25 February 2013

Bundesbank/Weidmann: Fiscal and monetary policy - Dancing too close?

Weidmann stressed that only together can France and Germany solve the current crisis. "As the largest economies in Europe they already contribute significantly through the rescue mechanisms. Stabilising monetary union requires that both countries are economically and politically strong."

France is the second largest economy in the euro area. It is home to many renowned firms, it has a strong domestic market, and it has favourable demographics – in particular when compared to Germany. But France has acknowledged the importance of sound public finances and a competitive economy. And with the “National Compact for Growth, Competitiveness and Jobs“ the government has laid the foundation for some very promising reforms. Furthermore, the social partners agreed on labour market reforms at the beginning of this year. This could be an important step toward achieving a better functioning labour market.

However, regarding fiscal consolidation, more challenges lie ahead. One of them is to meet the commitments under the Excessive Deficit Procedure. According to the last projection by the European Commission, France will not meet the deadline to reduce the deficit 2013 to below the reference value of 3 per cent of GDP. This has now posed the question of whether the deadline should be postponed or not.

It is certainly true that it is more difficult to meet deficit targets in the context of weak economic growth. However, in the current situation we need to recognise that we are faced with a crisis of confidence. There has been a partial loss of confidence in our fiscal rules as well as in the will of European countries to consolidate their public finances. Moreover, there is the criticism that deficit targets may, in fact, become a moving target. In such an environment it is in my view particularly important for the heavyweights in EMU to give clear signals, which boost the credibility of the fiscal rules and agreements in EMU and the credibility of their consolidation strategy.

I do not advocate a strict Ricardian view here. I do believe, however, that peoples’ concerns about increasing adjustment needs in the future will affect their spending and investment today. Thus, it is important that governments adhere to the consolidation plans they announced. This will inspire confidence, which is an important prerequisite for the economy to grow.  A failure to signal the necessary commitment will not contribute to improving the confidence of investors and consumers in the euro area.

To a large degree, the imbalances we observe are driven by structural problems and are not temporary but persistent. And a persistent current account deficit might become a risk. The longer a country’s current account is in deficit the more foreign liabilities this country piles up. Eventually, these liabilities have to be paid back which might become difficult if the inflowing capital is not invested wisely. Once the willingness or the ability to repay comes into question capital flows might reverse. This is highly disruptive as spending and investment would have to adjust abruptly.

Central banks should not find themselves dancing too closely with fiscal policy. To paraphrase one of my predecessors: If you dance too close with fiscal policy she will marry you. And the offspring are usually higher inflation and reduced fiscal discipline.

The solution to the crisis requires a common approach. A common approach that is suited to tackling the underlying causes of the crisis. At the national level, this should include consolidation of public finances and structural reforms. But that is certainly not enough. We also have to improve the framework of monetary union. This includes reestablishing market mechanisms and the liability of investors for their decisions at all levels: We need mechanisms that allow banks to fail without triggering a systemic crisis – a well-designed banking union would be a step in the right direction. We also need mechanisms that allow states not to be bailed out without triggering a systemic crisis – this includes, for instance, the introduction of capital requirements for government bonds and caps on banks’ exposure vis-à-vis single countries.

Full speech

© Deutsche Bundesbank