Klaas Knot: The future of EMU and the Netherlands' place in Europe
Speech by Mr Klaas Knot, President of the Netherlands Bank, before the OMFIF (Official
Monetary and Financial Institutions Forum), London, 17 February 2012.
* * *
Thank you for this opportunity to exchange views with you on this topical issue. Thank you
also for arranging for me to do so amid the splendour of this magnificent hall. I feel quite safe
standing here, for I understand the Armourers' Hall was among the few buildings that
escaped destruction in the Great Fire of 1666, and, in 1940, also survived a major blitz on
London, while the surrounding area was devastated. So one might say that this venue
symbolically suits my subject of today, for I am confident that in the distant future we will be
able to say that EMU still survives.
Speaking of which, I couldn't help but notice that the title of my talk as announced in the flyer
is "The Future of European Monetary Union", instead of "Economic and Monetary Union"
which the term "EMU" stands for.
Don't worry, you find yourselves in good company; many European governments are only
now starting to realize that they haven't paid enough attention to the "E" in EMU.
My talk today consists of two parts. In the first part, I'll focus on why it is that, for the
Netherlands in particular, it is so important that the European project will be successful. In
the second part, I'll discuss the implications of the European sovereign debt crisis for the
future design of EMU.
I will argue that at the root of the crisis we find some individual euro area countries pursuing
wrong policies and a failing system of mutual surveillance in the euro area. These
deficiencies pose a number of challenges for the future of EMU. While the introduction of the
euro has increased macroeconomic stability and furthered trade and financial integration, the
sovereign debt crisis clearly demonstrates that the job is not done yet.
The alliance of the Netherlands with Europe has always been strong and will remain so in the
future, if only because of its small size and geographical location. The same holds true for
the other "low country", Belgium.
By nature, Dutch people have always had a strong focus on Europe.
Just to illustrate this point, every pupil in high school has to learn at least two foreign
European languages. Foreign residents in the Netherlands even complain that it is hard to
learn Dutch in Holland, because everybody they speak to in Dutch replies in English, French
or German.
Another way to illustrate the Netherlands' focus on the outside world is to look at the
openness of its economy. If you take a look at Chart 2, you find openness defined as exports
plus imports as a percentage of GDP.
As you can see, in the US, exports plus imports are less than 30% of GDP.
In France, Italy, Spain and the UK, this indicator is between 53 and 63%. In the Netherlands,
exports plus imports are nearly 150% of GDP, and in Belgium and Ireland even more.
As a consequence of this openness, the realization of the single market and the introduction
of the euro later on did have a substantial positive impact on the Dutch economy. After all,
one of the most significant yields was the boost that EMU provided to trade. Driven by lower
transaction cost, lower exchange rate risks and more market transparency, trade within the
euro area developed more strongly than outside the euro area. Being a country of trade and
distribution by tradition, the Netherlands has taken advantage of these circumstances. For
sure, it is one of the reasons why the Dutch economy outperformed the euro area in terms of
GDP growth in 14 out of the last 20 years.
The strong alliance of the Dutch economy with Europe in general and the euro area in
particular also shows up if we look at its exports orientation. In Chart 3 you see this defined
as exports to the euro area expressed as a percentage of total exports. It follows that the
orientation on the euro area is the largest in the Netherlands. More than 60% of our exports
goes to euro area countries.
Given its close ties with the euro area, it is obvious that for the Dutch economy a solution of
the European sovereign debt crisis is of vital importance. If EMU were to fall apart, the
consequences for the open Dutch trading nation would be severe. Therefore, Dutch
policymakers and central bankers should do their utmost to solve this crisis. In what follows, I
will first focus on the causes of the sovereign debt crisis. Finally, I will present my views on
the implications for a stable design of EMU.
Over the last couple of months, European policy makers have done a lot to restore
confidence.
As a consequence, most stressed sovereign debt markets have calmed down substantially
(left-hand side of the graph). The most important development was the announcement and
finalisation of the Fiscal Compact, in which the political leaders of the euro area countries
(and most other EU countries) further strengthened the rules governing budgetary discipline
in Europe.
Furthermore, in March the capacity of the EFSF/ESM will be evaluated. We have to conclude
that the EFSF in its current form (based on guarantees) and size unfortunately has failed to
convince markets that all countries will get through this crisis unharmed. This is why we as
central bankers call upon the European governments to increase the emergency facility as
soon as possible.
The ECB also took further measures to avoid the sovereign debt crisis from severely
dragging down the real economy. It did so by introducing a refinancing operation with a
maturity of three years.
As Chart 4 shows, this operation attracted a lot of interest, with a total volume of
EUR 490 billion (right-hand side of the graph). This is not all "new" liquidity by the way, since
banks also rolled over operations with shorter maturities into this new facility. This provides
them with the liquidity security they need in light of the market tensions and, thus, helps
prevent a sharp reduction in credit supply to the economy.
At the end of this month, a second three-year operation will be carried out.
In analysing and solving the sovereign debt crisis, the focus was on fiscal and monetary
factors rather than on the macroeconomic causes of the crisis.
However, as I'll briefly demonstrate by means of Charts 5, 6 and 7, these causes are at least
as important as the fiscal slippages some countries allowed themselves.
At the start of EMU, per capita income levels between countries differed significantly. It was
assumed that catching-up countries would experience faster economic growth. This is what
did happen, but not quite to the extent expected.
Prior to the crisis, mainly Ireland, and to a lesser extent also Greece and Spain, showed
signs of real convergence. Their cumulative growth differentials compared to Germany
reached 20 to 45% in 2007.
Note that Italy and Portugal hardly experienced any real convergence towards the German
welfare level, even before to the crisis. Even the Netherlands "converged" more than these
countries.
Unfortunately, the catching-up process largely took place through debt, either public or
private. As Chart 6 shows, in some countries credit to the private sector grew by more than
10% a year for over a decade. As a result, their debt with the rest of the world ran up
tremendously. This was most dramatically the case in Ireland, which moved from a net
creditor position of 52% of GDP in 1999 to a net debtor position of 71% of GDP in 2008.
Note that the Netherlands is not doing particularly well with regard to this measure either.
This is mainly the result of the growth in mortgage loans.
In my view the high stock of mortgage debt is among today's biggest vulnerabilities of the
Dutch economy.
Besides being largely based on credit, real convergence was accompanied by high inflation,
as you find visualised on Chart 7.
Whereas Germany experienced lower inflation compared to the euro area average, the
inflation rates in Greece, Ireland, Spain and Portugal were much higher than the EMU
average.
This substantial deterioration of competitiveness mainly reflects the development of unit
labour costs.
The economic developments in Germany in the last decade have been phenomenal. The
time that Germany was called the sick man of Europe is not so far way. Partly due to the
supply of many low-paid workers from East Germany, the labour market institutions in
Germany were no longer sustainable. This has led to the so-called Harz reforms, which
made the German labour market more flexible and tempered unit labour costs and inflation.
Before EMU, the current euro area countries followed different economic strategies. Between
1970 and 1999, unit labour costs in Germany, the Netherlands en Austria grew by a factor of
2.5 to 3. During these 28 years prior to EMU, unit labour costs grew by a factor of 12 in Italy,
14 in Spain, 35 in Portugal and 55 in Greece. By regularly devaluing their currencies, these
countries were able to restore competitiveness. But after the launch of EMU, this policy
option was no longer available, of course.
The hope was that these countries would adapt to this new reality and unit labour costs
growth would slow down. But has this happened?
Chart 8 shows the cumulative growth of unit labour costs relative to the euro area average
from the start of EMU. While countries like Germany, Austria and Finland continued their
modest wage policies, unit labour costs in Southern European countries went up at a much
higher pace, undermining their competitiveness. This proved unsustainable. The countries
that found themselves in the top of the chart when the sovereign debt tensions started in
2009 - that is Greece, Spain, Ireland, Portugal and Italy - all ran into trouble one after the
other.
This is no coincidence. Currently, adjustments are hard-handedly being enforced by the
markets.
In the said countries, Ireland excepted, product and labour markets didn't function properly
and they still don't. Markets are overregulated and labour markets are highly inflexible. By
addressing these problems, labour productivity can increase, thereby lowering unit labour
costs. I am not saying this will be easy, but I'm convinced that such steps are absolutely
necessary for EMU to function properly.
As the chart also shows, in the Netherlands unit labour cost growth was also relatively high
during the first years of EMU. This, however, wasn't caused by the high inflation rates and
low flexibility of the labour market, but reflected the low unemployment rate in the
Netherlands in that period.
For many years, the unemployment rate in the Netherlands was the lowest in the euro area.
The divergences in unit labour cost developments and price competitiveness within the euro
area are reflected in the current account balances of the individual countries. As you can tell
from Chart 9, before the crisis, most southern European countries and, to a lesser extent,
Ireland experienced high and steadily increasing current account deficits, while the current
account surpluses of Germany and the Netherlands improved further.
For many years it was thought that in a monetary union, the current account balances of
individual countries were no longer relevant.
It was only the balance of payment of the euro area as a whole that mattered.
We know better now.
Of course, besides competitiveness problems, the crisis also had fiscal causes.
As can be told from Chart 10, the stability and growth pact didn't prevent some governments
from taking up old habits once they had fulfilled the convergence criteria that enabled them to
join EMU.
We shouldn't forget, however, that this was facilitated by some of the core countries of EMU.
When it became clear that fiscal policies in these countries wouldn't be able to meet the rules
of the Stability and Growth Pact, it was not the policies that were changed but the Pact.
This was clearly a mistake.
Besides, the gradual worsening of the budget balance in countries like Italy and Portugal was
partly due to their competitiveness problems.
Since devaluing out of these problems was no longer an option, the declined
competitiveness slowed down economic and employment growth.
This dampened tax revenues while stimulating social security expenditures.
Looking at it this way, the lack of fiscal discipline partly reflected the lack of macroeconomic
discipline.
More in general, budgetary policy was supposed to absorb temporary cyclical differences, by
allowing the automatic stabilisers to do their work.
For example, during a downturn, public spending automatically goes up as more people
receive unemployment benefits, while tax revenues decrease.
Such "automatic" response to cyclical developments stabilises the economy.
But in most member states, the automatic stabilisers have failed to operate properly since
1999.
Instead, a number of governments followed pro-cyclical budgetary policies, by loosening the
budgetary reins during the economic booms, and tightening them during the busts.
In other words, budgetary policies have hampered the functioning of EMU.
Budgetary discipline in EMU was supposed to be exacted not only by the stability and growth
pact, but also by market discipline.
Markets were expected to restrain profligate governments by charging them higher interest
rates and, thus, forcing them to change their ways.
As is evident from Chart 11, market discipline was largely absent during the first ten years of
EMU, allowing governments to pursue unsustainable policies. And when markets finally
started to differentiate between governments, they did so with a vengeance. Although market
discipline is now imposing necessary corrections, a stable monetary union cannot be based
on this mechanism. So what would a stable monetary union look like in my view?
As I argued earlier, some euro area countries have not fully adapted to the fact that they lost
the option of devaluation in order to restore competitiveness.
If they had, they would have increased their flexibility and growth potential by reforming their
labour and product markets.
Given the spillover effects of postponed structural reforms on the functioning of EMU, these
reforms cannot be the sole responsibility of the governments concerned, but should also
have a "European" dimension. This can take different forms.
One way could be to strengthen the macroeconomic imbalances procedure, by increasing its
focus and enforceability.
This could be done, for instance, by introducing more reversed Qualitative Majority Voting in
these areas.
Another way would be to introduce minimum standards or best practices in policy areas
where spillovers have turned out to be especially high, such as labour market policies.
Importantly, what should be avoided is harmonisation towards some kind of EMU average,
as this would force strong countries to reduce their competitiveness.
Secondly, debt ratios should gradually be brought well below the ceiling of 60%. This lower
debt ratio can only be realised and maintained through independent enforcement of the
European fiscal rules and by anchoring these rules in national legislation. A politically
independent European authority that can increasingly intervene in the fiscal policy of
countries breaking the agreements is essential here.
If - and only if - these conditions have been met, eurobonds could be a serious option.
Eurobonds could enhance the stability of EMU in several ways. They would prevent a
liquidity problem in one euro area country from needlessly transforming into a solvency
problem. Moreover, they could provide a fire wall against the danger of contagion. Although
eurobonds are not suitable as a crisis instrument, they could be the light at the end of the
tunnel for the people of vulnerable euro area countries.
For the people in those countries need to feel that their sacrifices will contribute to a
permanent solution; one that will safeguard them from the short-sightedness of both
politicians and markets.
As I said at the beginning of my presentation, it is obvious that for the Dutch economy a
solution of the sovereign debt crisis is very important, given its strong connections to the euro
area. And therefore, Dutch politicians and central bankers should do their utmost to solve this
crisis.
But what is it we can offer?
In my opinion a lot. Pragmatism, common sense and a focus on problem-solving are crucial
now and the Dutch happen to be famous - not to say notorious - for these characteristics.
Although we can be very principled on some issues and in many cases see eye to eye with
the Germans, these typically Dutch characteristics could help divided euro area countries to
stick together and solve this crisis. Pointing at the long-term perspective of eurobonds once
the necessary conditions have been met, is an example of this pragmatism and focus on
problem solving.
Let me finish this presentation by saying that finding a structural way out of the crisis will not
only be beneficial for the Netherlands, but also for the euro area, the rest of Europe, and,
yes, even for the world economy.
Thank you for your attention.
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