The specific challenge for monetary and macroprudential policy in the current debt crisis stems from the fact, that while both policy goals are affected the possibilities to contribute to crisis resolution are limited. Specifically with respect to monetary policy, there is the substantial risk that involvement in crisis resolution may entail a burden shifting from fiscal to monetary policy, and the ultimately necessary political action to address the root cause of the crisis might be delayed, incomplete, or not happening at all.
One of the severest forms of monetary policy being roped in for fiscal purposes is monetary financing, in colloquial terms also known as the financing of public debt via the money printing press. In conjunction with central banks’ independence, the prohibition of monetary financing, which is set forth in Article 123 of the EU Treaty, is one of the most important achievements in central banking. Specifically for Germany, it is also a key lesson from the experience of the hyperinflation after World War I. This prohibition takes account of the fact that governments may have a short-sighted incentive to use monetary policy to finance public debt, despite the substantial risk it entails. It undermines the incentives for sound public finances, creates appetite for ever more of that sweet poison and harms the credibility of the central bank in its quest for price stability. A combination of the subsequent expansion in money supply and raised inflation expectations will ultimately translate into higher inflation. In a monetary union of independent countries, one additional aspect that is often missed in the current discussion is particularly relevant. Monetary financing in a monetary union leads to a collectivisation of sovereign risks among the tax payers in the monetary union. It is equivalent to issuing Eurobonds. However, the redistribution of such risks and the related transfers between the members of the monetary union are clearly the task of national fiscal policies, and only the national parliaments have the democratic legitimation to make such decisions. For this reason, the Eurosystem’s mandate to ensure price stability rightly involves the prohibition of any kind of monetary financing.
Proposals to involve the Eurosystem in leveraging the EFSF – be it through a refinancing of the EFSF by the central bank or most recently via the use of currency reserves as collateral for an SPV buying government bonds – would be a clear violation of this prohibition. Incidentally a support of this scheme by governments would have also circumvented the parliamentary approval for additional rescue funds provided by Germany. These proposals have met the staunch opposition of the Bundesbank. The current crisis cannot be solved by destroying its stability oriented basis. Hence, I am glad that also the German government echoed our resistance to the use of German currency or gold reserves in funding financial assistance to other EMU members.
It is sometimes requested that Germany should contribute more strongly to international stabilisation. However, in my view the most important contribution at the moment is that Germany remains a stability anchor in EMU with regard to fiscal sustainability and with regard to its stability orientation. For example, the new national fiscal rules in Germany may increase confidence in sound public finances, which I believe is currently more important than any short-lived fiscal stimulus. Therefore, I would advise the German government not to weaken its fiscal stance by spending any revenue windfalls, but rather to continue the timely consolidation of the budgets at all levels of government.
From a short sighted perspective flirting with monetary financing may be perceived as a seemingly easy way out, but policymakers have to implement a true long-term solution to the crisis. The course of the crisis leaves no doubt about what this requires. First, on the national level the determination of the affected countries to return to a sustainable path of public finance and to undertake the necessary structural reforms is required. Second, as such action will inevitably entail painful and initially contentious adjustments, we need a framework within the monetary union which ensures sufficient incentives for the member states to follow this way nevertheless. So far, the decisions taken for crisis resolution within the monetary union have not addressed these issues sufficiently as the recent aggravation of the crisis has shown.
The October summit dealt with a number of important crisis issues. One definitely positive outcome of the summit was the decision to ensure sufficient capitalisation in the banking sector, given that contagion effects are a major reason for the severity of the crisis.
However, as we currently see, even positive outcomes of the summit fall short of expectation without the necessary consolidation and structural adjustments in the countries which are at the heart of the crisis. More generally, the euro area is currently caught up in the fact that its framework has, in the course of the crisis, increasingly lost consistency. This is harming the credibility of the current rescue packages. While risks stemming from undesirable and self-inflicted developments in individual countries have been increasingly communalised by the assistance packages, the ultimate decision-making power has remained on the national level and the conditionality that was intended to rein in national policymakers has been increasingly relaxed.
As a first step, a consistent strategy requires strict conditionality of the agreed financial help to be enforced in order to prevent the incentives to implement painful reforms and consolidation measures from weakening further. In the case of Greece, this must imply that the financial help, which is bound to strict consolidation and reforms, will be halted if Greece decides against the agreed adjustment process. It is an important and promising signal that policymakers from EMU member countries have stressed this point, too. What is often overlooked, however, is that uncertainty about the future of the adjustment programme can quickly make untenable the situation of central banks which continue to provide liquidity to Greek banks.
Furthermore, however, policymakers have to decide which direction the currency union is to take. As I have discussed in more detail in earlier speeches, there are in principle two conceivable ways to a consistent and economically sustainable framework for the monetary union. While the first would be a return to the founding principles of the system, but with an enhanced framework that really ensures sufficient incentives for sound public finances, the second way would imply a major shift entailing a fundamental change in the federal structure of the EU and involving a transfer of national responsibilities, particularly for borrowing and incurring debt, to the EU. Only a clear decision for either option lays the foundation to preserve the monetary union as a stability union in the long-run. It is up to governments in Europe to make this decision.
Institute of International Finance
With business and consumer confidence at their lowest levels since 2009, the Euro Area is at growing risk of a return to recession—entailing significant spillover effects for other economies worldwide. Against this backdrop, your meeting this week should focus squarely on setting out strong, convincing measures to revitalize global growth. [Emphasis in the original]
. . . it is essential that all parties come together behind the continued active role of the ECB in the secondary government bond market. [Emphasis in the original] This will allow time for national authorities’ adjustment efforts to take hold, and help stabilize markets at this crucial juncture. We would also emphasize that lower ECB policy rates at this point would enhance market stability as well as help bolster faltering regional economic growth.
There is a clear need to restore confidence in Europe’s banking sector, and the recapitalization plans for European banks are seen as a key part of the overall approach to this. But the scope and approach chosen will cause a number of serious problems. First, the market value of the debt of the countries most under scrutiny is likely to decline further as banks unload sovereign bonds. This is contrary to the goal of stabilizing and underpinning the outlook for sovereign debt in Europe. Second, the cost of raising capital in the current environment is prohibitive; European bank equity is trading close to 50% of book value, while the cost of issuing bank debt has risen sharply, by almost 2 percentage points over the past year. For some, new capital is not available in the market at all. Against that backdrop, it is inevitable that many European banks will shrink risk assets [Emphasis in the original] rather than try to raise expensive capital or be subject to forced capital injections. This will add to the financial sector deleveraging and contractionary pressures already evident in Europe. Data through September show that Euro Area bank credit growth remains weak, with lending to non-financial corporates increasing by only 1.4% in the first three quarters of 2011 compared to a year earlier. We estimate that if higher capital ratio requirements were to be met by mid-2012 relying only on retained earnings and a reduction in credit supply, overall credit exposure to the Euro Area private sector would need to decline by at least 5%. It is essential that the higher European capital requirements are a temporary measure as intended, not sustained over time and not seen as a new standard to be imposed more widely. [Emphasis in the original] These measures along with the proposed transactions tax could also result in an increase in financial market fragmentation, intensifying the pressures facing Europe.
A recent IIF study, reinforced by the latest economic and financial developments, provides compelling grounds for being less sanguine about the economic implications of reform. The study concludes that neither bank capital nor long term funding can be raised in the quantities implied by the totality of current requirements without significant cost implications. [Emphasis in the original] This highlights the risk that financial sector deleveraging will continue, with serious implications for the cost and availability of credit, and hence for economic activity and jobs. With unemployment in the Euro Area now at over 16 million—an increase of over half a million in the past six months and nearly 5 million from pre-crisis levels—this is a very pressing concern.
. . . it is essential for the official sector to begin viewing the banking system as an indispensible partner in fostering recovery, rather than an adversary on which it is necessary to impose ever more punitive measures with insufficient regard to coordination, cumulative effects, or interactions. [Emphasis in the original] Regulatory reform is needed and it will be accomplished. But unless it is accomplished in a way which permits banks to play their pivotal role in fostering recovery, the main benefits in terms of future stability combined with global prosperity will be lost.
BNP Paribas and Commerzbank are unloading sovereign bonds at a loss . . . BNP booked a loss of 812 million euros ($1 billion) in the past four months from reducing its holdings of European sovereign debt, while Commerzbank took losses as it cut its Greek, Irish, Italian, Portuguese and Spanish bonds by 22 percent to 13 billion euros this year.
European banks cut their foreign lending to the Greek public sector to $37 billion as of June 30 from $52 billion at the end of 2010, according to the most recent data from the Bank for International Settlements. European banks’ lending to the Irish, Portuguese and Spanish public sectors also fell.
Barclays said on Oct. 31 that it cut sovereign-debt holdings of Spain, Italy, Portugal, Ireland and Greece by 31 percent in three months. The Royal Bank of Scotland said on Nov. 4 that it reduced central- and local-government debt of those countries to 1.1 billion pounds ($1.8 billion) from 4.6 billion pounds at year-end.
Charles Dallara, the Institute of International Finance‘s Managing Director, said:
The market value of the debt of the countries most under scrutiny is likely to decline further as banks unload sovereign bonds. This is contrary to the goal of stabilizing and underpinning the outlook for sovereign debt in Europe.
A note from CreditSights said:
The recapitalization of European banks is also turning out to be a damp squib. This does nothing to fix the main problem of restoring sovereigns’ risk-free status.