06 February 2012

Andreas Dombret: New year, old problems – Europe's sovereign debt crisis

There are three questions I would like to examine more closely. Firstly, what actually caused the crisis? Secondly, how do we contain the crisis? Thirdly, where do we want to go with our monetary union in the long run?

The causes of the sovereign debt crisis

Severely unhealthy economic developments had apparently been brewing in several euro area countries for many years. These included, most notably, excessive lending, asset price bubbles and a loss of competitiveness. These structural problems were the breeding ground for the sovereign debt crisis.

The actual weak link at the launch of our monetary union, however, was the combination of a single monetary policy and a decentralised fiscal policy. Monetary policy, as you know, is set at the European level – by the European Central Bank. On the other hand, responsibility for fiscal policy rests with the individual Member States, i.e. at national level. However, in a currency area where fiscal policy is decentralised, the Member States have a relatively large incentive to borrow. If a country accumulates more and more debt, it does not face the consequences by itself as these are spread across the entire currency area – for example, through rising interest rates.

Looking back, it must also be noted that the financial markets did not exert the desired disciplining effect on fiscal policy. Investors turned a blind eye to the misbehaviour of some Member States for far too long. By the time the interest rates on government bonds started to rise, the damage had already been done.

Routes to a stable monetary union

And such a loss of confidence is just what we are facing right now. The public, and also the markets, have lost faith – in politics, but also in the architecture of our monetary union. The question is: how do we go about restoring confidence?

Firstly, government budgets need to be put back in order. This goes for all euro area countries but is particularly the case for those countries which have put off the necessary adjustments time and again. This is where the critics jump in to say that excessive saving damages economic growth. However, I think this is too short-sighted. Of course fiscal consolidation normally dampens economic activity. But there is no way the present situation can be described as “normal”! In fact, doubts about the sustainability of government finances are probably themselves a considerable drag on growth. The critics are right about one thing, though: consolidation alone is not enough to solve the problems we are facing.

Secondly, the countries affected by the crisis therefore need to conduct structural reforms in order to become more competitive and to promote economic growth. Such reforms are, naturally, difficult and painful. Ireland has shown, however, that they are possible, and the German experience has proven that they pay off in the long run.

And, thirdly, we need a stable architecture for our monetary union. Instead of constantly  patching up the results of fiscal policy mistakes and insufficient implementation of the  Stability and Growth Pact, the framework of monetary union has to be changed in a way such that sound fiscal policy is also truly guaranteed in future. In my view, there are two options open to the euro area: either we can return to the founding principles of monetary union agreed at Maastricht, or we should venture the step towards a deeper European integration which also includes fiscal policy.

Full speech

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