It is a pleasure to be here today, in the Group of Thirty, to discuss the main challenges on the road to a sustained recovery. I actually ask myself whether the title of the first session – “Crisis of the Eurosystem” – adequately reflects what is happening in Europe and more generally in the global financial markets. My 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 economies. To repeat a much used metaphor recently, we could say that euro area tensions are “the canary in the coal mine” of the challenges that policy-makers worldwide are going to face.
Let me elaborate by looking at the origin of the problem, i.e. the sustainability of public finances. In the aftermath of the Lehman failure, governments around the world seemed to rediscover Keynes. They injected huge amounts of borrowed money – public funds – to stabilise the economy after the shock of the Lehman failure. These policies worked, and averted a global depression. The success of those policies has led governments – encouraged by international organisations – to continue using expansionary fiscal policies to try pulling the economy out of the 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 current conjuncture. Let me discuss some of the underlying assumptions of the model. First, the initial fiscal impulse was successful in avoiding a depression because it helped to coordinate agents’ expectations, in the Keynesian or Knightian way of reducing uncertainty, thereby avoiding a vicious circle of recession and 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 severely 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 policy-relevant horizon. Third, the level achieved by the public debt in many countries may have impaired the effectiveness of further expansionary fiscal policy.
To sum up, while the fiscal expansion was successful immediately after the Lehman crisis, it may not be sustainable over time and may have to be corrected rapidly. 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 deficit and a lower debt ratio than other economies. There are two reasons for this. They 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 with 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. These measures are difficult to adopt, especially in countries with fragile political systems, such as those with minority governments or weak leadership, or where growth is projected to be slow due in particular to lost competitiveness or heavy reliance on external borrowing. Financial markets are testing each country, one by one, to see whether they are willing to adopt the necessary budgetary measures, starting with those which seem to be facing the greatest hurdles to consolidation.
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 area’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 inflation tax can solve the problem posed by the mounting public debt is an illusion that some people like to cultivate. For several reasons. First, people are less naïve 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 particular ‘surprise’ inflation, without provoking a more-than-proportional increase in 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 produce a major upward shift in the yield curve, inflicting major losses on the banks and financial institutions which have been heavily investing in these markets, potentially undermining the recovery.
In short, the impossibility of resorting to an inflation tax is forcing euro area countries to tackle the burden of public debt sooner rather than later. In other countries the illusion of being able to resort to the inflation tax might delay the adjustment, but the longer the treatment is postponed the harsher it’s likely 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 would exert strong pressure on euro area fiscal policies. The second assumption was that if the first assumption were insufficient to discipline public finances, then the Stability and Growth Pact, based on monitoring, peer pressure and sanctions, would do the job. The third assumption, reinforcing the previous ones, is that 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 economic 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 Member States, in particular during the first years of Monetary Union, as spreads narrowed 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 difficult to implement, technically and politically. Sanctions gave rise to tensions 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 stringent 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 fail, without infecting others, proved wrong. Several academics and commentators are still flirting with the idea that a partial default could be organised in an orderly fashion, with minor repercussions on the country itself and on its neighbours. But financial markets have shown how exposed they are to contagion – contagion 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 years, the euro area economy experienced a strong convergence in real economic activity together with a significant divergence in nominal cost and price developments, which gave rise to large payments imbalances within the Union. Countries with lower income per capita grew faster than the richer ones, in some cases catching up with them, partly through excessive external borrowing and a decline in competitiveness. These developments were not offset by conservative fiscal policies 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 implemented 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 find 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 difficult to perceive for the average taxpayer, and sometimes even for their elected representatives. Ultimately, the time it took to work out a solution – three months – was largely due to problems like those experienced in other countries faced with similar challenges. Remember the opposition by many members of the US Congress to the 1995 rescue package for Mexico, which was skilfully circumvented when the US Administration found USD 20 billion in the Exchange Stabilization Fund (which did not require Congressional approval). Remember also the initial vote against the TARP by Congress, even after the failure of Lehman Brothers, until markets slid further. These are all examples of the difficulties our democracies face in mobilising the appropriate resources to tackle major financial crises. They need to be explained to the public.
In the case of Greece, there was an additional complication: the previous government, 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 ordinary 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 particular between politicians and their electorates. These are differences which totally 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 dramatising 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 euro 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 could only increase following such dramatic declarations. By contrast, in other countries, leaders want to be seen as being in control of the situation and taking all sorts of initiatives to reassure their electorates. The media, of course, have 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 thought. Monetary Union is to some extent also a political union and subject to the challenges 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 European level over the last three months. First, Greece has negotiated an adjustment programme with the IMF, the European Commission and the ECB. It is a very tough fiscal programme and contains major structural measures that will fundamentally change the Greek economy. The programme is accompanied by a €110 billion financial support package from the IMF and the euro area countries, which has been passed by the 16 euro area countries’ parliaments. Second, measures have been taken to avert contagion. A European fund, consisting of €500 billion, to be supplemented 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 fiscal and structural measures to accelerate the stabilisation of their debt/GDP dynamics as from 2012. Other countries have announced that they will step up consolidation of their budgets for the coming year. Finally, the ECB has decided to intervene 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 decision-making processes. However, whenever a decision was needed it was ultimately taken. We experienced nothing like the TARP being voted down by a national parliament.
Each of these decisions had a positive, though short-lived, effect on market sentiment. Several market participants seem to be sceptical, in particular about whether the Greek adjustment programme will succeed. In their view – as far as I can understand – the programme is bound to fail for economic, political and European governance reasons. The logical conclusion is that Greece will default, at least partially, or restructure its debt. They are probably taking positions based on this conviction. The IMF, the euro area governments, the Greek government and the ECB however take a different view. They all consider that a default is not 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 the level of the debt-to-GDP ratio reached in Greece. It will produce a debt spiral which will lead the country into a recession and deflation. The problem is made 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 sustainability 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 the 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 embedded in the programme, affecting for instance the labour market, or at several liberalisations, and their impact on economic growth. The inefficiencies in the tax collection system, which have been aggravated before the elections, have also been overlooked. The perception that the Greek programme will not work looks more 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 the rest of the market; or the IMF’s 120 pages of rather tedious analysis describing 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 there is such a thing as an “organised” or “orderly” default. Argentina is sometimes 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 Lehman fail, as a way to eliminate moral hazard and achieve better functioning markets. 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 area countries and through the financial system.
The second argument of those who foresee a Greek default is political. The government of that country – they claim – will not have the political stamina to sustain 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 Greece to take measures to reduce its deficit by 4% of GDP. It did so in a few days 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 been 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 deficit compared with last year, whereas the target was 35%. A schedule for privatisation 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 alternative? Is it politically more palatable for a government to default? How would the millions of Greek savers react if suddenly they found out that part of their savings 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’ taxpayers? What would happen to the millions of euros in structural and cohesion funds that Greece receives every year from the EU?
Maybe you need a bit more than one page to give proper consideration to these factors.
Let me now turn to the euro area and consider the third argument which is sometimes made by market participants, namely that euro area governance has substantial weaknesses that undermine the viability of the single currency. I have already talked about the weaknesses of the current system. We should not forget, however, what has been created and what it has created. Overall, the combination of monetary and budgetary policies in the euro area has brought price stability and budgetary 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 Member States and the contagion they can cause for the area as a whole. This requires working both on the numerator and on the denominator, i.e. on the budget and on 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 the task force on economic governance chaired by President Van Rompuy, which met for the first time last week. Some Member States have already made their own proposals. There is a vast convergence on the direction to take. Some of the proposals are controversial, like sanctioning countries that break the rules, for instance, with a loss of voting rights or of other means of financial aid. The task force’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. However, 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 together and do the necessary to defend what has been achieved over the past ten years, and to improve it. The 16 countries believe, as do we at the ECB, that sticking to commitments, in particular in the case of the Greek programme, is essential for the credibility of the currency and the prosperity of its members, as would be the case for any other advanced economy or country. This is why the governments 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 earlier, monetary union is de facto a political union. It has to function and it will function.
Let me conclude. What we are currently experiencing is a crisis of public finances in advanced economies. It started with Greece, and the euro, because of the specific institutional framework which prevents Greece and the other euro area countries from using the inflation tax to overcome their budgetary problems. This will force euro area countries to address their fiscal positions earlier. It’s not easy. But it will be done, because it can be done and it has to be done in any case. And, last but not least, because there are no alternatives.
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