The economic crisis and the response of fiscal and monetary policy

Speech by Jürgen Stark, Member of the Executive Board of the ECB
Delivered at the Austrian Industrial Organisation
Linz, Austria, 8 June 2009

Following the default of Lehman Brothers in mid-September last year, the turmoil in financial markets which had started in August 2007 turned into a major financial crisis. Liquidity dried up, and credit flows to the economy slowed down. Problems in the financial system quickly spilled over to the real economy, and an adverse feedback loop between the real economy and the financial sector emerged. This has led to the most severe and synchronised global economic downturn for 80 years. The euro area has not been spared. Economic activity has declined sharply, and inflation is at its lowest level since the launch of the euro.

Monetary and fiscal authorities across the globe have responded quickly and decisively to these extraordinary developments. In particular, against the background of rapidly receding inflationary pressures and risks, the Eurosystem has taken monetary policy and liquidity management measures that were unprecedented in nature, scope and timing. Since October last year we have reduced the interest rate on the main refinancing operations by 325 basis points. We have also provided unlimited liquidity support to the banking system in the euro area to maintain the flow of credit. Likewise, governments in the euro area have reacted swiftly to stabilise the financial system and to counteract the adverse impact of the financial crisis on the real economy.

Looking ahead, both monetary and fiscal authorities will need to remain credible and effective, and to fulfil their respective responsibilities. In so doing, they will lay solid foundations for future economic recovery and long-term economic growth and job creation. The crisis has shown how important it is to have an independent central bank firmly committed to the objective of price stability. At the same time, governments must make a strong and credible commitment to a path of fiscal consolidation and thus comply with the Stability and Growth Pact. But they must also resist the temptation to further increase the size of the stimulus measures, as this could erode trust in the sustainability of public finances and undermine the effectiveness of the measures already adopted.

In my presentation today, I would like first to analyse the economic outlook and then discuss in more detail the policy measures taken in response to the crisis. I will then consider their implications and the lessons to be drawn from the crisis for central banks and monetary policy.

I will now turn to the policy measures taken in response to the current crisis. Both monetary and fiscal policy-makers have reacted in a forceful and timely manner, aiming to restore confidence. And indeed, as regards the Eurosystem’s monetary policy and liquidity management measures, it seems that our responses are bearing fruit. Confidence has returned to financial markets, and business surveys are picking up. I expect global and domestic demand to increasingly benefit from the significant economic stimulus and the measures taken so far to bring the financial system back to normal functioning.

The current crisis has increased the role of the government in the economy. Some bank rescue operations have involved outright nationalisations, so governments now have significant exposure to the financial sector. Similarly, the large fiscal stimuli packages adopted by many countries have led to a large increase in the size of the public sector in the economy.

At the same time, the turmoil is being interpreted by some as a crisis of the market economy. It has encouraged critics of the market economy to speak out and demand a much larger role in the economy for governments.

The financial system clearly needs a fundamental overhaul. Financial institutions have to take a different approach and adopt appropriate incentives. Risk-takers should be liable and not only reap the rewards of their actions but also bear responsibility for their consequences. We need to strengthen the regulation of the financial system, and in particular, we must improve the international cooperation between national supervisors of the financial sector. But let me hasten to add that policy-makers must not get carried away by recent events; they should act in a measured way, and not throw the baby out with the bathwater. While governments have had no alternative but to support systemically relevant financial institutions, they should, as a rule, keep their assistance to specific sectors or firms to a minimum. And when they do intervene, they should prepare clear and credible exit strategies. No matter how serious the current crisis is, the market economy remains the best way to organise our economic affairs. It is only 20 years ago since the breakdown of the socialist system in eastern Europe, which demonstrated the failures of central planning and heavy government involvement. Therefore, once we emerge from the current crisis, the role of government in the economy needs to be scaled back. Its presence in the banking sector must be gradually reduced as the restructuring of the sector starts to take effect. The stimulus measures must be reversed in due course. We have seen in the past how so-called temporary measures ended up being permanent.

An exit strategy is a comprehensive programme to withdraw and neutralise measures taken during the financial crisis, without causing any harm to the economy. If they have no well-defined exit strategy, governments may get bogged down and the positive impact of the measures taken may be undermined. A well thought-out exit strategy is needed to reassure economic agents that a timely restoration of the level playing field in the different sectors of the economy is the ultimate objective. As such, an exit strategy needs to contain clear criteria about the timing of the withdrawal of the financial support and the reversal of the fiscal stimuli.

In principle, the extra government debt incurred by asset acquisition should be covered by future sales of these assets. The state guarantees should serve to stabilise the banking system and would then not need to be called on.

As to the fiscal stimuli, euro area governments did not lay out clear exit strategies when they announced the stimuli. Some of their measures do not expire automatically or are not explicitly designed to be temporary. The possible difficulties of reversing the fiscal stimulus packages may hinder the return to sound fiscal positions in the short run. Under these circumstances, the peer pressure mechanism, on which the EU fiscal framework is based, may be weakened thus making more difficult a return to sound fiscal policies. As a matter of fact, countries with high fiscal deficits may be tempted not to put political pressure on their peers. Protracted excessive deficits may undermine the credibility of the EU fiscal framework, thus casting doubts on fiscal sustainability and jeopardising the Stability and Growth Pact.

In this respect, let me say that the current crisis has taught us an important lesson about the importance of preserving the public’s trust in the soundness of public finances. At the current juncture, euro area governments must make credible commitments to return to sound fiscal policies. Doing so in full compliance with the Stability and Growth Pact is the most credible exit strategy. This requires, first, a full reversal of the fiscal stimulus measures taken so far. This is necessary to ensure an efficient allocation of resources by minimising distortions in the incentives of economic agents and by avoiding a permanent increase in the size of the public sector. Second, governments must live up to their commitment to maintain fiscal discipline. This means that credible fiscal consolidation plans have to be implemented as early as possible, including a consolidation effort of at least 1% of GDP per annum where necessary. If euro area countries do not practise fiscal restraint seriously, the debt dynamics will be in danger of spiralling out of control.

The current crisis has shown how important it is for countries to consolidate during good economic times and to build a ‘fiscal reservoir’ from which they can draw in periods of ‘drought’. Many euro area countries failed to do so. They suddenly found themselves in this turbulent environment burdened by high fiscal deficits and debt ratios. Their room for fiscal manoeuvre was very limited, as was their capacity to adopt effective counter-cyclical measures when they were most needed. In addition, the developments in government bond yield spreads since last autumn have shown that, in uncertain times, financial markets increasingly discriminate between countries on the basis of their creditworthiness, including fiscal fundamentals.

We are seeing the first, timid signs of an economic recovery; investors are regaining their appetite for risk. It is critical that euro area governments boost confidence in the soundness of public finances as an element to support both the recovery and long-term economic growth.

As regards monetary policy, it is equally important to draw up a strategy for withdrawing in due course the extraordinary measures that have been implemented or announced. The ECB obviously cannot maintain the current degree of support indefinitely. We are providing substantial short-term support to the financial system and the real economy, and thereby ultimately maintaining price stability. But what if macroeconomic conditions warrant a removal of monetary stimulus?

In fact, we are prepared to take appropriate actions once the macroeconomic environment improves. We will ensure that the measures taken can be quickly unwound and the liquidity provided absorbed. This includes, for instance, unwinding the increase in the average maturity of our refinancing operations. Being prepared to exit from our non-standard measures – as soon as the macroeconomic conditions justify such a move – helps to maintain price stability over the medium term and to ensure a firm anchoring of longer-term inflation expectations.

Any changes in the operational framework will of course be communicated in good time. The ECB and the Eurosystem remain committed to pursuing a timely and transparent communication policy.

Likewise, the financial sector needs to live up to its responsibilities and not to become dependent on long-term funding through the ECB’s refinancing operations. It is important that the financial sector also helps to restore confidence among banks. Japan, since the early 1990s, has exemplified the economic damage that can result from not promptly restructuring an ailing financial system.

Some earlier attempts by policy-makers to stimulate the economy during downturns were ineffective and only led to higher inflation. The 1970s come to mind, when the surge in oil prices led to persistently high inflation and lower economic growth. Unsurprisingly, some people have been wondering if the exceptional measures taken by central banks and fiscal authorities during the current crisis will result in another period of high inflation. But the situation today is very different from the 1970s. The Eurosystem’s objective is to maintain price stability in the medium term, and nothing else. All our monetary policy decisions since the financial crisis erupted have been taken in order to safeguard price stability in a symmetric way. Maintaining price stability will remain the only objective that guides our decisions. This implies that the very accommodative monetary policy stance we are pursuing now will be reversed once the economy starts to recover and upside risks to price stability emerge again. The people of the euro area can trust our commitment to deliver price stability because they know we are independent and not subject to outside influence.

Let me now turn to the most important lessons I think we can draw from the current crisis with respect to monetary policy. I would like to raise three points.

First of all, the current crisis demonstrates, once again, how important it is for central banks to remain independent of political influence. Even if we are experiencing the worst economic downturn since the 1930s, long-term inflation expectations in the euro area remain solidly anchored in line with the ECB’s definition of price stability. This represents the strongest and most reassuring protection against a deflationary spiral, and it is the result of market agents trusting our commitment and ability to deliver price stability. Our independence, our clear mandate and our precise definition of price stability have been crucial factors in maintaining inflation expectations firmly anchored during these challenging times.

Secondly, although central banks may be charged with additional tasks in the aftermath of the crisis, their primary objective must remain the maintenance of price stability. We cannot allow any conflicts of interest to arise. The high-level expert group headed by Jacques de Larosière, former Governor of the Bank of France and Managing Director of the IMF, has identified a number of weaknesses in the supervisory framework both inside and outside Europe that contributed to the build-up of the current crisis. One of the group’s proposals is to give the ECB more responsibility for so-called macro-prudential supervision. This means supervision that aims to limit the risk of distress in the financial system as a whole, but does not extend to supervision of individual financial institutions.

Building on the de Larosière report, the European Commission has recently proposed to establish a European Systemic Risk Council (ESRC), chaired by the ECB President.

The ECB welcomes the Commission’s proposal. Establishing the ESRC will substantially improve the present institutional arrangements for risk assessment at EU level. Much of the work that will be done by the ESRC also be useful for assessing risks to price stability. But I would also like to stress that maintaining price stability must remain the primary objective of the Eurosystem. With only one tool at our disposal – the interest rate – we cannot achieve more than one objective. Therefore, it is particularly important for any risk warnings from the new Council to be translated into policy action by the responsible authorities as effectively as possible. The ECB cannot use its policy interest rate to mitigate risks that are not directly related to price stability. At the same time, price stability is the best contribution we can make to financial stability.

My third point concerns the important role played by monetary analysis – and in particular the role of asset prices – when assessing the risks to price stability over the medium term. Price stability is our primary objective, but this does not imply that we only focus on short to medium-term movements in inflation. Any build-up of financial imbalances which could pose risks to price stability in the longer term could be overlooked under a restrictive short-term approach. The ECB’s assessment of risks to price stability is well equipped to detect these types of risk as it is based on a comprehensive economic and monetary analysis – its well-known two-pillar strategy. The first pillar, the economic analysis, is common to most central banks. This analysis basically consists of identifying risks to price stability in the short to medium term by analysing the interplay between aggregate supply and aggregate demand in the economy.

The second pillar, the monetary analysis, plays a more prominent role at the ECB than at other central banks. The ECB pays special attention to monetary developments in recognition of the fact that monetary growth and inflation are closely related in the medium to long term. Analysing developments in credit, and in particular loans to the private sector, is helpful in extracting the relevant signals from the monetary developments. This analysis also implies a regular monitoring of asset price developments and their implications. This analysis will become even more prominent in the future. The ECB has been a pioneer when it comes to monetary analysis, and with the benefit of hindsight, we can say that the monetary analysis served us well in recent years. Back in 2005, the monetary analysis was already indicating upward risks to price stability coming from strong growth in money and credit, driven by a rapid increase in asset prices, and house prices in particular. This led us to increase interest rates in a series of steps starting in December 2005, at a time when the economic analysis was providing more mixed signals. The decision to tighten monetary policy at an early stage may be one reason why financial imbalances in the euro area did not develop as far as in some other countries.

To conclude, let me summarise my main points. The world economy is in its worst recession since the 1930s, and the euro area economy is no exception. The fiscal and monetary authorities have responded forcefully and their efforts are slowly starting to bear fruit. The pace of the economic contraction appears to be slowing down, and confidence indicators have improved somewhat.

The crisis has highlighted the importance of sound public finances. Governments need to consolidate during good economic times in order to have room for manoeuvre during not-so-good times.

With respect to monetary policy, the crisis has demonstrated the importance of having an independent central bank credibly committed to price stability. The pre-crisis years also showed the usefulness of the monetary analysis, the second pillar in the Eurosystem’s assessment of risks to price stability. In particular, it helped to maintain a medium-term perspective.

Looking ahead, the fiscal and monetary authorities have an important role in sustaining the economic recovery. Governments must devise and enact credible strategies to exit from the banking sector and to ensure that the discretionary policy measures adopted during the crisis will be reversed. Their full compliance with the Stability and Growth Pact is the best tool to solidly anchor market expectations. Furthermore, the ECB’s commitment to maintaining price stability is the best contribution monetary policy can make to sustaining economic recovery and long-term economic growth.

The ECB is well prepared to take appropriate action and also to exit from its non-standard monetary policy and liquidity management measures in a credible manner once the macroeconomic environment improves.

Most importantly, we will continue to deliver on what we are expected to deliver, which is to maintain price stability, and to provide an anchor of confidence in difficult times.

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International Monetary Fund, World Economic Outlook (2008). Chapter 5 "Fiscal Policy as a countercyclical tool." October

Perotti, R. (2002). "Estimating the effects of fiscal policy in OECD countries." ECB Working Paper no. 168.