jose manuel gonzalez - paramo : what has europe learnt from the crisis? speech by mr jose manuel gonzalez - paramo, member of the executive board of the european central bank, at the omfif conference “ on the cusp : the world economy at a turning point. strengthening stability at a time of challenge and change. ”, frankfurt am main, 15 march 2012. * * * the euro area ’ s “ missing institutions ” from its conception the euro was and has been a unique and ambitious project. it combined a centralised monetary policy with decentralised economic policies, and to paraphrase tommaso padoa - schioppa, created a currency that did not belong to a single nation - state. a key finding for the euro area, arising from the crisis, is that this construction was not complete. in particular, the euro area did not have certain institutions we associate with political federations and that act as shock - absorbers against the negative effects of imbalances. the key lesson from the crisis, therefore, is that the euro area needs to compensate for these “ missing institutions ” by establishing a much stronger economic and financial union. a central area where the absence of shock - absorbing institutions has been felt is via intra - euro area current account imbalances. these imbalances existed for many years prior to the crisis, but were largely ignored as theory told us that they could always be financed through cross - border financial flows. however, it is now clear that current account imbalances – while not being the only proximate causes of the crisis – are not benign and imply vulnerabilities which can be transmitted to the euro area as a whole. on the financial side of the current account, persistent intra - area imbalances imply that some public or private sectors are living beyond their means, year after year. if, as was the case in some euro area countries, these imbalances are also linked to the large build - up of external liabilities by an over - leveraged domestic banking system that engages in excessive risk taking, this may also create the conditions for the kind of twin sovereign - bank crises which we have witnessed over the recent period. private liabilities can quickly become sovereign ones when governments are required to recapitalise banks or guarantee bank funding, leading to sovereign debt crises. at the same time, sovereign liabilities can undermine domestic banking sectors given the high exposure of euro area banks to their own governments ’ debt

and the link made by markets of the cost of funding of banks with that of their respective sovereign. such negative effects may potentially be better mitigated in political federations given their stronger shock - absorbing institutions. for example, if a particular state in the u. s. were to experience a build - up in private sector liabilities that threatened its local banks, the responsibility for recapitalisation and deposit insurance would fall on the federal government – through institutions like the u. s. treasury and the federal deposit insurance corporation. this means that a u. s. state cannot be brought into financial difficulties by a mismatch between the size of its banking sector and that of its local economy, whereas a euro area country can – as we saw in ireland. on the real side of the current account, persistent trade imbalances within the euro area also reflect accumulated competitiveness losses in deficit countries. the problem may be masked while growth is driven by credit and consumption, as was the case in some euro area countries before 2008. but when there is a reversal in financial flows and foreigners are no longer willing to finance the further accumulation of external debt, accrued competitiveness losses come to the fore. this can result in particular regions suffering sustained low growth and unemployment. bis central bankers ’ speeches again, these negative effects may be more manageable with the shock - absorbing institutions of a political federation. a homogenous language and culture may facilitate labour mobility, providing one channel for adjustment – although recent evidence suggests this effect is not as significant in the u. s. as previously thought. at the same time, having a large federal budget creates a natural stabiliser as federal spending on “ big ticket ” items like social security, healthcare and defence redistributes incomes between rich and struggling regions. constructing a sui generis response it is clear that the way ahead for the euro area cannot involve trying to construct the institutions of a political federation overnight. this implies that the euro area needs a different approach to ensure the smooth functioning of monetary union that can compensate for some of these “ missing institutions ”. this approach has two main pillars. the first pillar is to strengthen fundamentally the governance procedures which prevent imbalances from arising. with fewer shock - absorbing institutions to mitigate crises when they arise, the euro area has learned that it must become more effective at preventing imbalances. this process has involved tightening the rules for fiscal policies and creating a much needed framework to monitor broader macroeconomic im