26 August 2013

Bundesbank/Weidmann: Striving for a stable framework for monetary union - An old debate revisited

Vulnerabilities in the original framework

In 1988, the Delors Committee tried to find an architectural model for an economic and monetary union capable of accommodating the inherent tension in that concept. They sought to construct a stable European house, knowing full well that tremors in individual Member States might shake the structural soundness of the entire building. Why was the draft made back then unable to prevent the crisis we are experiencing today?

First, it should be noted that although one key point – the risk of macro-economic imbalances – was indeed recognised by the Delors Committee, consideration was not made for it to be incorporated into the final Maastricht framework. The Maastricht framework instead focused on the one central supporting pillar: the fiscal rules designed to curb government deficit and debt levels. These rules were complemented by the no bailout clause – that is, the principle of individual responsibility. But this pillar proved unable to provide sufficient support. Banking supervision also remained a national responsibility, which meant that there was no institution which set the same high standards for banks, irrespective of their home country, and took account of cross-border interactions which were outside the field of vision of national supervisors.

The capital markets' disciplinary effect on governments likewise proved to be inadequate. Why that didn’t work is quite easy to explain. Back then, the Basel Committee on Banking Supervision made what turned out to be a momentous decision for the euro area. The new common set of international capital rules stipulated that government bonds be valued as risk-free assets, which meant that banks did not have to back them with capital.

This decision affected monetary union in two ways. First, it cast doubt over whether the no bailout clause could ever be enforced, given the huge differences in economic power and indebtedness between the Member States. Second, sovereign insolvency became less credible for reasons of financial stability.

A new home for monetary union

An alternative to the "Delors house", a properly functioning fiscal union would depend on the Member States transferring a substantial degree of national sovereignty to the community level by giving the community the necessary right to at least intervene in the event of unsound public finances. Transferring sovereignty on this scale would be a radical change that would require wide-ranging legislative changes nationally and at the European level. And above all, such a step towards greater integration would require not just political support but public backing as well. On this point, however, we should remain realistic: the will to do so is barely discernible at present.

All that remains, then, is to stabilise the building we have, strengthening the common set of rules. And, second, it means lending renewed force and making enhancements to the principle of individual responsibility.

Also, separating banks and sovereigns is important because the nexus between them actually even increased at times during the crisis. Studies suggest that it was notably the poorly capitalised banks in the crisis-hit states which took advantage of central bank refinancing to invest increasingly in high-yield domestic government bonds during the crisis. Several incisions will be needed if we are to sever these links. The first of these will be the Single Supervisory Mechanism, which is tasked with preventing banks from getting into difficulties at an early stage. We further need the European recovery and resolution mechanism to ensure that if a credit institution needs to be restructured or wound up its owners and creditors will bear a fair share of the losses.

In a nutshell, over a medium-term horizon, government bonds should be treated just like other bonds or loans to enterprises. Appropriate risk-weighting would drive yields higher for unsound sovereigns and raise their refinancing costs. Hence, the market mechanism would force these governments to exercise greater fiscal discipline.

The role of monetary policy

The ECB Governing Council agrees unanimously that monetary policy cannot solve the crisis. The most it can do is buy time. Monetary policy has already helped substantially in preventing a further escalation of the crisis. However, this has taken it a long way into uncharted – and dangerous – territory.

It’s no secret that I am critical of the ECB’s government bond purchase programmes in particular. If Eurosystem central banks buy government bonds issued by countries with poor credit ratings, this will distribute the risks of unsound fiscal policy among all the euro area states. Monetary policy thus weakens the principle of individual responsibility and entails redistribution, which is really the prerogative of fiscal policymakers. Such redistribution can only be legitimately authorised by democratically elected parliaments and governments.

Thus, the most valuable contribution which monetary policy can make towards overcoming the crisis is safeguarding its credibility and upholding public confidence in the euro. It can do so best of all by focusing clearly on its primary mandate of safeguarding price stability.

Full speech

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