Yves Mersch: After the EMU rescue - which way for Europe?
Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at a lecture in
memory of Mr Pierre Werner, organised by the Official Monetary and Financial Institutions
Forum (OMFIF), London, 14 October 2010.
* * *
Your Excellencies,
Ladies and Gentlemen,
Neither the European Coal and Steel Community Treaty of 1950, nor the 1957 Treaty of
Rome dealt extensively with currency. This might have been because convertibility after
World War II was not very wide-spread and capital controls were the norm.
Belgium was one of the first countries to establish free movement of capital but only within a
dual exchange rate regime. This particularity had been one of the reasons for Luxembourg to
emerge as a financial activities center for Europe.
The principle of fixed exchange rates had been a feature of the international framework for
currency stability after World War II for the economies of Europe, North America and Japan.
The Bretton Woods System was based on gold and the US dollar as the predominant
monetary standard and worked for several years with almost no frictions. By 1968 a new era
of currency instability threatened when market turbulence forced the revaluation of the
German Mark and the devaluation of the French Franc. These developments clearly
revealed the weaknesses of the Bretton Woods System as well as the threats to the common
market and specifically the common agricultural policy.
Ideas of a new European currency framework gained momentum and Luxembourg's Prime
Minister Werner, also Minister of Finance, was asked to steer a Committee mandated to
design the path to an increased economic and monetary integration of the six then members
of the European Economic Community. That report, finished on the 8 October 1970 and sent
to the Ministers of Finance in the first instance, laid down the achievement of Economic and
Monetary Union by 1980.
The youngest member of the Committee and the only one still alive is Prof. Dr. Hans
Tietmeyer. It was he who at the first meeting of the Governing Council of the ECB insisted on
the seating arrangements to be changed from countries in alphabetical order to members'
family name in alphabetical order. In doing so, he was truly loyal to the spirit of the Werner
plan.
In deed, if it took another 20 years after the Werner plan deadline before a single currency
was established -, for reasons that would take another conference to explain - it is worth
revisiting the Werner report finalized 40 years ago. We can call it truly visionary. Although
many of the proposals of the original Werner plan have been realized, some of the original
thoughts were ignored or diluted and we might with the benefit of hindsight, ask ourselves
whether this has not been a mistake. Of course, the Werner report originated in a different
environment when the Union with its original six members still was aiming at a final goal of
something like a federal Europe. When, after several run-ups, turbulences and tensions, the
goal of a single currency was eventually achieved with the introduction of the Euro in 1999,
not only had the number of member states increased, but it had become clear that despite
the single currency, there would not be a political union to accompany that currency. National
sovereignty in the economic policy-making area would be preserved. Nonetheless, recent
turbulences highlight the inherent tensions of European integration, especially those between
a monetary policy in which sovereignty is pooled while economic policy remains under
national sovereignty. Tensions translate into dynamics either for progress or for regression.
True enough, even during the intergovernmental conference that was to lead to the
Maastricht Treaty, there were parallel negotiations for the development of a political union.
The political union made only limited progress, while the detailed draft for EMU was hailed as
a breakthrough for European integration. In truth, it was once again a compromise between
the pooling of sovereign competences at the European level in the monetary area - with
optin and opt-out clauses for some countries - and the economic union where ultimate
responsibilities remained at the national level. Many features were similar to the Werner
report like a three stage approach with a warming up period (ten years in the Werner plan,
eight years in the Maastricht Treaty) or the abolition of all capital controls.
Inside the Werner Committee, the discussions had centered on the sequence of transfer of
powers to the European level. Foremost Germany argued that monetary union should follow
political union. This so-called crowning theory was inspired by historic developments in other
countries. The others on the contrary considered monetary policy union as a powerful
catalyst for deeper integration in other policy fields that must follow.
Today, I want to focus on another feature. The Werner report supported the idea of an
independent institution for fiscal monitoring and coordination. This thought clearly reflected
the concept that a single monetary policy would be supported by sound public finances. More
concretely, the report called for ever closer economic policy coordination with an agreed
framework for national budgetary policies. At the institutional level, it suggested a "centre of
decision for economic policy". This coordination body for economic policies should have
been established alongside the European system of central banks, i.e. the monetary
authority. Both institutions were to be independent from the national governments, being
politically accountable only to a European Parliament. This independent economic authority
should have influenced the national budgets with a focus on the level and the direction of the
balances as well as the financing of deficits and the use of surpluses, respectively. The
Werner report also advocated a certain degree of tax approximation especially for cross
border activities.
When the Intergovernmental Conference on EMU started, Europe had endowed itself with a
Parliament, but with limited powers and no capacity to levy taxes and to control centralized
policy making at European level. Most European resources were transfers from national
budgets. Tax sovereignty was left untouched after a timid attempt to change tack in the
socalled Guigou group set up by President Mitterrand to prepare the Conference. During the
Conference an attempt by Belgium and Italy to move into the tax area ran into massive
resistance.
Political union was off the agenda and loose coordination of economic policies was deemed
sufficient. It was believed that market discipline would install responsible behavior in the
fiscal and competitive position of countries. The land grabbing attitude of the European
Commission pretending to be the economic and fiscal authority in the event of more
integration indirectly strengthened the case for the intergovernmental approach and the
socalled own responsibility of each individual country in this respect.
It can seem surprising that governments were so confident about market discipline and
reactive national policies when one major factor of self-correction within a currency union
was by design rather weak in Europe, namely labour mobility.
True, progress has been made in language knowledge, university students exchange,
diploma recognition and access to professions. Mobility is good at the lower and higher skill
ends, but the high share of closed public service in Europe, non-portability of pension rights,
rigid labour laws and cultural differences make labour mobility a slow process.
Therefore in 1997 the Treaty was complemented by the Stability and Growth Pact which has
mostly focused on fiscal deficits. The result proved insufficiently coercive and was even
further weakened when Germany and France failed to abide by the rules in 2003. The
absence of a meaningful macro-economic surveillance led to heterogeneity which was
further accommodated by the absence of expected market reactions. Today we have to
acknowledge that market reactions often come with delays and then tend to overreact.
But let me be clear: Forty years after the Werner report and eleven and a half years after the
introduction of the single currency, for me, the verdict is unambiguous: Monetary policy within
the Euro area has been a success. It is widely accepted that the best a central bank can do
in supporting economic growth is delivering price stability. The ECB has delivered price
stability. Even though real GDP in the Euro zone has grown by only 1.5 % per year in the first
decade since its establishment, while the US economy expanded by 2.2 %, this difference
can to a large extent be explained by the greater population growth on the other side of the
Atlantic. On a per capita basis annual real GDP growth rates are very similar, 1.2 % in the
US versus 1.0 % in the Euro area. The Euro area's economic growth rebounded strongly in
the second quarter of 2010, driven by higher investment and replenishment of inventories.
Last week the IMF revised its figures for growth in the Euro area upwards in line with earlier
ECB projections. Incoming hard and soft data for the second half of the year do not warrant
increased pessimism.
In the course of the crisis of the past three years the ECB and the Eurosystem were forced to
act very fast, boldly and innovatively in order to ensure their long term goal of price stability
and the functioning of the transmission mechanism. Their monetary policy interventions were
successful. The recovery of the European economy is ongoing and the tensions in the
financial systems have eased somewhat, although it is still too early to claim victory.
But we have to draw the lessons from the recent experience. With the eruption of the crisis in
September 2008 the accumulation of private debt was suddenly stopped. The problem of
excessive indebtedness was not solved, however. Fiscal rescue packages, the impact of
automatic stabilizers, and the support of the financial system including guarantees to the
banking sector led to a significant increase in public leverage to levels unprecedented in
peacetime. In other words, parts of the excessive private debt load were shifted to the public
sector.
The crisis exposed institutional weaknesses. Some had their source inside the financial
system. Despite some initial temptations for re-segmentation of prudential competences, the
response will be at the European and at the EU27 level. It will consist of the implementation
of new concepts and institutions aiming at de-risking the financial industry. Liquidity
monitoring through a monthly liquidity coverage ratio and a yearly net stable funding ratio will
be complemented by macro prudential surveillance in a European System Risk Board closely
associated with the General Council of the European Central Bank. The US equivalent to this
Systemic risk Board held its inaugural meeting at the beginning of this month.
Three European Agencies for banking, securities markets and insurance start with a mostly
coordination function, but have certain evolutionist competence clauses in their statutes.
They have to walk the narrow line between cross border activities of banks and integration of
markets on the one hand and competences remaining at national levels like deposit
guarantee schemes, resolution procedures, insolvency legislation, i.e. everything that
pertains to the tax payer who remains fiercely protected by national governments despite the
spill-over effects of cross border activities, on the other hand.
To tackle these effects through a potential 351 bilateral Treaties in so many areas among
27 member states, can hardly be seen as a stable equilibrium in decision making nor a level
playing field for economic activities in a single area.
The new institutional set-ups at EU level therefore face some of the same problems we
experience within the Euro-area. The ultimate goal will however be the same: foster
economic welfare through integration of markets and market players.
This obviously will also be beneficial for the optimal functioning of a single monetary policy at
Euro area level. The transfer of private debt into public debt as such was similar to what was
observed in the whole industrialized world. But the weak institutional framework for fiscal
discipline at national and at Euro area level as well as the absence of control by financial
markets was emphasized in some countries by three developments:
1. an overextended national financial system
2. an insufficiently strong starting position in the cyclical downturn in terms of deficit
and debt
3. a rapidly deteriorating competitive position as shown for example in unit labour costs
or current account balances
Suddenly markets reacted and overreacted while Governments excelled in denial and cloak
and dagger stories.
This slow reaction forced the ECB into action as a back-stop exposing the unfinished work of
the institutional set-up of EMU just as the financial crisis had exposed failures in the
macroprudential area throughout the industrial world.
In both cases, the welfare price of overly relying on market reaction only has become clear.
Now credible deleveraging has been implemented in many countries. This action should
allow those countries to be back on a sustainable trajectory of growth in the medium term.
A crisis management facility, the EFSF, has been set up as a symbol for the existence of a
"community of destiny" that is a monetary union. A common destiny engulfs solidarity. But
solidarity presupposes responsibility. This means that crisis prevention mechanisms are
even more important than crisis management facilities. And we have to recognize that before
a fiscal deterioration occurs and needs corrective actions, we ought to detect early signals in
the macro economic imbalances of economies that share a single currency.
To overcome the macro-economic heterogeneity within the Euro area, an explicit and clear
framework for the surveillance of competitiveness is needed with the aim of correcting large
imbalances. Despite having a single currency and central bank, national economic policies
remain insufficiently aligned. Forty years ago (!) the Werner plan was very outspoken on this
issue: "Having regard to the marked differences between the member countries in the
realization of the objectives of growth and stability, there is a grave danger of disequilibria
arising if economic policy cannot be harmonized effectively".
The needed framework is not aimed at increasing the power of the Commission in
macroeconomic surveillance in the EU but at highlighting the Euro area dimensions of surveillance
and policy adjustments. This dimension requires more automaticity with a focus on countries
with vulnerabilities, competitiveness deterioration and high debt levels. It should foresee
graduated sanctions at a sufficiently early stage to reinforce compliance. It should take aim at
national rigidities that are incompatible with a currency union, like automatic indexation
mechanisms of wages and pensions.
On the fiscal side, it is also worth remembering the emphasis that the Werner report put on
an independent fiscal authority.
The quality and independence of economic analysis is crucial.
Several suggestions could be made in this respect, for instance increasing the role of the
Commissioner in charge of Economic and Financial Affairs akin to the role of the
Commissioner in charge of competition. External assessment could also be provided by a
Committee of "wise persons". Quality and reliability of statistics need to be reinforced,
deadlines in procedures reduced, scope of discretion of exceptional circumstances curtailed
and more automaticity introduced. I hope that the Van Rompuy Task Force is bolder on
those issues than were the Commission's proposals.
To conclude:
In line with the vision of the Werner Plan, the integration of Europe as an evolutionary
process has to continue. The financial crisis of the last three years has uncovered the
institutional shortcomings of the current framework and exposed gaps in the existing
economic governance regime.
To make sure that the Euro will continue to be a stable and credible currency, monetary
policy has to be supported by sound public finances and balanced and sustainable economic
growth in the member states of the Euro area. A strengthening of the Stability and Growth
Pact, preventing and correcting macroeconomic imbalances at an early stage, and more
effective enforcement via gradual sanctions for non-compliant euro-area countries will help to
achieve this goal. An independent fiscal authority would help to advance the institutional
deepening of the Euro zone and, in this respect, reflect the spirit of Pierre Werner.