23 May 2013

ECB/Constâncio: The European crisis and the role of the financial system

Constâncio discussed the root causes and key initial drivers of the crisis, as well as the role of the international financial crisis, originating in the US, in triggering the European crisis.

Beginning with the first perspective on the causes, the oldest narrative of the crisis, progressively corrected by academics but still popular with some segments of public opinion, goes more or less like this: There was essentially nothing wrong with the initial design of EMU, and the crisis resulted mostly from the fact that several peripheral countries did not respect that design – in particular the fiscal rules of the Stability and Growth Pact – which generated the sovereign debt crisis. This is the “it was mostly fiscal” narrative, which can be easily connected to two of the others: fiscal indiscipline led to economic overheating, wage and price increases implied loss of competitiveness, and this then led to the balance of payment crises.

In some cases, inappropriate fiscal policies certainly made a contribution to the imbalances. it would be asking too much of fiscal policy to think that it could have significantly offset this explosion of private expenditure. This is because budget multipliers of very open economies in periods of normal economic activity are generally quite small. With low fiscal multipliers, too large policy-induced changes in expenditure or revenues would be needed to dampen the cycle. The required budget surplus to offset the private imbalances in the euro area would have been totally unrealistic and unfeasible.

Facing losses on several of their assets, banks were forced to rebalance their portfolios in order to meet regulatory capital standards. They rapidly increased their holdings of “safe” government debt, as a rule denominated in domestic currency. This development was especially obvious after the collapse of Lehman Brothers which triggered an unprecedented flight-to-safety. At the same time, in many euro area jurisdictions public finances were strained to the limit by the recession-induced collapse in tax revenues and by the necessity to recapitalise failing banks. Overall, this meant that banks were becoming more exposed to their sovereigns at precisely the moment when sovereign creditworthiness was declining – creating the conditions for the infamous “bank-sovereign loop".

The full effects of these developments emerged in 2010 when sovereign debt tensions appeared in countries with large recent increases in public debt and budget deficits, and/or poor long-term growth prospects due to neglected structural reforms. In this way, the general banking crisis developed into fiscal crises in specific European countries, causing severe recessions in those under stress and at some points endangering the stability of the euro area. The way in which this phase of the crisis developed took some observers by surprise, in particular the contagion effects, self-fulfilling cycles and possibility of multiple equilibria. Contagion has been demonstrated to exist in the euro area from sovereigns to sovereigns and from sovereigns to banks, in both directions.

Given the root causes I have outlined, the need for a deep financial and regulatory reform was naturally a key lesson from the crisis. In what concerns Europe, the banking union is therefore a central pillar of the strategy to make our Economic and Monetary Union more effective and robust. To stabilise EMU over the long-term, however, requires a more fundamental review of the institutional architecture. The minimalist approach pursued at Maastricht was found to be inadequate in the context of highly integrated financial markets. In recognition of this, the Presidents of the European Council, Commission, Eurogroup and ECB have been asked lay out a roadmap to complete EMU over the next decade.  Having been thoroughly stress-tested over the last three years, everyone now have a much clearer idea of what rules and institutions are essential for monetary union to function effectively. In the view of the four Presidents, a stable EMU needs to be built on four pillars: financial union, fiscal union, economic union and political union. The most important concept underlying this vision is that, to maximise its benefits, the single currency needs strong common institutions. Strong institutions to supervise and stabilise the single financial market. Strong institutions to guide fiscal policies. Strong institutions to coordinate economic policy, guarantee competitiveness and encourage sustainable growth. And strong institutions to engage citizens more closely in the European project.

Full speech

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