30 October 2013

Bundesbank/Weidmann: The institutional and economic policy challenges posed by the sovereign debt crisis

In a speech to the Economic Forum 2013, Weidmann argued that an operational framework which reinforces the principle of liability and reduces mutual dependencies was needed to stop individual countries or banks jeopardising the entire system.

To put an end to the crisis in the euro area once and for all, we need to address the weaknesses and false incentives which led to its onset in the first place. Institutional arrangements, such as the Stability and Growth Pact and the no bail-out clause, were, of course, put in place to prevent a build-up of excessive debt by Member States. Unfortunately, however, these fiscal rules lacked the necessary punch, not least because they led to a situation in which potential sinners were passing judgement on fellow sinners.

It was hoped that the financial markets would have a disciplining effect, but this, too, proved not to be the case. For many years, Greece was highly indebted, but paid little more for its debt than Germany or France. It seems that investors simply couldn’t imagine that the other Member States would allow one of the euro area countries to default – and they weren’t entirely wrong about that, as we now know. Although the founding fathers of monetary union provided for the risk of undesirable fiscal developments, no corresponding institutional arrangements were made for other factors, such as the erosion of competitiveness or excesses in the financial sector. The bailout funds helped to stabilise the euro area, but did not address the underlying problems. What’s more, the very existence of the bailout fund creates new false incentives. That is why I am in favour of using it only as a last resort and advocate structuring the conditions in such a way that countries are not encouraged to take advantage of them.

In effect, however, the numerous crisis measures increased mutual liability within the euro area without establishing any sufficiently effective control rights in return. This upset the balance between liability and control. This balance must be restored to safeguard the long-term stability of monetary union.

For the time being, the only answer to the crisis is to strengthen the Maastricht framework. In doing so, more needs to be done to render the fiscal rules more binding – rules which have too often been stretched and ignored in the past. New agreements, such as the revised Stability and Growth Pact and the Fiscal Compact, are steps in the right direction in this regard. However, it is vital that the new rules are applied in actual practice rather than existing only on paper. In this connection, it must also be possible – as a last resort – to declare governments insolvent without endangering the stability of the European financial system as a whole.

To improve financial stability, the heads of state and government in euro area countries have agreed to establish a European Banking Union. If implemented properly, this Banking Union can rectify deficiencies in competition in the banking sector through a strict single European supervisory mechanism. With an appropriate recovery and resolution regime, it can also strengthen the disciplinary effect which capital markets have on governments. The Banking Union once again puts the focus more squarely on the principle of liability. However, regulation must also be adapted if the vicious circle of reeling states and struggling banks is to be broken and not simply passed onto the European level.

That is why, over a medium-term horizon, government bonds should be treated just like other bonds or loans to enterprises. Obviously, new regulations such as these require appropriate transition periods so as not to further exacerbate the funding problems that some countries are experiencing. However, they are essential in ensuring that governments bear more responsibility for their own decisions in future and should therefore be adopted as quickly as possible. In the long term, it must be possible to declare both governments and large banks insolvent without endangering the financial system or without taxpayers having to foot the bill. Providing the right incentives is therefore not only important for fiscal and economic policy decision-making processes; it is also the key challenge for financial market reform.

Full speech

© Deutsche Bundesbank