The financial and fiscal crisis: a euro area perspective

Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECB, Le Cercle, Brussels, 18 June 2010

Introduction

I would like to thank the organisers of this conference for inviting me to present a euro area perspective on the current crisis. I often have the impression that people living in this area see what is happening in their countries and in the monetary union differently from many other people around the world. And these differences are as surprising to us in continental Europe as they are to those outside it.

Just to give an example, a US academic recently visiting the ECB in Frankfurt admitted quite openly his surprise at finding our own staff so convinced that the euro will survive this crisis. I must admit that I was surprised, if not shocked, to hear this scholar’s admission. After all, most US citizens believe that the dollar will survive the crisis. And rightly so, because few expect the US to cease to exist as a political entity because of the crisis. The euro area is not a political union in the same way as the US. But neither is it just an exchange rate mechanism that a country can join and leave at its own convenience.

But then what is exactly the euro? I hope you can give an answer by the end of this talk, at least implicitly. I won’t get into an existential discussion but I’ll try to explain what has happened in recent months and what we can expect. Allow me to do that by asking a few questions. What went wrong? How was it dealt with? What’s the alternative? Will the response work? Why was it so complicated? What’s missing?

There are two distinct parts to this analysis and sometimes they get mixed up. The first relates to specific developments in member countries, in particular Greece. The second concerns the overall architecture of monetary union. In considering these two aspects, and how they interact, we should not forget that we are currently in the midst of the deepest economic and financial crisis since WWII, a crisis not foreseen when the euro was conceived.

What went wrong?

Several things went wrong. The most important one was that until the crisis erupted, Greece hadn’t really pursued sound fiscal policies. And yet its overall public debt as a percentage of GDP was not ballooning, largely as a result of an unsustainable economic growth, fuelled by rising private debt, financed through capital inflows. On top of this, in 2009 Greece’s deficit more than doubled as a result of the global crisis and, gravely, because of an inflated and falsified pre-election budget.

Unlike countries which have their own currency, Greece cannot use monetary policy to inflate its debt away. Nor can it depreciate its currency to recoup lost competitiveness and grow its way out of its excessive debt. Unlike any region of a federal country, Greece cannot benefit from fiscal transfers from the rest of the euro area to offset its falling revenues and rising social expenditures linked to the recession. Neither is its labour mobile enough for any excess to be exported.

Greece is primarily responsible for this situation. However, since it is affecting the rest of the euro area, the other countries should have done something to prevent Greece getting into such a predicament. Why didn’t they?

The euro’s institutional architecture envisaged this kind of problem as being subject to a number of disciplinary mechanisms. First, financial markets should have put pressure on countries with excessive deficits and debts by charging higher interest rates. The prohibition of monetary financing by the central bank and the no-bail-out clause aimed to strengthen these mechanisms. Second, the Stability and Growth Pact should have constrained national authorities through procedures and rules aimed at avoiding excessive deficits and debts. Third, the Lisbon process should have increased the competitiveness of the economies of the Member States, avoiding excessive external imbalances.

These mechanisms didn’t work as expected. First, financial markets accommodated the high financing requirements of Greece’s public and private sectors for many years at relatively low interest rates. Only when the crisis exploded did the markets react, by suddenly stopping the capital flows. The contagion to other countries of the euro area, with problems of a similar kind but on a smaller scale, was very rapid. Second, the Stability and Growth Pact was not effective, because Member States have been unwilling to name and shame each other. Often they interpreted the rules in a benign way, not only for countries with a high but unsustainable growth rate but also for the largest ones. Both the preventive and corrective arms of the Pact failed. Finally, surveillance of competitive positions was very weak and divergences in countries’ external positions were underestimated and considered to be benign in a monetary union.

To sum up, it was both a conceptual and political failure. The nature of it was not that different from the regulatory failure in financial markets, which resulted from an excessive optimism in the self-correcting nature of markets and an incapacity to supervise and regulate parts of the economy which had become very powerful both economically and politically. The analogy is relevant because it emphasises, in both cases, the need to address not only the short-term problems caused by the failure but also the longer-term institutional dimension.

How was the problem dealt with?

There were basically two options for tackling the problem created by the Greek crisis: what I would call Plan A and Plan B. Let me start with Plan A, i.e. the tried-and-tested way.

Plan A consists of Greece implementing a fiscal and structural adjustment programme which would bring the budget and the debt under control. This plan was negotiated with the IMF, the European Commission and the ECB. It aims to bring the primary balance from a deficit of around 9% of GDP in 2009, to a surplus of around 6% in 2015. The programme is a standard IMF programme from the budgetary point of view, based on substantial expenditure cuts and revenue increases as well as improvements in revenue collection. It has also some important structural reforms aimed not only at improving long-run debt sustainability, like a pension reform, but also the performance of labour and products markets and thus strengthen growth potential. The projected GDP growth rate starts with a recession of -4% in 2010 and -2.6% in 2011, and returns to positive growth in 2012. The public debt is expected to stabilise, in proportion to GDP, in 2013 at a level of 149% of GDP and start falling thereafter.

The Greek programme is financed by a stand-by arrangement from the IMF, accompanied by bilateral loans by the 15 other euro area countries, for a total amount of €110 billion, which is equivalent to 46% of Greece’s GDP in 2010. It’s the largest IMF financial package, in proportion to a country’s quota. Funds will be disbursed according to a specific timetable, linked to the monitoring of the implementation of the programme.

The spreading of the Greek crisis to the other countries in the euro area was addressed by a tightening of the stability programmes of countries with higher debt and deficits and with accumulated competitiveness losses. Additional measures have been taken in several countries, in particular Portugal and Spain, to ensure that the targets set for 2010 are reached. Furthermore, the targets for the 2011 deficit have been revised downwards and measures have been announced to achieve these targets.

Finally, a European Financial Stability Fund has been created, based on existing funds amounting to €60 billion and on additional government guarantees of €440 billion and an expected contribution from the IMF of up to €250 billion. Overall, the European Fund can mobilise €750 billion to support any other country that embarks on an adjustment programme.

What’s the alternative?

There is widespread scepticism among academics, financial market participants and observers about whether Plan A will work, particularly in the case of Greece, because it is too harsh, it imposes too many restrictions and would ultimately be politically unsustainable. Plan A is for countries with liquidity problems, while Greece – they argue – has solvency problems. If Plan A is not viable, there is only one alternative – Plan B.

It’s not very clear what Plan B is. Some regard it as an ‘orderly’ debt restructuring by Greece, with a substantial haircut for bondholders which would alleviate the country’s debt burden. A further elaboration of Plan B also entails a return to the national currency – the drachma – with a devaluation which would allow competitiveness to be restored. The consequences of Plan B have not been considered in detail by its proponents, but this is considered as a secondary issue, to be assessed at a later stage.

That’s the main reason for the difference of view. Those who have seriously studied Plan B, in all its details, know that it is not only much harsher for the people of Greece, and for the other European countries. What’s more, it doesn’t work. And because Plan B doesn’t work Plan A is the only viable solution. Let me elaborate on this.

First, experience has shown clearly that within an economically integrated area like the euro area a currency devaluation does not allow a growth stimulus that would support faster fiscal consolidation. The countries which devalued their currencies - as Italy did after leaving the ERM in September 1992 - suffered large interest rate spreads for a protracted period, because of renewed uncertainty about the monetary regime after the devaluation as well as about the fiscal system. After each devaluation, inflationary risks rapidly appeared, which required more monetary tightening than would be the case within the euro. In fact, several countries, like Belgium, Ireland and the Netherlands, implemented their fiscal consolidation programmes while maintaining a stable exchange rate and a high primary budget surplus (i.e. net of debt interest). Another aspect that is often ignored is that the return to a national currency is not an event comparable to a change in parity in a pegged exchange rate regime. It would involve a renegotiation of all contracts, especially financial ones, within individual countries and between residents of different countries, with conflicting interests between debtors and creditors. In the event of legal disputes the international courts would be inclined to rule against the country which had decided to change its currency of denomination. This means that residents of that country would be severely affected by a change in the denomination of their contracts. A debtor country which imports capital from the rest of the euro area and devalues its currency would immediately suffer from an increase in its debt burden, which would exacerbate its difficulties. The country would probably suffer from an attempt by the population to maintain the euro as a unit of account and means of exchange, leading to parallel circulation.

To sum up, given the financial and economic integration achieved over recent years in the euro area, the possibilities voiced by some about a country abandoning the euro or about reconstituting the euro area in a reduced form would have highly detrimental effects on everyone, be they net creditors or debtors. It would be in nobody’s interest.

Even without leaving the euro area, a debt restructuring which would entail a substantial haircut for bondholders would hammer the domestic financial system and have serious repercussions on the real economy. As many countries which have undergone a restructuring in the past know well, access to capital markets would be impaired for many years, affecting not only the government but the whole country, with severe effects on the private sector. Finally, a restructuring would also have major political consequences if the loans made by the other euro area countries were not repaid in full. Greece’s access to the Cohesion Funds would most probably be called into question.

To sum up, Plan B would not put Greece in a sustainable position for the long term and would have a lasting economic impact on society. Greece would end up being politically marginalised in the European Union. The Greeks authorities know this.

Plan B would also have strong contagion effects on the other countries, starting from those with weaker fiscal positions, inside and outside the euro area. Such contagion effects have already materialised to some extent.

Plan A is preferable. All parties involved, both in Greece and in the euro area, have a strong incentive to ensure that it works.

Will it work?

It’s probably not enough to say that Plan B is worse than Plan A merely to ensure that the latter works. Ultimately Plan A is quite tough, especially in the case of Greece, but also for all the other countries which are embarking on austerity measures. There are two types of risk. The first is that these programmes are not economically sustainable and create a perverse debt spiral. The second is that they are not politically sustainable and will cause the respective population to ultimately give up and adopt Plan B as the default.

Let me examine both issues in turn.

First, let me consider the economic feasibility of the Plan A type of action, based on restoring fiscal sustainability. Let me start with some general considerations, and then turn to the specific case of Greece.

An analysis of the economic sustainability of any fiscal retrenchment is based on the economic impact of a restrictive budgetary policy. There is currently much discussion on the Keynesian and non-Keynesian effects of fiscal retrenchment, but I do not wish to go into that. I will nevertheless make two comments.

First, the theory that a fiscal retrenchment leads to an increase – rather than to a decrease – in the debt-to-GDP ratio is extreme. I have seen no empirical results confirming this, at least for industrial countries. A restrictive fiscal policy might well have a negative impact on growth, but not to the point of generating a perverse debt spiral. Experience has shown that countries with a significant primary surplus can still grow over time, bringing down the debt burden. Perverse debt results can be obtained in specific cases which are typical of emerging countries, where the debt is denominated in foreign currency. Under these circumstances, low growth makes the exchange rate unsustainable, and the more the exchange rate depreciates the more the debt burden rises, making it untenable as well. This was the experience of Argentina, which defaulted on its debt, although it was quite modest in relation to GDP (about 62% in 2001), but it was denominated in dollars, while the peg of the peso to the dollar had become untenable.

The second comment that I would like to make is that the whole discussion about the recessionary effects of fiscal retrenchments is flawed. It is like comparing apples with pears. The analysis often includes a baseline scenario describing an economy growing at a given pace but with an unsustainable fiscal policy. When a restrictive budget path is plugged into the simulation, growth decreases, at least in the short term, because of standard Keynesian effects. But the problem is that financial markets are totally excluded from the exercise. The baseline scenario assumes that a country can have an unsustainable fiscal policy for a long time without the financial markets reacting. Reality has proved this kind of model wrong. An unsustainable fiscal policy will, sooner or later, receive the attention of financial markets; they tend to react abruptly, generating a crisis which impacts heavily on the economy. At that point the fiscal adjustment required to restore debt sustainability is much harsher. In fact, a well-designed baseline scenario should include a sharp contraction in growth at a certain point in time, due to the unsustainability of the debt. A timely fiscal adjustment which puts debt dynamics back onto a sustainable path entails a stronger growth over time. Comparing the two scenarios would show that the expansionary and uncontrolled fiscal policy scenario is recessionary, not the timely adjustment one. The problem is that our economic models do not incorporate any relationship between fiscal sustainability and financial markets. They tend to wish it away, believing that economies can grow for ever even if their fiscal position is unsustainable.

These models lead to major mistakes in assessing policies. This affects not only policy-makers but also market participants and rating agencies. Greece is a case in point. The Greek government delayed for many months the measures needed to regain control over the budget, because of fears that it would impair growth prospects. Had Greece taken these measures earlier and avoided the financial crisis, growth would have probably been lower than the one projected at that time (in the autumn of 2009 the European Commission was projecting GDP growth in Greece to be-0.3% for 2010), but certainly higher than the one expected now (-4%) ^[1]. In addition, the fiscal adjustment would probably have been milder, and the loss of market access would have been avoided.

This suggests that a non-adjustment scenario is much worse for growth than an adjustment scenario, especially if the latter is timely. However, when rating agencies assess sovereign debt, they tend to use the same reasoning as the incorrect models. The solvency risk of a country which has implemented a fiscal correction should be lower than if it hasn’t followed that path. Strangely enough, Greece’s rating was not lowered because of government inaction. In fact, the downgrading occurred after the fiscal package was approved and implemented.

As far as the Greek recovery programme is concerned, the forecasts are based on the fact that Greece will implement, as part of the programme, some important structural reforms which will substantially improve the competitiveness of its economy. The first full review by the IMF will take place at the end of August. Yesterday the IMF, European Commission and ECB released a joint communiqué on the interim review mission, indicating that the Greek programme was on track.

Why was it so complicated?

The other argument for casting doubt on the feasibility of Plan A is political. According to some, the people of the advanced economies are not ready to accept tough fiscal retrenchment which would challenge their ‘acquired rights’ or perceived entitlements. It would stir public unrest, leading by default to Plan B.

I am not a political expert. But I have some doubts about the expertise of some self- proclaimed pundits who come up with catastrophic predictions about the way our political systems work, especially when faced with a crisis.

What has certainly been the case in the recent crisis is that many policy decisions have been taken far too late. There is no doubt that in many of our industrial countries the ruling political classes often do not have the knowledge, let alone the willpower, to explain to their citizens the need for restrictive fiscal measures. Measures are necessary not only because of the crisis but also because of an ageing population and lower potential growth rates. These would increase the burden on the future generation. As somebody once said, “there is no constituency for budget discipline”, because people have difficulty realising the medium-term dangers of unsustainable fiscal positions; they only do so when a crisis is imminent.

The recent crisis has shown that consensus in societies on tough and unpleasant actions is reached only when a crisis is looming, especially a financial crisis. Governments have to ‘use’ an impending crisis to justify and gain support for tough action. President Bush had to declare on television that “our entire economy is in danger” to gain Congressional approval of the TARP, to support the US financial system. The threat hanging over the euro was used in the euro area to garner support for the financial package for Greece from national parliaments. Explicit references to the financial markets have been made in several euro area countries in order to push through additional budgetary restraints or to adopt major reforms in the labour or financial markets. The bond market spread has become the main enemy, and the main rationale for tough policy actions.

The threat of financial crisis seems to overcome any internal opposition. Why is this? The reason seems to be that in many countries the people know that in the event of crisis Plan B would have very damaging consequences. Governments, businesses and citizens remember the devastating effects of devaluations, debt restructuring and capital controls. This is not to say that the decision to carry out fiscal retrenchment is easily accepted by citizens, but it seems to be easier if they see something even worse on the way. This strategy might be more difficult to pursue in countries where there is no recent memory of a financial crisis and a lower awareness of its negative impact. Some might harbour the illusion that the crisis will pass them by and only affect their neighbours. In today’s post-Lehman world with its dense network of economic and financial systems, that is indeed an illusion.

What’s missing?

I have focused so far on the measures taken to address the current crisis. They show that the political authorities are committed to implementing whatever is necessary to overcome the crisis within the euro area. Plan A is the only viable solution.

However, this crisis has also exposed the weaknesses in the institutional framework underlying the euro. Restoring confidence in the currency also requires strengthening that framework so as to prevent any recurrence of a crisis like the one in Greece. There is broad agreement on this.

Steps have been taken to strengthen the euro area’s institutional framework. A task force chaired by the EU President Van Rompuy will make concrete proposals to the Heads of State and Government by the end of this year.

The discussion is ongoing and the ECB is participating actively. Its position was made public yesterday. To sum up, we favour:

• stronger independent surveillance of the budgetary policies of the Member States, with more automatic implementation of the sanctions;

• an improved framework for competitiveness surveillance to ensure that countries continue to converge their economies, particularly within the euro area, so as to avoid the large imbalances of the past;

• a crisis management framework with strong conditionality to support countries which implement adjustment programmes.

The details of our position can be seen in the published document. Let me just add two comments on issues which have been part of the public debate. The first is on the possibility to expel a non-compliant Member State. This is not consistent with the political construction underlying the euro, and ultimately not a credible threat. Again, the euro is not an exchange rate mechanism that you can enter or exit when you want or when pressured by others. The second comment is on debt restructuring. Several commentators are proposing to include ‘orderly’ debt restructuring mechanisms to force countries to comply with the rules. The problem with this is that it is non-specific, as the debate which took place few years ago in the IMF on sovereign debt restructuring mechanisms showed. There is no such a thing as an ‘orderly’ debt restructuring, especially for advanced economies integrated in a monetary union. Those who propose it just assume that it exists, but forget to specify its functioning and its implications, particularly in terms of contagion to the whole financial system. It makes me think of the joke about how economists lost in the desert can open a can of beans without a can opener: they assume to have one!

The work of the Van Rompuy task force was discussed yesterday by the European Council and will continue until the autumn. I am confident that a constructive result will be achieved.

I would just like to mention a parallel reform which has been discussed over the past year and is currently under review by both the Council and the European Parliament. It concerns the reform of the regulatory and supervisory infrastructure in the EU, notably through the creation of three European supervisory authorities ^[2] (ESAs) and the European Systemic Risk Board (ESRB). The two issues may look separate, but they are not.

The recent escalation of the crisis has shown that sovereign risk can have an impact on financial institutions, in particular on banks. Furthermore, given the interconnectedness of the financial system, especially in the euro area, problems in one country are likely to affect the others. In particular, doubts about the soundness of banks in one country can spread to banks in the other countries. The problems in one country thus cannot be tackled in isolation from the rest.

The recent developments in the financial crisis call for a further strengthening of the ESAs. They should be able to react quickly to critical situations in any of the Member States, pressing the national authorities to take action to identify and remedy problems. If rules and procedures are needed to constrain national fiscal authorities, especially within the euro area, why shouldn’t they also constrain national supervisors? The fact that national taxpayers ultimately bear the cost of national bailouts, notably resulting from supervisory failures, is a pretext for maintaining national prerogatives. National taxpayers have too often had to pay also for supervisory failures in other countries. In an interconnected financial system supervisors cannot wait for a crisis to emerge before tackling it. When a crisis occurs in one country, it will produce contagion effects on the others. This is why supervisors should be independent enough to act pre-emptively, without waiting for the crisis to galvanise politicians into action.

The reforms of the supervisory and fiscal policy infrastructures in the euro area are interconnected. They are mutually dependent. We now have a unique opportunity to make a quantum leap in European integration. This will not be to the detriment of taxpayers. On the contrary, it will ensure that they suffer less in any future crisis.

The bottom line

The current economic and financial crisis – the worst since WWII – has affected the global economy and is affecting the functioning of the European institutions, in particular those underlying the euro. During the last few months a series of shock have hit the euro area which could undermine it. Some people have forecast its demise – prematurely.

The reality is different. The euro area institutions and countries have responded, challenge after challenge, with concrete measures. Strong fiscal adjustment packages have been adopted. Unprecedented structural measures have been announced and in some cases implemented, not least the decision to coordinate and publish the results of stress tests for the banking system. Financial support has been provided to a specific country and through a new institutional mechanism. Concrete proposals to strengthen the governance of the euro area are being discussed and will be approved by the end of this year.

One could say that these measures have been taken at a late stage and only under the pressure of markets, and following much public discussion. But this is ultimately what happens in democracies, and the fact that market pressure is back in the game and playing a role in disciplining countries is, after all, in line with the way the euro was constructed. These market pressures are exerted on the Member States because markets have confidence that the ECB will not inflate the problems away. In the euro area, fiscal problems have to be addressed by the fiscal authorities, through fiscal measures. Growth and competitiveness problems have to be addressed through structural reforms, not easy money. This might be considered by some as a sign of weakness in the short run. But in fact it is a sign of strength in the long run. If the euro area and its members continue to design and build the right adjustment policies over the coming months, they will emerge from this crisis stronger.

What the institutional framework of the euro area will look like in the near future is difficult to say. We should not make the mistake of reasoning by analogy and assume that unless the euro area resembles a fully federal system like the US it is bound to fail. Rather, we should take inspiration from Europe’s history and in particular from the periods when it was flourishing, in fact more so than some larger and monolithic states, which are sometimes more prone to make mistakes. Europe needs a mix of cooperation and competition among its members, something that is not easy to achieve. To be sure, the euro area needs more cooperation, especially in defending its common interests at a global level, but not to the point of eliminating competition, which is, after all, one of the strongest incentives for growth. If the euro area wants to grow at a stronger pace – and it needs to in order to play a role in the global economy – the solutions cannot all come from the centre, but have to rely on the prerogatives of the Member States and the policies which are still in their hands. This has been Europe’s key strength over the centuries and will continue to be in the future.