17 March 2015

BIS/Jens Weidmann: Challenges for the euro area: what progress has been made - what still needs to be done?

It could be argued here that major progress has already been accomplished, especially in the countries hit hardest by the crisis. What is now required are structural reforms that unleash innovative power and enhance productivity.

 

Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, at the Swiss Institute of International Studies, Zurich, 9 March 2015.

What progress has been made?

It could be argued here that major progress has already been accomplished, especially in the countries hit hardest by the crisis. I share this view. Indeed, much has been done to correct the macroeconomic imbalances that were a root cause of the euro-area crisis. 

Historian Harold James once likened the behaviour of member states before and after the start of monetary union to that of couples before and after getting married: "It was like what happens to couples who, once married, abandon some of their romantic and utopian intentions in day-to-day married life. At the most trivial level, men now leave unwashed socks lying around and women drop towels on the floor. In many cases, the situation then spirals from there -" 2 

Before the crisis, prices and productivity in some parts of the euro area had become increasingly divorced from one another. When the financial crisis hit and investors' risk-awareness grew, they refused to continue to bridge the resulting gap. 

But a lot has happened since then. For example, wage bargaining has been decentralised in many countries and wage indexation abolished or, at the very least, reduced. Consequently, wages can better reflect the specific circumstances of individual enterprises. This and other measures have brought prices and wages closer into line with productivity. Member states' price competitiveness increased significantly, to the point where current account deficits were completely eliminated in all crisis countries except for Cyprus back in 2013. Cyprus, too, is expecting to record a current account surplus in 2014. 

In addition, progress has been made in the consolidation of government budgets. The sustainability of public finances in countries such as Italy, Greece, Spain and Portugal has also been improved by adjusting pensions for demographic factors, with measures including an increase in the statutory retirement age. As a result, the pension system will be strengthened financially, much needed expertise will remain in enterprises and the demographically induced decline in the labour supply will be slowed down to a certain extent. 

Germany took this path at an earlier point in time, which makes it all the more regrettable that it is now back-pedaling a little on these reforms. 

What remains to be done?

The measures that have been introduced have helped improve the public finance situation and increase competitiveness. However, competitiveness should not just be the product of cost cuts. Prosperity ultimately hinges on productivity - and this is where efforts should be focused in the euro area. 

What is now required are structural reforms that unleash innovative power and enhance productivity. We need these reforms right now not least because they play a part in raising income expectations. What is more, areas in which higher income is expected in future are receiving investment today. Supply-side reforms can therefore support demand, too.

Responsibility for some areas in which there is a need for reform lies primarily with the European Commission and the European Council rather than at the national level.

[...]

Capital markets union

Differences in language and culture would suggest, however, that mobility in the European labour market will not be as high in the foreseeable future as in other currency areas. This makes it all the more important for other buffers to function effectively. 

Even in federal currency areas such as the United States, Canada or Switzerland, this buffer function is performed primarily by the capital markets. In the USA, for example, the integrated markets for capital cushion around 40% of total cyclical fluctuations between the US federal states. If a negative shock hits an industry or a specific region, then this loss is spread widely beyond the state. But in return, shareholders throughout the country also receive a share of the profits during the good times. 

When compared with the equity capital markets, the significance of the credit markets as a buffer is lower: around 25% of cyclical fluctuations are evened out via the credit markets. 

Fiscal cushioning mechanisms, however, are by far the least significant: only 10% to 15% of economic shocks are absorbed through public finances. 8 This last figure is similar in other federal systems. Only in Canada is the contribution considerably higher, at approximately 30%. 

In terms of their performance, fiscal buffers thus correspond more closely to the traditional leaf spring; only integrated capital markets are capable of providing the cushioning comfort of modern air suspension systems. Here, the equity capital markets, in particular, are an essential component.

The fiscal framework

Although the role fiscal adjustment mechanisms play in absorbing asymmetric shocks appears to be limited, fiscal policy remains at the centre of the debate on the euro area's future development. 

This is related to the incentives for running up debt mentioned earlier, created by the combination of a single monetary policy and national fiscal policies. As long as fiscal policies remain in national responsibility, the member states also need to bear the consequences of their policies themselves. Otherwise, incentives will be created to engage in unsound practices. 

The rescue measures taken during the crisis prevented any further escalation of the crisis and stabilised the euro area in the short term. However, elements of joint liability have also increasingly been introduced as part of these measures, while fiscal policy has remained a matter for national policymakers. Hence, there is a growing divide between liability and control, which can lead to growth in incentives for government borrowing. 

A frequently suggested solution to these euro-area stability problems is the introduction of a fiscal union with centralised intervention rights at the European level and joint liability. This is not a fundamentally new idea. Addressing the Bundestag in November 1991, for example, the then-Chancellor Helmut Kohl remarked that "the idea of sustaining economic and monetary union over time without political union is a fallacy". 

But we ought to remain realistic: there is currently no sign of any willingness - either in Germany or in our partner countries - to transfer fiscal policy sovereignty to the European level. Therefore, we will have to make do with the regulatory framework agreed on at the time by all parties - which places liability and control at the national level. 

But the principle of individual national responsibility requires a double safeguard. First, strict fiscal rules that prevent the development of unsound public finances. Second, a reliable ban that prohibits countries from providing each other with aid in times of financial distress. Only a credible no bail-out clause results in risk-appropriate pricing of a country's government debt by financial markets. The more debt a government takes on, the more expensive it becomes.

[...]

With its decision in favour of substantial government bond purchases, the Eurosystem has once again provided ex ante assistance. Governments and the European Commission must now use the time to strengthen the long-term conditions for growth in the euro area. 

Full speech

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