Challenges for policy-makers
The roots of the crisis, which is affecting most advanced economies, lie in the accumulation of excessive debt – both private and public. The solution is to go back to more sustainable – i.e. lower – levels of debts. The key issue is the speed of that adjustment. It is not easy to implement policies which encourage deleveraging and avoid an excessive impact on the economy, particularly in our societies, because those policies have to take into account several constraints. The first constraint is political. It derives from the fact that taxpayers are not particularly happy to shoulder an ever-heavier burden and to find themselves having to support the banking system or the public finances of other countries, some of which triggered the crisis in the first place by mismanaging their investments or their public finances. The second constraint that policy-makers have to work with relates to the functioning of financial markets. As the Lehman Brothers case showed, when a major event like the failure of a systemically important bank happens at a time of financial turbulence, markets tend to become completely dysfunctional, contagion spreads throughout the financial system, and ultimately the real economy is severely affected. The current sovereign debt crisis in the euro area has shown a similar degree of unpredictability. When a small euro area country got into difficulties, others were gradually affected, according to the depth of correlation between their domestic markets and financial instruments.
The third constraint that policy-makers have to take into account nowadays is the scarcity of resources available to tackle multi-dimensional problems like those posed by the crisis. At the outset, in autumn 2008, European countries were able, for example, to stabilise the situation by providing public guarantees to banks. Ireland was one of the first countries to make such a commitment. In the US the TARP was adopted, with the initial aim being to purchase distressed assets from banks and thus relieve their balance sheets. As the crisis developed, the commitments made to support the financial system led to an overexposure of some sovereigns, which took the form of higher debts and deficits on both sides of the Atlantic. Markets started testing the willingness of taxpayers in the various countries to sustain such an effort.
Well-meaning actions, undesirable consequences
In the middle of the crisis, Europe started to think about reinventing the wheel, trying to make it easier for debtors – especially States – not to repay their debts and to pin blame on the creditors, especially banks. There are two reasons for this. One is the need to save taxpayers’ money. The other is a desire to punish banks which, for many years, made large profits and nicely remunerated their managers even when they made poor investment decisions. If banks are forced to pay for such decisions, they will learn the lessons for next time. If you bail them out, they will make the same mistakes again and again.
The private sector involvement requires any financial assistance that is provided by the public sector to a euro area country to be linked to a parallel reduction in the value of the debt held by private creditors. It is the result of the Deauville agreement of October 2010, which was subsequently endorsed by the European Council in that same month. The ECB has expressed its opposition to this idea on several occasions. This idea has had a major impact on financial markets because it marks a departure – in two ways – from the practice which had guided crisis management since the inception of the IMF. First, it explicitly recognises the possibility of default or debt restructuring by a euro area country, while it was previously considered to be an ultima ratio solution, applied under exceptional circumstances to relatively poor countries with limited systemic relevance. Second, it makes financial assistance conditional on an engagement with creditors. In contrast, the IMF doctrine requires countries to engage with creditors only if the adjustment programme cannot put a country’s debt on a sustainable path. By making PSI automatic, the new approach blurs the distinction between solvency and liquidity crises, and thus makes the former much more likely.
Towards a comprehensive solution
Action is required in four main areas:
First, the governance framework should be strengthened to avoid any repetition of the problems which have caused the crisis. The measures adopted recently are a step forward. Further steps are needed, especially to reinforce crisis management, which may require Treaty changes, or a new Treaty among the 17 current members of the euro area. My concern about the current discussions is that while there are several interesting proposals dealing with fiscal policy – aimed in particular at strengthening the Union’s ability to constrain the budget of countries requiring assistance – little is being said about financial matters.
Second, given the crisis of confidence in the financial markets, backstops have to be identified to ensure the stability of the financial system, in particular banks. This means that markets – not only supervisors – have to be convinced that banks can withstand a worsening of the situation, both in terms of access to liquidity and in terms of absorbing potential losses through capital. The provision of liquidity is the responsibility of the central bank.
The third element of the comprehensive solution is the backstop to the sovereign risk to convince markets that liquidity problems affecting the euro area members will not translate into solvency problems. The European Financial Stability Facility has been put in place.
This leads me to the fourth issue, which is the case of Greece. This in itself would require a separate speech. All policy-makers involved, including governments and parliaments, should learn from the experience so far, in particular the fact that apparently easy solutions for taxpayers may turn out to be much more costly. Greece needs an overhaul of its economy, and that will take several years. A long-term solution should be found, bringing about sustainable public finances and a stronger economy. The sustainability of the debt should be ensured over time, looking not only at the level of the debt at a given point in time, but also at its trend and interest burden. Pressure should continue to be exerted on the Greek government and parliament to stick with the programme.
Conclusions
Breaking the spiral of negative feedback loops from a crisis-battered financial sector to sovereign entities – and then back from governments weakened by the financial crisis to the banking system – is crucial to restore confidence in the financial system. Halting that spiral requires a multi-pronged strategy that simultaneously addresses the fiscal and banking systems.
Over the last 18 months, European policy-makers have shown that they are able, in the end, to take decisions which safeguard the stability of the euro area financial system and defend the prosperity that we have built over the last 60 years. But they have done it too slowly, under the pressure of the markets, and that has ultimately increased the burden.
A comprehensive, timely solution is needed now. I am confident that Europe’s leaders will find it.
Full speech
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