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“Europe after the warm reboot”

Speech by Yves Mersch, Member of the Executive Board of the ECB,
Munich Seminars, Ifo Institute for Economic Research,
University of Munich, 13 January 2014

Professor Sinn,

Ladies and gentlemen,

Almost 25 years have now past since the Berlin Wall came down. The fall of the Wall symbolised the collapse of the entire Eastern Bloc and the economic model in place there. The former “socialist” countries subsequently had to start from scratch. Gerlinde and Hans-Werner Sinn described the revitalisation of eastern Germany’s economy very fittingly when they chose “ Kaltstart” (Cold reboot) as the title of their book.

Europe, too, came under immense pressure to take action as a result of the financial and government debt crisis. The case of the euro area, however, did not, and does not, call for a start from scratch. Nonetheless, extensive stabilisation measures, as well as both structural and institutional reforms, were necessary.

Europe’s “warm reboot” took place almost four years ago. That makes this a good opportunity to take stock. Where does Europe stand today? What challenges lie ahead?

That is what I would like to do here tonight, looking at the following three questions:

  1. First, what has occurred at the institutional level?

  2. Second, what can we make of the adjustments that have taken place in the Member States?

  3. Third, what challenges do we still have to face?

A more stable institutional framework at the European level

A stable monetary union calls for more than just a single monetary policy. The crisis has brought the weaknesses of the Maastricht Treaty painfully to light.

First of all, the Member States failed to comply fully with agreed rules. For example, most of the euro area countries, starting with the largest ones, repeatedly breached the deficit ceilings set by the Stability and Growth Pact – and the community of sinners put up with it. Second, too little attention was paid to emerging macroeconomic imbalances. Third, expectations that the financial markets would ensure budgetary discipline on the part of Member States were sorely disappointed. Fourth, there was no institution in place that could intervene to stabilise the situation in a crisis.

The crisis has caused all these weaknesses to be addressed. Both the institutional framework and the set of rules have been improved significantly: the Stability and Growth Pact has been strengthened through the adoption of the Fiscal Compact and what is known as the Six-pack. We now have a procedure in place for the early recognition and correction of excessive macroeconomic imbalances. The establishment of the European Stability Mechanism (ESM) has given us an effective crisis management body.

In the past, requirements alone proved incapable of satisfactorily resolving the problem of inadequate budgetary discipline because the Community tacitly accepted such breaches of the rules. That is why the new economic policy governance framework provides for quasi-automatic sanctions in the event of a Member State deviating from agreed benchmarks.

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It is not only the set of rules that has been improved and strengthened. A consensus was also reached on the need for a monetary union to be more highly integrated than a common market of independent states. The crisis has shown that wrong decisions on the part of individual Member States can have an impact on the EU as a whole.

This has caused the President of the European Council, Herman van Rompuy, together with the Presidents of the European Commission, the Eurogroup and the ECB, to propose putting in place the four elements of a true economic and monetary union: such a union should include not only a fiscal union and an economic union, but also a banking and political union.

We are currently working hard to get a banking union off the ground.

The goal of the envisaged banking union is to create a fully integrated, efficient and stable European financial market. Key to attaining that goal is an integrated banking market that will intensify competition for capital. That will result in a more efficient allocation of capital, thereby improving the financing conditions for enterprises. The enterprises, in turn, thereby gain the necessary financial leeway for investment that could have a favourable impact on economic growth.

For us as a central bank, an integrated banking sector means, above all, that our monetary policy is fully effective throughout the euro area. This is the only way in which our monetary policy can have a proper impact on the real economy.

Once the banking union and its two key elements – joint banking supervision and a joint bank resolution mechanism – are in place, they will help cut the close ties between bank and sovereign risks.

Structural adjustment in the euro area

While the euro area has been busy with the reform of its institutional framework, macroeconomic imbalances there have diminished considerably. This is reflected, no least, in the improved current account balances of countries that were hit particularly hard by the crisis. Taken together, those countries already recorded a small current account surplus back in 2012.

There is reason to assume that the underlying adjustments have largely been structural in nature.

Put simply, current account deficits can be reduced through two channels: either domestic demand falls in comparison with external demand (expenditure shifting), or there is a decline in the real effective exchange rate (expenditure switching).

Prior to the crisis, there were some euro area countries that had a current account deficit and, at the same time, consumed more than they were producing. Typically, an economy will again record a current account balance that is in line with economic fundamentals, and will be able to exploit its production potential in full, when both overall domestic demand and real exchange rates decline.

Prices often adjust only slowly. Moreover, in a monetary union, the countries involved cannot change the nominal exchange rate of their currency unilaterally. Any short-term adjustment of the current account thus takes place via the demand side. That has unpleasant side-effects: actual production falls below the production potential, meaning that the country concerned has a negative output gap, and unemployment rises.

In order to bring the internal and external balances back into line with one another, it is essential that the real effective exchange rate is reduced. This form of internal adjustment makes domestic products more attractive and fosters economic growth by way of higher net exports. It also means that a stronger focus on internationally tradable goods and services results in adjustment that is more conducive to growth.

The improvements in the current account balances of the “crisis countries” have indeed been due to a mix of declining domestic demand and real depreciation. Initially in the foreground in these countries was a painful decline in demand. In the meantime, however, the Member States concerned are gradually becoming more competitive again.

In Spain, for instance, the real effective exchange rate has fallen by almost 15% since the fourth quarter of 2007. The country has climbed from 42nd to 35th place on the World Economic Forum’s global ranking of countries’ competitiveness.

Since 2011, Portugal’s share of exports in GDP has increased by 11 percentage points, while that of Spain has risen by 8 percentage points. In Ireland, the share of exports in GDP has increased by around 25 percentage points since 2008. It was only initially that Ireland’s imports declined slightly – they are now already higher than the level prior to the crisis.

These developments show that adjustment is indeed possible, even within a monetary union.

But just how sustainable are these adjustments? Might they not be merely short-term developments due to the weakness of business activity in the countries concerned?

The improvements in the current accounts of the crisis countries are primarily structural in nature. What is involved is thus not an only temporary drop in domestic demand. That is why, viewed from today’s perspective, we regard the improvements to be sustainable.

Although the current account positions of the crisis countries could again change slightly once output there is back into line with the production potential, it is unlikely that the adjustments recorded to date will be reversed in full.

Better current account balances do not mean, however, that the crisis has been overcome. And it certainly does not mean that there is nothing left to do.

The level of unemployment, especially that of young people, is depressingly high in many countries. This calls for further structural reforms, although some progress has already been made in this field. The OECD [1] has found that the labour markets in Portugal, Spain and Greece are now more flexible than those in the so-called “core countries”.

In Greece, for instance, far-reaching labour market reforms have significantly reduced the cost of labour, and have thus improved the country’s price competitiveness. Since 2009, labour costs there have fallen by some 18%, with wage and salary adjustments the main driver of developments. Specifically, compensation per employee has decreased by around 20% over the period in question.

Labour market reforms can also strengthen the growth potential and increase prosperity. That can, of course, also lead to higher demand for imported goods and services. At the same time, however, improved labour market fundamentals ensure that the countries concerned become more competitive again. That, in turn, can help prevent current account deficits from rising excessively once economic activity in these countries regains proper momentum.

It is precisely in this area – in the still very tentative economic recovery – that I see the greatest challenge to be faced this year. Europe’s political leaders have learnt from the crisis. They have strengthened the institutional framework and have set a deepening of European integration in motion. And Member States are becoming more and more competitive. However, the economic recovery in Europe continues to be rather fragile.

The challenge: productive investment for more growth

Lastingly overcoming the crisis demands a return to sustainable economic growth in Europe. That calls for productive investment. Since the beginning of 2008, the main reason for declining growth has been the lack of investment in the euro area. Even the slight recovery in economic activity between 2009 and 2011 saw an only barely discernible increase in investment. Although it is quite normal for investment levels to vary, the decline in investment over the past five years was perceptibly sharper and continued far longer than in any recession in the euro area in the past 30 years.

Why is the investment ratio currently so low?

Some businesses have reduced their investment because their sales and earnings prospects are muted. The macroeconomic environment is occasionally bleak and some sectors are in the midst of restructuring. All this makes planning increasingly uncertain.

Other businesses regard further investment as unnecessary because they have adequate spare production capacity at their disposal.

Both banks and businesses need to reduce their, in some cases, excessive debt and are shrinking their balance sheets accordingly. That, too, reduces investment activity. Some enterprises simply lack the funds they need for investment. Their possibilities for obtaining financing are inadequate.

These are all cyclical phenomena. Apart from them, structural changes may result in lower investment at home. Examples in this respect are ageing societies with poor macroeconomic performance. In addition, the trend towards an outsourcing of production is also leaving its mark. And finally, consumption patterns are changing. For instance, the importance of cars as status symbol is on the decline.

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Although by far most investment is undertaken by enterprises, the political domain determines the fundamentals that create a favourable climate for investment. Even enterprises that can actually afford to spend money tend to limit their investment in times of political and economic uncertainty.

Moreover, public sector investment in key areas such as education and infrastructure add to the attractiveness of an economic location. Such investment improves conditions for production, and thus also attracts new private sector investors. In times marked by consolidation and the reduction of debt levels, however, this cannot be taken for granted. That is why it is all the more important, first, that those countries that have the financial leeway necessary for investment keep an eye on infrastructure needs and, second, that regulatory bodies do not raise barriers against, in particular, long-term investment projects undertaken by public and private sector partnerships.

In Europe, political and economic uncertainty has already diminished. The currently more stable macroeconomic environment there probably also owes something to the policy pursued by the ECB. We at the ECB will continue to do whatever we can within the scope of our mandate to eliminate any uncertainty.

  • Where monetary policy is concerned, this includes the reaffirmation by the Governing Council of its forward guidance, through which the planning security of market participants was increased by indicating that we continue to believe that the ECB’s policy interest rates will remain at their current or a lower level for a longer period of time.

  • With respect to the forthcoming assessment of the balance sheets or stress tests of the most significant banks in the euro area, we intend to publish details of the methodology at the end of this month.

It remains a task of the political domain to further reform the labour markets, to consolidate the public sector budgets in a sustainable manner, to make the judiciary more efficient and to reduce unnecessary bureaucracy. Complex and partially unclear insolvency proceedings may, for instance, have the effect of deterring investment.

In this respect, I certainly see room for improvement: in addition to greater transparency, out-of-court settlements should also be provided for. Moreover, I would regard early-warning systems and a speedier conclusion of judicial proceedings as feasible. All this can contribute to making a location more attractive to investors.

In order to ensure that the recovery of investment activity subsequently gains proper momentum, it is essential that enterprises have adequate financing at their disposal. In times marked by fragmented European financial markets, this is not always easy.

Bottlenecks in obtaining financing are an issue for small and medium-sized enterprises (SMEs), in particular. And such enterprises play an important role in Europe’s economy: 99.7% of all European enterprises fall into this category. They account for around 60% of all jobs in the euro area. Given the economic importance of SMEs in the euro area, their provision with adequate financing is a key element of ensuring a sustainable recovery of economic activity in the euro area.

These small and medium-sized enterprises obtain most of their financing from the banking sector. Direct access to the capital market is rare. That is why it is vital for the European banking sector to be restored to health. Only if this is done will banks again be able to pursue their core business and provide the real economy with credit.

The establishment of a banking union will contribute to making the banking sector more sound. In preparation of the single supervisory mechanism, we are conducting a comprehensive analysis of the most significant banks in the euro area. In the event of our revealing weaknesses in this exercise, the banks concerned will have to take measures to correct them.

Banks with sound business models, which will be supervised on the basis of harmonised European requirements, should be capable of providing the real economy with loans for productive investment. The fact that European banks are increasingly again gaining access to the international capital markets is a good sign in this respect.

The banking union is aimed at the establishment of a single European capital market. It marks the attempt to re-integrate the fragmented European market more closely again.

If that proves to be successful, enterprises will be able to raise a loan from a bank in a neighbouring country, rather than from its home country bank, whenever better terms and conditions offered there. Enterprises would then again be assessed in terms of the creditworthiness, rather than – as is currently the case – on the basis of their location.

A healthy, integrated banking sector is thus of significance. In addition, however, alternative sources of financing should be considered as well.

For smaller enterprises in particular, it is usually difficult to raise capital directly on the market. This is due, inter alia, to the fact that their financial situation is generally less transparent than that of larger corporations. That makes it difficult or more costly for investors to obtain adequate information for reasoned investment decisions.

A single database with information of the credit risk of SMEs would reduce the transaction costs of both investors and the enterprises themselves. Such a database might also contain other information provided on a voluntary basis.

In those countries in which this has not already been done, the national central banks might consider putting in place an internal system for the assessment of SMEs’ creditworthiness. That might also make it feasible to give interested third parties access to those credit scores.

However, it is also possible to indirectly facilitate small and medium-sized enterprises’ access to the capital market. That would require a revitalisation of the securitisation market that has virtually dried up in Europe. The reputation of asset-backed securities (ABSs) has been bad ever since the problems with mortgage-backed securities in the United States. However, there were hardly any defaults on securitisations in Europe. Between mid-2007 and the first quarter of 2013, the default rate on securitisations in the EU was only around 1.4%, while that in the United States was 17.4% over the same period. [2] That should be acknowledged by the regulatory authorities who should adjust and harmonise the equity capital requirements accordingly.

Robust European securitisation platforms could provide a sensible complement to bank-based financing.

Analogous to the German market for borrowers’ note loans, other Member States, too, might attempt to establish a regime for the private placement of securities in order to provide SMEs with further alternative ways of raising financing. To this end, common and standardised regulatory and accounting methodologies would be good to have.

Unfortunately, fragmented structures can also be found in the field of public sector support measures. Possible counteraction on the part of the political domain might be to encourage development banks such as Germany’s Kreditanstalt für Wiederaufbau (KfW) or its Spanish counterpart, the Instituto de Crédito Oficial (ICO), to engage in cross-border business, which would demand that the statutes of development banks be amended accordingly in some cases.

In addition, national development banks might coordinate their activities more closely with the European Investment Bank (EIB) and also increase their cooperation with one another. For example, they could exchange information on successful approaches and develop a set of tools for appropriate financial instruments.

If the political domain ensures that fundamentals are attractive and if sound enterprises again have the possibility to raise adequate financing, the basic prerequisites would be given to allow industry to invest again. If the investment involved is productive investment, this would help to consolidate the tentative economic recovery in the euro area.

Concluding remarks

That brings me to the end of my deliberations today.

Europe’s economy is gradually recovering from a phase of stagnation. Adjustment is taking place not only at the European level, but also in every single Member State.

The progress made in the so-called crisis countries, in particular, shows that macroeconomic adjustment can indeed be successful even in a monetary union. Such processes, however, take time and can be painful at times.

The challenge in 2014 and beyond remains the further development of the Economic and Monetary Union.

That means creating the prerequisites for sustainable growth, which includes improving the climate for investment and making it structurally easier for SMEs to raise bank loans and access the capital market. If we succeed in this, Europe could emerge from the crisis stringer than it was before.



[1]OECD indicators of employment protection (see http://www.oecd.org/employment/emp/oecdindicatorsofemploymentprotection.htm).

[2]Source:: Standard & Poor’s, “Transition Study: Less Than 1.5% Of European Structured Finance Has Defaulted Since Mid-2007”, 11 June 2013. See also Moody’s Investors Service, “Structured Finance Rating Transitions: 1983-2013”, 7 June 2013, as well as Fitch Ratings, “The Credit Crisis Four Years On … Structured Finance Research Compendium”, June 2012, and “EMEA Structured Finance Losses”, August 2011.

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