Jens Weidmann: Current developments in the euro area
Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank and Chairman of the
Board of Directors of the Bank for International Settlements, at the Bank of Slovenia, Ljubljana, 1
March 2017.
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1 Introduction
Governor Jazbec
Ambassador Riedel
Ladies and gentlemen
I am delighted to have the opportunity to return to Slovenia - and to Ljubljana. I was here just over
four years ago to attend the external meeting of the ECB Governing Council. So I already know
the charm Ljubljana holds for its visitors. This time, I will also have time to visit the National
Gallery, where I am especially interested in seeing the works of Slovenian artists. To me, art is
far more than mere decoration: it grants insights - for example, into a country's soul at a given
point in time.
Johann Wolfgang von Goethe, the great German poet, summed up this aspect of art as an
expression of our inner selves when he said: "The mediator of the inexpressible is the work of
art." Ladies and gentlemen, by accepting the invitation of the Bank of Slovenia to this event, you
no doubt had the expectation that I would express my views clearly. Indeed, this afternoon is
dedicated to a format that stands for arguments and facts - meaning the opposite of
"inexpressible".
In my speech I would like to shed some light on current euro-area developments and the
challenges ahead. I will then be glad to discuss with you the picture I have drawn.
2 Economic situation and monetary policy
The current economic situation of the euro area is quite good. The upturn has stabilised. With a
macroeconomic growth rate of 1.7%, GDP in 2016 actually grew more quickly than euro-area
production capacity; the output gap is gradually closing. Thus, unemployment in many euro-area
countries is falling; in 2016 the unemployment rate for the euro area as a whole declined by
almost 1 percentage point to 9.6%. That means it is now just a little less than 1 percentage point
above its average in the pre-crisis years. The current Eurosystem projection from December
assumes that the euro-area economy will continue to grow; namely by 1.7% this year and by
1.6% in each of the next two years.
A similar economic situation holds for Slovenia and Germany. Both countries currently benefit
from robust economic growth. In fact, capacity utilisation in Germany is yet perceptibly higher
than that of the euro area as a whole, employment is on maximum-value and confidence is quite
high, for both, consumer and enterprises. The Bundesbank's economists expect the economy to
grow at a rate of 1.8% in 2017, too. But this is nothing compared to the figures forecasted for
Slovenia. The European Commission is projecting growth rates of 3.0% in 2017 and 2018 due to
higher consumer spending and accelerating investment.
The robust economic upswing and rising capacity utilisation in the euro area will also drive up
price pressures gradually. Of late, however, inflation has risen even more strongly than expected
in the December projection, recently hitting 1.8%. This sharp increase in prices, however, is
attributable mainly to base effects and the higher oil prices of late - since the end of November,
oil has become significantly more expensive. Assuming that oil prices do not rise any further, I
see two notable developments.
First, inflation this year is likely to be well in excess of the figure projected to date; for Germany,
an upward revision of around one-half percentage point is expected - and this might also be the
case for the euro area as a whole. Second, we are likely to return to somewhat lower inflation
rates by the end of the year. This is because domestic price pressures are still comparatively
low at present. Core inflation, for example, which looks through energy price fluctuations and
other volatile components of the consumer price index, stands currently at around the 1% mark.
According to Eurosystem forecasts, however, it will slowly increase as the euro area continues
its economic recovery and it is expected to reach 1.7% at the end of the forecast horizon in 2019.
In this constellation, an accommodative monetary policy certainly continues to be appropriate,
though opinions differ over the right degree of monetary accommodation and the point in time at
which the price outlook will have firmed enough to justify a change in communication and
ultimately in the monetary policy stance. In this context, in my view some thoughts are worth
sharing.
First, monetary policy is automatically looser in the coming months, even without central bank
action: due to the increased inflation, the real interest rate declined. The effects are similar to a
central bank rate cut. Second, in the euro area, we are now far removed from the threat of
deflation, which is to say an expectations-driven downward wage-price spiral. Financial market
participants seem to have a similar take on it: the probability, derived from inflation options, that
the inflation rate will be negative in the next five years is now at its lowest point since the summer
of 2011. Personally, I have always deemed such a deflation scenario highly unlikely. Third, some
of the unconventional measures, which were taken in order to loosen the monetary policy stance,
come with a different risk-reward calculus than the standard instruments of monetary policy. I am
sure that it will come as no surprise that I am rather critical of government bond purchases.
This is because, in a monetary union of sovereign member states with a single monetary policy
and largely autonomous economic and fiscal policies, government bond purchases are not a
monetary policy instrument like our policy rates, for instance. Government bond purchases are
increasingly blurring the line between monetary and fiscal policy, and government funding costs
are depending to an ever greater extent directly on monetary policy decisions.
Euro-area central banks are now the largest creditors of their member states. All governments
ultimately pay nearly the same interest rate on the debt in central banks' balance sheets,
regardless of the country's creditworthiness. What's more: the larger the part of the debt that
central banks withdraw from the market, the less markets will exert their disciplining forces,
sanctioning unhealthy public finances with higher risk premiums. This is all the more worrisome
as the low-interest-rate environment offers few incentives for governments to consolidate their
budgets.
And indeed, fiscal policy in the euro area has been loosened noticeably over the past few years.
In contrast to what would be needed given the still high debt levels in many euro-area countries,
governments' savings in interest payments aren't being put towards the urgent goal of reducing
debt, but instead are being spent to a significant extent. John F Kennedy once said: "The time to
repair a roof is when the sun is shining." This is most certainly true. But if you don't want to risk
permanent damage to your house, you sometimes have no choice but to repair the roof when it's
raining.
I fear the danger of finance ministers becoming more and more comfortable with the high levels
of debt the longer these favourable financing conditions exist.
This could lead to a situation in which fiscal policy takes the bait of a sustainability illusion. And,
when the monetary policy reins have to be tightened due to increasing price pressure, the
Eurosystem could come under political pressure to make high levels of debt sustainable through
low interest rates. This, however, would put price stability at risk.
Against this backdrop, it is essential that the Eurosystem is independent. After all, history has
shown that independent central banks are better able to safeguard price stability than dependent
central banks. This is also one of the key findings enshrined in the economic literature of the
1970s and 1980s. To quote the words of Otmar Issing, former ECB chief economist: "Central
bank independence is indispensable if monetary policy makers are to be expected to pursue the
primary objective of a central bank to maintain price stability and to do everything in their power to
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achieve this." On the other hand, independence does not give a central bank carte blanche to
do as it pleases; it obligates the central bank to interpret its monetary policy mandate narrowly,
meaning to maintain price stability. This is because central banks' independence in monetary
policy matters is not a self-evident feature of a sovereign democracy given that other areas of
economic policy are subject to parliamentary control.
Monetary policy has to avoid the markets' perception that the central bank is only willing to
counter downward pressure on financial markets with an accommodative policy stance but
refrains from tightening the reins in times of higher price stability risks due to the fear of triggering
market turbulences. The so-called "Greenspan put" illustrates the moral hazard that can come of
such an asymmetrical approach. In extremis, monetary policy can even be held hostage by fiscal
policy or the financial markets.
At the same time, it is a matter of fact that the success of central banks in fulfilling their mandate
also depends on factors they cannot control. Sound public finances are only one precondition;
prudent measures to generate growth and to foster the stability of the European monetary union
are other examples.
3 Politics and the economic setting
3.1 Creating prosperity
Ladies and gentlemen
Contrary to what some believe - or might wish - it is not the responsibility of central banks to
ensure sufficient growth and economic convergence: it is the responsibility of the member
states. Or to put it metaphorically: it's not enough for a car to have a tank full of "liquidity" if you
want to speed up. Someone still has to rev up the engine.
Financing costs in the euro area are exceedingly low; the Eurosystem has done its part in
maintaining access to bank credit. In my view, financing conditions are no obstacle to private
investment, but muted long-term growth prospects are. In the end, it's the politicians who hold
the key that can unlock long-term economic growth. That's why the Governing Council has been
tireless in calling for structural reforms - for example, in tackling the impact of demographic
change. Both Germany's and Slovenia's long-term economic outlook is dampened because
demographic change will hit our countries particularly hard. In the coming years, more people in
both countries will be retiring than young people entering the job market.
But while the ambition should be to move into a higher gear on reforms, there are signals that we
have already shifted back down to a lower gear. "Going for growth 2016", a recent study by
the OECD, shows that since 2013 the speed of reforms has slowed down, especially with regard
to measures in the fields of "innovation policy, public sector efficiency or product and labour
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market regulation".
It is clear that each country has its own economic situation and preferences - meaning there's
no such thing as a "one size fits all" approach. But I am convinced that measures which lead to
sound public finances as well as competition-based economic systems with flexible labour and
product markets would foster long-term growth. Let me give you an idea of what could be
achieved by implementing the appropriate reforms. The International Monetary Fund (IMF)
conducted a study to determine which OECD countries have the most growth-friendly tax
regimes, labour markets and social insurance systems. IMF economists then calculated what
would happen if euro-area member states closed half of the gap to the leaders. The result is that
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annual euro-area growth in subsequent years would be just under one percentage point higher.
Making it easier for new firms to enter the market is one type of reform that helps to raise
competition and innovation. Measures which ease the process of setting up a new business and,
where necessary, eliminating red tape would boost growth potential, too. Lowering the barriers
that prevent enterprises from exiting the market would likewise foster growth. It would facilitate
what Joseph Schumpeter called "creative destruction". OECD research suggests that
policyinduced exit barriers matter for productivity growth, because fewer exits lead to less scope for
productivity spillovers and the misallocation of capital, labour and skills. It concludes, for
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instance, that insolvency regimes should be streamlined. The creation of a common services
market and a single digital market in Europe could also speed up long-term growth. Studies
show that this could yield twice the growth effect unleashed by the creation of the common
5,6
market for goods.
Additionally, companies in the euro area would benefit from a deeper and more integrated capital
market. This would also improve financial stability, because equity flows would be less prone to
sudden stops. Hence, more equity financing makes companies more shock-resistant, thereby
supporting growth and jobs. This is where the Capital Markets Union comes in. Currently,
European companies largely rely on bank debt - in relation to GDP, about four times more than
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in the United States. Improving and harmonising regulation could help to make equity markets a
better funding source for enterprises. The integrated equity markets in the US cushion around
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40% of total cyclical fluctuations between federal states. If a negative shock hits an industry or a
specific region, then this loss is spread widely beyond that region. Creditors, on the other hand,
are not exposed to losses - except in the event of insolvency. In other words: equity is a shock
absorber, debt is a shock amplifier.
But let me state clearly at this point. I am not pushing for the European financial system of the
future to look exactly like the American one. What is needed, however, is to supplement Europe's
financial system, not supplant it.
Finally, investing more in skills and education promises to deliver rich rewards, too. This would
not only boost labour productivity, but also reduce the risk of workers losing their jobs. Thus, it
would enable them to better cope with the structural change induced by globalisation and
technical progress. Labour market flexibility can also contribute to higher employment and
growth. Germany is a point in case here. Research shows that the labour market reforms
implemented in the middle of the last decade in combination with the moderate wage policy
definitively contributed to the fact that employment in Germany went up significantly and that the
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country overcame the crisis better than other countries in Europe. At the same time, however,
despite having contributed to preventing a further rise in income inequality, some see these
reforms as an explanation for the increasingly widespread perception that globalisation comes at
the expense of the low-skilled workers.
3.2 Preserve open markets and a competition-oriented economy
Ladies and gentlemen
The economic growth of our countries will also be influenced by one additional factor: the future
of global trade. Not least Ljubljana is a very good example of the welfare-enhancing effects of
trade. Emona, too - the ancient predecessor of Ljubljana the early Christian times - was a
thriving city thanks to flourishing trade.
These days, however, open markets don't seem to be very popular anymore. As all of you know,
the decision by UK voters to leave the European Union and the result of the presidential election
in the US have also been interpreted as signs of growing scepticism about globalisation.
Elsewhere in the world, too, many people are mainly seeing the disadvantages which
globalisation - and technological progress - unquestionably entail for some.
Public concerns on matters like these need to be taken seriously. But it's safe to say that barriers
and exclusion would be the wrong response. That's because open markets boost prosperity.
Free trade makes production more efficient by allowing specialisation and, therefore, by using
economies of scale. By increasing competition, it lowers the prices of goods and facilitates the
spread of new ideas and technologies. This, in turn, leads to more innovation and growth. Think
of the more than 3,000 year-old wheel which was found in the moor of Ljubljana. It is surely
undisputable that the invention of the wheel catapulted the well-being of mankind much as the
invention of money did when it spread throughout the world.
However, while the effects of globalisation on overall welfare are generally positive, this does not
necessarily apply for each of us all the time. The invention of the wheel, for example, left the
owners of pack animals worse off rather than better off, even though it did bring relief to mankind
in general. The right reply to public concerns about a competition-based economy with open
markets is not to build up barriers. Instead it would be to enable as many people as possible to
benefit from it and to shield the rest from its negative aspects. This would mean enhancing
education, but also improving the flexibility of goods and labour markets. And it would mean a
well-targeted and transparent tax and transfer system which could act as a cushion. The
interplay of these factors was well-known to the mentor and creator of the so-called "social
market economy" in Germany, Ludwig Erhard. For him, this is the foundation of what he neatly
encapsulated with the phrase "Prosperity for all". In any case, together with the German
government I appreciate the opportunity to discuss the issue of open markets and fair trade in the
current G20 process under the German presidency.
Ladies and gentlemen
If I might be permitted one side note: an accusation has been made that Germany is taking
advantage of the United States and other countries with an undervalued currency. In my view,
this criticism is actually beside the point. While there is a kernel of truth in the argument that
the US dollar is currently strong, the United States has, up until recently, enjoyed a very
favourable competitive position for almost a decade. These ups and downs in exchange rates,
and thus also in terms of price competitiveness, are entirely within the realm of normal
fluctuations.
The fact that Germany's economy is highly competitive certainly isn't the outcome of
manipulative policy, either. While its competitiveness certainly does benefit from the low external
value of the euro, this is predominately due to different monetary policy paths on both sides of the
Atlantic, which also reflects different cyclical positions, as well as to policy announcements by
the new US administration. Additionally, German enterprises are competitive because they are
excellently positioned in global markets and offer innovative products. The very high current
account surplus of 81⁄2% of GDP is mainly attributable to this.
Given the foreseeable demographic change, current account surpluses for Germany are quite
appropriate at the present time, as this reflects how Germans provide for old age, amongst other
things. The assets held abroad will later be depleted as more and more employees retire and run
down their savings. German investors, then, are harnessing the higher returns on offer in regions
with faster-growing economies, not at least in Slovenia, where German enterprises are the third
most important investors. In my view, this seems to be a situation in which both sides win.
That said, however, the high current account surplus we see today in Germany cannot be put
down to demographics alone. And also the low oil price, which diminished the cost of imports,
explains only part of the high surplus.
It would nonetheless be wrong, in my opinion, to scale back this surplus by adopting economic
policy measures that deliberately erode the competitiveness of German enterprises or by
embracing debt-fuelled government spending, as some have been calling for. First, the import
content of German exports is quite high. Intermediate inputs and goods delivered by other
euroarea countries account already for nearly 40 percent of German exports. So, making German
exports less attractive also weakens component suppliers, including those located in other
euroarea countries. Second, with capacity utilisation currently running at above-average levels, a
government expenditure programme would not only be pointless; it would also be of little benefit
to other countries. The ripple effects would be too small. And if monetary policy were to react
with higher policy rates, the effect on the economies in other euro-area countries could possibly
be negative.
At the same time, it is appropriate that public investment increases given the need to improve the
infrastructure and provide more education. What is also indispensable, however, is a more
growth-friendly environment to foster private investment and growth.
3.3 Institutional framework of the EMU
Ladies and gentlemen
Economic uncertainty is the enemy of investment. That is true not only of uncertainty over the
future of global trade but also of uncertainty over the stability of the European Monetary Union. It
is crucial that we also make the institutional setting of the EMU more stable and restore trust, for
instance by abiding by the agreed rules.
The financial and sovereign debt crises in the euro area had one major characteristic in common
- both saw a core economic principle being violated: the liability principle. German economist
Walter Eucken, who was another founding father of Germany's social market economy, once
said very aptly: "Those who reap the benefits must also bear the costs." If banks assume they
are too big to fail, they will be tempted to make the most of this implicit insurance and take on
excessive risks, at the expense of society at large. This is exactly what happened before the
financial crisis. This kind of implicit insurance is not altogether unlike the framework of the
European Monetary Union, where a single monetary policy exists alongside 19 largely
autonomous economic and fiscal policies. I have already mentioned this special feature of our
monetary union.
As the crisis taught us, this set-up potentially exposes the EMU to vulnerability. Because at the
end of the day, the community may have to foot the bill for unhealthy developments in individual
member states if it wishes to prevent the stability of the union as a whole from coming under
threat. The option to spread the consequences of unsustainable policy across the entire
monetary union might weaken the incentives to run sound policies, in particular a healthy
budgetary policy. This is why institutional safeguards were put in place before the euro was
launched: the Stability and Growth Pact, the no-bail-out clause, and the ban on monetary
financing of governments. Unfortunately, these safeguards failed to prevent public debt from
ballooning in some euro-area countries. The crisis played a role in this, but so did the fact that
the fiscal rules were repeatedly violated and the capital markets didn't sanction these breaches
because the no-bail-out clause lacked credibility.
When doubts about the debt sustainability of some euro-area member states surfaced during the
sovereign debt crisis, the urgently-taken rescue measures helped to prevent the crisis from
escalating. But they did so by mutualising fiscal liability on a substantial scale. Economic and
fiscal policies, on the other hand, essentially remained a national prerogative, though the fiscal
rules have admittedly been adapted. As a result, the balance between liability and control has
been thrown out of kilter. However, striking an even balance between liability and control is crucial
for the functioning of the EMU. In theory, there are two possible ways to restore this balance:
through deeper integration, or through greater national responsibility on the part of the individual
member states.
The first solution would be to create a fiscal union with centralised decision-making powers.
While a fiscal union would not guarantee sound fiscal policymaking, it could certainly mitigate the
deficit bias of individual member states. But let's be honest here. A fiscal union approach is not
on the cards, because it implies the delegation of sovereignty to the European level in a
substantial scale. As long as there's no willingness to transfer national sovereignty to the
European level, there will be no basis for mutualising sovereign risks.
And that's why a European Deposit Insurance Scheme (EDIS) is also not the right institutional
response in restoring the balance between liability and control in the euro area at the current
point in time. As long as actions taken at the national level, such as drafting insolvency laws, or
very high stocks of government bonds on banks' balance sheets can have a substantial impact
on the health of financial institutions, the European Deposit Insurance Scheme would allow risks
arising from national decisions to be shifted to the European level. This would send the wrong
incentives to banks and investors alike. The mutualisation of risk would not go hand in hand with
the necessary mutualisation of control rights - irrespective of the Single Supervisory Mechanism
that has been put in place.
Whenever - as a reaction to the Brexit-vote - calls are made for greater mutualisation of debt, I
think it's rather like a ship that is listing: when the passengers - eager to help - rush to the lower
side of the ship then, contrary to their good intentions, they are not helping to remedy the
unfortunate situation at all but are, in fact, making it worse.
The second way to restore the balance between liability and control, meanwhile, would be to
strengthen the Maastricht approach based on individual responsibility. This would leave
economic and fiscal policy, as well as ultimate liability for public debt, in the hands of the
individual member states. But how could such a decentralised approach work better in future
than it has done in the past?
Although the rules were changed after the crisis, the European Commission was granted more
flexibility in interpreting them. And it has used this flexibility quite a few times so far - and always
to interpret the rules very loosely. As a result, the binding force of the budgetary rules is weaker
than ever before - as we can see, for instance, in the budgetary developments in France, Spain,
Portugal and Italy. One way of ensuring that the rules are binding would be to install a new and
independent authority, a fiscal council. This institution would not be exposed to the same political
conflicts of interest as the Commission, which has to assess whether national budgets comply
with the Stability and Growth Pact and hammer out political compromises between the interests
of the different member states. Of course, the European Council ultimately holds the key to the
success of any budgetary control. Its determination to enforce the rules and support the
Commission in a strict interpretation is all-important.
"Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But,
when it is used imprudently and in excess, the result can be disaster." This statement by
former BIS chief economist Stephen Cecchetti and his colleagues Madhusudan Mohanty and
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Fabrizio Zampolli is directed not only at private debt but at public debt as well. They show that
excessively high private and public debt is a risk not only to financial stability but also to
economic growth. According to their estimations, in the euro area we are already in the danger
zone - at least with regard to corporate debt, at 105% of GDP, but also in terms of public debt, at
91%. And so this is one more reason why effective limits for government debt are urgently
needed.
Binding fiscal rules and an institution that observes their adherence are just one component of a
consistent reform agenda. Additionally, it is important for capital markets to resume their role of
disciplining national fiscal policy. As for enterprises, more deeply indebted countries ought to pay
higher interest rates. This will only happen if the no-bail-out clause in the Maastricht Treaty really
does have teeth. Therefore, it must be possible to restructure public debt without posing major
risks to the financial system.
The July 2016 edition of the Bundesbank's Monthly Report describes what needs to be done to
make this possible. There are two reforms I would now like to mention. First, we need to sever
the sovereign-bank nexus. A strong inter-linkage between banks and sovereigns increases the
probability of a bail-out by other member states and weakens incentives for risk-oriented pricing.
And it is precisely this sovereign-banking nexus that contributed to a mutual intensification of the
crisis in the euro area, when banks suffered from declining prices for sovereign bonds in their
balance sheets and countries from struggling banks in their territory. The European banking
union already marks a huge step towards untangling this dangerous embrace. However, to
complement the banking union, it is also crucial that we do away with the preferential treatment
of sovereign debt in banking regulation. This implies that, similar to banks' lending to the private
sector, sovereign exposures will need to be backed by capital and also be part of a large
exposures regime.
A second measure concerns the design of the European Stability Mechanism's financial
assistance programmes. The ESM is there to provide resources to countries that apply for
an ESM financial assistance programme. However, these funds are generally used not only to
cover budget deficits, but also to redeem maturing sovereign bonds. By implication, when a
programme is activated, European taxpayers are, in essence, bailing out the respective country's
creditors. This does not exactly foster willingness on the part of member states to agree to
restructure a programme country's debt. Instead of a truly viable solution being reached, when
push comes to shove, a strategy of muddling through would win the day. That's why the
Bundesbank is proposing to add a clause to the government bonds of euro-area countries which
automatically extends the maturity of bonds by three years if the member state in question
applies for ESM assistance. This way, the initial creditors would remain liable, and if the
government debt really did need to be restructured, that could be done in an orderly fashion
without jeopardising financial stability.
The financial crisis also showed, however, that wobbling banks can cause sovereigns to
stumble. To cut this part of the nexus, financial market regulation has already been improved
substantially. In the euro area, a common restructuring and resolution regime (the Single
Resolution Mechanism) and a bank supervision body under the aegis of the ECB (the Single
Supervisory Mechanism) are in place. The Single Resolution Mechanism and the Bank Recovery
and Resolution Directive (BRRD), which assure the harmonised implementation of the rules
throughout all member states, substantially strengthen the principle of individual responsibility in
the banking sector, thereby reducing the likelihood of public bail-outs. And in this sense, both are
important elements not only to protect tax payers but also to make the euro area more stable.
However, the first line of defence in making a bank resolution less likely is the establishment of
higher capital requirements for banks, as the Basel Committee on Banking Supervision already
decided in principle six years ago. The good news is: the resilience of the European banking
sector went up significantly. This is proven by the fact that Common Equity Tier 1 (CET1) for the
directly supervised SSM banks rose after the financial crisis to 12.8% by mid-2016, and that this
level is well above the unchanged aggregated capital demand of the Supervisory Review and
Evaluation Process (SREP) for 2017 of around 10%. Nevertheless, it is important that Basel III is
implemented in a timely manner. This would also reduce regulatory uncertainty for banks, which
in my view is a serious burden for them.
4 Conclusion
Ladies and gentlemen
writer Mary de Rachewiltz once called money the obscene Doppelgänger of creative writing,
because both are made from nothing, their economies both hinge on moderation and efficiency,
yet they both tend to proliferate.
As a central banker, I know rather more about monetary policy than about literature. But I do
know that too many words can be just as inflationary as too much money. I'm certainly aware,
however, that I've used quite a number of words to clarify