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ECB: Ten years of the euro: Successes and challenges in light of the current financial market developments
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Speech by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECBat the Hochschule KarlsruheKarlsruhe, 6 May 2009
To avoid a repetition of the hyperinflation of the interwar years, the Deutsche Bundesbank was granted a high degree of independence following the Second World War. Over the 50 years or so of the Deutsche Mark’s existence, annual consumer price inflation averaged 2.8%. A number of other countries experienced much higher inflation over this period, particularly in the 1970s and 1980s. Many Germans were therefore sceptical prior to the Deutsche Mark being replaced by the euro ten years ago. We now know that this scepticism was unfounded. So, in the first part of my speech, I will briefly describe the euro’s success in its first ten years. I will also explore the question of why lasting price stability is important, not only from an economic perspective, but also from a social perspective. I will then take a look at some of the key challenges we are currently facing and try to draw some initial lessons from the current financial crisis. I would also like to consider where we in Europe might be today if we did not have the euro.
The euro’s success is even more remarkable if one takes into account the number of price shocks during the past ten years, notably the continuous increase in oil prices between 1999 and mid-2008. Over this period crude oil prices rose from around USD 10 per barrel in 1999 to a peak of almost USD 150 per barrel in 2008, and there were also substantial rises in international food prices. Likewise, on the domestic side, we have witnessed almost regular increases in indirect taxes and important administered prices in most member countries of the euro area over the first ten years. As illustrated by Chart 1, the inflation performance of the euro area compares very favourably with that of the period leading up to 1999. [Chart 1: Inflation rates before and after the introduction of the euro]
Firm anchoring of inflation expectations is essential for solid economic growth, job creation and the cultivation of trust regarding asset formation and savings. Low rates of inflation, together with well-anchored inflation expectations, have resulted in nominal and real interest rates across the euro area that have been low by both historical and international standards. Low interest rates and the associated low borrowing costs have had positive effects on investment and employment in the euro area. Such a favourable outcome in terms of price stability, the credibility of monetary policy and institutional robustness had not been expected by many critics of the euro prior to the creation of Monetary Union. In particular, it was constantly argued that the ECB’s single monetary policy could cause problems because a uniform approach in the form of a single monetary policy would not do justice to all the countries of the euro area, given the existing economic and structural differences. They argued that it would be too restrictive for countries with low levels of growth and too loose for countries with high levels of growth, and counterproductive in any case. It was also argued that national fiscal policies would be incompatible with the single monetary policy conducted by a supranational central bank. Finally, from an institutional point of view, there were doubts whether the presidents and national central bank governors in the Governing Council of the ECB would be able to act in a truly European spirit, rather than in the national interests of their respective countries.
But, ten years on, measured against the achievements in terms of monetary policy, credibility and price stability, there is widespread agreement that the euro has performed very well. In fact, none of the above-mentioned fears have materialised. This is tangible proof of the robustness of the Eurosystem (the ECB and the national central banks of the euro area countries), and of the fact that the ECB’s monetary policy decisions are based on shared values and common principles. The Austrian economist Joseph A. Schumpeter stated that “a nation’s monetary system is a reflection of everything that the nation wants, suffers, and is. … Nothing says what a nation is made of so clearly as what it does in terms of its monetary policy.” Allow me, therefore, to briefly explain why it is so important to maintain price stability over the medium term and then I will present the main benefits of lasting price stability. First of all, price stability fosters trust in money and in property rights more generally. In particular, it preserves the purchasing power of money and protects the real value of income and wealth. Price stability is also important for the weakest groups in society, who suffer most from high and volatile inflation rates. As a consequence, maintaining price stability also contributes to social cohesion.
Price stability is a precondition for sustainable growth and job creation. Prices can generally be seen as the traffic lights of the economy. A higher price is a signal for the producer of a good to continue or increase production. It signals a change in the relative scarcity of the individual good, compared with other goods. Similarly, a low price tells the producer to reduce or halt production. Without price stability, however, prices lose their signalling function, as it is no longer clear whether a change in price is due to a change in the relative scarcity of the individual good or caused by a change in the general price level. With high, volatile inflation, it becomes more difficult to distinguish between the two causes and it is more complicated for producers to know whether they should increase production or not. Furthermore, price stability over the medium term reduces risk for investors, which contributes to lower interest rates. This makes investment projects more profitable, which again leads to higher levels of employment and economic growth. The past decade is also testament to the fact that price stability goes hand in hand with economic growth and job creation. In the first ten years of Europe’s single currency, the number of people employed in the euro area has risen by approximately 18 million, which is equivalent to an annual increase of nearly 1.3% (see Chart 3). This compares favourably with the 1990s, when fewer than 8 million jobs were created, corresponding to an average annual increase over this period of 0.6%. Price stability was of course not solely responsible for this; changes in employment patterns are affected by many factors. However, these developments strongly confirm that a monetary policy oriented towards price stability is fully compatible with job creation. Price stability helps to ensure that necessary corporate restructuring does not get left on the backburner and also fosters wage differentiation across sectors, regions and qualifications, with positive effects on economic growth and employment.
At the same time, the euro has made an important contribution to economic and financial integration within Europe. The single currency has enhanced our ability to take advantage of the single market, and trade and capital ties between euro area countries have grown significantly. For example, cross-border trade in goods and services in the euro area has increased by 10 percentage points as a share of GDP since the introduction of the single currency (see Chart 4). Trade between individual euro area countries now accounts for about half of their total imports and exports. At the same time, trade with countries outside the euro area has also developed very dynamically. [Chart 4: Trade between euro area countries] The euro has promoted competition, price transparency and price convergence. It has lowered transaction costs and eliminated exchange rate risk.
In addition, the euro has made a significant contribution to the integration of financial markets in Europe. One example of this is the marked increase in cross-border investment in securities within the euro area, as illustrated by Chart 5. [Chart 5: Cross-border holdings as a share of total holdings of short-term debt securities issued in the euro area]
Let me now turn to the ongoing financial market turbulence and its implications. Since August 2007 the global financial markets have experienced extensive corrective realignments. The repercussions of the turbulence were initially visible in the financial market in the form of dramatic increases in risk premia and increased volatility in interest rate movements. Thereafter, upheaval on the financial market led to a severe and synchronised economic downturn across the globe, the deepest since the beginning of the Great Depression in 1929. The current crisis, therefore, poses grave challenges to the financial industry and central bank community, as well as to supervisory and regulatory authorities and national governments. The outbreak of the financial market turbulence was not entirely unexpected, however. Both the ECB and other institutions had warned of macroeconomic imbalances and systematic undervaluation of risks in the years leading up to the crisis. Those years were characterised by an extended period of low interest rates, low inflation and sustained economic growth, both globally and within the euro area. At the same time, liquidity was abundant and default risks were considered by many to be very low. This environment strengthened investors’ risk appetite. In particular, with financial market participants expecting this environment to continue for quite some time, risks were systematically underestimated and the search for ever higher yields intensified. As a result, commercial banks readily granted credit for house purchases to households that otherwise could not have afforded it, and without adequately assessing their creditworthiness or credit default risk. At the same time, in an attempt to achieve higher yields, a number of innovative and increasingly complex financial products were offered, particularly in the United States. One prominent example of this was the bundling of mortgages in new and highly complex financial products and their resale as new securities to third parties via global financial markets. Bundling mortgages and distributing them was supposed to spread the overall risk. But this did not work as it was intended to. On the contrary, as the risk was ultimately transferred to a third party, the relevant incentives were not in place for the loan providers to make sure that the borrowers would be able to repay those loans. At the same time, many of those that ended up bearing the risk underestimated the extent of that risk. It eventually became evident that this practice was viable only as long as house prices in the United States continued to increase. When the many years of increases in house prices came to an end and house prices started to fall, problems soon emerged, including in the euro area, as banks here were among the buyers of these securities. Investors suddenly began to doubt the quality of their assets. This led to a sharp correction in prices on the financial markets, accompanied by a withdrawal of funds from the markets, leading to corresponding liquidity shortages for banks.
The banking sector has been facing significant challenges since financial market tensions intensified. For instance, the declared cumulative write-downs and credit market losses of European banks amount to almost USD 360 billion so far, or about EUR 270 billion. These problems have played a decisive role in the subdued lending to companies and households in the euro area. This is, on the one hand, due to the cutback in debt capital positions on banks’ balance sheets and the general tightening of credit standards. On the other hand, the demand for loans has fallen as a result of the overall weakening of economic activity. Developments in borrowing and lending have an impact on the real economy in that they play a particularly decisive role in trends in investment activity. Response to the crisis
From the very beginning of the crisis, the ECB has acted in a decisive and appropriate manner. It has taken a number of measures unprecedented in nature, scope and timing. The ECB has provided an extremely large amount of liquidity support to banks. In fact, when tensions first emerged in August 2007 the ECB was the first central bank worldwide to respond. By making changes to its operational framework, the ECB made sure that all solvent banks would have sufficient access to funding. When the crisis intensified in September last year, we introduced a number of new measures. Most importantly, we provided banks with unlimited access to liquidity at fixed rates for up to six months. The ECB also expanded its list of assets eligible for use as collateral in the Eurosystem’s credit operations. As a result of these new measures, the size of the Eurosystem’s balance sheet has expanded by a substantial EUR 600 billion and now stands at 16% of GDP, compared with 10% in mid-2007, with some volatility over that period. This mainly reflects the expansion of the provision of liquidity to the banking system, which plays a crucial role in the funding of the euro area economy. In other major economic regions, funding via debt securities, which has suffered more severe disruption, is of greater importance. In this respect, all the unconventional liquidity measures taken by the ECB have been tailored to the needs of the euro area. Notably, they have eased banks’ balance sheet constraints and thereby certainly helped to avoid a sudden collapse in the supply of credit and the emergence of a systemic crisis. In line with the substantial weakening of global demand and economic activity, inflationary pressures and risks have been diminishing. As a result, the ECB’s policy rates have been cut by 3 percentage points since the intensification of the crisis last October. These rate reductions, together with the liquidity management measures, have had a significant impact on money market interest rates. Since last October overnight money market rates have fallen even more steeply than the ECB’s policy rates. Money market rates in the euro area have now reached very low levels by international standards. Lower money market rates have also led to lower interest rates for private households and firms, although the decline in money market rates has so far been greater than the decline in interest rates on credit for households and firms. The fiscal authorities in the euro area have also demonstrated their capacity to react rapidly to exceptional circumstances. In a coordinated effort, the national governments of the euro area have provided support to the banking system, most notably through recapitalisation and guarantees for liabilities and assets. The funds provided under the package announced to stabilise the financial sector through these types of measure amount to 23% of the euro area’s GDP. The overall fiscal stimulus – through discretionary policy measures and the effect of automatic stabilisers – amounts to 3.6 percentage points of GDP for 2009 and 2010. All of these measures were necessary to support the functioning of the financial system, but they also imply a considerable fiscal burden in that fiscal debt and deficit ratios may increase substantially. In fact, what matters is not only the size of the fiscal stimulus, but also the potential to enhance confidence and effectiveness. While the fiscal measures introduced by euro area governments during the crisis have succeeded in cushioning the adverse impact of the crisis on the economy, it remains essential that countries return to sound fiscal policies and thereby, in a credible manner, stick to their commitment to respect the provisions of the Stability and Growth Pact. Overall, during the ongoing financial market turbulence, the euro area and the EU as a whole have proved their capacity to act decisively and promptly under difficult circumstances. National measures have been coordinated in a pragmatic manner with a view to enhancing their effectiveness through mutual reinforcement. Lessons from the crisis The current financial crisis has pointed to a number of weaknesses that need to be addressed if we are to avoid a similar crisis in the future. Some weaknesses are rooted in the current design of the international financial system. This is particularly true with regard to the lack of transparency and accountability within the financial system. In this respect, much relies on financial players themselves taking responsibility for evaluating risk more effectively and increasing transparency as regards risk. In addition, various initiatives at national, European and international level aim, in particular, to improve the robustness of the financial system. Two recent reports – the Turner Report, written by Lord Turner, Chairman of the British Financial Services Authority, and a report by a high-ranking group of experts on financial supervision, led by Jacques de Larosière, former Governor of the Banque de France and former Managing Director of the IMF – contain a range of valuable reform recommendations. In addition, a group of experts recently provided a fitting analysis of the shortcomings of the current financial system in a report on the future of the banking sector in the Netherlands.
[1] I would like to highlight three areas where I think change is necessary: there needs to be an increase in transparency, a dampening of pro-cyclicality and an improvement in institutional design in the field of financial supervision and regulation. First, the financial sector needs to become more transparent. It is quite striking that, despite the regulatory advances and the progress of information technology in recent decades, some financial market segments have been characterised by products that have proven to be hard for investors – never mind rating agencies, supervisors and regulators – to understand and value. One possibility here would be to standardise products and transactions and to ensure that transactions take place via regulated exchanges or clearing houses. Furthermore, all systemically important institutions, markets and instruments should be subject to an appropriate degree of regulation and oversight. One such example is the market for derivatives. For most of these financial contracts, the conditions are agreed upon between the two parties and the instruments are traded “over the counter". Trading activities on this “OTC derivatives market” are subject to much less regulation than those on markets for products traded on the stock exchange, and the post-trading infrastructure is also less developed. Given the systemic relevance of these markets, the ECB supports the swift development of improved post-trading infrastructures, so as to enable more effective management of credit and operational risk, as well as to improve the transparency of these markets.
The ECB welcomes this proposal. The establishment of a European Systemic Risk Council should substantially improve the assessment of risks to financial stability at the EU level. In order for the new Council to perform its tasks in an optimal manner, three requirements must be fulfilled. First, the ECB must have timely access to the relevant information, including information concerning individual institutions. Second, risk warnings from the new Council should be translated into effective policy action. And third, for the new Council to be independent and effective in its decision-making, it is essential that it have a solid institutional and legal basis. I also think the current crisis holds some lessons for monetary policy. The crisis has shown us that a stable financial system is a prerequisite for price stability. Everyone is agreed that each central bank has one instrument at its disposal, namely monetary policy, to achieve its goal of price stability. However, not all are agreed on which prices a central bank should be concerned about.
The extent to which monetary policy should take asset prices into account has been a long-standing debate among central bankers and academic economists. The ECB’s definition of price stability identifies a specific price index – namely the Harmonised Index of Consumer Prices (HICP) – as the one to be used for assessing whether price stability has been achieved. As the HICP is a consumer price index, asset prices such as house prices or stock prices are not included. This does not mean that asset prices are not important from a monetary policy perspective. To the extent that changes in asset prices have an impact on the outlook for prices, a central bank that aims to maintain price stability will need to respond to these changes. One could argue that asset prices should play a greater role in monetary policy considerations. According to this school of thought, as the build-up of an asset price bubble might have severe economic consequences in the longer term, central banks should try to deal with the bubble pre-emptively. To put this in more concrete terms, it is argued that the central bank should increase interest rates when asset price inflation reaches a certain level, even if the impact of this inflation on the outlook for consumer prices is not obvious. In academic literature, this approach is often referred to as “leaning against the wind”.
The second pillar, monetary analysis, is given a prominent role at the ECB. Analysing developments in borrowing and lending, particularly loans to the private sector, is helpful in extracting the relevant signals from monetary developments. This analysis also fosters the regular monitoring of asset price developments and their implications. Consideration of these aspects must become more extensive and systematic in the future. Strengthening the ECB’s role in financial supervision should contribute to ensuring that proper consideration is given to the possible build-up of financial imbalances when making monetary policy decisions. The current crisis has demonstrated that risks to financial stability are accompanied by risks to price stability. Central banks must give even greater consideration to these risks in their analyses.
As the saying goes, “the proof of the pudding is in the eating”. The last ten years are evidence of the fact that the euro has made a significant contribution to a stronger and more integrated Europe. The single currency has created an environment where price stability is king. The euro has also proved itself in the current financial market crisis. Thanks to the broad availability of euro liquidity, the currency has facilitated the stabilisation of the financial system. The financial crisis has posed huge challenges for financial market participants, governments and central banks. In order to be able to deal with these better in the future, we must pay particular attention to three lessons learnt from the current crisis. First, we need to pay more attention to considerations regarding financial stability and systemic risk. This is also essential in the overall assessment of the risks to price stability over the medium term and in respect of the ECB’s conduct of monetary policy. The ECB’s involvement in macro-prudential supervision within the proposed European Systemic Risk Council will be a welcome step in this direction.
Third, there must be an improvement in regulation and oversight. In this respect, all systemically important institutions, markets and instruments should be subject to an appropriate degree of regulation and oversight. For example, the ECB supports initiatives to swiftly establish infrastructures for systemically relevant markets such as the OTC derivatives markets. The biggest challenge we now face is the need to reform the financial sector in a way which benefits the real economy, pulls us quickly out of the crisis and combats potential risks to price stability. Over the last ten years we have been successful in achieving the last of these things and we intend this to continue in the future.
[1] Advisory Committee on the Future of Banks in the Netherlands (2009): Restoring trust. ﻿
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