Unedited Event Transcript

Restoring Sustainable Growth and Job Creation in Europe

Peterson Institute for International Economics, Washington, DC December 18, 2014

Keynote Address Fabrizio Saccomanni, Director General Emeritus of the Bank of , former Minister of Economy and Finance of Italy

Chair: C. Fred Bergsten, Peterson Institute for International Economics

Fred Bergsten: Could I ask everyone to resume his or her seats and we will resume the program?

It’s a particular pleasure to introduce as our luncheon speaker, an old friend and very high former official, Fabrizio Saccomanni. Fabrizio, as I’m sure all of you know, was until earlier this year, Minister of Economy and Finance in Italy. He’d been in that position for about a year in what was obviously a very crucial time for Italy’s response to the crisis and an effort to put the economy back on a stronger footing for the future. And he’ll talk to us I’m sure in part about that.

For many years, Fabrizio was a leading light at the Banca d’Italia. He began there back in 1967, was Managing Director for International Affairs from 1997 and most recently served as Senior Deputy Governor of the bank just prior to his move to the Ministry of Finance. Fabrizio spent five years here in Washington on detail to the IMF, so he has that in his background as well. He spent three years at the European Bank for Reconstruction and Development in London as well. And so, has a very rich background across the whole range of international economic and financial institutions as well as in Italy.

Since he left government earlier this year, he has a very rich and diversified portfolio. He teaches at the London School of Economics, he teaches in , he’s become Vice President of the Italian equivalent of the Council on Foreign Relations and is actively engaged with us here at the Institute as a member of our Advisory Committee and a good friend, a close confidant and colleague for many years. And I think there’s nobody better to talk to this group today about where Europe is going, some ideas for how to strengthen the outlook that we’ve been talking about this morning than Fabrizio Saccomanni.

Welcome back to the Institute.

1

Fabrizio Saccomanni: Well, thank you, Fred, for your very kind words. It feels so very good to be back to the Peterson Institute and I’m glad to see a lot of old friends who have joined us for it to hear my little talk. I think the topic has been indicated that I should discuss about the outlook for the European economies, for the European Union, the Eurozone and also take into account to the role of the Italian presidency in the second half of this year and more generally, the Italian economic situation.

Now, I think a lot of the issues that I will be addressing have already being discussed in the panel this morning where a lot of interesting ideas have been mentioned. So, I will try to address in many ways the same questions, bringing in the experience I’ve made as Minister of Finance and Deputy Governor of the in the crucial period of the European crisis.

So, let me first briefly mention what is the—in terms of the economic outlook or what are the possible scenarios for the European economy. I mean, the first scenario is the rosy one. I mean, if you talk to some of my colleagues in what is called the Core Europe, they continue to be rather confident that, “Oh, if we continue to apply the medicine that the doctors have indicated to us…” I mean, for Europe of supply side plus the structural reform or plus fiscal consolidation, then a moderate recovery is probably going to take place and inflation will gradually move back to 2%, consumption and investment will pick up based on low interest rates, the easy monetary policy of the , the decline of oil prices. So, they expect a return of confidence that would support this kind of rosy scenario.

In my feeling, the probability of this scenario taking place is very low. I mean, I would call it the impossible dream in many ways because there are so many, so many difficulties in implementation.

Now, the second type of scenario, which I would call a muddle-through scenario is probably the one who has the higher probability, which assumes – as some of the panelists have indicated this morning – a continuation of the situation of very low growth or near stagnation with low inflation, but no technical deflation in the technical sense of the word. I mean, very low inflation for a long period.

And now, the impact of this situation on the policy framework of the European Union is probably going to be sort of affected by this situation in the sense that one can assume that the process of fiscal consolidation will probably slow down in a number of countries. There is the probability of the activation of the excessive deficit procedure by the European Union in connection with some countries.

2

The pace of our structural reform is probably going to be delayed. There will be pressure for the European Central Bank to accommodate these developments with a more supportive policy, monetary policy, possibly with some degree of quantitative easing. And, as it has been indicated, the interest rates are going to remain very, very close to zero for a long period. But there is going to be some probably tensions appearing on the spreads of particularly for some peripheral countries.

The euro is probably going to continue to remain weak. I think I agree with what Fred said earlier on. I think one, just looking at the sort of the outlook for interest rates between within the United States and Europe in the period ahead, one would see a period of a possibly continued weakness of the euro.

But nevertheless, the unemployment in this scenario is going to remain high, particularly among young people. So, I think the key issue here is that we are going to have serious political risks in Europe, certainly social tensions and growing support for political parties that are against the euro, against austerity, against the European Union more generally. So, this is a very, very disturbing scenario, which however, would not necessarily precipitate the European Union in a full-fledged crisis.

Then the third scenario instead is a crisis scenario or a crisis of a new existential crisis of the euro. Namely, a crisis that could indeed bring again the question whether the euro as it is can continue to survive. And, the features of this crisis obviously would be that there would be severe spreading out of deflation throughout Europe, which will make fiscal consolidation and debt reduction very, very difficult to achieve and so there will be higher real interest rates, there will be a sharp widening of the spreads. So, there would be the risk that at the time when the economy is in depression, you’ll have an additional contraction impact from higher interest rates that will affect consumption and investment in a very negative way.

And then I think that would probably bring back what was called the redenomination risk of the euro. Namely, the risk that people would be asked to accept repayment of their claims on the euro with a different currency. And so, again, the policy scenario under this type of situation would be to put all the burden on the European Central Bank. There will be obviously a lot of pressure for the ECB to adapt a policy of quantitative easing. There would be also a strong possibility in this type of generalized situational crisis for the activation of the outright monetary transactions, which has been sort of announced in 2012, but not activated because it is a conditional instrument that requires some sort of a memorandum of

3 understanding that every country would have to sort of agree with the European Central Bank and possibly with the troika.

But, in a situation of generalized crisis, I assume that the drafting of this memorandum of understanding would not be very difficult. I mean, everybody knows what should be included in these type of documents and under the pressure, the drafting could be facilitated. But then again, in a situation like this, the pressure for the breakup of the euro or to exit from the Eurozone or sort of re-suspending key elements of the European construction would be very, very strong. And also, there might be a very strong financial repercussions throughout the world economy given the size of the European Union.

Now, this third scenario is probably, I mean, has a low probability, but low but not negligible. And I think it would be wrong to ignore the risk that this situation may appear. Now, how is the European Union shaping up its policy response to deal with these type of scenarios? Because of the three scenarios I have outlined only one is rosy, but with almost zero probability. The other two are rather serious.

So, I think the first conclusion that one, I mean, has to remember, is that the first existential crisis that Europe was confronted with found the European Union institutions not prepared. As it has been mentioned, we didn’t have the instruments to deal with the sovereign banking crisis that took place after Lehman Brothers. And then, we were forced by the crisis to develop, I would say under duress, the kind of institutions and the instruments that were needed to cope with the crisis. Although this would probably apply more to the next crisis rather than to the one that was affecting us at that time. So, we have created a number of institutions, but I think in the end, as we all know, it was whatever it takes formula invented by that eventually made possible to resolve the most acute phase of the crisis.

Now, also the present crisis, the risk of deflation of protracted slow growth, I think requires new measures, new instruments, new institutions and I think it is now rather clear what the European Union would need. It would need a more balanced macroeconomic policy framework that would allow Europe to perform, at the same time, countercyclical policies using the monetary policy instrument, the fiscal policy instruments and structural reform.

Now, this has been explicitly said by Mario Draghi in his speech and injects on all and subsequently, but I think the new President of the European Commission has formerly, in his inaugural speech, he has formally endorsed this new policy framework. And, the idea that you have

4 to act simultaneously with these values, policy instruments, seems to be again broader consensus.

So, I will not talk about monetary policy because I think there has been already some discussion and I think, in my view, I tend to believe that if the situation were to deteriorate to the point that I mention, I’m sure that the European Central Bank will introduce quantitative easing and will adopt appropriate policy. I think the key issue to me where I would like to devote some attention, is the question of whether European Union can use the fiscal policy instrument or can ever sort of a demand side policy as it has been advocated, I mean, certainly by academic economists from a long time, but recently also, as I said, by prominent officials like Draghi and Juncker.

Now, I think this is a complicated issue and it has at least two dimensions. There is the question of whether there is a way through a process of coordination to have a more procyclical fiscal policy approach by national country, by national fiscal policy actors and whether there is the possibility of using the European institutions for this kind of function.

Now, in doing this, I remember that we discussed with Tommaso Padoa- Schioppa, whom I’m sure you all remember, what to do in a situation like this already in 2010. And, he was fond of using a very clear formula, which said, “We have to have austerity at the national level, but we have to have recovery at the EU level.” So, there is this sort of division of labor countries so that they have particularly problems on the public finances. They have to follow strictly, but it is the European Union that has to also to take over at all in this field.

Now, let’s look first at national fiscal policy. Can they provide a significant stimulus that would affect the outlook for Europe at the national level? I think the rules that we have in place in Europe for fiscal policy coordination were designed for a very different purpose, were designed to protect the integrity of monetary policy from the risk of sort of unsound fiscal policies. So, to protect actually the rules of the treaty, which are sort of no financing of public deficits, no bailout and a procedure against excessive deficit. So, these policies are very difficult with this kind of sort of starting point to have some sort of countercyclical role to be played within this procedural framework.

The only instrument that is open from this point of view is the so-called Macroeconomic Imbalance Procedure, the MIP. Now, this Macroeconomic Imbalance Procedure in principle was agreed as a sort of countervailing factor vis-à-vis, the excessive deficit procedure, which is already a strong teeth and strong sanction. As it turned out, this procedure is very weak. It does not use targets. It uses only certain indicators. It has

5 also a certain element of overlapping because among the indicators, it includes also the fiscal imbalances to show a country that has sort of a fiscal imbalance. Like Italy is subject to the Macroeconomic Imbalance Procedure while Germany, for example, has a surplus current account, which has been for three years above the level of 6% of GDP is not subject to any particular sanctions.

So here, there is a one instrument that possibly with some reform and I will mention an idea in a moment.

Then, the other arm that could be used, as I said, is the EU institutions. Now, the EU institutions basically, there is the European budget, this is one possibility. Then, there is this new fund presented by President Juncker that is again designed to provide an important amount of new investment for infrastructures. And then there are sort of the activity that the European Union has done over the years to promote investment by the private sector that would sort of facilitate the creation of the European capital market.

Now, on each of these three items, I would like to make a few comments. Now, the EU budget obviously needs to be reformed. At present, it’s only mostly a sort of a redistributive instrument. It takes funds from the states and then it redistributes them in different countries, there is a lot of emphasis for each country to get back as much money as they put in, the net benefit and then so forth. This is, I think, a very strong limitation, which President Juncker has already recognized in his program.

And in fact, he advocates a midterm review, which will take place in 2016 to reform the budget and particularly, there is the issue of endowing the EU budget of own resources, having some sort of financial resources derived from European taxes, if you want. The name is not very appealing, but I think it would certainly avoid this sort of very strange things that the contribution to the EU budget go through the national budget and that, I think, creates the kind of problem that I mentioned earlier in which for political reasons, each country would want to show that they are getting their money back. It’s not only the United Kingdom, but basically, all countries have the same political pressure.

And also, one distortion that comes from this approach is that the last—the next—I mean, the budget that we have now has been reduced because the idea is that all countries are now tightening their belts and reducing their expenditures, so we have to reduce also the European budget. And it is strange that in this way, you miss the opportunity to have some sort of any countercyclical role to be played by the budget.

6 So, I think here, there is a need to look at this issue in depth and I think Mario Monti has been asked once again to prepare a report on how to improve the functioning of the budget and in particular to look at how to create its own resources. So, I think in my view, it would be if we manage to have access to this idea of giving to the budget to some own resources, those resources should have been devoted to some sort of countercyclical function. There should be some sort of a buffer stock that could be used in the situation of crisis, for example, to create risk sharing facilities for private investment, perhaps to give more contribution to the fund, the Juncker fund that I’m going to mention in a moment.

So, there are various possibilities if the budget indeed is endowed with some degree of discretionality in the use of its own resources.

Now, the fund, the Juncker fund, the famous 315 billion plan, I think the Presidents that had been experienced before the setting up of this fund, I must are not very encouraging. I think, when I was Minister in 2013, we pushed the European Union to create some sort of a common fund using resources of the European Investment Bank and some structural funds of the EU budget to lend to SMEs because there was the moment in which there was a very, very severe lack of credit to the SMEs. This project where lots of studies and papers, eventually was not approved.

And, the reason was that the member countries, some member countries objected to the fact that the EIB should do this kind of activity because they might put their Triple A rating at risk. And also again, for the problem I mentioned earlier, countries objected to the fact that funds that had been given to them under the EU budget should be reallocated to a different purpose for other reasons. So I think the model that Juncker is now advocating is not very different from that. He’s setting aside €16 billion from the funds already in the European budget and €5 billion from the European Investment Bank. So, I hope that we don’t have the same kind of problems that we already had in the past because obviously this is going to have a very negative impact on the credibility of this project.

But one way of resolving this problem, on the first possibility, would be to increase the capital of the European Investment Bank, which has already been increased by €10 billion in 2012, but eventually, this would be a situation that cannot be avoided if one wants to see the EIB to expand strongly its investment activity.

The second possibility would be – and here, I think that could be one consequence of the reform of the Macroeconomic Imbalance Procedure – would be to ask, introduce some sort of a sanction in the procedure whereby countries that have for a very long period of time balance of payment surplus and that is not being corrected should be asked to invest

7 part of their—obviously, they have a big capital outflow as a result of the current account surplus. And part of this outflow capital should be diverted to support the activity of this European structural and investment fund of the European Union.

It would be, I think, still a difficult political process to introduce such type of sanction, but I think it would be easier to have something like that than to force a country to reflate generally its economy, which I’m sure all the political establishment in Germany, for example, will not accept.

And then, there is the third item, which is the activity of the European Union in the promotion of private investment. And, I think a lot of work and studies have been done in this. I think again Mario Monti started in 2010 proposing to invest in the so-called infrastructures of the single market. And, I think from that report in 2010, there’d been sort of a number of studies, there was an important green paper by the European Union on long-term investment and there were reports by private experts. The Giovannini-Moran report of 2013 described a lot of solution that could facilitate the creation of a genuine European market.

And also, I think the Italian presidency worked very hard to have approved the so-called European Long-Term Investment Fund Directive, but when you read all these documents, you have the impression that we are talking about a still work in progress. And I think Juncker again has clearly indicated that we need to have as an objective, the creation of a capital market union. And so, this is still, as I said, work in progress.

And then, in this area, what one probably would need to do is to have a clear European strategy in terms of what do we really want in terms of investment in infrastructures because there is a lot of talk about connecting the European grids in energy, telecommunication, in gas, electricity and so forth. But, we need probably to use the competition policy to bring around the table all the utilities that in single countries still are operate under the sort of conditions of monopolies and force them to identify what are exactly the interconnections that can be achieved.

And I’m sure that if there what probably investors should normally want in this field of some sort of regulatory security. Now, the identification of a regulatory regime that is going to be applied to these crucial areas in the medium run, it will be possible to bring in this kind of private investment in support of the efforts of the European Union. Otherwise, it will be as it is now. There is also money sitting around and then not much investment is being done.

So, these are the way I see the situation now. Frankly, if I can sum up, there is not the kind of strong break with the past, breakup in the tradition

8 and we’re not really turning the page on policy mistakes of the past. I think there is a sort of, I would say, an incremental approach in trying to, again, create a stronger, stronger governance in the European Union. I think Italy—I would like to stop now, but just a few words.

I think Italy has been promoting this kind of stronger integration at the European level for many years. And it has been said already, I think there has been a lot of continuity in the action that the governments of Mario Monti, of and now, are putting forward and significant reforms have been inter-used. I think we need to continue. There is a lot of work to be done.

But I think if I can credit Italy certainly with some result during this turn of its presidency, has been the emphasis on investment and reviving investment. I think this was one point that was put forward also in connection with the decision about the selection of the new president of the European Commission. And I think the fact that now, the question of reviving investment, reviving the support to the economy to reduce unemployment and to strengthen our infrastructural network is clearly on the table.

So, it’s not going to be an easy task, but I think the experience of the past is that perhaps Europe reacts not immediately and not with the necessary speed, but indeed, it can continue to sort of push forward with the sort of ambitious European construction that was originally in research. Thank you.

Fred Bergsten: Thank you, Fabrizio.

Fabrizio Saccomanni: Thank you, Fred.

Fred Bergsten: Fabrizio, thank you very much. We’ve got a few minutes for questions. We’ve got here an unusual opportunity with somebody who is in the eye of the storm at the middle of his government dealing with this until very recently. So, please let me invite questions from the floor. Krishna, anybody else, go ahead.

Male Speaker: Thank you. So, I very much enjoyed your comments. You talked in some detail very thoughtfully about possible reforms to the fiscal arrangements. I wanted just to ask your quick thoughts as to what scope you see for a stronger collective governance of structural reform policies within the Eurozone.

Fabrizio Saccomanni: Well, I’m glad you asked this question because I think there was an opportunity that was somehow missed. Because at some point, there was the idea in 2013 to discuss some form of contractual arrangements in

9 which countries would agree on a very sort of a punctual and precise agenda for reforms in return for something. Now, the discussions eventually did not go very much forward because, first of all, there was disagreement on what would be the quid pro quo for reform that some people said that like virtual reform have their own reward. I mean, you don’t need to be given anything else and be happy with it.

And so, at some point, I remember I discussed this with President Van Rompuy and he said, “This is a good idea. We have to find perhaps a different wording.” But a contractual obligation or contractual arrangements do not have a very positive connotation, but he’s only said, “No, no, I mean, there is no consensus or neither on the side of those who push for reforms and neither on those who have to do the reforms.”

So, they see a lot of risk in this and so this will be a job for the new commission, but we were at the end of 2013. And so, I’m afraid that again, the political calendar in Europe is a problem from this point of view because we now have lost completely 2014 from this point of view because of, first, there was the German elections, now, and then the European elections, now, the new commission and so forth. So, it’s difficult for Europe to work with this kind of political calendar.

Fred Bergsten: Fabrizio, I very much like your idea of sanctions on the surplus countries. But as you said, that’s not likely to be accepted on the Rhine. But how about using a little different language? Because your proposal was actually rather modest to suggest that the surplus countries, beyond some level, should channel some of the capital outflow attended to those surpluses into the European support funds.

Fabrizio Saccomanni: Yes.

Fred Bergsten: So, instead of calling it a sanction, why not embed into the rules of the game some kind of norm or guideline or expectation that surplus countries beyond the certain level would partially finance those surpluses in exactly the way you indicate. And not think of it as a sanction but as a natural component of the external financial mirror of the current account surpluses. If one tried to do it something along those lines, what do you think? It’s a very good idea. I’d like to see if there was some way to get it moving ahead.

Fabrizio Saccomanni: Yeah. Well, no, I think I used the word ‘sanctions’ so in order to make the point because all this sort of European procedures are normally assisted by sanctions. And, the Macroeconomic Imbalance Procedure, in fact, has no sanctions except some sort of a variable admonition coming from the council and so forth. But, I would certainly think that if we were to move into the implementation stage of a proposal like this, the warning that you

10 suggest would be certainly much easier to be discussed and accepted eventually.

Although, I am convinced that the situation is difficult also because, I mean, our German friends argue that a lot of their surpluses vis-à-vis countries that do not belong to the European Union and that. And so, I mean, it’s going to be a complicated issue. But, I think I wanted to signal here the need to also from—I mean, we are talking about the signals in many ways and to give a signal so that these kind of procedures are more balanced.

Fred Bergsten: Right.

Fabrizio Saccomanni: And, because for example, the Multilateral Imbalance Procedure says that deficit country above 4% of GDP is subject to sanction, but above 6%, so there is already a bias in favor of the surplus country already in the way that the procedure is structured.

Fred Bergsten: Time for one more question. John Lipsky.

John Lipsky: Thanks. And thanks for those remarks, Fabrizio. Despite hopes for a Capital Markets’ Union, the European Union economy will remain bank dominated for the near term. And there’s I think a general perception or consensus that in the wake of the crisis, the deleveraging of Eurozone banks and actions that otherwise tended to segment national markets within the Eurozone has been one of the factors holding back your Eurozone growth.

Obviously, we just constituted the single supervisory mechanism, completed the AQR and the stress test didn’t seem to have much impact on market perceptions of the relative credit worthiness of banks. There’s still the implementation to go of this CRD for and the inconsistencies in reform proposals between the Eurozone and the UK banking reforms. How quickly do you think the banking system can return to a positive credit growth and a supportive role for your Eurozone growth?

Fabrizio Saccomanni: Yeah. Well, I think I agree with you that the initial phase of the process of banking union with the asset quality review, the comprehensive assessment, the stress test was certainly an important factor in sort of forcing the banks perhaps to the leverage further or to be extremely careful in increasing lending, particularly to risky or riskier customers.

So, from that point of view, I think talking to the Italian banks, I see that they consider this was now a major obstacle regarding that that could be considered past or overcome. But, as you said, and again, I agree, there are a lot of other things that are still pending. And in a way, I’m sorry that the

11 perception of the markets continues to believe that this process was not strong enough. I think I may be biased. From the Italian point of view, he was certain and very strong as far as Italy was concerned, in the sense that basically the stress test assumed a complete repeat of the sovereign debt crisis of 2011. I mean, with the spreads back to 500 and something and all that, plus a pro-execution of very severe recession.

Now, these stress test conditions were in a way tailored on a country by country basis. And so, in the case of Italy, it was assumed that to be severe at that, the test should, as I said, envision these kind of catastrophic developments, while for countries had the stronger economic or public finance position, the stress conditions were considered milder.

But, at the end of the day, I think what needs to be done is to complete the process of banking union, because frankly, everybody knows that there are three pillars in a banking union: banking supervision, banking resolution and a scheme for guaranteeing their deposits. Now, we have the first pillar is in full place. The second pillar is half of it, in the sense that we don’t have a full resolution mechanism when certainly we don’t have the European type of backstop that was in a way necessary.

And also, there was a long discussions, which kept us on the table during the night when I was at the [inaudible 00:47:00] and basically, the possibility of using the European stability mechanism to sort of backup the resolution mechanism was refused because it was considered by some of our colleagues as sort of the way to reopen a crack in the wall for a transfer union, which is the sort of uppermost concern in the core countries.

But, the question of having a system in which you have centralized the banking supervision, which may in certain cases lead to the decision that certain bank has to be resolved. And then the resolution with mostly financed by national resources is something that – let’s hope we don’t have that kind of a program – but if it happens, I’m sure there will be a lot of discussions whether the banking supervision authorities took the right decision, did they know exactly what they were talking about and so forth. If there was some sort of a European backstop, I think that would be much more credible.

And third, on the deposit guarantee scheme, as we say in Italy, we are still my dear friend, so at the beginning of the letter, because we still don’t have a commitment to go beyond some sort of greater harmonization and coordination of existing national scheme. So, I think that that would be an important element.

12 But I think one point, John, that you perhaps implied is that I think we should do more to create indeed additional sources of funding other than banking and developing new instruments, otherwise, it will be difficult to promote investment activity in any significant sense.

Fred Bergsten: There were several other people who wanted to ask questions including my own RA, Michael Jarrett. I apologize to all of you because we do have to turn now to our next panel on structural reform.

But before doing so, I want to say deep appreciation to Fabrizio. We want to thank you for not just today, but for all you’ve done for your country, for Europe, for the world over so many years. We look forward to working very closely with you going forward and thank you especially for being with us today.

Fabrizio Saccomanni: Thank you.

Fred Bergsten: Fabrizio.

Fabrizio Saccomanni: Thank you.

13