Lucas Papademos: The dual crisis - economic impact, policy response
and exit strategy
Speech by Mr Lucas Papademos, Vice-President of the European Central Bank, at the
HighLevel Panel Debate on "Europe in the Economic and Financial Crisis: How to bring back
prosperity for everyone?", organised by the European People's Party, Brussels, 4 May 2009.
* * *
I. Introduction
Let me start by thanking the organisers for inviting me to this policy debate on how to
overcome the current economic and financial crisis and bring back prosperity for everyone.
This subject remains topical and challenging. Lately, among the generally gloomy reporting
on the state of the economy, we have observed some positive signs emanating from market
developments and confidence indicators suggesting that the economy is stabilising. Indeed,
one indicator that has recently surged is the one measuring the use of pertinent metaphorical
expressions: we hear of "green shoots"; "glimmers in the dark"; and, the more traditional,
"light at the end of the tunnel". Some indices suggest that the pace of deterioration in the
global and European economies is slowing, and equity markets seem to reflect expectations
of improving prospects. But it will take some time before our economies fully recover and
grow at a robust and sustained rate.
The theme of this debate rightly emphasises two important issues that are relevant for public
policy: first, the dual character of the current crisis, which is both financial and economic and,
second, the need to also focus on the longer term. The actions of policy makers and market
participants should not only aim at overcoming the current difficulties, but should also
consider the strategy and measures that will ensure sustained prosperity and that crises
such as the current one will not occur again.
Accordingly, in my remarks I will address three issues:
•
first, the evolving nature of the ongoing crisis and its potential total impact on the
European economy;
•
second, the rationale and the effectiveness of some of the measures being
implemented to resolve the problems we are confronted with; and
•
third, the need to implement reforms and adopt an appropriate exit strategy, from
the extraordinary policy interventions, so as to improve the functioning and
resilience of the financial system and achieve sustained economic growth in an
environment of monetary and financial stability.
II. The evolving nature of the crisis and its economic impact
The nature and scope of the crisis has evolved substantially since it erupted in the summer
of 2007. Initially and for a considerable period of time, it was mainly an episode of strong
financial turbulence that affected certain segments of the credit market resulting in large
writedowns on a class of assets (complex structured products) that affected a relatively
limited number of institutions in advanced economies. Progressively, and especially since
mid-September 2008, it has evolved into a global crisis affecting advanced, emerging and
developing economies; and it has spread across economic sectors. The, more or less,
synchronised decline or deceleration of economic activity worldwide has been accompanied
by a collapse of world trade that has further depressed global economic activity.
A key feature of the current crisis is the mutually reinforcing interaction between, on the one
hand, the weakening of economic activity and the rising unemployment and, on the other
hand, the process of deleveraging and repair of banks' balance sheets and the persisting
tensions in some financial markets. The weakening of economic activity has been impairing
the quality of bank loans thus adversely affecting banks' capital positions and their
willingness to extend credit to the private sector. This, in turn, imposes constraints on
economic activity and the ability of firms and households to service their debts, increasing
the likelihood that banks will suffer further credit losses and tighten their lending standards.
Therefore, the main immediate policy challenge is to prevent the emergence of a strong
adverse feedback loop between the real economy and the financial sector.
Before examining the effectiveness of the policies being pursued to address this challenge,
let me briefly refer to the impact of the crisis on the economy and the financial system of the
euro area. Since the financial turmoil deepened and broadened in the autumn of 2008, its
impact on the economy has increased substantially. The significant deceleration in real GDP
growth in the euro area to 0.8% in 2008, from strong growth rates of 2.7% in 2007 and 3.0%
in 2006, reflects the sharp contraction in activity by 1.5% in the fourth quarter of last year.
The latest available information suggests that aggregate output recorded a further sizeable
decline in the first quarter of this year. The recent forecasts by the IMF paint a gloomy picture
for economic activity in the euro area, with real GDP projected to decline by 4.2% in 2009
and by 0.4% in 2010.1 The European Commission also predicts a significant contraction of
euro area GDP this year, by 4.0%, and still slightly negative growth of -0.1% for 2010.2
What is behind these forecasts? Two important determinants, among others, that have been
adversely affecting private consumption and investment are the perceived unusually high
uncertainty surrounding the European and global economic outlook and the exceptionally low
confidence in the financial system. Reducing this uncertainty and restoring confidence will be
crucial for increasing the effectiveness of the policy measures being implemented and the
pace of the recovery.
The estimated total potential impact of the ongoing crisis on the value of assets held by
global and European financial intermediaries is very large and has recently been revised
upwards. According to the IMF, the total potential writedowns on assets originated in the
United States, Europe and Japan could reach USD 4.1 trillion over the period 2007 - 2010,
of which USD 2.8 trillion would be borne by banks. The total expected writedowns on assets
- both loans and securities - held by European banks are estimated at USD 737 billion. It is
useful to distinguish between the actual losses incurred so far, and potential future losses. In
Europe, the reported writedowns (on securities and loans) of banks so far3 amount to almost
USD 358 billion (of which euro area banks account for less than USD 173 billion). At the
same time, a total of USD 382 billion of fresh capital has been raised by European banks (of
which USD 190 billion was raised by euro area banks). Therefore, the newly injected capital
into European and euro area banks exceeded the reported writedowns.
Looking forward, the potential further losses of European banks until the end of 2010 are
estimated at USD 750 billion.4 It is important, however, to keep in mind that estimates of the
potential future writedowns on assets are based on many underlying assumptions
concerning the future path of economic activity, asset market developments and the
calculation of impairment charges on loans. These estimates are therefore subject to a
substantial margin of error. There is, however, one important point concerning the estimated
potential future writedowns of European banks. They mainly reflect expected losses on loans
and to a lesser extent further writedowns on securities. This underscores the significance of
pursuing policies that can prevent, or at least limit, the negative feedback loop between the
banking system and the real economy. And this brings me to the appropriate policy
responses.
III. The rationale and effectiveness of policy measures
The nature and scope of the crisis has required the concerted and parallel implementation of
(1)
three types of policy responses: macroeconomic policies to stimulate aggregate demand;
(2) the provision of liquidity by central banks to ensure the orderly functioning of money
markets, contain spillover effects on the financial system and foster the financing of the
(3)
economy; and government measures to repair and strengthen bank balance sheets so as
to stabilise the banking system and help restore the provision of credit to the economy.
There are three general points I would like to make at the outset concerning the magnitude
and effectiveness of these policy actions. First, the overall effectiveness of the measures
depends not only on their design but also on their implementation which must be timely, well
targeted and concerted so as to simultaneously address financial market stresses and the
weakening of economic activity, thus preventing the development of adverse feedback
dynamics between the financial system and the real economy. Second, policy actions must
be implemented in a manner that helps achieve the immediate objectives of stabilising the
financial system and supporting economic activity, and at the same time, (ensures that the
recovery of the economy will be sustained) lays the foundations for sustained growth and
prosperity.
The third point concerns the appropriate size of the economic stimulus and the nature of the
other measures taken across countries and economic regions. The features of the policy
strategies pursued, the precise design, magnitude, and implementation modalities of the
relevant policies need not be identical across countries or economic areas, for instance, on
both sides of the Atlantic, or - for that matter - on the two sides of the English channel.
Some differences in size or scope are warranted by different economic and financial
conditions as well as by different institutional structures. Having said that, the general
orientation and the overall strategy of the policies being pursued have been similar in all
major economies. This commonality derives from our shared analysis of the causes of the
crisis, its evolving global character and the lessons that have been drawn about the
appropriate policy responses and the need for concerted actions across the globe.
Let me now focus on central bank policy in the euro area. Since the eruption of the financial
turmoil, the ECB has acted decisively providing and managing liquidity in the interbank
currency market so as to foster its orderly functioning and ensure that banks have adequate
access to central bank funding and can continue to finance the economy. The provision of
liquidity by the ECB to the euro area banking system has been extraordinary in size and
scope. It has involved the implementation of non-standard measures, such as the provision,
since last October, of unlimited funding in euro at fixed interest rates over periods up the six
months against an expanded list of eligible assets for use as collateral in Eurosystem
refinancing operations. In addition, the ECB has supplied liquidity in other currencies, notably
US dollars, on the basis of a swap agreement with the Federal Reserve. These money
market interventions contributed to the growth in the size of the Eurosystem's balance sheet
which has increased since the financial turmoil broke out by around EUR 600 billion,
between end of June 2007 and end of April 2009, and had reached EUR 1.51 trillion (or USD
2.01 trillion) by the end of April. This figure is equal to 16.0% of the nominal GDP of the euro
area. For comparison, the balance sheet of the Federal Reserve System was USD 2.03
trillion or 14.0% of the US nominal GDP.
The extraordinary expansion of liquidity provision to the euro area banking system has made
an important contribution to the financing of the economy because of the dominant role of the
banking system in the financing of the private sector in the euro area. More generally, the
generous provision of central bank money has ensured that banks' funding constraints and
perceived liquidity and counterparty risks have not caused a systemic crisis. Nevertheless,
bank lending standards have been tightened and credit growth to the private sector has
declined. The latter is partly a consequence of reduced demand for bank loans and partly a
result of the deleveraging process in the banking sector and persisting stresses in the bank
wholesale funding markets.
As the financial crisis deepened and broadened from mid-September last year, inflationary
pressures and risks diminished in the euro area and globally. This was mainly due to the
substantial weakening of global economic activity and the accompanying marked decline in
commodity prices. Moreover, and despite the huge increase in the provision of central bank
liquidity, broad money (M3) growth and the expansion of credit to the private sector
decelerated, confirming that the upside risks to price stability were abating. In response, the
Governing Council reduced the key ECB interest rates by an unprecedented 300 basis points
between October 2008 and April 2009. As a result of the lowering of the key policy rates and
the provision and management of liquidity, money market rates have declined even more
from the peaks reached in October 2008. For example, the six-month Euribor rate was 1.56
% at the end of April, almost 400 basis points lower than its peak value last October (5.45%)
and virtually the same as the corresponding Libor rate (1.51%) in the US dollar money
market. Thus, over the past seven months conditions in the euro area money markets have
significantly improved and they are virtually the same as, or even better than, those in other
major money markets. These favourable money market developments have gradually been
reflected in a decline in bank lending rates, especially on short-term credit to the private
sector.
Later this week, the Governing Council will assess, on the basis of the latest available
information and analysis, the medium-term outlook for and the potential risks to price
stability, and, accordingly, will decide on the appropriate monetary policy stance and,
possibly, on the implementation of further non-standard measures to foster market
functioning. For this reason, I will not elaborate on these issues and will turn next to an
assessment of the measures taken by governments to support the banking system and on
necessary reforms to strengthen its stability and resilience.
The support that has been provided by governments to the European banks has been
substantial. For example, banks in the euro area have received EUR 113 billion of capital
injections from governments and EUR 300 billion of government guarantees. Moreover, a
number of asset relief schemes, involving the removal of impaired assets from banks'
balance sheets on the provision of guarantees to limit the valuation losses of such assets,
are in different stages of implementation. The Eurosystem provided advice for the design of
these measures, in the form of recommendations, for instance on the pricing of
recapitalisation and of government credit guarantees, which aimed at ensuring that such
measures would contribute to safeguarding financial stability and restoring an adequate flow
of credit to the private sector, while preserving a level playing field within the Single Market to
the maximum extent possible.
The implementation of the bank support measures has been gradual over the past few
months. In the euro area, only one third of the commitments for capital injections had been
used until the end of April and a smaller fraction, less than 18%, of the commitments to
guarantee new bank debt have been called for. The use of government credit guarantees
varies considerably across countries reflecting several factors. It is still too early to accurately
assess the effectiveness of these government measures in improving the longer-term
funding of banks and in fostering bank lending to the private sector. The evidence is
relatively limited and the positive impact of the bank support measures cannot be easily
disentangled from the negative effects of other factors on the bank funding and credit
markets, notably of the weakening economic activity.
IV. The need for financial reform and an exit strategy
Overall, the combination of significant macroeconomic stimulus, the provision of unlimited
central bank liquidity and the wide range of government measures to strengthen banks'
balance sheets will jointly support the economy's recovery and alleviate stress in the financial
system. Their impact will become progressively more visible in the coming quarters. The
effectiveness of these policies over time will depend on the extent to which other factors
reinforce or counteract their positive impacts. There is, therefore, no room for complacency
as several risks and uncertainties lie ahead, including the extent and duration of the
deleveraging process in the banking systems as well as in the non-financial sectors of a
number of countries. Moreover, the pace of recovery will crucially depend on how quickly
confidence will be restored in the prospects of the economy and in the soundness and
resilience of the financial system.
To this end, it is essential that the revealed weaknesses in the functioning of the financial
system and the inadequacies of the regulatory and supervisory framework are effectively and
promptly addressed. In particular, there is a growing consensus among policy-makers about
the need to strengthen and broaden the regulatory framework and to develop
macroprudential supervision globally and in the European Union.
Even if we agree on the objective, attaining it is undoubtedly a great challenge. There are
different views about how to best achieve that goal. At the initiative of the European
Commission, the group chaired by Jacques de Larosière undertook a comprehensive review
of the EU framework for financial regulation and supervision and proposed, among other
innovations, the creation of a European Systemic Risk Council with responsibility for
macroprudential supervision. The ECB welcomes the group's report and broadly supports its
recommendations for macro-prudential supervision, as well as the related communication
issued by the European Commission. The proposed establishment of the Systemic Risk
Council under the auspices of the ECB and the Council's composition are a recognition of
the extensive analytical capabilities developed by central banks in the fields of monetary and
financial-stability analysis, their relevant expertise, and their closeness to the financial
markets.
The development of effective macro-prudential supervision is especially challenging because
the institutional framework does not exist. We are therefore called upon to create something
entirely new - and the ECB and the entire European System of Central Banks stand ready to
assume the macro-prudential supervision tasks envisaged in the report of the de Larosière
Group and to provide the necessary analytical and logistical support to the Systemic Risk
Council. For the new Council to function effectively, three key requirements will have to be
fulfilled. They relate to the input, the output and the institutional foundation of the Council's
work:
•
First, the Systemic Risk Council will need to have a comprehensive and relevant
information base that draws on both macro- and micro-prudential supervisory
information in order to be able to identify and assess the risks and vulnerabilities in
the EU financial system as a whole, to issue risk warnings and to adopt related
macro-prudential policy recommendations. Close cooperation and well-functioning
information-sharing mechanisms between the new Council, national
microprudential supervisors and the proposed European System of Financial Supervision
will therefore be indispensable.
•
Second, adequate institutional mechanisms need to be in place to ensure that the
risk warnings and the related recommendations issued by the Systemic Risk Council
are translated into effective action.
•
Third, for the Systemic Risk Council to be effective, legitimate and independent in its
decision-making, a solid legal basis is essential. Such a basis will also provide legal
clarity regarding the tasks to be performed and the access to the necessary EU-
wide macro- and micro-prudential information, subject to adequate confidentiality
arrangements.
The development of an effective framework for macro-prudential supervision in the EU is an
important policy priority which should be accompanied by the strengthening of the
arrangements for micro-prudential supervision. Macro- and micro-prudential supervision are
complementary processes and the interplay between them should be smooth and efficient.
V. Conclusion
Let me conclude with a few remarks on another important policy challenge that must be
addressed in order to ensure long-term prosperity by adopting an appropriate exit strategy
from the extraordinary macroeconomic stimulus and support measures. And I will focus on
fiscal policies. It is evident that that the economic downturn, discretionary fiscal measures to
stimulate economic activity and government intervention to support the financial sector have
had a substantial impact on public finances. The latest information and the Commission's
forecast today indicate a serious fiscal deterioration.5 The current focus of fiscal policy on
supporting the economy's recovery is warranted. At the same time, due attention should be
paid that current actions do not undermine the integrity of the EU fiscal framework. It is
essential to preserve the public's trust in the sustainability of public finances. Therefore, fiscal
policy needs to have a credible exit strategy from the current extraordinary circumstances.
Governments need to be credibly committed to achieve sound fiscal positions as soon as
possible and to fully apply the provisions of the Stability and Growth Pact.
We are living in very challenging times, and bringing back prosperity to everyone - as
referred to in the topic of today's debate - is unquestionably key priority. But just as we
currently experience a dual crisis - an economic and financial crisis - our response should
also be of a dual nature: we should do what is necessary to support economic recovery,
while at the same time being mindful of pursuing a credible and sustainable exit strategy
from the current extraordinary policy interventions, once conditions normalise again.
Thank you for your attention.