When Professor Krämer and I agreed on today’s meeting one year ago, our discussions took place against the backdrop of the first nine months of the financial market turbulence. Central banks had reacted and provided banks with additional funds in the form of reserves, in particular to stabilise the money market.
Today, one year on, some additional challenges have been added to those we were facing then. I’m therefore very happy to have the opportunity to be here in Karlsruhe today to talk about the current challenges relating to monetary policy and our experiences during the first ten years of the euro. It is my pleasure to speak at the Hochschule Karlsruhe, which, since its foundation in 1878 under the name “Großherzogliche Badische Baugewerkeschule”, has, as your website informed me, become the most popular university in Germany with recruiters. In the nineteenth century, when the university was still operating under its original name, the official means of payment was the Mark, with Germany having adopted the gold standard in 1873. Under this currency arrangement, each country set the value of its currency in relation to gold. Coins were made out of gold and banknotes could be exchanged for gold at the central banks. This also implied that the exchange rate towards other countries participating in the gold standard was fixed. For instance, one US dollar cost 4.20 Mark.
With the outbreak of the First World War, the gold standard was abandoned. As a consequence, the value of banknotes no longer had a reliable anchor. Hyperinflation occurred in 1922 and 1923, as more and more money was printed to finance public expenditure. Thus, by 1923 one US dollar cost around 4.2 billion Mark. Distrust, despair and desolation were the consequences in Germany, thereby undermining fundamental democratic principles and ultimately preparing the ground for the Second World War.
To avoid a repetition of the hyperinflation of the interwar years, the Deutsche Bundesbank was granted a high degree of independence following the Second World War. Over the 50 years or so of the Deutsche Mark’s existence, annual consumer price inflation averaged 2.8%. A number of other countries experienced much higher inflation over this period, particularly in the 1970s and 1980s. Many Germans were therefore sceptical prior to the Deutsche Mark being replaced by the euro ten years ago. We now know that this scepticism was unfounded.
So, in the first part of my speech, I will briefly describe the euro’s success in its first ten years. I will also explore the question of why lasting price stability is important, not only from an economic perspective, but also from a social perspective. I will then take a look at some of the key challenges we are currently facing and try to draw some initial lessons from the current financial crisis. I would also like to consider where we in Europe might be today if we did not have the euro.
Ten years ago, on 1 January 1999, the euro was introduced as the common currency of 11 Member States of the European Union. This was a unique step following many years of thorough preparation. Now the euro is used by around 330 million citizens in 16 countries. It has established itself as a stable currency, accepted in financial markets worldwide. Looking at the inflation performance over the first decade of Monetary Union, the ECB has fulfilled its mandate under the Maastricht Treaty, which is to maintain price stability for the euro area as a whole.
With inflation averaging slightly more than 2% during this period, the euro area has witnessed a decade of stable prices. This contrasts sharply with the fears that prevailed before the introduction of the euro, in particular in Germany, that the euro would be less stable than the Deutsche Mark and that the newly established, supranational ECB would not be in a position to deliver on its promise to keep prices stable. In fact, in its first decade the euro has, on average, been as stable as the Deutsche Mark was in the 1990s.
The euro’s success is even more remarkable if one takes into account the number of price shocks during the past ten years, notably the continuous increase in oil prices between 1999 and mid-2008. Over this period crude oil prices rose from around USD 10 per barrel in 1999 to a peak of almost USD 150 per barrel in 2008, and there were also substantial rises in international food prices. Likewise, on the domestic side, we have witnessed almost regular increases in indirect taxes and important administered prices in most member countries of the euro area over the first ten years. As illustrated by Chart 1, the inflation performance of the euro area compares very favourably with that of the period leading up to 1999.
[Chart 1: Inflation rates before and after the introduction of the euro]
Longer-term inflation expectations have also been well anchored during the last ten years, at levels in line with price stability. Chart 2 illustrates various measures of inflation expectations, both based on surveys and derived from market expectations. All measures indicate that inflation expectations are relatively close to the Governing Council of the ECB’s target of keeping annual inflation rates below, but close to, 2%. This means that market participants trust the ECB to continue to deliver on its mandate of maintaining price stability over the medium term, reflecting, in particular, the smooth functioning and the credibility of the ECB’s monetary policy.
[Chart 2: Various measures of inflation expectations]
Firm anchoring of inflation expectations is essential for solid economic growth, job creation and the cultivation of trust regarding asset formation and savings. Low rates of inflation, together with well-anchored inflation expectations, have resulted in nominal and real interest rates across the euro area that have been low by both historical and international standards. Low interest rates and the associated low borrowing costs have had positive effects on investment and employment in the euro area.
Such a favourable outcome in terms of price stability, the credibility of monetary policy and institutional robustness had not been expected by many critics of the euro prior to the creation of Monetary Union. In particular, it was constantly argued that the ECB’s single monetary policy could cause problems because a uniform approach in the form of a single monetary policy would not do justice to all the countries of the euro area, given the existing economic and structural differences. They argued that it would be too restrictive for countries with low levels of growth and too loose for countries with high levels of growth, and counterproductive in any case. It was also argued that national fiscal policies would be incompatible with the single monetary policy conducted by a supranational central bank. Finally, from an institutional point of view, there were doubts whether the presidents and national central bank governors in the Governing Council of the ECB would be able to act in a truly European spirit, rather than in the national interests of their respective countries.
But, ten years on, measured against the achievements in terms of monetary policy, credibility and price stability, there is widespread agreement that the euro has performed very well. In fact, none of the above-mentioned fears have materialised. This is tangible proof of the robustness of the Eurosystem (the ECB and the national central banks of the euro area countries), and of the fact that the ECB’s monetary policy decisions are based on shared values and common principles.
The Austrian economist Joseph A. Schumpeter stated that “a nation’s monetary system is a reflection of everything that the nation wants, suffers, and is. … Nothing says what a nation is made of so clearly as what it does in terms of its monetary policy.” Allow me, therefore, to briefly explain why it is so important to maintain price stability over the medium term and then I will present the main benefits of lasting price stability. First of all, price stability fosters trust in money and in property rights more generally. In particular, it preserves the purchasing power of money and protects the real value of income and wealth. Price stability is also important for the weakest groups in society, who suffer most from high and volatile inflation rates. As a consequence, maintaining price stability also contributes to social cohesion.
Price stability is a precondition for sustainable growth and job creation. Prices can generally be seen as the traffic lights of the economy. A higher price is a signal for the producer of a good to continue or increase production. It signals a change in the relative scarcity of the individual good, compared with other goods. Similarly, a low price tells the producer to reduce or halt production. Without price stability, however, prices lose their signalling function, as it is no longer clear whether a change in price is due to a change in the relative scarcity of the individual good or caused by a change in the general price level. With high, volatile inflation, it becomes more difficult to distinguish between the two causes and it is more complicated for producers to know whether they should increase production or not. Furthermore, price stability over the medium term reduces risk for investors, which contributes to lower interest rates. This makes investment projects more profitable, which again leads to higher levels of employment and economic growth.
The past decade is also testament to the fact that price stability goes hand in hand with economic growth and job creation. In the first ten years of Europe’s single currency, the number of people employed in the euro area has risen by approximately 18 million, which is equivalent to an annual increase of nearly 1.3% (see Chart 3). This compares favourably with the 1990s, when fewer than 8 million jobs were created, corresponding to an average annual increase over this period of 0.6%. Price stability was of course not solely responsible for this; changes in employment patterns are affected by many factors. However, these developments strongly confirm that a monetary policy oriented towards price stability is fully compatible with job creation. Price stability helps to ensure that necessary corporate restructuring does not get left on the backburner and also fosters wage differentiation across sectors, regions and qualifications, with positive effects on economic growth and employment.
[Chart 3: Employment]
At the same time, the euro has made an important contribution to economic and financial integration within Europe. The single currency has enhanced our ability to take advantage of the single market, and trade and capital ties between euro area countries have grown significantly.
For example, cross-border trade in goods and services in the euro area has increased by 10 percentage points as a share of GDP since the introduction of the single currency (see Chart 4). Trade between individual euro area countries now accounts for about half of their total imports and exports. At the same time, trade with countries outside the euro area has also developed very dynamically.
[Chart 4: Trade between euro area countries]
The euro has promoted competition, price transparency and price convergence. It has lowered transaction costs and eliminated exchange rate risk.
The euro has boosted direct investment within the euro area. Mergers and acquisitions in the euro area have also risen noticeably.
In addition, the euro has made a significant contribution to the integration of financial markets in Europe. One example of this is the marked increase in cross-border investment in securities within the euro area, as illustrated by Chart 5.
[Chart 5: Cross-border holdings as a share of total holdings of short-term debt securities issued in the euro area]
Let me now turn to the ongoing financial market turbulence and its implications. Since August 2007 the global financial markets have experienced extensive corrective realignments. The repercussions of the turbulence were initially visible in the financial market in the form of dramatic increases in risk premia and increased volatility in interest rate movements. Thereafter, upheaval on the financial market led to a severe and synchronised economic downturn across the globe, the deepest since the beginning of the Great Depression in 1929. The current crisis, therefore, poses grave challenges to the financial industry and central bank community, as well as to supervisory and regulatory authorities and national governments.
The outbreak of the financial market turbulence was not entirely unexpected, however. Both the ECB and other institutions had warned of macroeconomic imbalances and systematic undervaluation of risks in the years leading up to the crisis.
Those years were characterised by an extended period of low interest rates, low inflation and sustained economic growth, both globally and within the euro area. At the same time, liquidity was abundant and default risks were considered by many to be very low. This environment strengthened investors’ risk appetite. In particular, with financial market participants expecting this environment to continue for quite some time, risks were systematically underestimated and the search for ever higher yields intensified. As a result, commercial banks readily granted credit for house purchases to households that otherwise could not have afforded it, and without adequately assessing their creditworthiness or credit default risk. At the same time, in an attempt to achieve higher yields, a number of innovative and increasingly complex financial products were offered, particularly in the United States. One prominent example of this was the bundling of mortgages in new and highly complex financial products and their resale as new securities to third parties via global financial markets. Bundling mortgages and distributing them was supposed to spread the overall risk. But this did not work as it was intended to. On the contrary, as the risk was ultimately transferred to a third party, the relevant incentives were not in place for the loan providers to make sure that the borrowers would be able to repay those loans. At the same time, many of those that ended up bearing the risk underestimated the extent of that risk.
It eventually became evident that this practice was viable only as long as house prices in the United States continued to increase. When the many years of increases in house prices came to an end and house prices started to fall, problems soon emerged, including in the euro area, as banks here were among the buyers of these securities. Investors suddenly began to doubt the quality of their assets. This led to a sharp correction in prices on the financial markets, accompanied by a withdrawal of funds from the markets, leading to corresponding liquidity shortages for banks.
Problems first emerged at the short end of the money market, where banks borrow from and lend to each other. Normally, the rates in this segment of the money market are close to the key interest rates set by central banks. Chart 6 shows the spread between the expected central bank rates and the market rates. As you can see, in August 2007 there was a sudden jump in the spread between these rates. This reflects the fact that banks became unwilling to lend to each other because they feared that the other bank would not be able to repay the loan. In order to obtain a loan, banks had to pay higher interest rates to compensate for the increased risk. You can also see that the spread widened dramatically in September last year in the wake of the collapse of Lehman Brothers. However, the spread has declined significantly in recent months, although it is still far above the levels that prevailed prior to the financial market turbulence.
[Chart 6: Spreads in the money market]
The banking sector has been facing significant challenges since financial market tensions intensified. For instance, the declared cumulative write-downs and credit market losses of European banks amount to almost USD 360 billion so far, or about EUR 270 billion. These problems have played a decisive role in the subdued lending to companies and households in the euro area. This is, on the one hand, due to the cutback in debt capital positions on banks’ balance sheets and the general tightening of credit standards. On the other hand, the demand for loans has fallen as a result of the overall weakening of economic activity. Developments in borrowing and lending have an impact on the real economy in that they play a particularly decisive role in trends in investment activity.
From the very beginning of the crisis, the ECB has acted in a decisive and appropriate manner. It has taken a number of measures unprecedented in nature, scope and timing. The ECB has provided an extremely large amount of liquidity support to banks. In fact, when tensions first emerged in August 2007 the ECB was the first central bank worldwide to respond. By making changes to its operational framework, the ECB made sure that all solvent banks would have sufficient access to funding. When the crisis intensified in September last year, we introduced a number of new measures. Most importantly, we provided banks with unlimited access to liquidity at fixed rates for up to six months. The ECB also expanded its list of assets eligible for use as collateral in the Eurosystem’s credit operations.
As a result of these new measures, the size of the Eurosystem’s balance sheet has expanded by a substantial EUR 600 billion and now stands at 16% of GDP, compared with 10% in mid-2007, with some volatility over that period. This mainly reflects the expansion of the provision of liquidity to the banking system, which plays a crucial role in the funding of the euro area economy. In other major economic regions, funding via debt securities, which has suffered more severe disruption, is of greater importance. In this respect, all the unconventional liquidity measures taken by the ECB have been tailored to the needs of the euro area. Notably, they have eased banks’ balance sheet constraints and thereby certainly helped to avoid a sudden collapse in the supply of credit and the emergence of a systemic crisis.
In line with the substantial weakening of global demand and economic activity, inflationary pressures and risks have been diminishing. As a result, the ECB’s policy rates have been cut by 3 percentage points since the intensification of the crisis last October. These rate reductions, together with the liquidity management measures, have had a significant impact on money market interest rates. Since last October overnight money market rates have fallen even more steeply than the ECB’s policy rates. Money market rates in the euro area have now reached very low levels by international standards. Lower money market rates have also led to lower interest rates for private households and firms, although the decline in money market rates has so far been greater than the decline in interest rates on credit for households and firms.
The fiscal authorities in the euro area have also demonstrated their capacity to react rapidly to exceptional circumstances. In a coordinated effort, the national governments of the euro area have provided support to the banking system, most notably through recapitalisation and guarantees for liabilities and assets. The funds provided under the package announced to stabilise the financial sector through these types of measure amount to 23% of the euro area’s GDP. The overall fiscal stimulus – through discretionary policy measures and the effect of automatic stabilisers – amounts to 3.6 percentage points of GDP for 2009 and 2010.
All of these measures were necessary to support the functioning of the financial system, but they also imply a considerable fiscal burden in that fiscal debt and deficit ratios may increase substantially. In fact, what matters is not only the size of the fiscal stimulus, but also the potential to enhance confidence and effectiveness. While the fiscal measures introduced by euro area governments during the crisis have succeeded in cushioning the adverse impact of the crisis on the economy, it remains essential that countries return to sound fiscal policies and thereby, in a credible manner, stick to their commitment to respect the provisions of the Stability and Growth Pact.
Overall, during the ongoing financial market turbulence, the euro area and the EU as a whole have proved their capacity to act decisively and promptly under difficult circumstances. National measures have been coordinated in a pragmatic manner with a view to enhancing their effectiveness through mutual reinforcement.
The current financial crisis has pointed to a number of weaknesses that need to be addressed if we are to avoid a similar crisis in the future. Some weaknesses are rooted in the current design of the international financial system. This is particularly true with regard to the lack of transparency and accountability within the financial system. In this respect, much relies on financial players themselves taking responsibility for evaluating risk more effectively and increasing transparency as regards risk. In addition, various initiatives at national, European and international level aim, in particular, to improve the robustness of the financial system. Two recent reports – the Turner Report, written by Lord Turner, Chairman of the British Financial Services Authority, and a report by a high-ranking group of experts on financial supervision, led by Jacques de Larosière, former Governor of the Banque de France and former Managing Director of the IMF – contain a range of valuable reform recommendations. In addition, a group of experts recently provided a fitting analysis of the shortcomings of the current financial system in a report on the future of the banking sector in the Netherlands. 
I would like to highlight three areas where I think change is necessary: there needs to be an increase in transparency, a dampening of pro-cyclicality and an improvement in institutional design in the field of financial supervision and regulation.
First, the financial sector needs to become more transparent. It is quite striking that, despite the regulatory advances and the progress of information technology in recent decades, some financial market segments have been characterised by products that have proven to be hard for investors – never mind rating agencies, supervisors and regulators – to understand and value. One possibility here would be to standardise products and transactions and to ensure that transactions take place via regulated exchanges or clearing houses. Furthermore, all systemically important institutions, markets and instruments should be subject to an appropriate degree of regulation and oversight. One such example is the market for derivatives. For most of these financial contracts, the conditions are agreed upon between the two parties and the instruments are traded “over the counter". Trading activities on this “OTC derivatives market” are subject to much less regulation than those on markets for products traded on the stock exchange, and the post-trading infrastructure is also less developed. Given the systemic relevance of these markets, the ECB supports the swift development of improved post-trading infrastructures, so as to enable more effective management of credit and operational risk, as well as to improve the transparency of these markets.
Second, in my view, we need to try to dampen the excessive pro-cyclicality of the financial system. By this I mean that it typically becomes much easier to acquire funding during booms, whereas credit standards are normally tightened during economic downturns. In the same vein, investment risks are typically systematically underestimated in good times, whereas they tend to be overestimated in times of crisis. In this way, the financial system stimulates the booms and exacerbates economic downturns. This is exactly what we have been witnessing in the course of the current crisis. Ideally, we would want a financial system that worked the other way around, thus dampening booms and providing a stimulus for stabilisation during economic downturns. Some first steps have already been taken towards counteracting the pro-cyclical effects of supervisory regulations. Discussions are currently underway regarding changes to equity capital regulations and reporting in the area of risk provision. In addition, the introduction of a borrowing limit or leverage ratio is being considered. These measures all aim to reduce pro-cyclicality in the financial system and improve its stability.
A third lesson we can draw from the current crisis is that it is necessary to take a more system-wide approach to financial market regulation and supervision. It is not enough to ensure that individual financial institutions are solid. Greater emphasis must be placed on the stability of the financial system as a whole – not least the cross-border links between the various components of the financial system. The de Larosière group proposed giving the ECB more responsibility within this field (i.e. that of macro-prudential supervision) by establishing a European Systemic Risk Council under the auspices of the ECB. The main tasks of this new Council would be to pool and analyse information, monitor relevant developments, make recommendations on macro-prudential policy and issue risk warnings.
The ECB welcomes this proposal. The establishment of a European Systemic Risk Council should substantially improve the assessment of risks to financial stability at the EU level. In order for the new Council to perform its tasks in an optimal manner, three requirements must be fulfilled. First, the ECB must have timely access to the relevant information, including information concerning individual institutions. Second, risk warnings from the new Council should be translated into effective policy action. And third, for the new Council to be independent and effective in its decision-making, it is essential that it have a solid institutional and legal basis.
I also think the current crisis holds some lessons for monetary policy. The crisis has shown us that a stable financial system is a prerequisite for price stability. Everyone is agreed that each central bank has one instrument at its disposal, namely monetary policy, to achieve its goal of price stability. However, not all are agreed on which prices a central bank should be concerned about.
The extent to which monetary policy should take asset prices into account has been a long-standing debate among central bankers and academic economists. The ECB’s definition of price stability identifies a specific price index – namely the Harmonised Index of Consumer Prices (HICP) – as the one to be used for assessing whether price stability has been achieved. As the HICP is a consumer price index, asset prices such as house prices or stock prices are not included. This does not mean that asset prices are not important from a monetary policy perspective. To the extent that changes in asset prices have an impact on the outlook for prices, a central bank that aims to maintain price stability will need to respond to these changes.
One could argue that asset prices should play a greater role in monetary policy considerations. According to this school of thought, as the build-up of an asset price bubble might have severe economic consequences in the longer term, central banks should try to deal with the bubble pre-emptively. To put this in more concrete terms, it is argued that the central bank should increase interest rates when asset price inflation reaches a certain level, even if the impact of this inflation on the outlook for consumer prices is not obvious. In academic literature, this approach is often referred to as “leaning against the wind”.
Taking asset prices into account may pose problems. However, monetary policy-makers should try to mitigate the risk of the build-up of a bubble by being aware of the effects their policy decisions can have on the financial system.
The ECB’s assessment of risks to price stability is based on a comprehensive economic and monetary analysis, known as its “two-pillar strategy”. The first pillar, economic analysis, is common to most central banks. It 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 analysis includes the study of the interaction between a number of macroeconomic and financial variables. The variables we look at include, just to name a few, aggregate output, private consumption, investment, fiscal policy, capital and labour market conditions, different price and cost indicators, the exchange rate, the global economy, the balance of payments and financial markets.
The second pillar, monetary analysis, is given a prominent role at the ECB. Analysing developments in borrowing and lending, particularly loans to the private sector, is helpful in extracting the relevant signals from monetary developments. This analysis also fosters the regular monitoring of asset price developments and their implications. Consideration of these aspects must become more extensive and systematic in the future.
Strengthening the ECB’s role in financial supervision should contribute to ensuring that proper consideration is given to the possible build-up of financial imbalances when making monetary policy decisions. The current crisis has demonstrated that risks to financial stability are accompanied by risks to price stability. Central banks must give even greater consideration to these risks in their analyses.
As mentioned, the euro was very succesful in its first ten years. But it is clear that the current economic crisis represents the greatest challenge for the euro so far.
Let’s be realistic: 2009 will be a difficult year. According to the most recent macroeconomic projections by ECB staff, published in March of this year, the euro area economy is expected to contract by between 2.2% and 3.2% in 2009. Since then, other international institutions have published even more pessimistic forecasts. According to the forecast by the European Commission, for example, the economy is expected to shrink by 4% this year. This means, among other things, fewer jobs, higher unemployment, less investment and fewer exports. 2009 will be a year of necessary adjustments for banks, firms and private households, but these adjustments will lay the foundations for a return to more stable and improved economic conditions.
That said, we should not forget how Europe would look today without the euro. In addition to the financial market turbulence, the problems in the financial sector and the economic downturn, we would be facing potentially large fluctuations between Europe’s national currencies.
[Chart 7: Real effective exchange rates]
The currencies of some of the countries outside the euro area have experienced considerable fluctuations during the current crisis, as illustrated in Chart 7. Both the Swedish krona and the pound sterling have declined substantially in value since September 2008 and some of the most recent countries to join the EU have seen even larger fluctuations in their currency’s purchasing power. This is an additional source of uncertainty for these countries. The current turmoil has also confirmed an advantage the euro has, namely that, in stormy seas, it is better to be aboard a large ship than a small boat. The euro has had a very important stabilising effect in difficult times.
The many benefits of the euro under the current circumstances are also highlighted by the fact that many central and eastern European countries have expressed a wish to join the euro area as quickly as possible. This is no surprise, given that many countries have already made progress towards adopting the euro. Nevertheless, all countries must first fulfil all of the relevant criteria before they may join the euro area.
I would like to emphasise that the euro area is not a closed shop. Five new countries have joined since the start of Monetary Union in January 1999, with Slovakia becoming the newest member of the euro area in January of this year. The door is open to all those that meet the clearly stated and predefined criteria for membership of the Economic and Monetary Union.
As the saying goes, “the proof of the pudding is in the eating”. The last ten years are evidence of the fact that the euro has made a significant contribution to a stronger and more integrated Europe. The single currency has created an environment where price stability is king. The euro has also proved itself in the current financial market crisis. Thanks to the broad availability of euro liquidity, the currency has facilitated the stabilisation of the financial system.
The financial crisis has posed huge challenges for financial market participants, governments and central banks. In order to be able to deal with these better in the future, we must pay particular attention to three lessons learnt from the current crisis.
First, we need to pay more attention to considerations regarding financial stability and systemic risk. This is also essential in the overall assessment of the risks to price stability over the medium term and in respect of the ECB’s conduct of monetary policy. The ECB’s involvement in macro-prudential supervision within the proposed European Systemic Risk Council will be a welcome step in this direction.
Second, pro-cyclicality within the financial system must be restricted. In this regard, it will be crucial to come up with appropriate regulatory tools to effectively smooth out business cycle fluctuations.
Third, there must be an improvement in regulation and oversight. In this respect, all systemically important institutions, markets and instruments should be subject to an appropriate degree of regulation and oversight. For example, the ECB supports initiatives to swiftly establish infrastructures for systemically relevant markets such as the OTC derivatives markets.
The biggest challenge we now face is the need to reform the financial sector in a way which benefits the real economy, pulls us quickly out of the crisis and combats potential risks to price stability. Over the last ten years we have been successful in achieving the last of these things and we intend this to continue in the future.
 Advisory Committee on the Future of Banks in the Netherlands (2009): Restoring trust.
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