Financial Times: We are at a dangerous point for the eurozone. People are now talking openly about the eurozone breaking up. Is that possible?
Jens Weidmann: For me, the eurozone as a whole is not at stake. What we face is a sovereign debt crisis that now shows contagion effects on other eurozone countries. The seriousness of that crisis is apparent, but it’s not a crisis of the euro. The point I’m making these days is that the current approach to tackling the crisis shows inconsistencies that have repercussions on the credibility of this approach. These inconsistencies relate to the fact that we are pooling risks more and more in a framework that relies on fiscal policies decided at the national level. We need a debate now about the future architecture of the monetary union – that is, whether one wants to move back to the Maastricht framework, which needs to be improved, or whether there is a willingness and political support to move towards a more integrated union where you delegate national sovereignty on fiscal issues to a European level.
FT: So what is the correct response to Greece?
JW: Greece has agreed on an adjustment path. We finally need to implement what has been decided. Market turmoil comes from the fact that this implementation has been questioned – and not because the plan is not credible.
FT: Was it a mistake to change the terms of the Greek private sector involvement [PSI] in October?
JW: The Bundesbank has pointed out from the start, that one of the dangers of these PSI negotiations is that PSI might appear an easy way out of self-inflicted problems. If this is the case, you achieve the opposite of what you wanted to achieve. You will have more contagion instead of containment of the crisis because it’s seen as a potential model for other countries. Once decided, reliability and trust in agreements is very important, especially in a crisis like this one – which is basically a confidence crisis. One of the effects of the renegotiation of the PSI is that the perception of sovereign risk in the market has further changed. There is now substantial private sector involvement that will apparently not trigger the credit insurance of the Greek exposure. So at least for some countries, the risk profile of their sovereign bond markets has deteriorated.
FT: But what about an involuntary writedown? If you have rules, there have to be consequences when the rules are not obeyed.
JW: All the financing that was given to Greece and was necessary to buy time for structural reform, relies on Greece sticking to the adjustment programme. If it doesn’t, the basis for this help would no longer be there – with all the consequences that entails.
FT: You talked about consequences if Greece doesn’t stick to the adjustment plan. Should that include an exit from the eurozone?
JW: That’s not a discussion that I want to join.
FT: If funding to Greece did stop, the ECB would have to decide how to deal with the Greek banking system. How should the ECB should act in that kind of case?
JW: I don’t want to speculate what would happen if somebody decided this way or another way. Regarding the role of the eurosystem [of eurozone central banks], I will just confirm to you that we will act according to our mandate and provide liquidity to solvent banks and ensure price stability – this is our task. It’s the task of governments to ensure that banks in Greece are solvent. We provide liquidity to solvent banks against adequate collateral.
FT: What’s the way out now for Italy? Yields have risen to unsustainable levels. Does Italy need a bail-out?
JW: You are rushing to conclusions in saying that the interest rate levels are unsustainable. Of course this level may not be sustainable in the long run if there is a lack of fiscal discipline and economic growth remains low. But in the short run I do not think it is such a big an issue. What we are facing in Italy is an acute confidence crisis, and only the Italian government can resolve that crisis by implementing what has been announced. Italy is very different from Greece in a lot of respects. I’m confident that Italy will be able to deliver.
FT: With its bond buying, is the ECB trying to help Rome, or put pressure on Rome?
JW: It’s not about helping Italy or penalising Italy. The ECB Governing Council has always stressed that the Securities Markets Programme is about ensuring the monetary policy transmission process., But it comes with risks. The risks are reflected in our balance sheet. There’s also a risk that you mute the incentives that come from the market. Recent experience has shown that market interest rates do play a role in pushing governments towards reforms. You have seen that in the case of Italy quite clearly.
FT: In principle, the ECB could buy up a lot more bonds and keep the yields where it wanted …
JW: We have a mandate and we have to stick to our mandate. Fixing an interest rate for a country is certainly not compatible with our mandate. You would guarantee a certain refinancing cost for a government and you could not argue that this was not monetary financing. The stated purpose of the SMP is to cope with dysfunctional markets and it’s not to ensure a specific spread for a specific country.
FT: Is the Italian bond market dysfunctional at the moment?
JW: What we see is a reaction to the political problems in Italy and the lack of implementation and I wouldn’t consider that as dysfunctional. You can argue whether there’s an overreaction or not, but the main reason is the political situation and the lack of implementation in Italy – and that we can’t fix.
FT: What, then, is the role of a central bank in a crisis like this?
JW: The role of the central bank is clearly defined. It is to ensure price stability and to support the competent authorities in ensuring financial stability. With this formulation, it is clear that the responsibility for financial stability lies with governments. The EFSF [the European financial stability facility] or the ESM [its successor, the European stability mechanism] are ways to buy time and, in that sense, are sensible instruments.
FT: But isn’t the problem with the eurozone that there is no stabilising anchor and only the European Central Bank can perform that function?
JW: There was such an anchor, the stability and growth pact. It was just that this pact was not respected, it was softened.
FT: Can you explain why the ECB cannot be lender of last resort?
JW: The eurosystem is a lender of last resort – for solvent but illiquid banks. It must not be a lender of last resort for sovereigns because this would violate Article 123 of the EU treaty [prohibiting monetary financing – or central bank funding of governments]. I cannot see how you can ensure the stability of a monetary union by violating its legal provisions. I think the prohibition of monetary financing is very important in ensuring the credibility and independence of the central bank, which allow us to deliver on our primary objective of price stability. This is a very fundamental issue. If we now overstep that mandate, we call into question our own independence.
FT: The impression is that the Bundesbank will stick by principles until the whole house burns down …
JW: Right now we’re talking about the EU treaty and I don’t see how you can build trust in a system that violates laws.
FT: Are you a pragmatist?
JW: I am president of an institution which is bound by a legal framework. We should respect the division of labour in a democracy. This has nothing to do with pragmatism or dogmatism.
FT: What if there is a conflict between Article 123 and the risk of a refinancing crisis for Italian debt?
JW: That assumes that you can address the issues in Italy with liquidity and that’s not the case. This whole debate completely blurs responsibilities. Furthermore, monetary financing will set the wrong incentives, neglect the root causes of the problem, violate the legal foundations on which we work, and destroy the credibility and trust in institutions. You won’t solve the crisis by reducing incentives for the Italian government to act. It’s really an absurd debate in which we are telling institutions: don’t care about the law.
FT: How should the EFSF be financed? Should European countries pool their special drawing rights at the IMF?
JW: EU governments have decided how to finance the EFSF. They agreed on guarantees for the EFSF and, in their last meeting, on two options on how to leverage the EFSF – by an insurance model or a special purpose vehicle. Instead of working on implementing these approaches, we now have the next idea that is completely out of the realm of what has been discussed previously. I don’t think it builds confidence in crisis resolution capabilities if from week to week, from one meeting to the next, you are questioning your last decision. SDRs are a part of our foreign exchange reserves. Using foreign reserves as capital of an SPV whose only purpose of is to fund governments is just a thinly-veiled form of monetary financing. For exactly that reason, the IMF itself is not allowed to do this operation.
FT: Some in Washington have suggested the ECB could lend, directly or indirectly, to the IMF, which could then help Italy. Would you rule that out as a possibility?
JW: Again, the crucial point is that the eurosystem is not permitted to lend to eurozone member states – no matter whether this is done directly or indirectly by using the IMF as an intermediary. In contrast, if you talk about regular IMF instruments the existing financing structure is preserved. The Bundesbank has always lived up to it’s responsibilities in adequately funding the IMF.
FT: How big do you think the EFSF’s lending capacity has to be to be effective?
JW: I think the EFSF has the resources to deal with the problems in the eurozone. I don’t want to say that leverage is not useful, but you just have to be aware that this is not a magic wand. Markets will look through financial engineering and it is clear that all the leverage will in the end increase the expected loss on the guarantees. What matters is whether there is political will in the countries standing behind the EFSF to honour the guarantees.
FT: Do you think the insurance model of leverage is credible to the markets?
JW: My main concern is the credibility of the construction and the assessment of whether the guarantees are honoured. I think the insurance model has been put into question by the recent decisions on the PSI.
FT: You referred to two paths for the future of the eurozone: the return to Maastricht, or the move to fiscal union. Do you have a preference between the two?
JW: This is a genuinely political decision. The duty of the central bank is to illustrate ways that would ensure a stability-orientated basis of the monetary union. It’s up to policymakers then to make a choice between these models.
FT: Does your idea of fiscal union involve eurobonds?
JW: It does not necessarily involve eurobonds. If there was a political decision in favour of fiscal union, you could of course issue eurobonds at the end of the integration process. But this is not something I’m asking for. In both models, you would penalise rule violations. In the Maastricht model, the rules would be the stability and growth pact, with automatic sanctions for violations and the no bail-out clause. In the fiscal union model you also need strict rules for deficit and debt. If you breached those rules you would need to delegate your national sovereignty on fiscal policy to a supranational level. I think the true question at the heart of this is: are governments, parliaments, and people ready to accept a supranational level, a European level that assumes the ultimate responsibility for fiscal policy, at least in case of a breach of the rules? In my view, the declaration from leaders at the last EU summit was not clear enough. They talked about minor treaty changes. But this is not a minor change – this is a major change with follow-up changes in national constitutions. Without clear answers, you might not have the basis for a stability-orientated monetary union.
FT: And do you need an orderly sovereign default mechanism in either model?
JW: In the “Maastricht-plus” model, if you wanted to enforce the no bail-out clause, then of course an orderly restructuring mechanism is an important element.
FT: When you talk about a stability-orientated monetary union, is it the same as saying that other countries have to be more like Germany?
JW: No, it’s not about being more German or not being German. Fiscal solidity is not only a German issue, and the crisis has clearly revealed its importance as the basis of financial stability and political stability.
FT: With its large export surpluses, some see Germany as part of the problem for other eurozone countries …
JW: What you have to see is that we have already had our reform process. Remember what Germany has done in reforming its labour market. What we are seeing are partly the fruits of those reforms. We all have to become more competitive. Of course we have to recognise that imbalances are an issue. At the same time, I think this debate sometimes lacks analysis in that a surplus or deficit is, per se, not something that is always good or always bad. If you have an ageing population then a trade surplus makes sense to provision for that by accumulating capital outside your own country.
FT: Why shouldn’t Germany, which has total credibility in financial markets, loosen its fiscal stance?
JW: Germany has that credibility because it followed a specific fiscal path in the past, and it should not lose that track record and credibility by abandoning that path. It’s very important that Germany remains the stability anchor within the monetary union.
Besides, I think that the effects on the euro area of a shortlived fiscal impulse from Germany are largely overestimated.
FT: Will we see a recession in Germany?
JW: Because of reforms in the past, Germany is in a better position if you look at the growth figures. The labour market is also in a more robust position than in many other euro area countries and this is again the effect of those past reforms. The third quarter of German growth is still quite robust, but we will experience a moderation of growth in the fourth quarter of this year and the first quarter of next year. However, downside risks have clearly increased.
FT: Given the forecast for a sharp fall in inflation next year, do you see scope for further ECB interest rate cuts? Your predecessor saw 1 per cent as a floor for the main ECB interest rate. Do you see that also as a floor?
JW: I won’t speculate about the future actions by the eurosystem and limits to future action. We decreased rates because of expectations that growth forecasts would be revised downwards and inflationary pressure will recede. So currently the policy stance is appropriate.
FT: If the economy turns a lot worse and deflationary risks seem much bigger than inflationary risks, are people not going to worry that there is nothing left in the ECB toolbox?
JW: Our baseline scenario is not the one you described, but rather a deceleration in growth rates and I think our toolbox will be appropriate to cope with this. To come back to the starting point of our debate: the risk scenarios you’re talking about have a lot to do with the current sovereign debt crisis. In my view this underlines the importance of governments acting decisively.