lorenzo bini smaghi : intervention at sveriges riksbank conference “ monetary policy in an era of fiscal stress ” intervention by mr lorenzo bini smaghi, member of the executive board of the european central bank, in the panel “ challenges for monetary and fiscal policy ”, at the sveriges riksbank conference “ monetary policy in an era of fiscal stress ”, stockholm, 17 june 2011. * * * it is a pleasure for me to contribute to this sveriges riksbank conference entitled “ monetary policy in an era of fiscal stress ”. the subject is indeed a very topical – and global – one. not just in europe but around the world, the crisis has progressively acquired a fiscal dimension that may be with us for a number of years to come. against this background, it may be useful for me to briefly look back over the relationship between monetary policy and fiscal policies, stressing in particular the challenges that monetary policy may face in an environment of sharply rising fiscal deficits and debt. coming from the ecb, i will of course primarily focus on the euro area experience and lessons. if, in a simple one - country setting, sovereign debt becomes unsustainable, the central bank always retains the option – in theory and partly in practice – to monetise the debt. the shortterm implication of such monetisation is that sovereign credit risk will be replaced by both an inflation and exchange rate risk. in other words, the currency of that country will no longer be considered as a good store of value, either domestically or externally. none of the above constitutes a feasible scenario for the euro area, which is characterised by a unique combination of centralised monetary policy - making and largely decentralised, albeit closely coordinated, fiscal policy - making. this one - monetary - policy - and - many - fiscalpolicies approach is at the heart of the institutional arrangement which governs the interactions between monetary and fiscal policies in the euro area. importantly, the treaty specifically excludes any “ fiscal dominance of last resort ”, due to the prohibition of monetary financing. so what are the implications of all this? ruling out the possibility of monetising sovereign debt in turn rules out inflation and exchange rate risks. however, if we exclude the possibility of monetising the debt and of bailouts between countries, the risk of sovereign default could arise. furthermore, this type of risk may emerge in financial markets in a rather disruptive way,

does not shield countries that are expected to follow an unsustainable fiscal course from sooner or later being forced to pay higher credit risk premia on their government bonds relative to more disciplined countries in the union. the treaty explicitly prohibits that individual governments, which run policies that are not sustainable, can be bailed - out by other governments or by the ecb. in recent years budgetary developments in the euro area have not been fully satisfactory and there is growing concern among market participants and observers that consensus on the importance of fiscal discipline is weakening in the euro area. while fiscal accounts in the euro area have been affected by the sluggish economic growth experienced in the past two or three years, it is undeniable that, in general, the resilience of fiscal deficits in the euro area is mainly due to high - and, sometimes, very high - structural public expenditure, which, by definition, are not dependent of the cyclical developments. it is of crucial importance that euro area member states take advantage of the ongoing recovery and focus on the pursuit of balanced budgets or surpluses in the medium term. such a policy would contribute to ensuring that the conditions for long - term growth in the euro area are strengthened and to meeting the challenges arising from an ageing population. empirical evidence supports the conclusion that comprehensive fiscal consolidation programmes, if appropriately designed and credible, can have favourable effects on confidence, investment conditions and thereby on output growth even in the short term. notably, if fiscal reform is based on the consolidation of public expenditure rather than on an increase in taxation, the adjustment in fiscal accounts would tend to support both private consumption and investment - because the current and expected after tax disposable income of household and firms increases. comprehensive and credible expenditure - based fiscal stabilisation programmes would in particular have positive supply effects as well. a number of empirical studies suggest that there are two main reasons why this can be the case. first, lower expected deficits reduce long term market interest rates, which creates more opportunities to invest and increase the productive potential of the economy. second, following the reduction in labour taxation that is possible when public expenditure is reduced, the expectation of higher after - tax income induces higher labour supply and mitigates wage increases, thus boosting the country ’ s international competitiveness and job creation. the role of structural reforms a stability oriented macroeconomic policy framework is not sufficient to ensure that high long - term growth is achieved. when private agents take their decisions over