Andreas Dombret: The future of Europe and the euro - what
monetary policy can and cannot do
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank,
at the University of Pretoria, Pretoria, 14 August 2017.
* * *
Ladies and gentlemen,
Amongst economists there is an old saying: "When America sneezes, the world catches a cold".
In fact, this saying is now so commonplace that it is impossible for me to trace its origins. Over
the years, countless variants have been invented. If you look it up on the internet you will find that
the same has been said about Germany, China and many other countries.
In my view, the fact that this saying has become so widespread does not mean that the world
has become an unhealthier place or that economic commentators lack inspiration. What it does
say is that the world has become increasingly interdependent over the past decades.
With more and more goods being transported from one continent to another and with ever more
capital flowing freely across borders, what happens on one side of the world very much matters
to the other, and vice versa.
And this brings with it a need to engage in dialogue, to exchange views about local developments
and global challenges.
So let me first and foremost thank the South African Institute of International Affairs and the Chair
of Monetary Policy here at the University of Pretoria for providing me with this opportunity for such
dialogue today.
I believe one issue currently being discussed in many countries is whether the successful role
that central banks around the world have played in mitigating the consequences of the financial
crisis might, in the long run, undermine the pillars of their success. And this question certainly is
not confined to just the advanced economies, which have seen the largest central bank
interventions in the past few years.
But before I get to that topic, I will first say a few words about the economic situation in the euro
area.
1. Economic situation in the euro area
Policymakers in Europe learned what increased global interdependencies meant during the past
few years when they had to deal with the sovereign debt crisis. The poor economic performance
in Europe contributed to the world economy not recovering as fast as some wished.
So whenever I attended international policy meetings, I was pressed on what solutions European
policymakers had in store for solving the crisis.
I always responded that the only sustainable solution was to correct the macroeconomic
imbalances in the euro area, and that this adjustment process would take some time.
After all, the sovereign debt crisis was not least the result of a slow but steady loss of price
competitiveness in some countries in the euro area. The loss of competitiveness went hand in
hand with a build-up of excessive foreign indebtedness - partly due to high public deficits and
partly due to high deficits in the private sector.
When the markets began to doubt that these debts could be repaid, they pulled the plug. Some
countries in the euro area were effectively shut off from the capital markets. In countries where
the reason for the sudden stop was not already a fiscal crisis, it soon became one as sovereigns
struggled to rescue their banking systems.
To regain the trust of the markets, the affected countries had to undertake reforms to regain
competitiveness. But regaining competitiveness takes time. Time that these countries did not
have.
The situation was calmed down after the member states of the euro area hastily tailored a
rescue fund which has now become a permanent institution, the European Stability Mechanism.
The Euro system - i.e. the ECB and the national central banks of the 19 member states of the
Euro area - also needed to take measures to prevent the crisis from escalating. These included
targeted purchases of bonds from member states with poor credit ratings. Some of these
measures not only proved controversial within the ECB Governing Council, but also raised a
number of fundamental questions about the limits of monetary policy.
These emergency measures bought the countries time to restore their competitiveness and to
consolidate their public finances. Most of the former crisis countries have indeed managed to
reduce or even eliminate their current account deficits. But the wage restraint that was
necessary to improve price competitiveness together with the ongoing efforts to consolidate
public finances have dampened growth and price pressures in the euro area.
This is one of the reasons why the recovery after the financial crisis took somewhat longer in the
euro area than in other advanced economies, such as the United States and the United
Kingdom.
But for some time now, the recovery in the euro area has become increasingly robust and
broadbased. Real GDP has been growing now for 16 quarters. And what is probably equally important,
almost all countries are sharing in the recovery. There has recently been an improvement in
growth in France, Italy and Spain, for example. This means that growth in the large euro area
countries is no longer diverging.
The economic outlook has improved, too. The European Central Bank, for example, has raised
its forecast for the euro area slightly - to 1.9% for this year and 1.8% for next year. The
International Monetary Fund even expects the euro area economy to grow by 2.1% this year as
well as next year.
The outlook for Germany is similarly positive. The current projection of the Bundesbank expects
the German economy to grow by 1.9% this year and 1.7% in 2018. But this projection is still from
April. Since then, key economic indicators have performed strongly. So I wouldn't be surprised if,
in the end, growth this year would turn out to be somewhat higher.
And there is a growing consensus that downside risks to this outlook have receded such that
overall risks are now more balanced.
Within the ECB's Governing Council, the improved economic outlook has led to a consensus
that price pressures are expected to increase, too. In addition, there is consensus that the
spectre of deflation has now disappeared. This is reflected in the current projection of the ECB.
Its economists expect prices in the euro area to rise by 1.6% at the end of the forecast horizon in
2019.
These are important conditions on the route to a normalisation of monetary policy. However, the
signs of a sustained turnaround in terms of inflation are muted, so far. There is therefore a broad
consensus on the whole that an expansionary monetary policy is very much justified. Where
perspectives do differ, though, is on how strongly the ECB should step on the monetary policy
pedal and what instruments it should use.
But while the situation is improving, the euro area has not yet returned to full strength. The
comprehensive emergency measures to which politicians and the Eurosystem resorted have
prevented the crisis from escalating, but they have not yet made the euro area durably stable.
So at the moment, discussions over further reforms of the euro area are continuing. The main
question in these discussions is how to balance fiscal and economic self-responsibility with
solidarity.
2. The role of central banks
But that is not my main topic today. Rather, allow me to point out that the major role that central
banks played, first in containing the immediate effects of the financial crisis and then in drastically
easing financial conditions to stimulate demand, must not lead to an overburdening of central
banks.
This is not only an issue in the euro area. The ultra-loose monetary policy that had been enacted
by many large central banks since the outbreak of the financial crisis certainly prevented a
sharper downturn at the time and contributed to the recent improvement of the global economic
outlook.
But this was not without consequences. By introducing unconventional measures, such as
longterm refinancing operations or assets purchases, central banks have begun to intervene ever
deeper in financial markets.
Both the Bank of England and the US Federal Reserve have expanded their balance sheets from
roughly 5% of GDP in 2008 to more than 20% in 2017. During the same period, the ECB has
increased its balance sheet from roughly 15% of GDP to more than 40%. In Japan, the
corresponding increase was from 20% to 90%.
My impression is that, since the onset of the crisis - which is to say first the financial and
economic crisis, then the sovereign debt crisis - more and more is being expected of monetary
policy. When it comes to the euro area, some even see the ECB as the only player capable of
taking action.
In any case, the actions of central banks have been brought much more to the forefront of media
and political interest since the financial, economic and debt crisis.
In 2015, for example, the annual meeting of central bankers in Jackson Hole was met by
demonstrators, and they came from both ends of the political spectrum. At one end, there were
those demanding that monetary policy do more to kick-start the economy, and at the other end,
those who were protesting against central banks interpreting their mandates too broadly and
pursuing a policy of cheap money.
And in the euro area, historically low policy rates and the extensive asset purchase programmes
have led some to discuss whether and in what way monetary policy affects the distribution of
income and wealth.
Upon closer examination, the claim that very low interest rates increase in-equality by driving up
asset prices is somewhat too straightforward. This is because low interest rates prop up the
economy, thereby leading to greater job security and higher wages. Furthermore, they relieve
pressure from public finances. This benefits taxpayers. It is therefore rather doubtful that the
accommodative non-standard monetary policy measures of recent years have caused inequality
to increase overall. In any case, such was the finding of an analysis published by the
Bundesbank in our 9/2016 edition of our Monthly Report.
I have the impression that discussions like these seem to start spreading to other countries that
are not even making use of non-standard measures.
At least I understand that, in South Africa, too, some are calling for a more expansionary
monetary policy in order to support socio-economic transformation. I am following all these
developments with some concern.
This year, the Bundesbank is celebrating its 60th anniversary. This occasion has also provided
us with an opportunity to take a look back at the 1970s, when many of the advanced economies
were plagued by double-digit inflation rates.
One reason for this malaise was the prevalent economic thinking of that time. The belief in many
countries was that cheap money could be used to fight rising unemployment.
It was German chancellor Helmut Schmidt who famously put this thinking in a nutshell: "I would
rather have 5% inflation than 5% unemployment," he once said.
This view was met with opposition in the Bundesbank. Former Bundesbank President Otmar
Emminger once warned: "If you flirt with inflation, you'll end up marrying it."
And unfortunately, that's precisely what happened. In many countries, rising unemployment was
caused by structural factors - and there was little that monetary policy could do about these. The
attempt to use accommodative monetary policy to tackle structural problems was bound to fail -
and so it did. This resulted in high inflation rates and high unemployment - a phenomenon that
later came to be known as stagflation.
Germany and Switzerland got through the 1970s with comparatively low inflation and
unemployment rates. Politicians and central bankers in other countries gleaned from this that a
stability-oriented monetary policy ultimately needs to be free from political interference and that
central banks should set policy, first and foremost, with the goal of price stability in mind.
By that time, economists had arrived at this conclusion on purely theoretical grounds. Jan
Tinbergen, who was later awarded the first Nobel Prize in Economic Sciences, had already
argued back in 1952 that, for each policy target, there must be as many instruments as policy
objectives.
For monetary policy, whose only instrument is the interest rate, the Tinbergen principle means
that there may be also only one target: Price stability.
In the three decades prior to the outbreak of the financial crisis in 2007, many countries did
indeed issue their central banks with narrower mandates geared towards price stability. At the
same time, monetary policy-making institutions became more independent. Major central banks
brought their models increasingly into line with that of the Bundesbank, which has always
enjoyed a large degree of independence.
These developments peaked with the foundation of the ECB, with the Bundesbank's
independence serving as its blueprint. This concept was successful, and it was possible to
combat inflation in almost all of the advanced economies.
Independence and a narrow mandate for central banks are important achievements. The thought
that these achievements might be questioned deeply unsettles me.
In a democracy, ceding control over monetary policy to a central bank can only be legitimised if
the central bank is provided with a narrow mandate: to maintain stable prices.
Using monetary policy for other purposes entails risks to price stability and could, in the long run,
lead to the independence of central banks being questioned.
Allow me to also mention a separate, but related, point. It would be wrong to conclude from the
massive central bank interventions that we have observed in recent years that central banks can
stimulate growth on a sustainable basis. Monetary policy cannot do that.
Monetary policy can stimulate or slow down the economy in the short term if this is required by
the mandate to maintain price stability. Putting the economy on a higher permanent growth path,
however, is something that central banks cannot achieve - even if they wanted to.
Only governments can put the economy on a higher permanent growth path - namely by
implementing appropriate labour market, economic, as well as social and tax policy reforms.
Let me give you an idea of just what could be achieved by effecting the appropriate reforms. The
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 was
that annual euro area growth in subsequent years would be just under one percentage point
higher.
3. Conclusion
Ladies and gentlemen, I started my short speech with a saying economists have about the world
economy. There is also a saying about central bankers: The ambition of central bankers should
be to be boring. It was coined by former Governor of the Bank of England, Mervyn King.
I hope I have not given you the impression that my ambition today was to be boring. And anyway,
Mervyn King was not alluding to events like this but rather to the management of the economy. In
my view, this also means that central banks should concentrate on maintaining price stability.
In one of his last interviews, former President of the Bundesbank Karl Otto Pöhl once put it like
this: "A central bank must never be a political instrument. Politicians must accept that price
stability is the main objective of central banks." Over the past few decades, great progress has
been made in many parts of the world in the pursuit of stable prices.
Today, I have tried to highlight that this was due, not least, to the fact that many central banks
have become more independent and have been given a narrow mandate. It is my sincere hope
that this consensus continues. It is very much worth preserving.
Thank you very much for your kind attention.