19 April 2012

Peter Praet: The role of the central bank and euro area governments in times of crisis

The exceptional dimension of the crisis – the real threat it presents for the prosperity of the people in Europe and around the world – requires a forceful response by national and international authorities. However, several factors are limiting the capacity of authorities to react around to world. Most importantly, the weak fiscal positions of many countries are placing severe constraints on the capacity of governments to – somehow – spend their way out of the crisis.

The euro area economic governance framework and the crisis

The fiscal constraints in EMU – given the two reference values, namely the ceilings of 3 per cent of GDP on budget deficits and of 60 per cent of GDP on government debt – are probably the best known elements of the fiscal framework. But the framework was, in fact, far more comprehensive, even before the recent reform of economic governance. A set of rules imposed preventive limits on government borrowing, requiring Member States to achieve close-to-balance budgets over the business cycle. These rules were meant to place debt on a sustainable footing and, at the same time, to create fiscal room for manoeuvre for “rainy days”.

European Union legislation clearly rules out the monetisation and bailout options. Article 123 of the Treaty on the Functioning of the European Union prohibits any form of monetary financing of public debt or deficits; Article 124 forbids privileged access to financial institutions by the public sector; and the “no-bailout clause” in Article 125 precludes that one Member State becomes liable for the liabilities of another Member State. These articles are based on sound economic principles. Monetisation would inevitably lead to higher inflation, with the well-known costs to economic prosperity. Transfers between euro area Member States would – particularly in the absence of far more rigid fiscal rules and sanction mechanisms at European level – risk creating significant moral hazard effects in the beneficiary countries, and would thus further undermine the long-term economic stability in the euro area.

Also, the ECB has long warned against the third option – the restructuring of sovereign debt in the euro area. The exchanging of debt, as in the case of Greece, should remain a unique event. In this respect, it must be noted that the contagion effects of such measures are difficult to control, as has been demonstrated by the high volatility of financial markets over the past year. In addition, debt restructuring does not in itself address the underlying economic fiscal and structural imbalances.

The ECB’s response to the crisis

During the crisis, the ECB has been confronted with unprecedented threats to monetary stability in the euro area. Broadly speaking, these have come from two sources: first, the deflationary forces stemming from the economic downturn, and second, the impairment of the transmission of its monetary policy, which reflected to the growing tensions in financial markets.

First, we used our standard monetary policy measures to address the downward pressures on price stability that resulted from the sharp slowdown in economic activity in the crisis. In full consistency with our mandate, we reduced our key policy interest rate rapidly between October 2008 and May 2009, from 4.25 per cent to 1 per cent. In other words, we reduced our policy rate faster than any euro area country has ever done in recent history.

Second, we took additional non-standard measures to ensure that our interest rate decisions were transmitted effectively to the broader economy, despite the volatilities in the financial sector. If banks cannot easily access the money market or other sources of finance, they may not extend credit to households and companies, to the detriment of economic growth and employment.

The euro area governments’ responses to the crisis

The sovereign debt crisis has taught us unequivocally that – in spite of the no-bailout clause in Article 125 of the Treaty – the euro area countries are not insulated from one another. In an integrated single European market with a single European currency, spillover effects from one Member State to the other should make us all take a strong interest in the pursuit of sound fiscal and structural policies by our European partners.

Because of the close integration of the European economies, governments have also set up a European crisis resolution mechanism, the European Stability Mechanism. Its purpose is not, as some have argued, to bail out euro area countries that have failed to pursue sound economic policies. Its stated purpose is to safeguard financial stability if one or more countries endanger the euro area as a whole.

Conclusion

To conclude, the ECB’s policies have been guided by price stability considerations, with policies targeted at those elements of the crisis that threatened to prevent it from fulfilling its mandate.

Responsibility for the resolution of the sovereign debt crisis rests with the governments of the euro area Member States. Major progress has been made in terms of fiscal consolidation and the enhancement of the euro area governance framework.

But we are not there yet. Governments need urgently to implement their fiscal consolidation programmes and to accompany these with well-designed structural reforms in the labour and product markets. The new fiscal and macro-economic rules of the European governance framework need to be implemented to the letter. And the crisis management mechanisms at the euro area level need to be designed so as to ensure financial stability in the euro area.

Full speech

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