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First, the financial crisis demonstrated - quite compellingly - that financial contagion is the flip side of European financial market integration. We have learned that deep financial integration, without a commensurate deeper integration of financial stability policies is unstable. This potential vulnerability has been characterised by Dirk Schoenmaker as a “financial trilemma”: the three objectives of european financial integration, european financial stability and national supervision of banks cannot be achieved at the same time. The existence of this trilemma was confirmed in the euro area experience. Indeed, as it happened, enormous capital inflows channelled by banks of core countries to banks in the periphery allowed for large financial imbalances in the public and private sectors of recipient countries. When these flows turned into outflows as the economic environment deteriorated after 2008, these imbalances not only led to problems for the countries concerned but also produced contagion to other parts of the euro area.
Second, we have learned that shock absorbers at the national level are insufficient in the face of a major financial and economic crisis. Hence the European level has an important role to play. The design of the euro area assumed that stabilisation would take place at the national level and to a large extent automatically. Stabilisation would be provided by national fiscal policies that would respond to idiosyncratic national conditions. Accordingly, a fiscal brake at the EU level, codified in the Stability and Growth Pact, was designed to prevent fiscal profligacy, preserve fiscal space and hence allow automatic stabilisers to play out in full during downturns. Moreover, country-specific shocks were expected to become ever less important as the euro would spur market integration and the flexible single market to allow an easy and fast rebalancing after such shocks.
However, the scale of the shock after the 2008 financial crisis was unprecedented in a number of countries and it far exceeded their national shock absorption capacity. The euro area had no mechanisms to provide financial support for countries in difficulty and stave off cross-border contagion; there were no area-level institutions to prevent governments from being pulled down by their domestic banking systems. This underscored the pitfalls of a design that relies exclusively on the national level to fulfil the stabilisation function.
Third, we have learned that governance of economic policies at the EU level has to be broader and deeper than anticipated prior to the crisis. Besides fiscal surveillance, which essentially focused on public deficits, there was believed to be no need to closely monitor macroeconomic imbalances and disequilibria on the labour, product or financial markets. Disequilibria originating from the private sector were supposed to be only short-lived and eliminated by market forces.
Responses to the crisis
So how has Europe incorporated these lessons into its policy responses to the crisis? It is useful to conceive of the European response in two phases. First, Europe has had to respond to what might be called the acute challenges, by which I mean the shifts in investor sentiment and market psychology that have led to market panic and cross-border contagion. These had to be addressed to manage the on-going crisis. Second, it has had to respond to the systemic aspects of the crisis, by which I mean the underlying economic and institutional weaknesses that have led these acute effects to appear. These have to be addressed to find a sustainable solution to the crisis and prevent a re-emergence.
a. Acute challenges
The acute challenges have been addressed, first and foremost, by establishing crisis management tools at the European level. This included the temporary European Financial Stability Facility and Mechanism in May 2010 and more recently the permanent European Stability Mechanism. Their significance cannot be overstated. Financial support can now be given swiftly and efficiently, conditional on strong macroeconomic adjustment. This arrangement maintains the core principle that Member States are responsible for their economic policies, while at the same time removing the tail risk of a self-fulfilling liquidity/solvency crisis. This partly remedies the lack of a ‘federal’ shock absorber, while not altering the fundamental balance of competencies within the euro area, which would require fundamental Treaty changes. The capacity of these arrangements also ensures sufficient scope for support. The ESM is a permanent institution that can raise up to €500 billion in financial markets – actually, one of the world’s largest and most flexible international financial institutions.
b. Systemic challenges
As regards the systemic aspects of the crisis – the underlying economic and institutional challenges that lie at the heart of Europe’s current difficulties – reforms have taken place on two main levels. First, Member States have undertaken major internal and external adjustments to reduce fiscal and macro-economic imbalances. Encouragingly, it is those Member States with the deepest vulnerabilities that have undertaken the most far-reaching adjustments.
Fiscal governance has been strengthened on several occasions. Very recently, 25 EU countries signed up to the Treaty on Stability, Coordination and Governance, known as the European Fiscal Compact, and which entered into force in the beginning of this year. Member States commit to run structurally balanced budgets and introduce a respective fiscal rule into their national primary legislation. Additional regulations have strengthened the European fiscal governance framework, of which the final pieces – the so-called “two-pack” – will significantly add to the fiscal rule book for euro area countries. It will be important to have the new rules fully implemented and complied with. This should give credibility to fiscal policies, hence reducing investor concerns about fiscal sustainability.
The absence of any oversight framework for macroeconomic policies has been redressed through the creation of a dedicated procedure for the monitoring of macroeconomic imbalances such as excessive credit growth or exuberant house price increases. In addition, a new idea of “reform contracts” will be explored further next year, by which Member States would commit to specific measures to boost competitiveness and receive targeted financial support from the euro area in return.
c. Towards a Banking Union
However, the most significant governance development has been the commitment to create a real banking union in the euro area – to resolve the “financial trilemma” I referred to at the beginning of my remarks. Its first component is the elevation of supervisory responsibilities to the European level.
In mid-December last year, the Finance Ministers of the EU Member States unanimously reached an agreement on the legislative framework for a Single Supervisory Mechanism (SSM) through the attribution of banking supervision tasks to the ECB. This legislative framework is expected to be enacted in the course of the first quarter of this year. The establishment of the SSM is essential for the functioning of Monetary Union. The independent supranational supervision by the SSM will help to restore confidence in the banking sector. This should reverse the trend towards financial fragmentation, prevent flows of deposits due to the lack of confidence, and help restart a well-functioning interbank market.
The Single Supervisory Mechanism, although very important, is only the first step towards a banking union. The next step is the establishment of a Single Resolution Mechanism – a necessary complement to the SSM. Building on a strong legislative framework on bank recovery and resolution (which is under preparation) such a Single Resolution Mechanism, with a Single Resolution Authority at its centre, is essential to enable timely and impartial resolution decisions focused on the European dimension and to minimise resolution costs. It will contribute to breaking the vicious bank-sovereign nexus and minimise the risk of supervisory forbearance in the absence of workable resolution options. The European Commission will present a proposal in the course of the year.
d. The monetary policy response
Let me also briefly touch upon the response of monetary policy. As you know, our primary objective is to maintain price stability in the euro area. Neither our mandate nor our resolve to deliver on it has changed in the face of the crisis. However, the range of instruments we use to achieve price stability had to be widened. The crisis severely damaged the transmission mechanism of monetary policy and thus changes in the ECB’s key interest rates could not be transmitted uniformly across the euro area. Moreover, the sources of disruption in the transmission varied over time. Hence, we used different types of non-standard measures as the crisis evolved: we provided liquidity in fixed-rate, full allotment mode, considerably extended the maturity of central bank credit, widened the eligible collateral set, bought government and covered bonds outright and reduced reserve requirements.
This is also the case for the last measure we announced: the Outright Monetary Transactions – OMTs. The OMTs are designed to tackle unfounded fears of the reversibility of the euro that distorted the sovereign bond markets in the euro area. The perceived redenomination risk had led to a fragmentation of financial markets along national borders and jeopardised the singleness of our monetary policy. Thus, the OMTs were designed as a credible backstop to self-reinforcing negative market expectations and has been successful in alleviating some of the acute crisis challenges I have alluded to before.