21 January 2013

ECB/Cœuré: The three dimensions of the euro area crisis

I see three key dimensions of crisis that we have to deal with. The first one takes the form of a classic debt deleveraging cycle. This dimension is probably the most visible materialisation of crisis but it is only a symptom of the underlying problem. In fact, there is a deeper dimension which I will refer to as a second dimension of the crisis, the “crisis of the social contract”. The latter reflects a fundamental misalignment between the economic status that industrial countries have grown accustomed to and the material conditions that are affordable without a profound shift in economic policies. But in engineering such a shift, a third dimension comes to the fore, namely a crisis of the institutional architecture. As regards this third dimension, I will focus on the European context where policy-makers have to conduct a fundamental overhaul of EMU simultaneously with their acute crisis fighting efforts.

Debt deleveraging

Let me emphasise two issues at this stage. First, while the depth of the current crisis in Europe and in other industrialised countries is unprecedented in recent history, its structure is by no means unique. For example, much of the above-mentioned evolution could be observed in the Asian crisis in the late 1990s and in countless currency crises in developing economies before and since.

Second, from a broader perspective, the concrete manifestation of the deleveraging pressures is of secondary relevance: whether the strains show up on governments’, households’ or firms’ balance sheets has important short-run distributional implications. But ultimately, they confront policy-makers with the same challenges: in the acute crisis phase, they have to promote and control the balance sheet adjustments – which are necessary – by way of policies that avoid depressionary spirals of the kind seen in the 1930s. Once they succeed, economic activity will likely resume its upward trend, albeit from a lower base. At this stage, the common challenge for policy-makers is to ‘re-base’ growth on a new and sustainable trajectory. And the extent of this rebasing can be substantial. For example, the latest IMF World Economic Outlook suggests that estimates for potential output in advanced economies may have to be revised downwards by around 10 percentage points in level compared with pre-crisis trends, not to mention possible revision in trend growth rates.

A misalignment in the social contract

This brings me to the second dimension of the debt crisis, which is the recognition that governments around the world have entered into long-term commitments beyond the limits of sustainability. Importantly, these commitments are not necessarily the product of an explicit contract, like a bond or a loan. In fact, in large part they take the form of implicit policy promises.

The re-basing of economic activity thus has broader implications. Inevitably, it forces countries to reassess their social contracts. And such a reassessment is nowhere more visible than in the fiscal domain where political consensus is translated into tangible distributive choices.

To understand this dimension, it is useful to consider a stylised version of the inter-temporal government balance sheet: the government has explicit financial liabilities – as recorded in gross government debt figures. And it has assets, including for instance its stakes in publicly owned companies and holdings of public capital more broadly. But these two items are comparatively small. Much more important are implicit fiscal assets and liabilities. Implicit fiscal assets are the discounted value of all future tax revenues. Implicit fiscal liabilities are the discounted value of all future primary expenditure.

If the residual value of the balance sheet or ‘public equity’ is negative, then somebody has to pick up the bill at some point: either taxes have to increase – implying a loss for the taxpayer; or government expenditure has to be reduced – implying a loss for those who benefit from public services; or the value of the debt has to be reduced – which means a loss for the creditors. In this framework, monetisation of government liabilities through a permanently higher inflation rate is comparable with a tax imposed on consumers. In all industrialised economies, it is explicitly discarded by central banks’ price stability mandate.

The incomplete institutional architecture of EMU

Engineering such shift in policies requires a sound and robust institutional environment with an ability to produce political consensus – which brings me to the third dimension of the debt crisis in Europe, namely the incomplete architecture of Economic and Monetary Union.

In this regard, the crisis has uncovered four shortcomings in particular: first, the EU fiscal rules were incapable of promoting prudent fiscal policies in good times; second, there was no robust mechanism to prevent macro-economic imbalances within the EU or to correct them; third, insufficient coordination of macro- and micro-prudential supervision of financial sectors allowed a build-up of vulnerabilities in banking sectors; and finally, the absence of a crisis management framework frustrated efforts to contain contagion between countries and between the balance sheets of banks and sovereigns, respectively.

In several European countries, the current episode of fiscal austerity is sometimes attributed to the renewed focus of the institutional setting on budgetary discipline. But, in fact, the ongoing fiscal tightening is a necessary consequence of the misalignment of the social contract: already during the boom period preceding the crisis, public commitments in these countries were entered into at the cost of future generations; the crisis then revealed that: first, projected expenditure was too high in view of plausible revenues; and second, these projected revenues had to be revised downwards as the whole economy was rebased downwards. Moreover, the problem is by no means specific to the euro area, as vividly documented by the intense political debates in other industrialised economies, such as the US, the UK or Japan. The misleading attribution of fiscal austerity to European governance arrangements creates excessive political costs for the much-needed strengthening of institutions, and should be rejected.

Full speech

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