Solidity and solidarity in the euro area Speech delivered at the German Embassy in Rome

Check against delivery.

1 Introduction

Your Excellency Dr Wasum-Rainer

Ladies and gentlemen

Thank you for your invitation. It is pleasure to speak to you today on the topic of solidity and solidarity in the euro area.

You will no doubt be aware that the euro area is also known as European Monetary Union, or EMU for short. Tommaso Padoa-Schioppa, one of the founding fathers of the euro area, once quipped that this was an apt name in more ways than one. Just like its Australian namesake, he joked, it was impossible for the euro area to go backwards.

There were two messages in his witty remark: first, that he saw monetary union as an irreversible process; second, that, for him, it was a chain reaction in which "each step resolved a pre-existing contradiction and generated a new one that in turn required a further step forward".[1]

Tommaso Padoa-Schioppa once also dubbed the euro a "currency without a state" in a reference to the unique design of European monetary union - that is, the way it fuses a single monetary policy and autonomy in economic and fiscal policy matters.

This blend of a common monetary policy and broadly autonomous national economic and fiscal policymaking in 19 different countries at last count could potentially be a source of very major problems indeed.

To a degree, this institutional design faces a "commons problem" not unlike the threat facing Earth's finite natural resources - a matter which Italy, to name but one, explored back in 2007 by setting up a commission chaired by Stefano Rodotà.

If we wish to gain a better understanding of how our joint currency is designed, then, we ought to look into what, in economic theory, is known as the tragedy of the commons.

Take overfishing, for example. A single fisherman who catches too many fish leaves fewer behind for others in his profession and ultimately jeopardises the long-term sustainability of fish stocks. Overfishing, then, is dangerous for the fishing community. But an individual fisherman is out to net as many fish as possible, ignoring the interests of other fishermen or future generations of fishermen.

That's pretty much what it's like with sovereign debt in a monetary union. Running a high level of government debt might be appealing for an individual country, but it does damage to the euro area as a whole. For mounting levels of debt in a single member state can drive longer-term interest rates sky high for all the countries in the euro area. And if excessive indebtedness in a given country poses a threat to financial stability, it can take the entire currency area to the very brink and potentially force its member states to accept liability for that country's debts. But that would contradict a cornerstone of monetary union - the liability principle.

Another potential knock-on effect of excessive indebtedness at the member-state level is that monetary policymakers might come under pressure to subordinate their price stability mandate to a monetary policy stance aimed at securing sovereign solvency - a state of affairs that economists call fiscal dominance.

A "currency without a state", then, needs rules that coordinate national policies - that's something the founding fathers were also well aware of. That's why the no bail-out clause and the ban on monetary financing stand alongside the Stability and Growth Pact in the rules coordinating the functioning of monetary union.

To safeguard the solidity of monetary union, the Maastricht Treaty sets tight constraints for financial solidarity between member states. Solidarity within the meaning of the Maastricht Treaty mainly means that countries should be accountable for their own actions without expecting others to carry the can for their decisions.

This, it was thought, would also ensure that financial markets had a disciplinary effect on national fiscal policymaking - the idea being, if you run up more debts than others, you should also be expected to pay higher interest rates in the capital markets.

As we all know, these rules coordinating monetary union based on the principle of individual national responsibility were unable to nip undesirable developments in the euro area in the bud.

When the crisis erupted, the financial woes of individual countries threatened to engulf the entire monetary union. The response was to create the European Stability Mechanism (ESM), an instrument which allowed financial assistance to be granted to member states that had run into difficulties.

This move prevented matters from coming to a head. But stretching the no bail-out clause to its very limits can give rise to a new set of serious economic and political problems. After all, the more a country can tap financial assistance, the greater the risk of action and liability drifting apart. That contradicts the fundamental economic principle that whoever makes a decision must also take responsibility - which is to say: assume liability - for the consequences of that decision.

And not just that. A situation where countries feel unable to repay the assistance they have received can spark political tension - as, too, incidentally, can the programme conditionalities which are designed to put the countries receiving support back on their feet. These conditionalities are frequently regarded as undue interference in matters of national sovereignty.

So is a currency without a state vulnerable to crises and unstable over time - as figures such as former German Chancellor Helmut Kohl appeared to believe. In his government policy statement marking the Maastricht conference, Dr Kohl said, "Recent history, and not just in Germany, has taught us that the idea of sustaining economic and monetary union over time without political union is a fallacy".

And only recently, Italy's Finance Minister Pier Carlo Padoan echoed Kohl's remarks by saying, "A stronger monetary union needs strong common institutions".

So does monetary union really need political union over time? Has the decentralised approach to coordination anchored in the European Treaties been a failure? And is financial solidarity possible without diluting the incentives for sound fiscal policymaking in monetary union? These are the questions I would like to address today. But I would like to kick off with the question of how monetary policy can contribute to stability in the euro area.

2 Monetary policy

Monetary stability is good for everyone - let me count the ways. First, price stability means being able to pay one's way tomorrow on today's income. Second, it also makes retirement saving easier to plan.

Third, monetary stability is important from an economic perspective as well because it allows businesses to calculate what an investment will cost and what return it will deliver. The more money fluctuates in value, the more uncertain investment becomes and the lower growth will be in the long run.

All these reasons convinced the member states of the euro area to opt for an independent central bank committed solely to price stability that was modelled on the Bundesbank. And with inflation running at an average of 1 1/2 % since it was created, it has been roughly as successful in maintaining price stability.

Incidentally, there is another gratifying effect of a monetary policy that is geared to price stability: it can help stabilise an economy impaired by demand shocks. That's because frail demand dampens not just the economy itself but price pressures as well. The central bank responds to a demand shock by easing its monetary policy, bringing stability not only to the inflation rate but also to economic output. And if monetary policymakers raise policy rates in response to mounting inflation, they are also preventing the economy from overheating.

So monetary policy in the euro area cushions shocks - but only if those shocks are cyclical in nature rather than structural problems, and if they are noticeably taking their toll on the euro area as a whole.

Let's take a look at the current state of play. The economy is growing, that's true, but price pressures are very feeble. So it's quite right that the euro area's monetary policy is in expansionary mode.

Yet the unsatisfactory growth is more than just a result of demand being too weak - the euro area still hasn't fully digested the economic fallout of the crisis. The persistently high level of unemployment is just one indication of this, and unemployment in the euro was already too high before the crisis struck. This tells us that large parts of the economic problems facing the euro area are structural, rather than cyclical in nature.

Unemployment in the euro area ran at an average of 8.7 % between 1999 and 2007 - even though excesses in some euro-area countries' real estate markets had caused construction activity, and thus employment in the construction sector, to balloon. Hence the need for Europe to embrace reforms like Italy's Jobs Act which lower obstacles to hiring staff as a way of creating additional new jobs.

But other structural reforms are important as well, in each individual country and at the European level. The focus here must be on putting government finances on a sustainable long-term path and creating competitive economic structures. And there are some countries where it is a question of putting the most elementary structures in place - creating a dependable and functioning administration and an efficient and reliable court system, and boosting the overall efficacy of the public sector.

In some euro-area countries, on the other hand, the high levels of household and corporate debt as well as the large holdings of loans at risk of default are hampering economic activity overall, and investment and lending in particular. With the newly created possibility of a bank rescue fund taking on non-performing loans, Italy, too, is on the right track in this regard.

That said, growth potential is slowed not only by the very high levels of household debt. Very high levels of public debt also act as a brake on growth, as shown in empirical studies like the one by Cecchetti, Mohanty and Zampolli.[2] A brief look at the euro-area countries also appears to back this up. Otherwise the countries with high debt levels would typically be drivers of economic growth - but they're not.

A string of euro-area countries have made huge progress in scaling back their fiscal deficits since the onset of the sovereign debt crisis - indeed, Greece, Ireland and others deserve plaudits for paring back their annual deficits by ten percentage points or more. But countries are still frequently crashing through the 3 % deficit ceiling. And if the cyclical improvements are factored out of the euro-area countries' budget deficits, adjusted for interest expenditure, for the past two or three years the relevant primary surpluses have either been treading water or have even been receding.

Essentially, the opportunity opened up by the ECB's highly accommodative monetary policy stance to bring down structural deficits particularly quickly has been squandered. This could become a problem for debt sustainability when the ECB Governing Council needs to once again tighten monetary policy in order to fulfil its mandate of price stability.

In my view, there is a danger here that the currency union's next problem of confidence is in the making - and pressure is building on the Eurosystem to step into the breach left by fiscal policy.

On the goods markets, too, policy needs to be geared more towards growth. Some European countries have rules which inhibit the growth of small enterprises. But when highly innovative small businesses are prevented from scaling new heights, this also stunts economic growth.

Strong competition is required for a market economy to prosper, be innovative and show high productivity growth. It is therefore important, among other things, to eliminate the red tape involved in setting up a business. This is a major hurdle across much of Europe and, I might add, especially so in Germany. 

Therefore, Europe's common market also needs to be extended to cover digital products. The 28 separate digital markets that currently exist in Europe must finally be turned into a pan-European digital market.

Here, as with the capital markets union, it is the European Commission that sets the pace. Broad, well-developed capital markets offer fresh sources of funding for businesses and thus hold out the promise of additional growth.

Taking all of these considerations into account, three key things are important in my view.

First: I see no contradiction between growth and fiscal solidity. A looser fiscal policy can temporarily jump-start economic growth. However, lasting growth cannot flourish on an ever-growing mountain of debt - this is precisely what the sovereign debt crisis in Europe has made clear. Rather, what is decisive is the growth-enhancing orientation of fiscal policy, which is something that Mario Draghi, too, pointed out once again last week at the ECB press conference. So it is less about the volume of spending, per se, than about the right design of fiscal policy in terms of revenue and expenditure.

Second: Even monetary policy can only support the economy in the short term. However, it cannot do anything to combat structurally low growth or structurally high unemployment. And because it must gear itself towards the monetary policy requirements of the entire currency area, it is also barred from separately addressing the needs of individual countries.

Targeted support from the Eurosystem for individual countries, such as bond purchases for crisis-stricken euro-area countries, is problematic in my view. This is because it blurs the lines between monetary and fiscal policy and harbours the danger of fiscal risks being redistributed via central bank balance sheets.

Third: A higher longer-term growth trend also leads to higher longer-term real interest rates. This, in turn, gives monetary policymakers greater leeway to raise interest rates. This would alleviate investors' anxieties regarding a persistently low-interest-rate environment. Instead of arguing for ever more measures to loosen monetary policy, sustainable steps should be taken towards more growth.

3 Institutional framework of monetary union

Monetary policy oriented towards price stability reacts to shocks to the extent that they impact the price outlook in the euro area as a whole.

However, it cannot absorb shocks that only affect individual countries. Such shocks therefore present member states with particular challenges. This is because the abolition of exchange rates means they can no longer be used as an economic safety valve.

Exchange rates in the euro area disappeared when the euro was launched, and with them the exchange rate risk. In the absence of this risk, capital flowed from countries with previously low interest rates to countries that, on account of the interest rate risk, had higher interest rates prior to the currency union. As a result of these capital flows, the interest rates of the individual member states converged almost entirely. The country risk premiums therefore largely levelled out, despite the soundness of budgetary policies varying to a very considerable extent.

As it would later turn out, capital did not flow solely into productive investments, but also into private and government consumption. When, in the wake of the financial crisis, doubts emerged as to whether individual debtors or even entire euro-area countries could still properly service their debts, their funding stopped abruptly and interest rates skyrocketed.

As a result, many banks were in danger of not being able to absorb their losses. Therefore, the states felt compelled to rescue the institutions with taxpayers' money.

The upshot was, in most cases, an increase in the government debt mountain, which in turn put banks back into hot water because of their large holdings of government bonds. Some euro-area countries needed fiscal assistance from other member states and the International Monetary Fund - and this despite the no bail-out clause of the EU Treaty. Ailing banks and reeling governments therefore dragged each other down during the crisis.

The high level of debt held by both banks and states is a result of a shared problem: the drifting apart of action and liability.

While banks, due to their size or economic significance, could, in the case of imprudent lending, hope to receive assistance from their governments, and thus from the taxpayer, if necessary, euro-area countries benefited from the fall in risk premiums after the euro was introduced. At least until the onset of the sovereign debt crisis, the financial markets clearly assumed that if it came to the worst, fiscal solidarity would prevail in the euro area - and they weren't entirely wrong about that.

3.1 Bail-in instead of bail-out

Much has since been done to ensure that in future banks will themselves be liable for their investment and lending decisions.

In the euro area there is a Single Supervisory Mechanism which aims to ensure that banks are monitored with the same rigour in all member states.

Above all, however, banks must hold in reserve more and higher-quality capital in order to be better able to absorb losses. And if their capital is still insufficient to cover losses, creditors are then called on. The use of taxpayers' money is only considered as an absolute last resort.

The financial risk therefore lies with those who provide the bank with capital and who receive interest or dividend payments in return. And this is a good thing. Indeed, Mark Carney, Governor of the Bank of England, is absolutely right when he says that there must be an end to banks privatising profits and socialising losses.

The higher capital requirements and the bail-in rules ensure that banks' shareholders and creditors bear potential losses. This makes banks more resilient and reduces contagion effects, should a bank nevertheless run into difficulties.

3.2 Two paths to a viable fiscal framework

However, for the long-term stability of the currency union it is not only important that action and liability are aligned at the level of the banks. This principle must, once again, also apply to a greater extent in policy decisions in the euro area.

There are two conceivable paths to achieve this. Either states transfer both decision-making power and liability for budgetary issues to the European level, for example in the form of a European fiscal union. Or the states continue to make their own budgetary decisions but are then held liable for the consequences.

A real fiscal union could indeed restore the balance between action and liability. While a fiscal union in itself is no guarantee of sound fiscal policy decisions, it does, in principle, alleviate the commons problem. For example, if binding fishing quotas in common fishing grounds are set and enforced for every single fisherman, this safeguards fishing stocks as a whole.

That said, mutualising liability among the euro-area countries without a corresponding joint control function would be the wrong path. This is because it would tend to strengthen rather than weaken the existing incentive to run up debt in a currency union.

This is a point that I see differently to Pier Carlo Padoan, for example. He considers that risk-sharing and the mutualisation of liability are strong incentives to heed the rules and prevent opportunistic behaviour.

I wouldn't be so optimistic. To illustrate this point on risk-sharing and the mutualisation of liability, let's take the example of bicycle insurance. This would need to provide strong incentives for the policyholder to always carry the bike indoors in order to protect it from being stolen. Bicycle theft would be rare as a result and insurance premiums low. And yet, the opposite is true.

When I enquired about taking out bicycle insurance the last time I visited my bike shop, I left having quickly abandoned the idea. An insurance policy that would allow me to sometimes leave my bike outside at night has such high premiums that I could buy a new bike every three years with the same money. The premium is significantly higher than for policies that only insure bikes if they are stored indoors.

Ultimately, this boils down to the well-known problem of moral hazard, which forcefully demonstrated its perilous nature during the financial crisis, but which is as old as the concept of insurance itself. Many insurance policies, with their complicated clauses and deductibles, are aimed precisely at curbing this moral hazard problem.

But just what kind of transfer of sovereignty are we talking about in the case of a fiscal union?

Let me give you an example. Last year, when the Italian budget was announced, Matteo Renzi said that Italian fiscal policy was made in Italy and was not something the country would allow to be dictated by bureaucrats in Brussels. In a fiscal union, this would change. Member states would have to comply with the requirements set by a European fiscal authority. Similarly, if a European unemployment insurance scheme were introduced, control over labour market rules would have to be transferred to the European level.

A fiscal union would consequently be the biggest step in the integration process since the introduction of the euro. It could not be achieved without making comprehensive changes to the European Treaties or holding referendums in the member states. The same would apply to the idea of a single euro-area ministry of finance with its own budget and to a system granting rule-based powers to intervene in existing national budgets. I consider these to be major obstacles. At the moment, I cannot see any willingness to overcome them - in Italy, Germany or elsewhere.

If we wish member states to retain their national sovereignty in fiscal policy matters, the only remaining option is to anchor action and liability at the member state level, as provided for in the existing Maastricht framework.

The Maastricht framework used two mechanisms to force national fiscal and economic policymakers to pursue a stability-oriented policy path - fiscal rules and financial market discipline. As I mentioned earlier, neither of them has proven to be particularly effective.

In fact, since monetary union was launched, some countries, including Italy, have breached the rules of the Stability and Growth Pact more often than they have complied with them. Germany, too, played its part in watering down the binding effect of the rules between 2003 and 2004.

The fiscal rules may now have been amended in response to the crisis, but that has made them much more complicated, and the Commission can now exercise greater discretion in monitoring them.

I see this as a problem, because the Commission is exposed to a conflict of interests. On the one hand, it must operate as the guardian of the treaties and ensure that the rules are heeded. On the other, it is also a political institution that is supposed to strike a balance between a wide variety of interests.

Torn between these two challenges, the Commission has repeatedly shown that it is prepared to accept compromises at the expense of fiscal discipline. Just consider the repeated extensions it has made to the deadlines for deficit countries to take corrective action. One solution could be the creation of an independent European fiscal authority which takes on the Commission's current tasks in the field of budgetary surveillance.

A functioning decentralised approach would also mean addressing the glaring inconsistencies in the existing framework, which undermine the principle of individual responsibility and therefore weaken the incentives to pursue a sound fiscal policy.

Although the EU Treaty prohibits bail-outs and the monetary financing of governments, the capital regimes for banks nonetheless treat government bonds as risk-free. During the crisis, if not beforehand, this assumption turned out to be a fallacy. Banks must therefore hold sufficient capital against sovereign bonds on their balance sheets. After all, they have to do so for loans to private borrowers as well. I also think it is important to limit banks' exposure to individual sovereigns.

To prevent "cluster risk", that is risk that is so great that one defaulting borrower could bring down an entire bank, they are required to comply with large exposure rules. Government bonds, however, are currently not covered by these rules. Consequently, banks often hold so many home country sovereign bonds that this item alone exceeds their total capital.

For this reason, there is currently a risk that restructuring sovereign debt could lead to the collapse of the affected country's banking system. If we can introduce regulation that ensures that sovereign bonds cease to be a cluster risk, we will be able to sever this bank-sovereign nexus, which in fact served to fan the flames of the crisis.

In addition, if absolutely necessary, it will allow sovereign debt to be restructured without bringing down the financial system. This lends extra credibility to the principle of individual responsibility - for both sovereigns and investors.

Capping the amount of debt issued by a single sovereign that a bank is permitted to hold does not necessarily mean that it has, in all, less sovereign debt in its portfolio. It can - up to the relevant limit - still acquire other countries' debt, thus spreading its credit risk. And, of course, if it buys bonds issued by other euro-area countries, the exchange rate risk on its balance sheet does not increase.

Obviously, introducing new rules such as these would involve transitional periods. But it is precisely because we need these transitional periods that we must decide quickly which course to take.

Doing away with the preferential regulatory treatment of government debt would force the markets to take greater account of differences between individual countries' risk profiles. Countries that pursue unsustainable policies would then face rising risk premiums.

I also believe that reducing the banking risk created by government bond holdings is a key prerequisite for the possible introduction of a joint European deposit guarantee scheme.

Let me explain briefly what I mean by this. To date, deposit protection schemes in the euro area have been organised at the national level. During the crisis, we saw deposits being withdrawn from the banks on a large scale, which revealed that trust in those particular national deposit protection schemes had faltered. That is why the Commission proposes to combine the national systems, so that, even in the event of a major asymmetric shock, confidence in the relevant banking system is not shaken.

This actually sounds plausible at first, particularly since the large, systemically important euro-area banks are now also being supervised uniformly by the ECB. However, an argument against the over-hasty communitisation of deposit protection is the fact that euro-area member states still hold considerable sway over the quality of bank balance sheets. This stems not only from national legislative powers such as national insolvency laws, but also from the substantial sovereign exposures in banks' balance sheets previously mentioned.

Therefore, as long as banks have large volumes of debt issued by their own governments in their balance sheets, a joint deposit protection scheme also means communitisation of fiscal risk. That would be something akin to agreeing to insure a bicycle, only to find out later that it isn't a bike at all, but an extremely expensive BMW or Ducati, and that the insured party can increase the value of the bicycle by almost as much as he wants.

However, creating a regulatory framework based on individual responsibility will require more than just changing the capital regulations for government bonds. We would also have to ensure that the parties that took the risks in the first place - the investors - are liable for the consequences.

As things currently stand, a member state with no access to the financial market can apply for an ESM rescue programme, under which financial assistance is conditional on economic reform. If everything goes to plan, deficits are reduced, growth potential rises and access to the capital market is restored.

But if things do not run smoothly and the member state loses access to the market permanently - in other words, if the issue is not a liquidity problem but a solvency problem - debt will have to be restructured. At this point, however, part of the liability will have already been passed on to European taxpayers because, during the programme, the ESM will have stepped in for the private holders of the matured government bonds.

One way of changing this would be to automatically extend the maturity of all bonds by three years as soon as a government applies for ESM assistance. This would drastically reduce the need for funding through such a rescue programme, which would then only be required in order to spread the fiscal adjustment over a longer period, thus simplifying this procedure, but not to replace maturing sovereign bonds with ESM loans.

4 Conclusion

The saying that a speaker should exhaust the topic, not the audience, is probably true. I will therefore draw to a close.

Tommaso Padoa-Schioppa once described the creation of the euro as "a chain reaction in which each step resolved a pre-existing contradiction and generated a new one that in turn required a further step forward."

The crisis has shown that the introduction of the euro has not brought this chain reaction to an end. The banking union already represents a major step towards further integration. But we must now decide whether we dare to make the final great leap towards integration or whether we should strengthen the Maastricht framework, which is based on the principle of individual responsibility.

I agree with Mario Draghi, who says that: "Those who claim only a full federation can be sustainable set the bar too high".

Closer political integration would, of course, be one way of making the euro area more robust. But even a fiscal union would mean changes to the European Treaties, and referendums in the member states. This is the only way a true transfer of fiscal sovereignty to the European level could be achieved. And without the full transfer of sovereignty, the mutualisation of liability increases the commons problem and also, potentially, tensions among member states.

If we shy away from relinquishing sovereignty, the only alternative is to strengthen the existing framework to make the euro area more stable. Even then, action and liability would again be aligned, as my French colleague François Villeroy de Galhau and I mentioned in our recent joint article.


  1. Padoa-Schioppa. 2004. The Euro and Its Central Bank: Getting United After the Union. Cambridge, MA: MIT Press.
  2. Stephen Cecchetti, Madhusudan Mohanty & Fabrizio Zampolli, 2011. The real effects of debt, BIS Working Papers 352, Bank for International Settlements.