10 May 2012

Peter Praet: Managing financial crises – the role of the European Central Bank

Mr Praet said that disentangling the web of mutually reinforcing risk factors is the number one challenge economic policy-makers are facing. The ECB has played an important role in confronting this challenge.

Since the onset of the crisis, financial market turbulence and the associated deterioration in credit conditions and overall economic confidence have dragged down the real economy. The resulting downward impact on economic activity has led to an erosion of tax bases and taken a massive toll on public finances. The concomitant threats to debt sustainability, in turn, have required several governments to adopt ambitious fiscal consolidation measures during the downturn to regain control of their fiscal positions. Furthermore, the financial and economic crisis forced many governments to intervene in domestic banking sectors, again placing severe strains on fiscal positions in several cases. Vice versa, fiscal sustainability concerns have rapidly spilled over to the financial sector, thus giving rise to a vicious cycle that is difficult to break.

Disentangling this web of mutually reinforcing risk factors is the number one challenge that we, as economic policy-makers, are facing. As I will show, the ECB has played an important role in confronting this challenge. By cutting its main policy rates and introducing additional measures to directly address liquidity and funding constraints in the banking sector, it has bought time to facilitate the structural adjustment of the financial industry. It belongs to governments to continue their efforts to ensure fiscal discipline, restore competitiveness and to remove remaining shortcomings in economic governance at the European level. Identifying and addressing these shortcomings is key for the future.

However, the ECB’s exceptional measures should not distract from the fundamental causes of the crisis and the adjustments needed in the fiscal, structural and financial domains. The institutional architecture in the EU has to ensure that Member States live up to their responsibility for restoring fiscal sustainability and competitiveness and for implementing effective financial supervision. It is crucial to clearly separate the central bank’s responsibilities from other policy domains, such as fiscal sustainability and financial stability.

Therefore, efforts to reinforce the economic governance framework at the European level are indispensable. In this regard, European policy-makers have made important progress recently. As a result of the strengthening of the fiscal rules of the Stability and Growth Pact and the introduction of the fiscal compact, Member States now face stronger incentives to adopt sound budgetary policies, which are crucial for a smooth functioning of EMU. These derive, inter alia, from the requirement for national authorities to legally adopt a fiscal rule, preferably at constitutional level, stipulating that the general government deficit remain below 0.5 per cent of GDP in structural terms. The new Macro-economic Imbalances Procedure constitutes a useful mechanism requiring governments to adopt competitiveness-enhancing policies and tackle potential sources of financial instability in their domestic economies. The establishment of the European Supervisory Authorities and the European Systemic Risk Board has led to closer cooperation in micro- and macro-economic supervision within the EU that is commensurate to its deep economic and financial integration. Finally, the creation of firewalls in the form of the European Financial Stability Facility and European Stability Mechanism will contribute to isolating the euro area as a whole from financial turmoil affecting individual or a small group of countries. By providing financial assistance linked to strong and comprehensive conditionality, these mechanisms should also grant recipient countries additional time to overcome structural deficiencies in specific sectors of their economies.

While the EU governance framework thus contains some key elements necessary to overcome the current crisis and mitigate future crises, it is now paramount that all these elements are implemented in a swift and steadfast manner.

Moreover, to meet the challenges with which our economies will be confronted over the coming decades, most notably in the form of population ageing and increasing competition from emerging market economies, structural reform efforts aimed at boosting long-term economic growth should be high on the European agenda. Only if productivity and competitiveness keep pace with these challenges will Europe be able to preserve a standard of living similar to that we enjoy now. To mark this commitment to fostering long-term economic growth, key principles for sound and sustainable growth could be enshrined in the common economic governance framework.

Full speech

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