Economic governance and financial stability
Speech by Vítor Constâncio, Vice-President of the ECB,
at the Meeting of the Contact Committee of the Heads of the Supreme Audit Institutions (SAIs) of the European Union,
Luxembourg, 13 October 2011
Dear Mr President,
Ladies and Gentlemen,
Thank you very much for the invitation to join you today for this seminar on the possible implications of the recent reforms in EU economic governance for EU Supreme Audit institutions and the European Court of Auditors. It is an apposite time to do so. Of course, important reforms have already been adopted in a number of policy areas. These reforms have substantial implications for the use of public funds, both at national and at EU level. As such, they deserve close scrutiny from an accountability and public audit standpoint, as you have outlined in a recent position paper. That said, I believe this is not the end of the road. Europe – and in particular the euro area – must go further and complement its successful monetary union with a genuine economic union.
In my intervention today, I will first focus on the main lessons learned from the crisis for the set-up of economic governance. I will then review the latest changes in the economic governance rulebook of the euro area, including the first experience with the European Semester as well as progress in financial supervision. I will close with some reflections on further reforms needed to achieve a true economic union. Naturally, speaking from the perspective of the European Central Bank I will concentrate my remarks on what is more relevant for the euro area.
1. Lessons from the crisis
The crisis has laid bare a number of severe shortcomings of the governance framework of the euro area. In order to remedy those in a profound and durable manner, we first need to draw the right lessons from the crisis.
The first lesson was that the implementation of the Stability and Growth Pact (SGP) did not contribute to fiscal policies consistent with membership of a single currency.
In an economic and monetary union, fiscal policies have to be consistent with rates of sustainable growth and price stability. Instead, despite the “good times” between 1999 and 2008, fiscal policies were largely pro-cyclical: few countries maintained a budgetary position in structural balance and many ran deficits. Peer pressure to correct imbalances was largely absent.
In some cases, this indiscipline precipitated serious fiscal challenges when recession began in late 2008. In others, fiscal policy reinforced nominal divergence and macroeconomic imbalances.
A more effective SGP is therefore required for all euro area countries.
The second lesson was that disciplining fiscal policy in a monetary union was not enough to avoid instability. For some countries the main source of imbalances was not the increase in public debt but rather the surge in private debt. For instance, for Spain whereas the public debt was reduced 26.3 percentage points in relation to GDP between 1999 and 2007, the total private debt increased by 116.2 percentage points. For Portugal while public debt increased in the same period 18.7 percentage points of GDP, the total private debt went up by the much higher figure of 61.5 percentage points.
However, the euro area lacked an institutional framework to identify and correct macroeconomic imbalances. The result was that large current account imbalances reflected the build-up of public and private sector debt, creating external vulnerabilities that were exposed when the crisis broke.
Establishing a permanent framework for surveillance of such imbalances is essential for the future.
The third lesson was the absence of appropriate frameworks for policy co-ordination in areas essential for competitiveness and sustainable growth.
For countries that share a single currency and cannot devalue, maintaining nominal price and cost growth in line with the euro area as a whole is essential. From 1999 onwards, however, developments have not followed this path.
For example, a number of euro area countries internalised the fallacy that temporarily elevated national productivity and inflation rates warranted persistent wages increases out of line with the euro area as a whole.
That approach could have been valid if inflation differentials were driven by healthy catching-up effects, but in many cases they were largely the outcome of inappropriate macroeconomic policies and debt-financed booms in domestic demand. Wage developments were therefore not sustainable.
Much greater policy co-ordination is now needed to reinforce the euro area dimension in national income policies and economic policymaking in general. In particular that a medium-term inflation rate of below, but close to, 2% over the medium term is the appropriate benchmark at the national level.
The fourth lesson was that financial supervision in the Europe was lagging behind financial integration.
Monetary union led to a structural increase in financial interlinkages within the euro area, in particular via the growth of systemically relevant large cross-border banking groups. Yet, the regime for financial supervision remained fragmented.
National supervisors that were supposed to supervise cross-border banks had no mechanism to resolve conflicts. The EU level financial services committees had only advisory powers and the ability to issue non-binding guidelines and recommendations.
The result was that a large build-up of systemic risk in the financial sector went largely unnoticed – risk which in many cases was ultimately transferred to the balance sheet of the sovereign.
A supervision regime commensurate with the reality of financial integration in the euro area is therefore an urgent need.
The final lesson was that sovereign debt challenges in individual euro area countries – no matter their size – can undermine the stability of the euro area as a whole. To the surprise of some, “sudden stops” episodes occurred in the euro area, as if the single currency was not a common currency of all members. Since member countries do not control their currency, they are vulnerable to liquidity episodes and multiple equilibria. Creditors’ assessment can change e.g. by effect of contagion, even when fundamentals would not justify it.
The high degree of financial integration within EMU means that, if left unchecked, contagion in the banking sector can spread rapidly via cross-border holdings of sovereign debt. For sovereigns themselves, sudden shifts in market re-pricing of risk can lead to unexpected liquidity challenges.
These dynamics underscore the importance of strengthening the mechanisms that prevent such risks – the SGP, surveillance of broader macroeconomic imbalances, and stronger financial supervision.
However, the liquidity dry-outs and the contagion risks also call for stronger backstop mechanisms, to provide significant, albeit temporary, liquidity assistance.
For the same reason, a permanent crisis management framework is appropriate for the euro area.
The general overriding lesson stemming from all these points is that monetary union requires a higher degree of integration in what regards fiscal and macroeconomic policies as well as supervision policies which should involve more controls from the centre and between governments. In fact, central bankers have been saying this all along. Already in 1991, Hans Tietmeyer, Vice- President of the Bundesbank at the time, argued: “Monetary union is not just a technical matter. It is in itself, to some extent, a political union”. Ten years later, in 2002, Duisenberg repeated that “to move towards Economic and Monetary Union was a profoundly political act”. President Jean-Claude Trichet has talked about the need for a “quasi fiscal union” with a true “ European Finance Minister”. Governance was ineffective in the euro area because Member States failed to interiorize all the implications of what they had agreed in Maastricht in 1991. Sharing a single currency within a single economic and financial market creates high and complex interdependence. This means that decisions taken in some parts of the euro area affect other parts in very direct ways. Even more importantly, in a monetary union, some specific national problems can only be dealt with through decisions taken jointly, with a euro area perspective. Writing into the Treaty that economic policies should be treated as “a matter of common concern” is all well and good, but in practice, economic policy co-ordination was governed by an implicit “principle of non-interference” among governments. The essential mutual surveillance could not work if peer pressure degenerated into “peer neglect”.
2) Response to the crisis
With the limits to existing governance processes so clearly on display, European leaders have embarked on a major overhaul of the EU economic governance framework. The reforms undertaken since 2010 were broad based and attempt to address all the five lessons of the crisis that I just mentioned.
These lessons show us that the crisis was an interlinked phenomenon involving the public sector, real sector and financial sector. Consequently, a comprehensive response to the crisis needs to address all these sectors and the ways in which they are interconnected.
There is strong momentum behind reinforcing economic governance to prevent and correct fiscal and broader macroeconomic imbalances.
The package of six legislative reforms recently agreed by the Council and the European Parliament, introduces a new surveillance procedure for macroeconomic imbalances, with an alert mechanism based on a scoreboard of key indicators. An enforcement mechanism allows the Council to fine euro area countries in case of repeated non-compliance with recommendations. This closes an important lacuna in the economic governance framework.
The new legislative package also reinforces the SGP to focus more on fiscal sustainability and reducing government debt levels.
Important steps have also been taken towards improving policy co-ordination.
The "European semester" was introduced on 1 January this year to encourage better ex ante co-ordination of economic policies. From now on, national programmes for fiscal and economic policies will be submitted and assessed at the same time. The first implementation of the European Semester in 2011 was far from optimal. On substance, some stability and convergence programmes and national reform programmes lacked specificity and ambition and were based on implausible macroeconomic assumptions. As regards procedures, the time available for the review of the Commission’s recommendations by the Council was too compressed and did not leave sufficient room for a true peer review. Therefore the systematic tendency, at least for a number of countries, to weaken the Commission’s recommendations addressed to them during the Council review was not prevented
Euro area leaders have decided to deepen further policy co-ordination by creating the “Euro Plus Pact”. The Pact aims to address deep challenges related to competitiveness and productivity in the euro area. However, one of its main weaknesses is that its voluntary and inter-governmental nature risk making it nothing more than a set of political declarations if there is no proper monitoring and follow-up. Therefore, making the requirements of the Pact legally binding for euro area countries and anchoring it in the European economic governance framework would strengthen it considerably.
Major reforms have already taken place in the field of financial supervision.
Following the recommendations of the de Larosière Report, the European System of Financial Supervisors (ESFS) was established to reinforce the European framework for micro- and macro-prudential supervision.
It comprises the three new European Supervisory Authorities (ESAs) for banking, insurance and securities markets; and the European System Risk Board (ESRB), which will monitor, identify and prioritise systemic risks to financial stability. This framework will play an important role in managing the interdependencies of a closely integrated single European financial market. Nevertheless, the new policy tools at the disposal of the ESAs and ESRB are, for most part, soft tools. Only in exceptional cases, such as emergency situations, can the authorities take directly binding measures. However, even in such cases the so-called ‘fiscal clause’ applies, which provides that the ESA’s powers cannot impinge on national fiscal responsibilities. This arrangement does not go far enough for the euro area, and I will make some suggestions on how to improve it later on.
In addition, the Commission will present before the end of the year its proposal to establish an EU framework for cross-border crisis management in the banking sector and the creation of an European resolution regime for financial institutions.
Finally, euro area leaders have agreed to establish a permanent crisis management facility, the European Stability Mechanism (ESM). The ESM builds on the ad hoc stability facilities established in 2010 to arrest contagion and thereby preserve overall financial stability in the euro area. In spite of some shortcomings stemming from the rigidity of its instruments, the creation of the ESM is of enormous importance.
3) Looking ahead
a. Making further steps towards a genuine economic union
The experience of the first twelve years of EMU - and in particular the current sovereign debt crisis – suggests that the limits of soft policy coordination have been reached. Unsound economic and budgetary policies pursued by individual euro area countries can endanger financial stability in the euro area as a whole. Such spillovers among euro area countries clearly justify, in my view, deeper integration of fiscal, structural and financial policies. We need a new quality of EMU governance, going well beyond the scope of the recently agreed economic governance package, towards a fully fledged economic union. Of course, this will not happen overnight and, in line with the step-by-step approach underlying the European construction, there will be a gradual process of further economic integration.
In the long run, I see it as inevitable that substantial competences in economic governance, financial integration and supervision and in the field of external representation be transferred from the national to the EU level. Naturally, this major overhaul of the construction of the Monetary and Economic Union will entail a comprehensive Treaty change.
In the short run, we should focus on how to optimise the current governance framework. At the European level, I have already stressed the need to implement in an ambitious manner the economic governance package. Euro area Heads of State and Governments should take responsibility and ownership for economic governance issues – and should therefore meet regularly. The Eurogroup should have a a full-time President. In addition, internal reforms in the Commission should also be pursued to guarantee its greater independence, for instance through a stronger role for the ECFIN Commissioner in the College, akin to the Competition Commissioner, or the establishment of an independent chief economist in DG-ECFIN.
All of those reforms at EU level will only have a marginal effect, if not matched by efforts at national level. We do not want countries to do the right things just because “Brussels” says so – but because their own citizens want and prescribe it. Euro area Member States should be ambitious in implementing strong national fiscal frameworks. For instance, ‘debt brakes’ in national constitutions serve as a good commitment device that prevents the formation of unsustainable debt levels. Moreover, independent national fiscal institutions, producing independent forecasts, should be set-up to avoid any optimistic bias. All Member States should implement structural reforms in order to strengthen their competitiveness and employment, increase the flexibility of their economies and enhance their longer-term growth potential. Finally, to enhance the euro area’s growth potential, further progress is needed in the implementation of the Single Market, in particular in the field of services.
b. Strengthening the euro area dimension of financial supervision
The decision of 17 countries to share a common currency has far reaching consequences not only as regards the coordination of their economic policies but also in the field of financial stability. In order to achieve a genuine economic union, financial supervision needs to be substantially improved.
In my view, the higher degree of financial integration fostered by the single currency, characterised by a single money market and a particularly close interconnectedness among financial institutions, markets and market infrastructure, should also be reflected in a more centralized financial supervision for the euro area. The aim of the euro area should be to construct a supervisory framework that reflects the single market in financial services. This could take the form of granting the European Banking Authority specific powers for the euro area. Another option would be to involve the Eurosystem more closely in the micro-prudential supervision of banks, given that in 12 out of the 17 euro area countries the national central banks have full responsibility in banking supervision and taking into account the trend in a number of countries to confer supervisory tasks to their respective central bank.
Such steps would allow addressing more effectively financial sector imbalances that are particularly dangerous within the euro area – and thus preventing negative feedback loops emerging between the financial sector and the sovereign.
This must be complemented by establishing a European resolution fund with a mechanism for burden-sharing between Member States. I am fully aware that, in the near term, this is politically not easy. However, we do see some progress, and be it out of acceptance of factual necessity: the EFSF and the ESM can be used to provide loans for banking sector recapitalisation, which reflects the recognition that crisis management for sovereigns and for financial institutions is increasingly intertwined. Perhaps over time this will provide the foundation for a more integrated European system of public and financial sector crisis management.
Ladies and Gentleman,
I have outlined the lessons from the crisis and reviewed the recent reforms in the field of economic surveillance and financial supervision. Improving economic governance is a work in progress and further steps will be needed to achieve a deeper integration to ensure the smooth functioning of the Economic and Monetary Union. It is important that those reforms are accompanied by appropriate measures to ensure transparency and accountability. In this regard, the European Court of Auditors and EU Supreme Audit institutions will have a central role to play. This is particularly crucial in those areas where public funds are involved, both at national and European level. This is important not only for the efficiency of the instruments and institutions of economic governance. It is of utmost importance for their accountability and acceptance by EU citizens.
In addition, your practical experience as guardians of public funds throughout Europe can provide EU policy-makers useful reflections and recommendations. I am therefore looking forward to today’s discussions and your ideas on how to improve European economic governance.
I thank you for your attention.