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Dr Jens Weidmann President of the Deutsche Bundesbank

A spirit of optimism in Europe – guidelines for crisis-proofing the euro area

XIII Ludwig Erhard Lecture

Berlin | 12.04.2018

1 Welcome

Mr Clement
Mr Pellengahr
Ladies and gentlemen

I would like to thank you very much for inviting me here today to deliver the 13th Ludwig Erhard Lecture.

My lecture centres on Europe and monetary union. But I’d like to start by taking a detour into the world of natural sciences. 

You’ve all no doubt heard of pitch, a tar-like resin. Pitch was traditionally used to make torches and caulk the seams of sailing vessels.

At room temperature, pitch is as hard as stone. But appearances can be deceptive, because pitch is actually a liquid. That said, calculations put it at over 200 billion times more viscous than water.

An experiment known as the pitch drop experiment, which was started over 90 years ago at the University of Queensland in Brisbane, proves that pitch is liquid. A professor poured hot pitch into a funnel and let it cool down. Three years later, he unsealed the neck of the funnel and waited for the first drop to fall. This took eight years to happen.

Some 90 years later, the tally is now at nine drops. The experiment is still going and was recorded in the Guinness World Records as the "world’s longest continuously running laboratory experiment". Of course, some may say that it’s also the world’s most boring experiment – but that’s a matter of personal opinion.

You’re probably wondering at this point what a long-term physics experiment in Australia has to do with Europe and the euro area. Well, there are certainly parallels.

For a start, there were those who saw monetary union as an experiment when it was founded – and an experiment that was doomed to fail, at that.

To a certain extent, supporters and opponents of the single currency disagreed on the form that monetary union would take – would it be solid, as in stable, or liquid, as in unstable? What’s more, there was a lack of consensus as to whether the euro would be a hard or soft currency.

Thanks to the pitch drop experiment, we know that pitch only appears solid at room temperature. And, getting on for almost two decades of monetary union, we know that the euro area isn’t as stable as its supporters would have hoped. But neither is it as unstable as sceptics had feared, with the euro proving itself to be a hard, stable-value currency.

In the experiment, it took almost a decade for the first drop to fall. In the euro area, meanwhile, it took a decade for the first serious crisis to emerge. Both show that, on occasion, it takes some time for an object’s true nature to be revealed.

2 Fresh momentum for the Europe debate

The crisis in the euro area exposed weaknesses in the architecture of monetary union. The regulatory framework anchored in the Maastricht Treaty was unable to prevent the crisis, nor did it envisage any mechanisms to overcome one.

It was only by means of ad hoc measures, such as bilateral aid for member states at the heart of the crisis, that it was possible to stabilise the euro area.

Since that time, institutional innovations such as the European Stability Mechanism (ESM), the banking union and macroprudential oversight have made the euro area more stable. Compared with 2010, back when the euro area was in the throes of the crisis, we are in a much better position.

In other words, a similar shock to the Greek crisis would no longer find the euro area in such an unprepared state, nor would it spread as easily to other countries.

But the euro area still hasn’t been crisis-proofed once and for all. And that’s why there’s actually a consensus among experts that further institutional reforms are needed to reduce the euro area’s vulnerability to crises.

All the more important, then, that the momentum which the debate has gained over the past few months doesn’t peter out but is rather harnessed to take huge strides forward.

That’s why my talk is titled "A spirit of optimism in Europe". I would like to bring home what, in my opinion, matters most when it comes to reform and, to some extent, formulate guidelines for crisis-proofing the euro area.

The spirit of optimism in Europe that I’m referring to here isn’t confined to monetary union but also includes the broader debate on the way forward for the EU.

This debate has, in no small part, been expedited by the Brexit decision. The UK’s withdrawal from the EU won’t just have grave implications for the UK – it will have serious consequences for the EU as well.

This is already evident in the rounds of negotiations about a new financial framework that have already taken place. What makes these negotiations especially difficult is that, while new tasks for the EU are being discussed, member states are showing little willingness to cede vested rights – and, what’s more, the departure of the UK, a net contributor, will cause the EU to suffer more from lost revenue than it will gain from reduced expenditure. With that in mind, we shouldn’t expect the negotiating partners to come to an agreement any time soon.

Brexit is a political decision. An economic rationale is hard to make out, but it’s safe to say that the exit will make both sides poorer – especially the UK. At any rate, I find the UK’s intention to leave the EU highly regrettable, particularly since it will deprive us of an advocate for market economy principles.

The Brexit debate does have a silver lining, though: it clearly highlights the benefits of EU membership and the cost of exiting the EU. Creating the single market and establishing the four basic freedoms are landmark achievements in securing economic integration in Europe that shouldn’t be jeopardised so easily.

Free trade gives consumers greater choice. It enables firms to specialise and take advantage of economies of scale, which increases production efficiency. Fiercer competition drives the price of goods down and speeds the spread of new ideas and technologies. The result is greater innovation and higher growth.

In addition, being part of the world’s largest single market affords you a certain level of protection when trade faces stiffer headwinds, as it does currently. Even so, the prospect of a trade war erupting between major economic areas gives great cause for concern and puts the global economic upturn at risk at a time when it has become more broadly based and picked up momentum.

We therefore have to seize the time remaining until the tariffs and countermeasures that have been announced come into effect to prevent the situation from escalating further. The multilateral world trading system needs to be toughened up and used to resolve conflicts.

Quite apart from the economic benefits, European integration is, first and first, a political achievement. The value of a single European voice and European solidarity is particularly evident in times of international tension.

However, the EU member states have shown anything but unity in the dispute over the reception and distribution of refugees. The refugee crisis has exposed hidden dissent and shortcomings in the EU’s ability to act, to the point where some are openly calling into question established procedures and mutual rights and obligations.

All the more important, then, to redefine, and conduct a fresh debate on, what Europe can and should do, on the one hand, and the areas in which members states are better suited to performing tasks in line with the principle of subsidiarity, on the other.

There is certainly a host of policy areas where communitisation promises to generate added value. That was the vision espoused by French President Emmanuel Macron when he spoke at the Sorbonne towards the end of September 2017; he singled out defence, border security and climate protection as areas where he could see joint responsibility working.

The guiding principle for the negotiations surrounding the EU’s future budget should therefore be a clear focus on tasks that can deliver added value for Europe, that is to say those which constitute a public asset for Europe. And the discussion as to what those tasks are needs to take place before the funding arrangements are hammered out.

And I interpret the willingness on the part of the new coalition government in Berlin to up Germany’s contributions as signalling a certain openness to participating in such a discussion, and not merely as acknowledging that Brexit probably means higher contributions will be required.

Furthermore, the coalition partners want to "strengthen the euro area in a sustainable fashion and push forward reform to make the euro better able to weather global crises".

But how can this be achieved? And what guidelines do we need to follow to crisis-proof the euro area? These are the questions I’d now like to look at in more detail.

3 Guidelines for the euro area

There is no shortage of proposals and concepts for crisis-proofing the euro area. Alongside Emmanuel Macron’s Initiative for Europe we have, of course, the European Commission’s roadmaps that build on the European Presidents’ Reports.

There is an Italian position paper, the concept devised by a group consisting of German and French economists and a concept put forward by IMF economists. Christine Lagarde presented some core elements of that particular concept here in Berlin a fortnight ago.

And over the past few years the Bundesbank, too, has contributed ideas of its own as to how institutional reform could make for a more crisis-proof euro area. As a central bank we are extremely keen to see a more resilient euro area emerge. Otherwise, monetary policy runs the risk of always needing to step into the breach when a crisis looms. The more often it does that, the more the public and politicians grow accustomed to that behaviour, and it becomes harder for monetary policy to focus on its mandate of maintaining price stability. 

After all, the euro area was established on the promise of monetary stability. In order to accomplish this, a mandate was drawn up for the Eurosystem that accorded price stability clear precedence over other objectives. In addition, the ECB and national central banks were granted far-reaching autonomy.

Both of these built-in features – prioritisation of price stability and independence – had their roots in poor past experiences with central banks which were reliant on politics or asked to target other objectives – and were grounded in relevant economic studies. And neither should be called into question going forward.

Of course, in the aftermath of the crisis, we need to consider what that can teach us about monetary policy. Who, for example, would have thought back when the euro was introduced that monetary policy would reach the lower bound and even remain there for some time?

But this must certainly not lead us to soften up on our objective of price stability. This is why I am against proposals that deliberately allow inflation to overshoot the 2% threshold for a time or raise the inflation target, as some distinguished economists have already suggested.

Nor should monetary policy be overburdened with additional objectives, such as ensuring the solvency of governments or banks – which, by the way, would not be compatible with the EU treaties, and for good reason.

At present, neither the mandate nor independence of monetary policy are under immediate threat. But there is nothing to rule out a change in circumstances that could make it harder to fulfil the mandate and lay claim to independence.

Because the success of a monetary policy geared towards stability also relies on member states having sound public finances plus financial systems and economic structures which are as productive as they are resilient.

But these are preconditions that monetary policy cannot create itself. Rather, it is forced to rely on others to act responsibly – and on a regulatory framework that promotes this. And that brings me back to the proposals for reforming the euro area.

Ladies and gentlemen

All serious proposals have one thing in common – they want to make the euro area more crisis-proof and place it on a more viable footing. They are all positively disposed towards Europe, then, and for all the debate over the relative merits of each concept, it is important that we acknowledge their good intentions and not deny them in our peers.

Incidentally, the issue of what makes a "good" European was one which occupied Ludwig Erhard, the namesake of this event.

Even in his day as Germany’s Minister of Economics, moves towards deeper integration were a controversial topic. And since he – unlike Adenauer, for example – viewed new European institutions with some scepticism, he was accused of being anti-integration and anti-Europe.

In 1955 he wrote on the topic that "to ask who is a good or bad European is to pose a flawed question. I for one am not prepared to have aspersions cast on my European leanings (…) merely because I ask the question differently and entrust all those involved with the task of examining whether there is really only one way and one means of achieving the European project or whether there are in fact other ways that might not lead us more swiftly and more effectively to our goal".

The struggle to forge good solutions for Europe has always occasioned heated debate, and it is important that these issues continue to sometimes be the subject of passionate discussion. After all, the reforms are very often bound up with pivotal decisions on the future nature of economic and monetary union.

The technical details of the various reform proposals sometimes mask a key point where the proposals differ: the weighting they each accord to risk sharing and joint liability, on the one hand, and to individual responsibility, a rules-based regime and the avoidance of false incentives on the other hand.

In short, some attach greater value to solidarity, others emphasise solidity.

This tension is much like the balancing act we see in the social market economy, which combines the goal of social balance with efforts to utilise and maximise economic performance – or allocational efficiency, as economists describe it.

These two elements – social balance and market processes – interact with each other in complex ways, forming a web of complementary and mutually dependent relationships.

Social balance is needed for the system to find acceptance among the general public, but on the topic of equal opportunities, it’s also a must in terms of exploiting growth potential to the full. At the same time, social balance relies on as much wealth for distribution being generated as possible, and redistribution has the potential to undermine the necessary incentive.

One major factor in the success of our social market economy is the fact that at the end of the day it has always managed to allow both elements to come into their own.

Similarly, a stable and strong monetary union requires both solidarity and solidity. Aligning actions and liability is what counts here.

Fiscal risk sharing occupies a central role in many of the proposals for reform. The thinking here is that risk sharing increases the stability of the euro area, and while these models acknowledge that joint liability does entail unwelcome incentive effects, they do not attach as much importance to them.

With this in mind, I would like to use the final part of my speech to raise two points, looking at some of the specific components of reform efforts. First, I’d like to talk about where I think the right balance might be lost. Second, I want to talk about what a consistent and crisis-proof regulatory framework that relies more heavily on rules and market economy principles without turning its back on solidarity looks like.

In this context, I’ll single out the proposal for a stability mechanism, the tasks of the ESM and the European deposit insurance scheme.

4 A look at specific proposals

4.1 Stabilisation mechanism

The declared aim of a stabilisation mechanism – sometimes also referred to as fiscal capacity, a stabilisation facility, or a euro area budget – is to counter severe shocks, particularly those of a country-specific nature.

In a similar vein, certain budget funds have been earmarked for economic stabilisation under the German government’s coalition deal.

In the context of the future EU financial framework, I have already mentioned the criterion of European added value, and I have considerable doubt as to whether a stabilisation facility provides this.

As long as member states have sound government finances and stick to the fiscal rules, they have enough leeway, in the event of an exogenous shock, to allow automatic stabilisers to do their job or to provide fiscal stimulus – especially as post-crisis financial market regulation has made rescue packages for banks less likely.

Furthermore, if a crisis does occur, the ESM is at the ready to ensure that government financing problems do not have a severe negative impact on the euro area. In such situations, the ESM provides financial assistance on the condition that reforms are carried out.

By contrast, the prospect of receiving unconditional assistance could weaken member states’ incentives to shield themselves from adverse developments or to pursue a stability-oriented policy.

It is also doubtful whether the distinction between exogenous shocks and domestic crises, or between cyclical fluctuations and structural problems, can be made in real time. But this is what would ultimately be necessary to ensure that assistance does not have a procyclical effect by arriving too late. Only then would it also be possible to deliver on the promise that such a mechanism would not establish permanent transfers between the member states.

In my opinion, far too little attention is being given to the fact that private forms of risk sharing can also cushion country-specific shocks. The more that enterprises source funding from other euro area countries, the more evenly the negative consequences of a country-specific shock are distributed across the currency area.

Equity capital, in particular, makes for an excellent buffer in this regard, as debt capital – bonds and loans – has to be serviced in full even in economically difficult times. The planned creation of a European capital markets union provides great opportunities on this front, and I therefore expressly support it.

However, if a fiscal stabilisation mechanism is nonetheless to be introduced for political reasons, a fully pre-financed fund – ie a traditional rainy day fund – would be far preferable to a fund with a capacity to borrow, which is what the IMF has proposed.

Interestingly, the rainy day funds in the United States – which are often referred to in the European discussion – are also pre-financed and do not have a mechanism for interstate transfers.

4.2 ESM

Another project is to further develop the ESM.

Sometimes a European Monetary Fund is proposed in this context. But I think this is misleading, as the tasks and objectives of the ESM are precisely not of a monetary policy nature, but of a fiscal and economic policy nature.

In my view, the ESM already does a convincing job of uniting solidarity and solidity. As I have already pointed out, it provides member states with financial assistance in severe crises, on the condition that reforms are carried out to remedy the causes of the crisis.

Some are calling for the intergovernmentally agreed ESM Treaty to be incorporated into European Community law. However, if this step were to undermine member states’ current say in decision-making, then it should be rejected, as there would be a mismatch between actions and liability. After all, it is the member states that are liable for the risks entered into by the ESM.

The ESM is currently the central tool for combating sovereign debt crises. It certainly makes sense to also give it a stronger role in crisis prevention going forward. This is because the competence that this fledgling institution has built up for managing crises would also be useful in preventing them.

The ESM could, for example, take on a role in the fiscal surveillance of member states. This is because the Commission tends to interpret the rules in a non-neutral way by taking political considerations into account.

If fiscal surveillance were carried out instead by the ESM, it would at least be clear where objective analysis ends and political compromise begins. It would also be easier for the public to tell whether the rules have been adhered to.

Furthermore, the ESM could play a coordinating role in the orderly restructuring of sovereign debt. In this context, the Bundesbank has long been proposing that the maturity of government bonds should be automatically extended as soon as a country applies for ESM assistance.

This way, the original creditors would still be on the hook, even in cases involving an assistance programme, and could still be bailed in if debt is restructured. In other words, unlike today, they will not be repaid with taxpayers’ money from other member states when assistance programmes are in place. This should boost their incentive to be more aware of risk when investing.

What is more, a country’s borrowing requirements would fall to the amount of its current deficit. The assistance loans could be considerably smaller, which would significantly enhance the ESM’s firepower.

ESM funds are also being discussed as a fiscal backstop for the European single resolution fund. However, expanding mutual liability in that way can only be considered once there is sufficient solidity, ie once legacy exposures on banks’ balance sheets have been further reduced and the build-up of new risks is under control. The reservations are thus similar to those concerning the premature creation of a single deposit insurance scheme.

4.3 European deposit insurance scheme

A European deposit insurance scheme would, without doubt, contribute to a more stable financial system, as it would reduce the risk of bank runs and complete the banking union. A study published yesterday by the ECB underscores this point.

However, in order to ensure that alignment between action and liability is maintained, such a system needs to be set up in the right way in terms of how contributions are calculated. And things need to be done in the right order.

Risks that have arisen under national responsibility should not subsequently be communitised. And the more that risks are reduced ex ante, the less that ex post distributional effects come into play.

Legacy risks include stocks of non-performing loans on banks’ balance sheets. While the average non-performing loan ratio has fallen by around one-third in Europe since 2014, in some countries it remains very high and well above pre-crisis levels.

Another problem are the stocks of government bonds on banks’ balance sheets – which, due to a regulatory loophole, are backed by little to no capital and are not subject to caps.

Before a deposit insurance scheme can be created, these sovereign default risks on banks’ balance sheets would need to be reduced so that the insurance scheme does not indirectly assume liability for them. The Bundesbank has therefore long been calling for an end to the preferential regulatory treatment of government bonds.

Risk-appropriate capital backing and caps on sovereign exposures would ensure that banks are better able to cope with sovereign debt restructuring without running into serious problems. That would also curb the need for fiscal support and ease the burden on monetary policy.

The disciplining effect of financial markets would be bolstered if the restructuring of over-indebted member states were more realistic and the no bailout rule in the Maastricht Treaty were more credible. The no bailout principle’s current lack of credibility is one of the central weaknesses of the current governance framework and needs to be addressed.

5 Conclusion

Ladies and gentlemen, before I conclude, allow me to once again summarise the guidelines for crisis-proofing the euro area.

  • The European Union should focus more of its attention and spending on tasks that create European added value.
  • Monetary policy’s primary objective of ensuring price stability must not be called into question. This also includes ensuring that institutional and economic arrangements are in place which allow the Eurosystem to properly deliver on its mandate.
  • A stable monetary union requires solidarity and solidity. It is essential that the alignment of actions and liability be maintained, and I’m talking here specifically about the individual parts of the euro area’s regulatory framework.

At the beginning of my lecture, I spoke about an experiment examining the physical properties of pitch, and I drew an analogy to the stability of the euro area.  

Analogies are sometimes helpful, but one shouldn’t stretch things too far, especially as significant differences usually also exist.

One key difference is that the physical characteristics of pitch cannot be changed. Pitch is a very, very viscous liquid and will remain so.

The euro area, by contrast, is a social construct; its level of stability is not a natural constant, but is the result of complex economic processes and framework conditions.

The physical state of the euro area can be shaped politically.

I hope I have provided some food for thought on how the euro area can be strengthened. And I hope that the spirit of optimism in Europe can be used for reforms that will make Europe and the euro area more robust.

Thank you for your attention.

Deutsche Bundesbank
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This speech was originally given in German. Translation provided by the Bundesbank.