Ladies and gentlemen,
As I was preparing these comments, I happened to re-read John Maynard Keynes’ open letter to President Franklin D. Roosevelt, published in the New York Times in December 1933. In it, Keynes tells President Roosevelt that the administration is engaged simultaneously in recovery and reform, and identifies a tension between the two. He worries especially about the risk that over-hasty reform impedes recovery.
There are some parallels here for Europe: we are also engaged in reform and recovery. But in fact we face the opposite concern to that expressed by Keynes. Without reform, there can be no recovery.
In saying this I am of course well aware of the argument that reform is better achieved in good times. I do not however find this argument particularly compelling.
First, all too often has reform been postponed in bad times on that basis, and then forgotten in good times.
Second, I am uncertain there will be very good times ahead if we do not reform now. This is because the problems we face in Europe are not just cyclical, but structural. Potential growth is too low to lift our economies out of high unemployment. It is also too low to allow us to overcome quickly the debt burden left over from this crisis and the period that preceded it. Thus, while stabilisation policies that raise output towards potential are necessary, they are not enough. We need to urgently raise that potential. And that means reform.
The third reason I am sceptical that reform should wait for better times is the results we have achieved already. Europe has in fact been in a reform process for several years, as many parts of our economy were broken during the crisis and needed to be repaired. We have taken many successful initiatives during what were, by any standards, bad times. And in several countries the first fruits of that endeavour are now becoming visible.
What I would like to do today is to sketch out for you how structural reform and other policy initiatives fit together to form a coherent strategy – what has been done so far to stabilise the euro area, and what still needs to be done to achieve a sustained recovery.
The recovery strategy began with repairing money, whose integrity had been challenged at the peak of the euro area crisis. The integrity of money means not only that money keeps its value over time – i.e. price stability. It also means that money is fungible across space – that is, between countries.
In this period, however, monetary and financial assets – government and corporate bonds, insurance products and the reserve assets backing them, and above all bank deposits – stopped being freely exchangeable across the whole euro area. In certain countries they became exchangeable almost exclusively within national borders. What was driving this process was the fear that assets held in the most fragile countries could be redenominated into currencies other than the euro.
As is well known, that fear was shown to be unfounded when the ECB launched its OMT programme, which successfully removed this threat to our monetary union. But this episode nonetheless caused significant damage to both the real and financial economy in the euro area. It exposed the fragility of a system where the creditworthiness of sovereigns was the ultimate guarantor of national banking systems. This is where the European banking union came in.
Banking union means three things: it means a single supervisory framework that applies the same rules across the euro area. It means a single resolution framework, so that if a bank does still fail, it can be resolved in the same way everywhere, irrespective of the fiscal strength of its government. And it means a system of deposit protection that provides depositors with equal confidence that their deposits are safe, regardless of jurisdiction.
We are now well advanced in creating such a system. The Single Supervisory Mechanism will begin operating in November. A Single Resolution Mechanism and Fund will begin in 2016. And a harmonised approach to the level and funding of deposit guarantee schemes across the euro area has been agreed, as a first step towards a single deposit guarantee scheme.
Repairing the financial sector and credit allocation
Different from the US, 80% of financial intermediation in Europe takes place through banks, making bank lending essential for SME financing, for the transmission of our monetary policy and for the allocation of resources in the wider economy. But the design of banking union alone – as ambitious as it is – will not be enough to repair the bank lending channel.
Bank lending is also being held back by a wider process: the ongoing deleveraging of the banking sector that is an unavoidable consequence of the previous credit bubble. Policy cannot influence much the scale of that deleveraging. But it can influence its form: namely that it happens in a way where banks quickly dispose of unwanted assets and raise equity, thus moving into a position to again supply credit normally.
In this context, it was crucial that, when the new European supervisor was agreed, it was also agreed to have an “entrance exam” before its introduction: a comprehensive assessment of banks’ state of health, carried out by the ECB. This was crucial not only because it will bolster confidence in the euro area banking sector, but also because of the positive response it has elicited from banks and supervisors.
Since the summer of 2013 the banks that will fall under our direct supervision have strengthened their balance sheets by almost €203bn. This includes €59.8 billion of gross equity issuance, €31.6 billion issuance of CoCos, €26 billion of retained earnings, €18.3 billion of asset sales, €17.6 billion of one-off items and additional provisioning, and about €50 billion of other measures.
But a cleaned up banking sector will also be a smaller banking sector. And while we are seeing a corresponding large rise in corporate bond issuance, it is funding mostly large corporates and not SMEs, which account for two-thirds of private sector employment. If we are therefore to avoid a situation where smaller firms face obstacles to accessing finance, our policies to repair the banking sector have to be accompanied by policies to develop capital markets.
That agenda is now being taken up in Europe. It was in part to support a more diversified financing mix that the ECB argued early on in favour of redeveloping markets for asset-backed securities (ABS), which provide a way for smaller, bank-dependent firms and households to access finance from non-bank investors. Together with the Bank of England, we have been and remain closely involved in the work to promote a better functioning securitisation market.
Looking further ahead, I am pleased that the incoming president of the European Commission has proposed to build a genuine capital markets union in Europe, which would do for capital markets what banking union will do for banks.
Repairing monetary policy
As it will take time to develop a European capital market, in the meantime we must operate in a financial system where – whether we like it or not – banks are dominant. As such, the deleveraging of the banking sector has naturally affected our policy: in several countries where banks have been lowering their loan-to-deposit ratios and rebuilding their capital, they have not been in a position to pass on our low interest rates to customers.
Our monetary policy has therefore operated on two fronts: on one side, engineering an appropriately expansionary stance in conditions of low inflation and substantial slack in the economy; and on the other, repairing the transmission process of monetary policy, so that this stance actually reaches firms and households.
On both fronts we have acted aggressively. We have progressively cut rates – going even into negative territory – so that they are now at the lower bound, and introduced forward guidance that rates will stay low for long. And we have facilitated the pass-through of these rates by banks by widening the pool of eligible collateral they can use for our operations, extending the maturity of our loans up to three years, and intervening in malfunctioning market segments.
Now, as the banking sector is progressively cleaned up and the deleveraging process reaches its conclusion, banks will have new balance sheet capacity to lend, and our monetary policy will become even more effective. I expect credit to pick up soon next year.
In this context, the ECB has recently launched a series of measures to make its stance more expansionary and add more stimulus to the euro area economy. Most important here is our new package of credit easing measures.
This package includes the Targeted Long-Term Refinancing Operations (TLTRO), which have a built-in incentive mechanism to encourage loans to firms. And it includes new programmes to purchase outright high-quality ABS and covered bonds, which will provide market incentives for banks to originate more saleable securities, and thus more loans to collateralise them.
These measures also fulfil a broader objective: they allow us to continue to steer policy while interest rates are at the lower bound.
They help us steer expectations about the future path of interest rates by underpinning our forward guidance. And, with our asset purchase programme – this is a pretty important point – we are transitioning from a monetary policy framework predominantly founded on passive provision of central bank credit to a more active and controlled management of our balance sheet. We expect our measures to have a sizeable impact on our balance sheet, and ultimately, through their impact on all channels of monetary transmission, on inflation.
Let me be clear: we are accountable to the European people for delivering price stability, which today means lifting inflation from its excessively low level. And we will do exactly that. The Governing Council has repeated many times, even as it was adopting new measures: it is unanimous in its commitment to take additional unconventional measures to address the risks of a too prolonged period of low inflation. This means that we are ready to alter the size and/or the composition of our unconventional interventions, and therefore of our balance sheet, as required.
Repairing fiscal policy
Alongside monetary policy, fiscal policy is needed as well. But for fiscal policy to be able to perform its stabilisation role, governments must have fiscal space, and the sustainability of public finances must be unquestioned. During the crisis, those two conditions were no longer met.
Reactivating fiscal policy has therefore had to be achieved in stages. First and foremost was repairing confidence in public finances – both through committed structural fiscal consolidation, and through strengthening the institutional framework for fiscal governance. Much has been achieved in this respect.
Governments have consolidated budgets. They have established medium-term credibility by strengthening the fiscal rules. And this has been one driver of their falling borrowing costs.
So to now call into question not just the letter, but also the spirit of the fiscal governance framework would be self-defeating. If this were to again cast doubt over fiscal sustainability, it would create a risk that borrowing costs, and hence fiscal policies, turn procyclical once more.
The whole point of the fiscal governance framework is indeed to generate confidence and certainty, not just in financial markets, but also among consumers, entrepreneurs, and of course between governments themselves. Any perception that the spirit of this governance framework is being breached effectively undermines the basic assumption behind our being together in a monetary union: that is to say we can coordinate our policies in a way that generates confidence for our citizens.
If confidence in public finances is assured, the next stage – and this is where we are now – is to exploit the available fiscal space, so that fiscal policy can work with rather than against monetary policy in supporting aggregate demand.  The aggregate fiscal stance must be supportive of aggregate demand in the current cyclical position, and this can and should be achieved within the existing rules.
Against this background, for governments and European institutions that have fiscal space, then of course it makes sense to use it.
Especially for those without fiscal space, fiscal policy can still support demand by altering the composition of the budget – in particular by simultaneously cutting distortionary taxes and unproductive expenditure.
And for all, there is the option to regenerate fiscal space, not just by tightening the budget, but by expanding their source of revenues. Higher potential output raises future government revenues and – if credible – can restore some margin for manoeuvre. This is where structural reforms enter the picture. And such reform would not only enable fiscal policy, but also make monetary policy more effective by allowing the private sector to take advantage of the conditions created by it.
Repairing the potential growth
What I am saying, in short, is that all our efforts to support aggregate demand will be more effective if accompanied by policies to boost aggregate supply. And this brings me back to where I started – to the need to raise potential growth.
Put simply, I cannot see any way out of the crisis unless we create more confidence in the future potential of our economies. Demand side policies can play a part in this by forestalling so-called “hysteresis” – a situation where workers are unemployed for too long and lose their skills. The quicker we can return the economy to potential, the less potential we will lose.
But such policies cannot alone provide the jolt to medium-term growth prospects that is necessary for a self-sustaining recovery – which is a recovery based on private sector investment.
For investment to grow sustainably over the medium-term, the right fundamental conditions need to be in place – namely, a rising workforce and rising productivity. For many European countries, there is scope to increase labour participation rates over time. But given demographic trends, raising structural growth will have to take place primarily through productivity.
Governments in the euro area know well what they need to do to achieve this objective.  They do not need our advice. They simply need to implement their specific national structural reforms. And the more vigorously they do this, the more credible an increase in growth potential will become, and the more quickly business and consumer confidence will return to the euro area.
The European level also has a role to play in creating an environment that supports productivity growth. For example, there are few European companies that are world leaders in the digital economy. Completing the single market in all its forms – digital, capital, services – would promote the financing of innovative firms and create a business environment that encourages investment in and adoption of new technologies.
I have today provided you with a description of the many ongoing reform and policy steps that, in combination, will lift the European economy out of what has already been too long a crisis.
The issue is not really whether policies to support demand should precede or follow policies to support supply. Reform and recovery are not to be weighed against each other. The whole range of policies I have described aims simultaneously at raising output towards its potential and at raising that potential.
This combination of policies is complex, but it is not complicated. Each of the steps involved is well understood. The issue now is not diagnosis, it is delivery. It is commitment. And it is timing.
I recently said of monetary policy that, at the current juncture, the risks of doing too little exceed the risks of doing too much. If we want a stronger and more inclusive recovery, the same applies to doing too little reform.
See speech by Mario Draghi, “Unemployment in the euro area”, annual central bank symposium in Jackson Hole, 22 August 2014.
For more on raising productivity and investment see speech Benoît Cœuré, “Credit and Investment in the European Recovery” , Portoroz, 26 September 2014.
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