not have a federal budget that
can respond instead, as in the US for example. So, for as long as this situation persists, it is
absolutely essential that national fiscal policies can perform their macroeconomic
stabilisation role alongside monetary policy, and react whenever a local shock occurs.
Fiscal policies are in fact particularly relevant for us, as a recent study demonstrates that
47% of an unemployment shock is absorbed by the automatic stabilisers in the EU,
compared with only 34% in the US.12
For national fiscal stabilisers to be able to play out in full, sovereign debt has to act as a safe
haven in times of economic stress. If it instead acts like private debt, and borrowing costs
rise under stress, governments' market access becomes constrained at precisely the
moment they most need it. Then, fiscal policy risks becoming pro-cyclical.
There are in principle two ways to protect the safe haven status of sovereign debt: the first is
a strong fiscal governance framework that is implemented in a credible manner. This means
having sufficient buffers over the cycle to absorb exceptional shocks, and having public debt
levels that are sufficiently low in good times that they can rise in bad times without disrupting
market confidence.
The second way is some form of backstop for sovereign debt.
In the euro area, due to various aspects of our institutional framework, we have very much
pursued the first approach, strong fiscal rules. And this provides an essential anchor for
confidence, not only for investors but also among firms and households, and crucially,
between countries. The importance of each country sticking to its commitments under the
Stability and Growth Pact should therefore be beyond debate.
Indeed, that a sound fiscal framework is necessary in a monetary union goes without saying.
Whether it is sufficient to safeguard fiscal policy as a stabilisation tool, however, has been
challenged by our experience during the crisis.
The EMU framework was grounded on the assumption that keeping one's fiscal house in
order would be enough to ensure market access and ward off contagion. And to be sure,
countries with more robust fiscal positions have on the whole enjoyed easier financing
conditions and have been more protected from spillovers. But we have also seen that this
protection is not absolute.
Ireland and Spain, for instance, had low public debts and deficits on entering the crisis yet
suffered serious contagion from Greece. And during the phase of the crisis where contagion
within the euro area was at its worst, almost all countries saw their credit default swap
spreads rise.
In other words, as panics can happen in financial markets, even abiding fully with the fiscal
rules cannot provide a cast-iron guarantee of affordable market access.
So what can governments do in these circumstances to safeguard fiscal policy as a
stabilisation tool?
First, this is precisely the kind of situation I mentioned earlier where we can and should aim
to better preempt economic shocks. The SSM is particularly important in this context, as it
should help prevent the kind of large financial imbalances we saw in countries like Ireland
and Spain, which subsequently spilled over to the public sector.
Second, markets are less likely to react negatively to temporarily higher deficits if
government debt is clearly sustainable over the medium-term. This can in part be achieved
through credible fiscal plans, which act on the numerator of the debt-to-GDP ratio. But it also
has to involve raising potential growth through structural reforms, which act on the
denominator.
And for this reason, governments in fact have a further incentive to enter into closer
Economic Union. Insofar as this acts as a commitment device that reforms will indeed by
implemented, it will help to raise future government income and improve debt sustainability.
And in doing so, it can even help create fiscal space today.
Moreover, using EU funds more effectively to boost both current demand and future potential
- which means raising investment - would have a similar effect on growth and debt
sustainability. I therefore welcome the Commission's new proposal to stimulate investment
spending in Europe. What matters is that its size complements the fiscal stance of national
governments, that it is deployed quickly so that it can support demand, and that it is targeted
towards those sectors where its impact on potential growth will be largest.
Still, a third conclusion seems unavoidable: that no form of stronger governance can entirely
remove the risk of self-fulfilling liquidity crises.
I do not think this is a controversial statement. It has already been acknowledged with the
creation of the European Stability Mechanism. And it is also what motivates the ongoing
discussion on establishing a backstop for the Single Resolution Fund: the idea is to prevent
sovereigns from losing market access based on self-fulfilling expectations of future bailouts.13
So over the longer-term, it would be natural to reflect further on whether we have done
enough in the euro area to preserve at all times the ability to use fiscal policy
countercyclically. But it is also clear that such a reflection would have to be part of a larger
discussion on how to reinforce common decision-making over fiscal policies and strengthen
accountability arrangements.
In other words, this could only take place in the context of a decisive step towards closer
Fiscal Union. And to make that step we would need to first see a process of convergence in
economic and financial policies in the ways I have described.
Conclusion
This brings me to my conclusion.
What I have argued today is that doubts over the viability of EMU will only be fully removed
when we have completed it in all relevant areas. This means Banking and Capital Markets
Union; it means Economic and Fiscal Union. In a monetary union no policy area can be seen
in isolation. Each interacts with and affects the other. And as such, completing EMU in all
areas strengthens and underpins the others.
Monetary union is more effective in securing the fundamental interests of citizens when
common interests are recognised as such; and when the responsibilities that come with
participating in a community are assumed in full. In other words, its ultimate success
depends on the acknowledgment that sharing a single currency is political union, and
following through with the consequences. And that requires commensurate accountability
and transparency arrangements.
All countries must benefit permanently from participation in monetary union. And this means
that the requirements I have laid out cannot be met only at the time when a country joins the
union, or for some of the time. They have to be met all the time. They have to be irrevocable
features of participation in monetary union.
And for that reason, the institutional arrangements that ensure those requirements are met
must ultimately be binding in nature, and permanent in form.