Keynote address at the EUROMONEY conference
Speech by Jürgen Stark, Member of the Executive Board of the ECB,
Berlin, 28 April 2010
Ladies and gentlemen,
In autumn 2008, the world economy entered the worst financial crisis and the deepest recession since the Great Depression. Both monetary and fiscal policies responded vigorously to this exceptional situation and thereby supported the recent recovery.
But the crisis is not over yet. The challenges of overcoming it and forestalling a repetition still need to be fully met. Many questions remain open. How much progress has been made in improving the stability of the financial sector? Given the dramatic rise in public debt, especially in advanced economies, will a sovereign debt crisis follow the crisis we have experienced in the financial sector? Is the current multi-speed recovery of economic growth at the global level sustainable?
Let me start with the banking sector. Bank profitability has improved, but remains subdued. Further credit-related write-downs are expected throughout this year. Banks have lowered their leverage ratios significantly by reducing risk-weighted assets and being more discriminating vis-à-vis riskier borrowers. Some pressure to continue de-leveraging persists owing to the increased loan portfolio risk and higher target capital ratios. But these developments have not, according to our analysis, led to credit constraints in the economy at large. Rather, the sharp decline in credit growth is a reflection of the even steeper decline in economic growth experienced over past quarters.
Let me turn to economic developments.
At the global level, economic activity is expected to grow by around 4% this year, while global trade is expected to increase by almost 6% (according to the IMF’s April WEO).
Strong growth in emerging market economies in Asia is a major driving force behind these figures. At the same time, advanced economies may be faced with the prospect of a protracted period of sluggish growth, given that the financial crisis is likely to have adversely affected their growth potential. According to a recent OECD study, financial crises in OECD countries are estimated to lower potential output by 1.5 to 2.4 percent on average, while the magnitude of this effect might be significantly larger in the case of a severe crisis. If history is any guide, we should also take note of IMF studies which have found that, in advanced economies, recessions associated with financial crises tend to be unusually severe and long-lasting, with output taking, on average, three years to recover to its pre-crisis peak.
In the euro area, recent information indicates that the recovery has continued to expand in the first few months of this year. Looking forward, euro area growth is expected to remain moderate, owing to ongoing balance sheet adjustments in the private sector, weak prospects for the labour market and low capacity utilisation. Available growth forecasts for 2010 put it at, on average, around 1%. The crisis is also expected to have lasting effects on our economy, as both the level and the growth rate of potential output will most likely be reduced for a long time.
Divergences in the strength of the recovery, both within and across regions, are expected to persist in 2010. The recovery in the United States is expected to be stronger than in some other advanced economies.
The question of the sustainability of the recovery, however, remains open, given high unemployment, continued high levels of household debt, low savings and ongoing tight credit conditions in some of the advanced economies.
However, over the medium term I expect per capita GDP growth in the euro area to be similar to that in the United States, as was the case over the period 1999-2009. The difference between the average annual GDP growth rate between the United States (+2.1%) and the euro area (+1.5%) was mainly due to differences in population growth (at 1.0% in the United States and 0.5% in the euro area).
Turning to price developments in the euro area, the annual increase in the HICP (Harmonised Index of Consumer Prices) increased to 1.4% in March, up from 0.9% in February, driven predominantly by rising commodity prices globally. The increases in commodity prices have been supported by dynamic growth in emerging market economies.
This notwithstanding, inflation expectations remain firmly anchored in line with our aim of keeping inflation rates below, but close to, 2% over the medium term. We expect inflation in the euro area to remain moderate over the policy-relevant horizon. The outcome of our monetary analysis confirms the assessment of low inflationary pressures over the medium term, with money and credit growth remaining weak.
We will therefore follow very carefully all developments over the period ahead, in particular price developments in commodity markets and in the emerging market economies, and their impact on global inflation trends. We also need to monitor very closely the possible adverse impact of fiscal developments on the inflation outlook.
Although the response of policy-makers to the crisis has certainly helped to avert an even more dramatic collapse in economic activity in the euro area and elsewhere, challenges abound. I am particularly concerned about the dramatic deterioration in public finances. Most governments in the advanced countries will exit the recession with the highest deficit and debt-to-GDP ratios recorded in times of peace.
In the euro area, according to the latest projections by the European Commission, the general government deficit is expected to exceed 6.0% of GDP in 2009, 2010 and 2011. In Japan, the government deficit-to-GDP ratio is foreseen to reach around 9.0% of GDP in these years, whereas the UK and US government deficits are expected to be in excess of 10.0% of GDP in the period 2009-11. These high government deficits are reflected in mounting government debt, which will reach 88% of GDP in 2011 in both the euro area and the United Kingdom, 100% of GDP in the United States and 200% of GDP in Japan.
These developments are the consequence of sizeable fiscal stimulus measures and of interventions in support of financial institutions in many advanced countries. But they also bear testimony to the sharp contraction in economic activity.
In the euro area, fiscal developments have become a major concern. The situation is particularly acute in countries that failed to consolidate their public finances during buoyant economic times. But this problem is not specific to euro area countries: other countries outside the euro area have also adopted a less prudent approach to the management of their public finances.
The current trend in fiscal policies is simply not sustainable. Without a very ambitious fiscal adjustment effort, the debt ratio is projected to continue rising in the next decades. With an annual structural deficit reduction of only 0.5% of GDP, it will take the euro area 20 years or more to return to the pre-crisis level of debt-to-GDP.
The challenges are particularly large for countries with relatively high government deficit and debt levels, as well as a rapidly ageing society, and even more so for those that face relatively high interest rates and low potential growth.
Outside the euro area, bringing the public debt ratio back to safer levels appears even harder for the United Kingdom, the United States and Japan. Given their high budget deficits and the high and rising debt levels, they must undertake very strong consolidation efforts to manage a reversal of the rising trend in public debt ratios.
Why are these fiscal imbalances cause for such great concern? For three reasons.
First, high levels of government budget deficits and debt may push inflation expectations up and place an additional burden on the monetary policy of central banks and their task of maintaining price stability.
Second, large fiscal imbalances may drive up (real) medium and longer-term interest rates, with adverse consequences for private investment. Given the large debt-financing needs of many advanced countries, this constitutes a serious risk for the recovery. Moreover, rising interest expenditure on government debt reduces the scope for public spending on other, growth-enhancing items. Taken together, this would reduce long-term growth. The higher the debt ratio, the worse will be the impact.
Third, deteriorated fiscal positions severely limit the ability of governments to counter adverse shocks, given the reduced budgetary room for the operation of automatic stabilizers. In addition, large budgetary imbalances reduce the scope for fiscal stimulus measures, and their effectiveness. A fiscal expansion in the context of high and rising government debt may trigger an increase in precautionary savings and counteract the expansionary impact.
The onus is now on governments to ensure that the crisis that initially affected the financial sector, and subsequently the real economy, does not lead to a full-blown sovereign debt crisis. Averting it will require very ambitious and credible fiscal consolidation efforts. In fact, substantially stronger consolidation efforts than those conceived so far are needed to bring the debt ratio down towards sustainable levels of below 60% of GDP and to prepare for the rising budgetary costs of the ageing population.
While fiscal consolidation may entail some costs in terms of lower economic growth in the short run, their longer-term benefits are largely undisputed. Such benefits come from a reduction of governments’ debt financing needs, leading both to lower long-term interest rates and to the release of revenues to finance more productive expenditure or growth-enhancing tax cuts. More leeway is then also created for the operation of automatic fiscal stabilisers in response to a cyclical downturn. In sum, fiscal consolidation is essential to secure public trust in the long-term sustainability of public finances, and to strengthen the foundations for sustained and durable growth.
At the European level, fiscal consolidation should be in line with EU countries’ commitments under the Stability and Growth Pact, which provides the appropriate framework for the coordination of their fiscal policies. Given past experience of a slow and hesitant correction of excessive deficits, I see strong arguments for strengthening the implementation of the Stability and Growth Pact and reinforcing its rules for fiscal discipline. This could be complemented with enhanced national budgetary rules and procedures that are consistent with the EU fiscal framework.
The economic and fiscal consequences of the financial crisis pose extraordinary challenges for monetary policy.
In response to the crisis and the ensuing subdued inflationary pressures, the Governing Council has lowered its key interest rates to historically low levels. In particular, it reduced its main refinancing rate by 325 basis points to 1%, a level not seen in recent history in any of the euro area countries. Overall, the Governing Council still views these low policy rates as appropriate.
In addition to these interest rate cuts, the Governing Council also introduced a number of non-standard measures to foster financing conditions and facilitate the transmission of lower key ECB interest rates to money market and bank lending rates. Notably, the Eurosystem provided unlimited funding support to banks, at maturities of up to one year. It also provided liquidity in foreign currencies, extended the list of eligible collateral and purchased covered bonds outright. These measures have contributed not only to lowering perceived liquidity risks on the part of banks, but also to a better flow of credit to households and firms than would otherwise have been the case.
The ECB’s approach differs from that of some other central banks in certain respects.
First, our outright purchases of securities have focused on the covered bond market, a market segment that is very important in Europe and a primary source of financing for banks. Conversely, we have refrained from buying government bonds, which is what other central banks have done rather extensively.
Second, rather than purchasing securities outright, we have relied primarily on repurchase agreements. As these repurchase agreements expire they will provide for a gradual phasing-out of our funding support to banks.
From the very beginning, we have been aware of the fact that keeping our non-standard measures in place for longer than necessary would entail the danger of creating harmful distortions. Therefore, we designed the measures with exit considerations in mind. In view of the improvements in financial market conditions seen since last spring, we have started to gradually phase out some of them.
More specifically, we have stopped providing liquidity in foreign currencies, and we have discontinued operations involving maturities longer than three months. While the Eurosystem will continue to provide liquidity support to the euro area banking system at very favourable conditions in its shorter-term refinancing operations, the refinancing operations at longer maturities will expire in the course of the year. What remains to be decided are, inter alia, the tender procedures to be applied in the main refinancing operations and the operations with a duration of one maintenance period, approximately one month.
We do not know today what normality will look like after the crisis. Likewise, we cannot be specific today about the design of the “final” post-crisis operational framework. Before deciding on this, we will need to consider thoroughly the lessons to be learnt from the crisis. However, the operational framework that prevailed prior to the turmoil seems to provide a good benchmark. It served us well prior to the crisis, and could be adapted quickly as circumstances worsened.
Let me conclude. The crisis is not over yet.
Our liquidity measures have been key in improving funding conditions for banks and in forestalling a collapse in money and credit. We are now in a position to gradually unwind our measures.
Banks are facing further write-downs, but balance sheet repairs have made some progress.
Economic growth in the advanced economies will recover only gradually. Given the multi-speed character of this recovery at the global level, there is something of a question mark behind its sustainability, not only because of the re-emergence of current account and savings-investment imbalances, but also because of the buoyancy of asset price developments in some emerging market economies. Now is the time to adopt the structural economic adjustments to overcome these imbalances, both at home and abroad.
Fiscal debt in advanced economies is, on average, approaching a level that is utterly unsustainable and needs to be swiftly and forcefully countered. This requires credible and very ambitious fiscal consolidation efforts. The tax burden is already too high in many countries. Fiscal adjustment will therefore have to be primarily expenditure-based, and it will need to be supported by structural reforms to boost potential output growth.
Against this backdrop, let me stress that any call to reduce the real value of public debt through higher inflation will be firmly opposed by the ECB. Price stability is a prerequisite for confidence and sustainable growth. The Governing Council will not yield to anxiety about public indebtedness. It will continue to deliver on its mandate, which is to maintain price stability over the medium term. All our decisions regarding the phasing out of supportive measures need to be seen within this context.