The crisis is not over but the turning point has passed, ECB President Mario Draghi said in a speech in Paris. In the summer of 2012 Europe’s policymakers shifted from “real-time” crisis fighting to a consistent strategy that outlines the path to recovery. Before that point, policy measures, often commendable in themselves, were taken under the pressure of events and often in the wrong order. Combined with the euro area’s institutional set-up this delayed the recovery.
The early phase of the “Great Recession” that came after the global financial crisis followed roughly the same pattern across advanced economies. A retrenchment in investment, trade and hiring sent government budgets into large deficits as they sought to offset the shock to nominal spending. Nonetheless by mid-2010 most advanced economies were showing signs of a gradual return to growth.
The euro area however suffered a second recession lasting until the second quarter of 2013. With hindsight, we can see that one reason for this was the policy response, which was the reverse of the ideal sequence: the Deauville agreement on private sector involvement in 2010 and Greek debt restructuring in 2011 took place while an effective backstop for solvent governments was still being constructed. The stress testing of banks and capital raising took place without a clear backstop for solvent banks.
This created market pressure on banks and governments, exacerbated by the euro area’s incomplete financial integration and a fiscal framework that was not strictly enforced. A number of governments did not have the fiscal space to absorb the shock presented to them or were unable to maintain the trust of the market while doing so. Instead of providing a counter-cyclical buffer, these countries had to convince investors of their debt sustainability, making it unavoidable that fiscal consolidation was front-loaded.
The turning point came when European policymakers acknowledged the need to complete the euro area’s institutional architecture, with banking union as a first step. This marked the beginning of a consistent strategy towards sustained recovery.
While the ECB’s Outright Monetary Transactions removed unfounded redenomination fears that put price stability at risk, banking union was needed to bring together fragmented national banking systems. The single supervisory mechanism (SSM), the single resolution mechanism and single resolution fund are important conditions for the reintegration of the single financial market.
The SSM now provides a catalyst for cleaning up the banking system in a way that promotes “good deleveraging,” avoids creating “zombie banks” and sets the stage for economic recovery.
The unavoidable consolidation of public finances has placed a larger burden on monetary policy to achieve price stability by managing aggregate demand. This has led to record low interest rates and forward guidance. The ECB’s accommodative stance will support a gradual closing of the output gap in coming years.
Meanwhile potential growth must be raised, although this is not a task for monetary policy. Structural policies to increase productivity and attract investment need to be put in place – the latter can be supported by a healthier banking sector, but regulation, tax and education also play important roles. Moreover, those who have experienced the crisis, or the economic volatility of the 1970s and early 1980s, know that recovery also stems from joint action. By making policies consistent across borders we have achieved positive results.
On accepting the Schumpeter Award in Vienna, ECB President Mario Draghi said 2014 and 2015 were set to be a period of recovery after two years of stabilisation and a return of confidence in the euro area. But the recovery “remains conditional on our pursuing the very policies that have brought about the return of confidence,” including growth-friendly fiscal consolidation, structural reforms and a committed monetary policy.
In his speech, Mr Draghi drew a parallel between the policies applied in the euro area with the ideas of economist Joseph Schumpeter, who spoke of “creative destruction” driving innovation and productivity growth. By cleaning up and repairing banks’ balance sheets, the ECB’s comprehensive assessment helps create the necessary conditions for resources again to flow to the productive economy. “By encouraging creative destruction in the banking sector, we can facilitate creative destruction in the wider economy and support the recovery.”
Deleveraging in the financial system was necessary, since too much debt has been built up in the run up to the crisis, but the question is what form this deleveraging should take, and at what speed it should be allowed, or encouraged, to take place. What we want to achieve, Mr Draghi said, is a ‘good’ form of bank deleveraging, where equity is built up, where deposits rise and where balance sheet reduction takes the form of swift asset clean-up, rather than a slow scaling back of the loan book while rolling over bad loans.
The ECB’s monetary policy is helping this process. As the recovery proceeds and inflation gradually increases towards levels closer to 2%, the ECB’s forward guidance, firmly reiterated by the Governing Council in its last meeting, creates a de facto loosening of policy stance, and real interest rates are set to fall over the projection horizon. At the same time, the real interest rate spread between the euro area and the rest of the world will probably fall, thus putting downward pressure on the exchange rate, everything else being equal. The strengthening of the effective euro exchange over the past one and a half years has certainly had a significant impact on our low rate of inflation, and, given current levels of inflation, is therefore becoming increasingly relevant in our assessment of price stability.
The risk of deflation, which would make deleveraging harder, is quite limited. But the longer inflation remains low, the higher the probability of such risks emerging. That is why the ECB has been preparing additional non-standard monetary policy measures to guard against such a contingency and why it stands ready to take further decisive action if needed, Mr Draghi said.
The euro area has made considerable progress on its reform agenda, says ECB President Mario Draghi. Speaking at a conference organised by Germany’s Bundesbank in Frankfurt he emphasises that euro area governments have improved their fiscal positions despite recessionary headwinds and stressed euro area countries have become more competitive. “In parallel, the architecture of EMU has been strengthened in ways that many would have considered inconceivable two years ago”, says Mr Draghi. The move towards a banking union is crucial not only for the functioning of the financial system, but also for the conduct of monetary policy.
Since the beginning of the crisis the ECB’s Governing Council has taken decisive steps to engineer a monetary policy stance that is commensurate with the subdued medium-term inflation outlook. But standard monetary policy in the form of rate cuts was not enough to ensure an appropriate monetary policy stance, because unwarranted fears of euro break-up impaired the monetary transmission, he says. Against this background the ECB announced Outright Monetary Transactions (OMT). Like all the ECB’s monetary policy measures, OMT served, says Mr Draghi, to ensure compliance with the bank’s price stability mandate.
“And it builds on an established monetary policy doctrine that has gained prominence not least through its successful adherence by the Bundesbank for several decades,” Mr Draghi says. “Namely that the central bank should be endowed with a clear price stability mandate and, within this mandate, should be allowed – in fact obliged – to use its instruments in full independence to deliver price stability.”
A banking union will contribute to more sustainable financial integration in the euro area, says ECB President Mario Draghi. Speaking at a conference celebrating the 20th anniversary of the European Monetary Institute in Brussels, Draghi explains how stronger supervision, cross-border banking integration and resolution frameworks can reduce the risk of financial fragmentation. It was that kind of fragmentation which contributed to the recent financial crisis.
Draghi explains that financial integration is necessary for an effective monetary union. But “the euro area did not succeed in achieving sustainable financial integration”, the ECB’s President says. “And we can see the importance of financial integration all the more in its absence.”
According to Draghi, financial integration before the crisis was incomplete. While the interbank market was fully integrated, retail banking remained fragmented. That led to a situation where banks used short-term and debt-based funding to increase lending to favoured domestic sectors such as real estate. “As banks’ assets were not well allocated, nor well diversified geographically, they were more vulnerable to domestic shocks. And as their foreign liabilities were mainly interbank, they could not share the subsequent losses with other jurisdictions.” So when the crisis hit, the cost of repairing balance sheets fell largely on their domestic fiscal authorities. “The result was the infamous bank sovereign nexus”, Draghi says.
A banking union will generate a higher quality of financial integration. The Single Supervisory Mechanism will enable supervisors to mitigate the possible destabilising effects of financial integration. It will also help to maximise the benefits of integration by creating a policy framework more conducive to cross-border banking. If problems still occur, the planned European resolution framework will help by improving private risk-sharing while insulating sovereigns. To reach that aim, Draghi makes a case to improve the design of the Single Resolution Mechanism and the Single Resolution Fund. The proposed ten-year period to mutualise national compartments into a single fund “creates uncertainty”, the President says. “We would see merits in doubling the pace of mutualisation to have a genuine European fund within five years.”