Safeguarding the future of monetary union Speech delivered at the German Embassy

Check against delivery.

1 Introduction

Your Excellency Ambassador Meyer-Landrut,

François Villeroy de Galhau,

Christian Noyer,

Esteemed ladies and gentlemen,

The foundation of Paris is a story shrouded in myth and legend. One such myth, chronicled in the Grandes Chroniques de France, is that Paris, a Trojan, founded the city and thus also gave it its name – just like Romulus is said to have done with Rome, Brutus with Britain, and Francus with France.

Another legend claims that it was Hercules’ journey to the Gardens of the Hesperides which inspired the foundation of Paris. It is said he was accompanied on his travels by the Parrhasians from the Arcadian region of the Peloponnese mountains, a journey which took them along the foot of the Montmartre hill. Once there, Hercules decided that his Parrhasian followers should settle down there, and he called them "Parisians".

Hercules was on his way to the Gardens of the Hesperides, in what is today Gibraltar, to harvest golden apples from the orchard there. This was already the eleventh Labour, out of a total of twelve, which King Eurystheus had given Hercules to perform.

Having been driven insane by Hera, queen of the gods, Hercules had killed his family. To atone for his actions, Hercules was forced to serve Eurystheus and perform whatever tasks the king might set him. These Labours, commensurate as they were with his bloody deed, seemed nigh on impossible at first. Yet when he reached the foot of Montmartre, he had already performed nearly all of them.

Paris, then, serves us as a reminder of everything that's possible – and of how much progress we have made towards the destination. An ideal location, then, to talk today about our economic and monetary union.

Ladies and gentlemen, the unification of Europe after the Second World War was a political vision. Peace and stability stand as the greatest achievements of the European Union, and rightly so. But the integration of Europe’s economies has acted as a notable catalyst for European unification. And even if we view it in isolation, economic integration has produced remarkable results.

Economic integration boosts prosperity in multiple ways. Free trade enables each of us to specialise in what we're best at. Economies of scale can be harnessed more readily. Plus a bigger market means greater competition. And that in turn promotes innovation and productivity.

Economic and monetary union has been the boldest step so far towards deepening economic integration and delivering on a twin promise: of price stability, and of stronger long-term economic growth.

There is a broad consensus that EMU has so far succeeded in delivering on the first of those promises. But the financial and sovereign debt crisis shook the euro area to its core, and I dare say that far fewer would now claim that monetary union has done likewise on the second. Taxpayers were forced to step in for billions upon billions of euro in bank losses. Joblessness in some member states rocketed to levels hitherto unseen in the post-war era. To all intents and purposes, European and global institutions became the ancillary government in individual countries. And many saw the rescue packages as the first step on the road towards a transfer union – something which had been categorically ruled out prior to the launch of monetary union.

But that should not blind us to the prosperity gains which economic integration in Europe has delivered. There are research papers which show that economic integration has made Europe richer – with GDP estimated to have risen by between 5% and more than 25%.[1],[2],[3]

And that additional prosperity is spread widely across Europe. The Gini coefficient, a widely used measure for economic inequality, is not higher today in Germany, France, Spain, Italy or Greece than it was when the European single market was established.

But for many, the challenges unearthed by the crises will have seemed to be nothing short of Herculean. Some, it appears, even thought them irresolvable. Indeed, a number of commentators, particularly on the other side of the Atlantic, but elsewhere, too, predicted that the euro would come crashing down.

That didn't happen, and in my view that would have been a disaster.

Yes, we do often have highly contentious debates. We struggle to find solutions and move things forward.

And yes, the results won’t always be to everyone’s satisfaction. Things do sometimes move in the wrong direction, and corrective action does need to be taken. But I’m confident. Because at the end of the day, we all have the same objective: mutual economic success, harmonious political cooperation, opportunities for all, and the preservation of a stable currency.

Let’s be honest, though – the future might also hold regional or sectoral crises in store which put the euro area to the test. And if a crisis does materialise, the European house we live in today will need to be sufficiently strong to withstand these headwinds.

Where exactly are we on our path towards making monetary union stable and prosperous over the long term? I wouldn't say that we have already accomplished more than 80% of our labours, like Hercules had done when Paris was founded. But we have already made good progress on our journey.

Take the situation in the labour markets, for instance. Today's unemployment rate in the euro area might still be a bit higher than it was before the crisis, but let’s not forget that the employment rate is up on the 2007 figure. In the United States, this rate still hasn’t returned to its pre-crisis level.

The labour market reforms implemented in the member states are working, then. They are helping more people to get into work than before the crisis.

Note that the template for successful labour market reform is always the same – a flexible jobs market combined with a backstop to support employees who happen to lose their jobs. The reforms initiated by the French government are following the exact same template. That’s good news for the entire euro area, because it is in Europe’s interest for France to have a strong economy.

We have made some progress at the European level, too. The banking union, for example, is a milestone on the path leading towards a truly unified European financial market. And it encapsulates the promise that investors should take responsibility for future bank misconduct, not taxpayers.

But there is another, more fundamental question which the crisis has raised, and that is whether a monetary union combining a single monetary policy and national economic and fiscal autonomy can function over the long term. Given that exchange rates have been removed, different adjustment mechanisms need to be in place to effectively smooth shocks which hit individual member states. Some countries were unable to perform this smoothing function during the crisis – partly because doubts surrounding the sustainability of their public finances prevented them from loosening fiscal policy to stabilise their economies.

Is a monetary union in which national governments retain responsibility for economic and fiscal policy matters a model which can function over the long run? Or does fiscal policy need to be integrated comprehensively in order to be able to cushion regional shocks using joint expenditure and transfers? That is the question I now intend to discuss.

2 Risk sharing in currency areas

Ladies and gentlemen, tomorrow is the 131st anniversary of the unveiling of the Statue of Liberty in New York, which was a gift from France to the United States. The history of France and the United States was not always free of rivalry, of course, but it is above all a story driven by mutual inspiration.

The best-known analysis of the US political system, for instance, was penned by a Frenchman: Alexis de Tocqueville’s Democracy in America.

And when Victor Hugo championed the idea of a United States of Europe back in 1849, his model was of course the United States of America.

So it’s worth considering whether there is anything Europe can learn from the United States? Notably, how are shocks that hit individual US states particularly hard cushioned in the United States?

The answer may come as something of a surprise to many. In the United States, it is not fiscal but first and foremost private forms of risk sharing which enable the burden of economic shocks to be spread across other US states.

Another way in which economic shocks are cushioned is through the distribution of business profits and losses throughout the currency area, because company owners are often resident in other US states. And if the losses become so huge as to prevent businesses from servicing their liabilities, those losses are often accrued by bond holders or a bank located in a different state.

So you see that the losses are spread to banks based in different US states. This of course creates additional channels of contagion, so banks need to be able to absorb these losses, otherwise the overall outcome will be pretty much the same. Banks, then, need to be adequately capitalised. That’s one of the main takeaways from the financial crisis.

In the United States, the sharing of losses across state borders absorbs around 40% of an economic shock.[4]

And that's not even counting another form of private risk sharing: enterprises and households that take out loans in different US states during an economic downturn to bridge a slump in earnings. In the United States this type of risk sharing smooths something like 25% of a shock.

Compared with the private forms of risk sharing, the fiscal risk sharing channel in the United States looks altogether more modest, accounting as it does for no more than approximately 15% of an economic shock.

The main fiscal smoothing channel is the fact that pensions and other federal payments to households in a federal state remains static in a downturn, but the federal tax authorities receive less in income taxes from that particular state. Federal spending on infrastructure and other public assets in that particular state has a similar smoothing effect.

3  Capital markets union

There are other currency areas, like Canada,[5] for example, where private forms of risk sharing play a greater role in smoothing country-specific economic shocks.

For all the constraints that inevitably crop up when comparing one country or currency area with another, it is clear that much could be achieved in the euro area if cross-border corporate funding were strengthened, particularly in the form of equity capital. Gouvernor Villeroy de Galhau[6] and I are the authors of a joint paper describing what that kind of capital markets union might look like.

A raft of measures will be needed to tear down the walls in European capital markets. Standardising national insolvency regimes is just one particularly important step worth mentioning. After all, investors need to count on having the same level playing field throughout Europe. Not only will that promote private risk sharing; it will also reduce capital flows into less productive businesses and stimulate flows in more productive ones. That will boost economic momentum, as OECD research papers confirm.[7]

On a general note, the development of equity capital markets, including in Europe, is suffering from what Christine Lagarde has called an "inherent debt bias embedded in the global tax system" – that is, the preferential tax treatment given to debt over equity capital.

Interest payments can be deducted from taxable income; equity costs cannot. Eliminating this bias would encourage businesses to make greater use of equity capital as a funding instrument. And that would facilitate greater private risk sharing whilst at the same time reducing the debt bias.

In his speech on the future of the EU, President Emmanuel Macron picked up on the idea of introducing a single EU tax band for businesses. For the reasons I mentioned earlier, that kind of harmonised tax regime should also do away with the unequal treatment of debt and equity capital.

And that would also have a positive side-effect: banks, too, would have less of an incentive to take up debt capital rather than equity. And holding more equity would also make banks more resilient to losses.

Alexis de Tocqueville once said that, "History is a gallery of pictures in which there are few originals and many copies." European economic and monetary union is without doubt a sui generis structure. But if we become more like the United States in terms of private risk sharing, that certainly won’t be a bad thing. After all, didn’t the Great Masters inspire each other?

Forging a comprehensive capital markets union and putting an end to the unequal treatment of debt and equity capital may represent a major step forward for the euro area, as far as the allocation of economic risk is concerned.

4 Banking union

Another way in which risk could potentially be shared might be for enterprises and households to take out cross-border loans in times of crisis. Yet this mechanism hardly worked at all during the crisis in the euro area. Depositors in crisis-hit countries lost confidence in their domestic banking systems and withdrew their deposits. Banks in the euro area also lost confidence in each other and reined in their lending.[8] The problems were exacerbated further when the supervisory authorities resorted to ring-fencing, an understandable move from a national perspective. The end result was that enterprises and households in the crisis-stricken countries could scarcely obtain loans at a time when they needed them most.

One of the steps taken in Europe to prevent a repetition of such events was to create the banking union. With its Single Supervisory Mechanism and rules on bailing in creditors in the event of bank failures, the European banking union bolsters the banking sector's resilience. This makes a loss of confidence in national banking systems less likely. And less danger of a fragmented financial system stabilises lending, particularly in turbulent times.

A common European deposit guarantee scheme could, in theory, even heighten this confidence. However, as with any insurance policy, one would have to make sure in this case, too, that the insurance does not encourage careless behaviour. Such risks can arise from recklessly granting credit to the private sector. But they can also result from providing sovereigns with too much credit. Since the onset of the sovereign debt crisis, at the latest, we know that loans to general government are not risk-free either.

Banks in the euro area have a sizeable share of sovereign bonds on their books. To insure euro area bank risks in such a situation would indirectly be tantamount to insuring fiscal risks. Given that the member states themselves still decide freely and independently on the level of government expenditure, this ultimately sets the wrong incentives. There is little motivation for banks to demand interest rate mark-ups in keeping with the risk involved. This, in turn, means that financial ministers see less of a need to pay adequate attention to the sustainability of public finances.

In the United States, this problem does not arise in quite the same way because most US states are forbidden by their constitution to take on debt. Thus, the US deposit guarantee scheme really does insure only bank risks, not fiscal risks.

The precondition for a European deposit insurance scheme, then, is that the size of government bond portfolios banks hold on their books is limited. Indeed, these holdings only became so inflated in the first place because – unlike with loans to the private sector – current regulation does not contain any rules about the size of government bond portfolios or the capital that has to be held to cover them. Loans to sovereigns should not be treated any differently from loans to enterprises or individuals.

5 Fiscal union

Ladies and gentlemen,

This brings us to another important takeaway when considering the federal structure of the United States. Each level is responsible for its own financial actions.

In the United States, with its federal structure, the uppermost level has its own budget, which is also controlled at the federal level. But the individual US states bear responsibility for the way they run their finances. For example, neither the US federal government in Washington nor any other US states came to the aid of the State of California when it experienced financial difficulties in the wake of the financial crisis. Incentives to embrace fiscal prudence can only be maintained if action and liability are in alignment.

This principle is also reflected in the rainy day funds in place in many US states, which were recently mooted as a possibility for the euro area, too. Since many US states are strictly forbidden to incur debt, they set budget surpluses aside in a rainy day fund to be used during an economic downturn. There is no financial equalisation scheme between the individual states, however.

In the euro area, the fiscal rules permit the individual member states to take on debt in order to stabilise the economy in a cyclical downturn. Proceeding from the medium-term objective of -0.5%, a euro area member state therefore has leeway of a full 2.5 percentage points to pursue an anticyclical fiscal policy. This makes the potential benefits of a rainy day fund less relevant for us.

However, this presupposes that the EU member states observe the budgetary rules, and by doing so, they can give themselves additional protection from losing the confidence of the capital markets. But of course, this does not exclude the possibility that the markets may also lose their trust in a country that is essentially solvent. The crisis has shown us that a lender of last resort for governments can make sense in exceptional circumstances in the euro area, too. An abrupt loss of market access leads to high adjustment costs, which is why the European Stabilisation Mechanism (ESM) was created. Financial assistance under the ESM allows governments to make an orderly economic adjustment over an extended period of time. In return, the government commits to implementing economic reforms.

The provisions of the ESM stipulate that assistance can only be granted to member states experiencing temporary illiquidity, and not those faced with insolvency. In an emergency, it can be very difficult to say for certain whether a debtor is temporarily illiquid or actually insolvent. In view of this, a proposal put forward by the Bundesbank envisages changing the contractual terms for newly issued government bonds in the euro area by introducing an automatic three-year maturity extension for all bonds, which would be activated the moment a government applies for an ESM programme.

What's crucial here is that the automatic maturity extension buys time to distinguish between illiquidity and insolvency without releasing investors from their liability and the risks being transferred to the taxpayer.

This would also significantly reduce the need for financial assistance under an ESM programme and greatly broaden the scope of the rescue mechanism. For example, had automatic maturity extension already been available to us in 2011, Portugal would only have needed funds to cover all its budget deficits until 2014, and therefore only half of the assistance that the country actually received.

I am also convinced that if it came to resolving a crisis in the euro area in future, the IMF would arguably play a far less prominent role and could, at most, be involved in an advisory capacity. To that extent, with regard to a stronger role for the ESM, another point that needs to be discussed concerns increasing the ESM’s overall clout.

Incidentally, the ESM means a substantial form of fiscal solidarity. Head of the ESM Klaus Regling believes the costs of an ESM loan to be two-thirds less than the costs of an IMF loan, as the ESM – unlike the IMF – does not charge a risk mark-up for its loans. In the case of Greece, for instance, the saving comes to 5.6% p.a. of economic output.

This is an important transfer to governments in need of assistance. These transfers are not permanent, however, and are tied to strict conditionality in order to prevent moral hazard as far as possible. Nor are permanent direct transfers necessary for a currency area to function, as the United States demonstrates. On the contrary, a division into the roles of provider and recipient risks undermining public acceptance of monetary union in the individual member countries.

But as President Macron has said, it may well make sense to move some policy areas to the European level. It is possible that issues like preventing climate change, securing external borders and developing common communications, energy and transport networks could be handled more efficiently at the European rather than at the national level. And if the joint financing of this expenditure is based on each member country's ability to pay, this can also act as an automatic stabiliser in the event of asymmetric shocks.

6 Monetary policy

Ladies and gentlemen, I would like to close my speech by saying a few words about monetary policy. The Eurosystem reacts to asymmetric demand shocks only inasmuch as the price outlook in the euro area as a whole might be affected, so it responds much more decisively to shocks that affect all member countries simultaneously.

Overall, the highly expansionary monetary policy stance has made a crucial contribution to the economic recovery we are currently witnessing in the euro area. It is taking a little longer to achieve our monetary policy objectives partly because enterprises and households in many euro area countries are still occupied with reducing their – in some cases – high levels of debt. Nor have the problems affecting parts of the banking system as yet been fully resolved, which is also weighing on the economic recovery.

On a positive note, most of the crisis-hit countries have already succeeded in strengthening their competitiveness and turned their current account deficits into surpluses. But improving price competitiveness through wage restraint is, naturally enough, also dampening domestic price pressures. In my view, however, the development of domestic price pressures identified in the projection are quite consistent with a path towards our definition of price stability.

Given the rather subdued inflationary pressure at present, an accommodative monetary policy stance remains appropriate in the euro area. Admittedly, opinions can differ on how much we should step on the accelerator in terms of monetary policy and what instruments ought to be used for that.

In saying this, it is obvious that, even after net purchases under the asset purchase programme (APP) have been discontinued, euro area monetary policy will remain highly accommodative. First, what is crucial for APP effectiveness is not so much the amount of monthly additional purchases but, above all, the total outstanding volume of sovereign bonds on our books.

And the APP stocks held by the Eurosystem will remain at a very high level even after net purchases have been discontinued. For as you know, the Governing Council of the ECB has taken a decision to reinvest the proceeds from the maturing bonds.

Second, the Governing Council has decided not to raise interest rates until after the net purchases have ended. Speaking metaphorically, that means we are not talking about putting the brakes on monetary policy, but merely about not pushing down on the accelerator any further. And against the backdrop of the ongoing, increasingly broad economic upswing, I do not think it is necessary. According to our projections, the output gap will be closed next year, and in the short term the economy could grow even more strongly than previously expected.

The Governing Council’s decision yesterday to significantly scale back the monthly purchase volume under the APP from the beginning of next year has to be seen in this context. From my point of view, it would have been appropriate to set a clear end date for net purchases, however – not least because, as you probably know, I am especially critical of government bond purchases in the monetary union. This is because purchases of this kind blur the boundary between monetary policy and fiscal policy.

7 Conclusion

Ladies and gentlemen,

The crisis confronted European monetary union with an enormous challenge. Alexis de Tocqueville once observed in his thoughts on the United States: "The greatness of America lies not in being more enlightened than any other nation, but rather in her ability to repair her faults." And precisely that is the issue at hand.

Hercules was given 12 years to perform his Labours. Though we still have a good deal of work cut out for us, we should endeavour to complete our tasks more quickly than he did.

I now look forward to our discussion!


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  2. Campos, N., F. Coricelli, L. Moretti (2014), "Economic Growth and Political Integration: Estimating the Benefits from Membership in the European Union Using the Synthetic Counterfactuals Method", IZA Discussion Paper No 8162.
  3. Boltho, A. and B. Eichengreen (2008), "The Economic Impact of European Integration", CEPR Discussion Paper No 6820.
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