15 September 2011

Lorenzo Bini Smaghi: Policy rules and institutions in times of crisis

Excerpted from the speech given in Rome by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central Bank, at the “Forum for EU-US Legal-Economic Affairs” organised by the Mentor Group.

These new circumstances have exposed a series of institutional problems related to the roles and responsibilities of various authorities at national and supranational level, a question which I would like consider today. One of the most discussed issues in recent months has been the risk of a confusion of roles, which may generate moral hazard and ultimately delegitimise the institutions and undermine their credibility.

In the European context, the question is posed in two specific dimensions. The first concerns the relationship between monetary policy and fiscal policy. The second concerns the relationship between the European and national institutions, specifically in respect of fiscal policy. Over the past 18 months we have been witnessing two important developments in Europe as a result of the crisis, involving both monetary policy and fiscal policy. The first one is the purchase of government bonds by the Eurosystem (the ECB and the national central banks) – the Securities Markets Programme (SMP) – and the second one is the European Financial Stability Facility (EFSF), which will become the European Stabilisation Mechanism (ESM) after the Treaty has been amended.

Before explaining these two new resources, we need to take a step back and remember the two basic premises of monetary union. The first is monetary stability, defined as price stability. The second is the stability of public finances. The European Central Bank, an independent institution capable of deciding on a single monetary policy for the euro area, was created to achieve the first goal. The second goal however is based on two mechanisms: the Stability and Growth Pact, which binds the public finances of member countries; and the discipline imposed by the financial markets. On paper, the framework seems almost perfect. A complete separation of monetary powers from fiscal powers creates the right incentives, so that each authority may effectively pursue its respective objective. The surveillance of fiscal policies ensures that these remain within predefined parameters, and if this does not happen sanctions are envisaged by the EU institutions and financial markets.

In reality, the framework is not perfect. The reason is that it relies on some simplifying assumptions, dear to economists, and perhaps even to lawyers. However, those assumptions do not always match the reality. Let me briefly illustrate two. The first assumption concerns the deterministic nature of the framework, which does not consider the possibility of shocks, of forecast errors, of disruptive elements, all of which can cause crises, in particular public finance crises. In other words, the assumption was made – largely theoretical – that there would be no crises.  The second simplifying assumption that was made by the founding fathers is that markets work perfectly and can assess the various risks at any time, including those arising from an excessive accumulation of public debt. The experience of recent years has shown that this is not the case.

As regards the European Central Bank, there is no doubt that it acts in full independence, with a clear primary objective, which is price stability in the euro area as a whole. In recent months, as in previous years, the ECB has taken – independently – measures commensurate with the gravity of the situation with the intent of pursuing the objective that it has been assigned. We are fully aware of the risks, related to a possible excess of activism on the one hand and benign neglect on the other. We have assumed our responsibilities in full, and seek to remind other institutions of theirs. We have explained the reason for our actions, the impact they have on market conditions and liquidity and its aims. We are subject to scrutiny by the public and the markets.

Anyone who thinks that the ECB has been excessively active on the market, for example on the market for government securities, or the opposite, must first of all demonstrate that such actions have not enabled the ECB to achieve its goal. I do not think there is any indicator –  based on market expectations, those of professional forecasters and other indicators – which shows that any of the interventions implemented have undermined the ability of the ECB to maintain price stability in the euro area in the years to come. So I regard many of the criticisms of the ECB to be the result of inadequate economic analysis, of insufficient knowledge of the crisis in which we find ourselves and of anxiety resulting from experiences in the distant past that are not relevant to the current situation.

There is no doubt that we are going through a difficult period for the economic and financial stability of the euro area. The will to act in order to defend what we have gained is not enough; drawing up plans for the long term is not enough either. Rapid action is needed by various policy-makers, with each living up to his own responsibilities. The consolidation of public finances and the restoration of competitiveness at a global level are the top priority. This result is not possible in many countries without calling into question prerogatives and rights that until now were regarded as acquired, which nobody wants to give up, but which in the current situation means rent positions, privileges, preferential treatment.

Full speech

© BIS - Bank for International Settlements