Challenges for the Euro Area, and the World Economy

Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECB
at “The Group of Thirty”, 63rd Plenary Session, Session I: The Crisis of the Eur
osystem,
Rabat, 28 May 2010
It is a pleasure to be here today, in the Group of Thirty, to discuss the main c
hallenges on the road to a sustained recovery. I actually ask myself whether the
title of the first session – “Crisis of the Eurosystem” – adequately reflects w
hat is happening in Europe and more generally in the global financial markets. M
y impression is that what we are now seeing primarily in the euro area reflects
a broader phenomenon, namely the sustainability of public finances in advanced e
conomies. To repeat a much used metaphor recently, we could say that euro area t
ensions are “the canary in the coal mine” of the challenges that policy-makers w
orldwide are going to face.
Let me elaborate by looking at the origin of the problem, i.e. the sustainabilit
y of public finances. In the aftermath of the Lehman failure, governments around
the world seemed to rediscover Keynes. They injected huge amounts of borrowed m
oney – public funds – to stabilise the economy after the shock of the Lehman fai
lure. These policies worked, and averted a global depression. The success of tho
se policies has led governments – encouraged by international organisations – to
continue using expansionary fiscal policies to try pulling the economy out of t
he recession and getting it back to the pre-crisis level.
The strategy is based on a model which may turn out to be inappropriate in the c
urrent conjuncture. Let me discuss some of the underlying assumptions of the mod
el. First, the initial fiscal impulse was successful in avoiding a depression be
cause it helped to coordinate agents’ expectations, in the Keynesian or Knightia
n way of reducing uncertainty, thereby avoiding a vicious circle of recession an
d deflation. The direct impact on domestic demand may have been more modest, as
shown in countries where the size of the fiscal stimulus was more contained but
nevertheless fared equally well. Second, potential growth might have been severe
ly affected by the crisis. As a result, the pre-crisis level of output, achieved
in a bubble economy, would not represent a sustainable objective over the polic
y-relevant horizon. Third, the level achieved by the public debt in many countri
es may have impaired the effectiveness of further expansionary fiscal policy.
To sum up, while the fiscal expansion was successful immediately after the Lehma
n crisis, it may not be sustainable over time and may have to be corrected rapid
ly. Financial markets seem to be giving increasing attention to this hypothesis.
And they have started to test it.
They have focused on the euro area, even though it has on average a lower defici
t and a lower debt ratio than other economies. There are two reasons for this. T
hey have to do with the particular institutional construction of the euro area,
which is built on two pillars.
One is the monetary pillar, which is supported by an independent central bank wi
th a clear price stability objective. This implies that the ECB will not use an
inflation tax to reduce the real value of government debt. Euro area governments
have thus to rely on budgetary measures to address their own fiscal problems. T
hese measures are difficult to adopt, especially in countries with fragile polit
ical systems, such as those with minority governments or weak leadership, or whe
re growth is projected to be slow due in particular to lost competitiveness or h
eavy reliance on external borrowing. Financial markets are testing each country,
one by one, to see whether they are willing to adopt the necessary budgetary me
asures, starting with those which seem to be facing the greatest hurdles to cons
olidation.
Let me digress briefly on this point. Some may think that the fact that the ECB
cannot use the inflation tax to bail out Governments is a weakness of the euro a
rea’s construction, because it obliges some countries to make fiscal adjustments
earlier than others. In my view, this is a strength. To believe that an inflati
on tax can solve the problem posed by the mounting public debt is an illusion th
at some people like to cultivate. For several reasons. First, people are less na
ïve than some might think – they dislike an inflation tax as much as other forms
of fiscal adjustment. Second, it’s not so easy to generate inflation, in partic
ular ‘surprise’ inflation, without provoking a more-than-proportional increase i
n interest rates, also in light of the short average maturity of public debt in
most countries. Third, a rise in inflation, and inflation expectations, would pr
oduce a major upward shift in the yield curve, inflicting major losses on the ba
nks and financial institutions which have been heavily investing in these market
s, potentially undermining the recovery.
In short, the impossibility of resorting to an inflation tax is forcing euro are
a countries to tackle the burden of public debt sooner rather than later. In oth
er countries the illusion of being able to resort to the inflation tax might del
ay the adjustment, but the longer the treatment is postponed the harsher it’s li
kely to be. End of digression.
The second pillar of the euro area construction concerns the economic and fiscal
dimension. It was based on four key assumptions. The first was that markets wou
ld exert strong pressure on euro area fiscal policies. The second assumption was
that if the first assumption were insufficient to discipline public finances, t
hen the Stability and Growth Pact, based on monitoring, peer pressure and sancti
ons, would do the job. The third assumption, reinforcing the previous ones, is t
hat if a member of the euro area were unable to implement sound fiscal policies,
it would be left to its own devices. The final assumption was that national eco
nomic policies would be geared to ensure convergence among euro area economies,
within a strengthened single market.
These assumptions turned out to be misplaced. Why?
One reason was that markets did not impose the necessary discipline on the Membe
r States, in particular during the first years of Monetary Union, as spreads nar
rowed on different government bonds independently of emerging potential problems
. Markets moved in a binary way, from all good to all bad, in an abrupt and pro-
cyclical way.
Another reason was that the Pact did not work as expected. Surveillance proved d
ifficult to implement, technically and politically. Sanctions gave rise to tensi
ons between national authorities and European institutions. The latter became a
scapegoat; they were accused of interpreting the Pact too rigidly and rigorously
. As a result, the rules were weakened and ‘politicised’, leading to less string
ent monitoring.
The third reason was that, in the midst of the worst crisis since World War II,
the belief that countries could be left to their own devices, and eventually fai
l, without infecting others, proved wrong. Several academics and commentators ar
e still flirting with the idea that a partial default could be organised in an o
rderly fashion, with minor repercussions on the country itself and on its neighb
ours. But financial markets have shown how exposed they are to contagion – conta
gion which, by the way, is not limited to the euro area. It’s global.
The final reason for these misplaced assumptions was that, during its first 11 y
ears, the euro area economy experienced a strong convergence in real economic ac
tivity together with a significant divergence in nominal cost and price developm
ents, which gave rise to large payments imbalances within the Union. Countries w
ith lower income per capita grew faster than the richer ones, in some cases catc
hing up with them, partly through excessive external borrowing and a decline in
competitiveness. These developments were not offset by conservative fiscal polic
ies to moderate domestic demand growth and to provide a buffer for any shocks.
The unique nature of the euro area institutional framework and the policies impl
emented by some of its members offer explanations for why the crisis erupted. I
will not dwell too much on how the crisis developed and why it took so long to f
ind a solution. The reasons are mainly political. They are not exclusive to the
euro area, but are part of life in all democracies, where the trade-offs between
the short-term costs and the long-term benefits of optimal solutions are diffic
ult to perceive for the average taxpayer, and sometimes even for their elected r
epresentatives. Ultimately, the time it took to work out a solution – three mont
hs – was largely due to problems like those experienced in other countries faced
with similar challenges. Remember the opposition by many members of the US Cong
ress to the 1995 rescue package for Mexico, which was skilfully circumvented whe
n the US Administration found USD 20 billion in the Exchange Stabilization Fund
(which did not require Congressional approval). Remember also the initial vote a
gainst the TARP by Congress, even after the failure of Lehman Brothers, until ma
rkets slid further. These are all examples of the difficulties our democracies f
ace in mobilising the appropriate resources to tackle major financial crises. Th
ey need to be explained to the public.
In the case of Greece, there was an additional complication: the previous govern
ment, in an election year, had hidden the sharp increase in the deficit (from 5%
to over 13% of GDP). This shocked the other governments in the euro area and or
dinary people too.
A further dimension, in the European context, is the difference in cultures and
sensitivities. They affect how issues are communicated within countries, in part
icular between politicians and their electorates. These are differences which to
tally disconcert financial markets. For instance, in one large euro area country
it was thought that public support for swift action could be achieved only by d
ramatising the situation, for instance, by telling the public that “the euro is
in danger” or by considering the possibility of expelling a country from the eur
o area. But it was not realised that, in the midst of a financial upheaval, such
words are like fanning the flames and that the cost of the support package coul
d only increase following such dramatic declarations. By contrast, in other coun
tries, leaders want to be seen as being in control of the situation and taking a
ll sorts of initiatives to reassure their electorates. The media, of course, hav
e a field day reporting on such apparently inconsistent activities.
What is clear is that Europeans have found out during this crisis that sharing a
common currency entails much deeper links than they might have initially though
t. Monetary Union is to some extent also a political union and subject to the ch
allenges that such unions face, possibly even on a larger scale.
All in all, a series of decisions have been taken, both at the national and Euro
pean level over the last three months. First, Greece has negotiated an adjustmen
t programme with the IMF, the European Commission and the ECB. It is a very toug
h fiscal programme and contains major structural measures that will fundamentall
y change the Greek economy. The programme is accompanied by a €110 billion finan
cial support package from the IMF and the euro area countries, which has been pa
ssed by the 16 euro area countries’ parliaments. Second, measures have been take
n to avert contagion. A European fund, consisting of €500 billion, to be supplem
ented by €250 billion from the IMF, has been designed to prevent other potential
cases. Third, measures have been taken by several countries to speed up fiscal
consolidation. In particular, Portugal and Spain have announced additional fisca
l and structural measures to accelerate the stabilisation of their debt/GDP dyna
mics as from 2012. Other countries have announced that they will step up consoli
dation of their budgets for the coming year. Finally, the ECB has decided to int
ervene in specific segments of euro area debt securities markets to improve the
functioning of the monetary policy transmission mechanism.
The way in which some of these decisions have been taken might appear cumbersome
, or even clumsy, especially to outside observers unfamiliar with European decis
ion-making processes. However, whenever a decision was needed it was ultimately
taken. We experienced nothing like the TARP being voted down by a national parli
ament.
Each of these decisions had a positive, though short-lived, effect on market sen
timent. Several market participants seem to be sceptical, in particular about wh
ether the Greek adjustment programme will succeed. In their view – as far as I c
an understand – the programme is bound to fail for economic, political and Europ
ean governance reasons. The logical conclusion is that Greece will default, at l
east partially, or restructure its debt. They are probably taking positions base
d on this conviction. The IMF, the euro area governments, the Greek government a
nd the ECB however take a different view. They all consider that a default is no
t a viable solution. And they have taken decisions consistent with this view and
put money – taxpayers’ money – where their mouths are.
Let me consider the arguments put forward by those who regard a Greek default as
unavoidable.
Their first argument is economic. The adjustment programme is too harsh, given t
he level of the debt-to-GDP ratio reached in Greece. It will produce a debt spir
al which will lead the country into a recession and deflation. The problem is ma
de worse by the loss of competitiveness suffered by Greece over the last decade
and the impossibility of devaluing the currency. Their reasoning is generally no
more sophisticated than that. Some analysts have put together a few numbers to
show that they are aware of the problem. But I have not seen a serious analysis
of the 120-page report produced by the IMF which looks at the various aspects of
the programme, including the impact of the structural measures on growth, the s
ustainability analysis or other features of the programme. Not one review of the
realism of the assessments made by the staff of the IMF and the Commission. In
fact, I suspect most market analysts have not even looked at the adjustment path
for the primary surplus which is embedded in the programme, which aims to reach
6% of GDP in 2015, a level no different from the ones that other countries in t
he past have implemented to consolidate their public finances. It’s a level that
a number of other countries – including some outside the euro area – will have
to achieve if they want to stabilise their debt. Most market analysts and other
observers have probably not even looked at the structural measures that are embe
dded in the programme, affecting for instance the labour market, or at several l
iberalisations, and their impact on economic growth. The inefficiencies in the t
ax collection system, which have been aggravated before the elections, have also
been overlooked. The perception that the Greek programme will not work looks mo
re like an assumption than the result of a serious assessment.
To summarise, I wonder which analysis is more serious and credible: the many one
-pagers, very well publicised – I must admit – which probably aim to influence t
he rest of the market; or the IMF’s 120 pages of rather tedious analysis describ
ing the contents of the programme, together with its risks.
Let me add that I have not read a single page on what a (partial) default of an
industrial country would mean for the country itself, for the euro area and for
the global economy. It’s often been stated – or should I say assumed? – that the
re is such a thing as an “organised” or “orderly” default. Argentina is sometime
s mentioned, as if anything orderly happened there since it defaulted. On top of
this, several of those who propose an “orderly default” also favoured letting L
ehman fail, as a way to eliminate moral hazard and achieve better functioning ma
rkets. We saw what happened.
The way the markets move every day shows what implications a default would have
for the Greek economy, its financial system and even the country’s membership of
the European Union. Just look at the screens and you’ll see the contagion under
way, spreading not only to peripheral countries but also to the largest euro ar
ea countries and through the financial system.
The second argument of those who foresee a Greek default is political. The gover
nment of that country – they claim – will not have the political stamina to sust
ain the adjustment effort over time, in the face of domestic protests, and will
sooner or later give up.
It’s an argument that seems to ignore events and facts, at least from the Greek
side. The Greek government was certainly slow in recognising the problem, but as
soon as it did it reacted swiftly. On 11 February the European Council asked Gr
eece to take measures to reduce its deficit by 4% of GDP. It did so in a few day
s and brought them to Parliament. The same happened for the IMF programme, which
was quickly negotiated and adopted by Parliament in less than a week. The prime
minister even expelled three members from his parliamentary group because they
abstained from voting. So far all the measures contained in the programme have b
een approved. The fiscal adjustment has been frontloaded. Budget data available
for the first four months of the year show an improvement of over 40% of the def
icit compared with last year, whereas the target was 35%. A schedule for privati
sation has just been approved by the government.
This is not to say that it’s going to be an easy ride. But what’s the alternativ
e? Is it politically more palatable for a government to default? How would the m
illions of Greek savers react if suddenly they found out that part of their savi
ngs is worth substantially less? Would any government get away with it?
And what would be the political future of Greece in the European Union if it did
not repay its debt to the German, French, Irish and all the other countries’ ta
xpayers? What would happen to the millions of euros in structural and cohesion f
unds that Greece receives every year from the EU?
Maybe you need a bit more than one page to give proper consideration to these fa
ctors.
Let me now turn to the euro area and consider the third argument which is someti
mes made by market participants, namely that euro area governance has substantia
l weaknesses that undermine the viability of the single currency. I have already
talked about the weaknesses of the current system. We should not forget, howeve
r, what has been created and what it has created. Overall, the combination of mo
netary and budgetary policies in the euro area has brought price stability and b
udgetary results which on average are better than those of most other economies.
The problem is that this is true on average, but not for all the members of the
Union, as it should be.
What is needed is a more resilient system, which avoids bad policies by the Memb
er States and the contagion they can cause for the area as a whole. This require
s working both on the numerator and on the denominator, i.e. on the budget and o
n economic growth. The way forward is twofold. It requires changes in the Member
States’ economic policies. And it requires a strengthening of the institutional
framework for budgetary surveillance.
The European Commission has published its first proposals to be considered by th
e task force on economic governance chaired by President Van Rompuy, which met f
or the first time last week. Some Member States have already made their own prop
osals. There is a vast convergence on the direction to take. Some of the proposa
ls are controversial, like sanctioning countries that break the rules, for insta
nce, with a loss of voting rights or of other means of financial aid. The task f
orce’s deliberations are intended to lead to concrete proposals for the European
Council by this autumn.
It is understandable to nurse doubts about the results of all these efforts. How
ever, looking at the decisions which have been taken in recent weeks and months,
one cannot doubt the determination of the 16 euro area countries to stick toget
her and do the necessary to defend what has been achieved over the past ten year
s, and to improve it. The 16 countries believe, as do we at the ECB, that sticki
ng to commitments, in particular in the case of the Greek programme, is essentia
l for the credibility of the currency and the prosperity of its members, as woul
d be the case for any other advanced economy or country. This is why the governm
ents of the Member States and the representatives of EU institutions will do all
that is needed to preserve that credibility and that prosperity. As I said earl
ier, monetary union is de facto a political union. It has to function and it wil
l function.
Let me conclude. What we are currently experiencing is a crisis of public financ
es in advanced economies. It started with Greece, and the euro, because of the s
pecific institutional framework which prevents Greece and the other euro area co
untries from using the inflation tax to overcome their budgetary problems. This
will force euro area countries to address their fiscal positions earlier. It’s n
ot easy. But it will be done, because it can be done and it has to be done in an
y case. And, last but not least, because there are no alternatives.
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