The President of The European Central Bank (ECB) Mario Draghi, hosted at the European University Institute in Florence, tackled the topic of monetary union and its central role in reducing and sharing risks across European countries. The crisis revealed some specific fragilities in the euro area’s construction that so far have not been resolved.
In addressing such issues, Draghi splits the history of the Great Financial Crisis into five different phases. The first phase took place quite homogeneously across all advanced economies, as all of them had a financial sector characterised by a poor risk management and an excessive optimism in the self-repairing power of markets. When the Lehman shock hit, banks exposed to toxic US assets ran into difficulties and some institutions, most of them located in Germany, France and the Netherlands, and were bailed out by their governments. These bailouts did not greatly affect these sovereign borrowers costs, however, thanks largely to the relatively strong fiscal positions of the governments implementing them.
In the second phase, the crisis spread to banks in Spain and Ireland that had similar weaknesses, but were instead overexposed to the collapsing domestic real estate market. The third phase, began when the Greek crisis shattered the impression that public debt was risk-free, triggering a rapid repricing of sovereign risk. These events spread contagion to all sovereigns now perceived as vulnerable by financial markets. Sovereign risk was then transmitted into the domestic banking sector through two channels, namely, banks’ direct exposures to their own governments’ bonds and negative confidence effects.
The fear of possible sovereign defaults had a dramatic effect on confidence in the domestic private sector. Any distinction between firms and banks, and between banks with and without high sovereign exposures, disappeared. In this way, the crisis spreaded to banks that did not have significant exposures either to US sub-prime assets or to domestic real estate, and therefore had not until then needed to be bailed out.
The fourth stage of the crisis was triggered by investors in both Europe and the rest of the world. Faced with a downward growth spiral, many investors reached the conclusion that the only way out for crisis-hit countries, given the institutional design of the euro area, was for them to exit from it. This would, it was believed, allow them to depreciate their currencies and regain monetary sovereignty. The fifth stage of the crisis then followed: the breakdown in monetary policy transmission across the euro area. Interest rates faced by firms and households in vulnerable countries became increasingly divorced from short-term central bank rates, and this posed a profound threat to price stability.
The unfolding of the euro area crisis yielded lessons for the financial sector, for individual countries and for the union as a whole. But the unifying theme was the inability of each of these actors to effectively absorb shocks. In some cases, because of their weaknesses, they even amplified those shocks. And the euro area as a whole was shown to have no public and very little private risk-sharing.
What makes membership of a monetary union work for all its members is a trade-off: what they lose in terms of national stabilisation tools is counterbalanced by new adjustment mechanisms within the currency area. In the United States, which is a relatively well-functioning monetary union, ex post adjustment plays an important role.
Where the euro area and the US differ more is in terms of ex ante risk-sharing – that is, insuring against shocks through financial markets, which plays two key roles in stabilising local economies in a monetary union. The first is by de-linking consumption and income at the local level, which happens through integrated capital markets. The second is by de-linking the capital of local banks from the volume of local credit supply, which happens through retail banking integration. Overall, it is estimated that around 70% of local shocks are smoothed through financial markets in the US, with capital markets absorbing around 45% and credit markets 25%. In the euro area, by contrast, the total figure is just 25%.
This calls for ad-hoc adressed policies: first of all, we need policies that make the financial system more stable, both by increasing the resilience of banks and by completing the banking union and the capital markets union. Secondly, an incomplete framework for bank resolution also deters cross-border integration. When resolution is not fully credible, it can create incentives for national authorities to limit capital and liquidity flows so as to advantage their depositors in the event of a bank failing. But when the new EU resolution framework is completed and working properly, such concerns about depositors should be quietened down.
Furthermore, public sector policies can complement private risk-sharing by increasing economic convergence and thereby building trust among cross-border investors. The crisis showed clearly the potential of some euro area economies to become trapped in bad equilibria. And plainly, as long as this risk exists, it will act as a deterrent to cross-border integration, especially for retail banks that cannot “cut and run” as soon as a recession hits. So, if we are to deepen private risk-sharing, the tail risk of bad equilibria needs to be removed, and replaced by policies that lead to sustainable convergence. This requires action at both the national and euro area levels.
We know that structural reforms boost growth: looking at the last 15 to 20 years, euro area countries with sound economic structures at the outset have shown much higher long-term real growth. However, while sound domestic policies are key to protect countries from market pressure, the crisis showed that, in certain conditions, they may not be enough. Markets tend to be procyclical and can penalise sovereigns that are perceived to be vulnerable, over and above what may be needed to restore a sustainable fiscal path. And this overshooting can harm growth and ultimately worsen fiscal sustainability.
This creates a need for some form of common stabilisation function to prevent countries from diverging too much during crises, as has already been acknowledged with the creation of two European facilities to tackle bad equilibria.One is the ECB’s OMTs, which can be used when there is a threat to euro area price stability and comes with an ESM programme. The other is the ESM itself. But the conditionality attached to its programmes in general also implies procyclical fiscal tightening.
So, we need an additional fiscal instrument to maintain convergence during large shocks, without having to over-burden monetary policy. Its aim would be to provide an extra layer of stabilisation, thereby reinforcing confidence in national policies. It is not conceptually simple to design such an instrument as it should not, among many other complexities, compensate for weaknesses that can and should be addressed by policies and reforms. It is not legally simple because such an instrument should be consistent with the Treaty. It is also certainly not politically simple, regardless of the shape that such an instrument could take: from the provision of supranational public goods – like security, defence or migration – to a fully-fledged fiscal capacity.
But the argument whereby risk-sharing may help to greatly reduce risk, or whereby solidarity, in some specific circumstances, contributes to efficient risk-reduction, is compelling in this case as well, and our work on the design and proper timeframe for such an instrument should continue. The people of Europe have come to know the euro and trust the euro. But they also expect the euro to deliver the stability and prosperity it promised. So our duty, as policymakers, is to return their trust and to address the areas of our union that we all know are incomplete.