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24 October 2011

Yves Mersch: Current challenges in the sovereign debt crisis


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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the SWF (Sovereign Wealth Fund) Forum, Montreux in Switzerland.


Need for clarification: the often forgotten strengths of the euro area

Some countries in the euro area face a combination of high levels of indebtedness, budget deficits and weak or absent growth. Amid growing market turmoil and the risk of contagion, an increasing number of economists call for debt restructuring in the affected countries. These proposals often share an anti-euro sentiment and seem to be in accordance with the naysayers who were taking potshots at the euro even before its inception in 1999.

However, many critics ignore the euro area’s strengths. There is a need for clarification. Let me start by stressing some facts:

  1. Since its inception almost 13 years ago, the euro area has experienced an unprecedented level of price stability.
  2. The euro area has logged real per-capita income growth of around 1 per cent a year since 1999, just below the US’s 1.1 per cent. Observers often look only at headline growth figures, where the difference is bigger. But the figures match once adjusted for population growth.
  3. During the same period of time, the euro area has created 14 million jobs, six million more than the USA.
  4. Contrary to common belief, the heterogeneity within the euro area is not significantly bigger than between US states.
  5. On a consolidated base, public finances are in a much better shape than those of other major currency areas. The euro area as a whole will run a budget deficit of about 4.5 per cent of GDP this year. The International Monetary Fund (IMF) expects a US budget shortfall of about 10 per cent this year.
  6. According to the IMF, the aggregate debt-to-GDP for the euro area stands at 87 per cent. For the US, the debt-to-GDP ratio in 2011 is expected to be 100 per cent.
  7. The current account is broadly in balance, different from other advanced economies of similar size. For this year the IMF forecasts a current account deficit of 3 per cent for the US. 

Still, there is no room for complacency. The sovereign debt crisis in several Member States of the euro area and financial markets turmoil indicate that we are facing very challenging times.

Currency without a state

There can be the case for moral hazard in so far as fiscal profligacy of one single Member State could be averaged out by the virtuous behaviour of the majority of the other countries. The incentive structure is flawed because it can lead to unsustainable fiscal policies of individual Member States, which in turn would generate negative spillover effects to the monetary union as a whole. With hindsight, we have to acknowledge that some countries allowed fiscal profligacy, weaknesses in the banking sector and deteriorating competitiveness. The institutional set-up could neither prevent nor resolve a severe crisis of the magnitude that we are currently experiencing. Although the instruments and procedures were available, they were either not implemented, ignored, or watered down.

In a nutshell: the euro area suffered from serious weaknesses in the fields of financial, fiscal and economic governance on the preventive side and had lacked a crisis resolution mechanism.

The epicentre of the global financial crisis has shifted from the US to the euro area. The rapid spreading of the crisis is reducing the options at hand to tackle the crisis. Europe has already taken important decisions to improve its crisis resolution mechanism and to strengthen preventive measures to avoid macro-economic imbalances and unsustainable fiscal policies. It is important to implement these rules now and make the institutions operational, as markets tend to lose patience. There is a strong appetite for a comprehensive solution. The banking sector must increase its resilience against sudden, external shock. This is particularly important in times of high market volatility and elevated uncertainty. Quick action is needed to clean up banks’ balance sheets and recapitalise them, where it is deemed necessary.

On top, countries with elevated debt levels and augmented budget deficits have to put public finances on a more sustainable path and spur growth by structural reform. Sovereign defaults should be avoided, as the cost most likely would outbalance the benefits by far. The ECB has repeatedly objected to all concepts of debt restructuring that are not purely voluntary or that have elements of compulsion; any credit events and selective default or default should be avoided. A strong and transparent commitment to sound public finances is the best weapon to combat market attacks.

Full speech



© BIS - Bank for International Settlements


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