THE FUTURE OF THE EUROPEAN

September 2015 CONTRIBUTORS CONTENTS

Bassanini, Franco Chairman, Cassa Depositi e Prestiti de Larosière, Jacques Managing Director International QUESTION ONE – How has the policy environment evolved 8 (2008–15) Monetary Fund (1978–87); Governor, Banque de Belka, Marek Prime Minister, (2004–05); (1987–93) The has had to steer a complicated mid-course betweeen taking an President, National (2010–) Linde, Luis M. Governor, Banco de España (2012–) active line to generate liquidity and occupying a too high-profile position in shoring up the , Benink, Harald Professor, Tilburg University (2008–); Marcus, Gill Chair, Africa (2007–09); which could lower reform pressure on governments. Member, OMFIF Advisory Board (2012–) Governor, South African Reserve Bank (2009–14) Bini Smaghi, Lorenzo Member, Executive Board, Marsh, David Managing Director, OMFIF (2010–) European Central Bank (2005–11); Chairman Société Mersch, Yves Governor, Banque centrale du QUESTION TWO – How have euro policy-makers reacted to the crisis? 12 Générale (2015–) (1998–2012); Member, Executive Board, Brinkhorst, Laurens Jan Minister of Economic Affairs, European Central Bank (2012–) The single currency was launched in 1998−99 with perceived shortcomings. The lack of a Netherlands (2003–06); Professor, University of Leiden; Noyer, Christian Deputy President,. European Central political union to complement monetary union, and the absence of a fiscal counterparty to the Member, OMFIF Advisory Board (2011–) Bank (1998–2002); Governor, Banque de France unified central bank, was regarded by leading figures as a handicap to be overcome. Burda, Michael Professor, Humboldt University, Berlin (2003–) (1993–); Member, OMFIF Advisory Board (2012–) Nugée, John Chief Manager Reserves, QUESTION THREE – Why has the ECB expanded supervision? 16 Delors, Jacques President (1996); Senior Managing Director, State Street Global (1985–94); Finance Minister, France (1981–84) Advisors (2000-13); Director, OMFIF (2014-) Extending the ECB’s remit into banking supervision has been a logical extension of its core areas Desai, Meghnad Professor, London School of Plender, John Chairman, OMFIF (2014-) of responsibility. But it was held up for years by wrangling and opposition from , on the Economics; Chairman, OMFIF Advisory Board (2010–) Praet, Peter Executive Director grounds that it would present the ECB with a potential conflict. Fleming, Stewart Senior Member, St Antony's College, (2000–11); Member, Executive Board, European Central Oxford; Member, OMFIF Advisory Board (2010–) Bank (2011–) González-Páramo, José Member, Executive Board, Reviglio, Edoardo Chief Economist, Cassa Depositi e QUESTION FOUR – What is the role of quantitative easing? 20 European Central Bank (2004–12); Executive Director, Prestiti BBVA (2013–); Member, OMFIF Advisory Board (2015–) Schäuble, Wolfgang Federal Minister of Finance, Much later than the other large central banks – a delay reflecting the fragmented state of the Green, David Head of International Policy Co- Germany (2009–) euro area, and the ECB's consequent lack of a smooth unitary decision-making process on such ordination, Office of the Chairman, Financial Services Scheidig, Frank Global Head, Senior Executive questions – the ECB started quantitative easing only in March 2015. Authority (1998–2004); Adviser to the UK Financial Banking, DZ Bank (2013–); Deputy Chairman, OMFIF Reporting Council Advisory Board (2010–) QUESTION FIVE – How can EMU be restructured? 24 Honohan, Patrick Governor, Central Schröder, Gerhard German Chancellor (1998–2005) (2009–) Thygesen, Niels Professor, University of Legitimate argument surrounds how much restructuring is required. One central aspect is to put Issing, Otmar Member, Directorate, Deutsche (1971–); Member, Delors Committee (1988–89); back the 'economic' in economic and monetary union. Bundesbank (1990–98); Member, Executive Board, Member, OMFIF Advisory Board (2010–) European Central Bank (1998–2006) Weidmann, Jens Head of Economics Department, Kornblum, John US Ambassador to Germany (1997– German Chancellor's Office (2006–11); President, QUESTION SIX – How do policy-makers see the future? 28 2001); Member, OMFIF Advisory Board (2010–) (2011–) If monetary union is to prosper and survive, a stronger political framework, indeed the vaunted 'political union', is required to complete the monetary architecture. Yet euro members hold diverse, sometimes contradictory, positions. Reconciling these is the task for coming years. Articles and commentaries from the above named persons, appearing in The Bulletin since 2010, are displayed in extract form in this report.

2 THE FUTURE OF THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org 3 In the vanguard

Meghnad Desai, Chairman, OMFIF Advisory Board

The financial and economic crisis has hit Europe hard, in particular, the states making up economic and monetary union. The turbulence has laid bare the fragility of the financial sector and exposed fundamental differences in the way financial markets perceive the members of the single currency bloc. We have witnessed, too, the difficulties confronting a monetary union without a fiscal and political union in countering asymmetric shocks.

While the movement for fuller political integration has stalled, the European Central Bank, deploying innovative policies, has moved to the vanguard of the rescue operation. Over the past six years, the ECB – while not departing from its overriding mandate to control inflation – has taken extensive measures to improve the workings of financial markets and create conditions to arrest economic decline. These measures underpin more fundamental political efforts to shore up EMU’s foundations.

This report on the evolution and future of the ECB investigates how the crisis has reshaped the EMU and its central bank. Through the lens of six years of articles and commentaries in the Monthly Bulletin, OMFIF has been keenly following developments as they happened. Authoritative writers from a wide variety of public and private sector backgrounds have contributed informed comments not only on contemporary developments but also on the challenges and opportunities for the ECB over the coming decade.

This OMFIF document, has been produced for the roundtable discussion in London on ‘The future of the ECB’ on 29 September 2015. This is both a summary of our deliberations so far and an attempt to answer six key questions about the ECB’s past, present and future. The report represents a work in progress towards a more comprehensive study on the ECB that we will publish next year. As a pithy guide to euro area decision-making, I commend it to our readers.

4 THE FUTURE OF THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org 5 Bank grows into political role

John Nugée, Board Member, OMFIF

As a result of the financial crisis the European Central Bank has evolved from a largely technical Third, it has lost its certainty of political support. In the period before 2007 the ECB was offered, central bank into a very important part of the political structure of the euro area and the and could expect to continue to receive, the support of euro member governments for its actions: . Not entirely of its own accord: most central bankers prefer to be technicians. they were neither controversial nor outside the accepted canon of orthodox central banking. Now it is at the centre of a dispute between euro area governments as to how the euro area For the first 10 years after its founding in 1998, the ECB experienced the relatively calm times of should be run, with each new programme being discussed not just in the central bank but also in the Great Moderation. This was a period for learning about central banking within a monetary the finance ministries of euro area countries. union and how to manage the euro area and its . The ECB acquired these technical skills rapidly, along with great respect. This third, political, arena is the most difficult for the ECB. The bank is the agent of the European Union and the euro area, and the creation of the member states. Since 2008, the tasks have changed. The ECB has had to learn how to manage a central bank of a common currency in more difficult times. In the process, the bank has lost three of its most The ECB lacks stand-alone legitimacy or political constituency: it exists to carry out, to the best of valued assets and gained a new role. It has maintained its statutory independence, enshrined in its technical abilities, the mandate that politicians give it. law in each of the 28 member states. As long as that mandate is clear, the ECB can execute it. But as the issues facing the euro area Yet it has seen this independence influenced, and to some extent constrained by, new political become more political and more controversial, so the mandate becomes less self-evident and the and economic realities that have sporadically called into question the existence of the single ECB needs guidance from above on what the political class wants it to do. currency itself. Without clarity and consensus from governments about the ECB’s mission, methods and The three assets which the ECB had in 2007 but no longer enjoys are three certainties that central objectives, there is no clear guidance, and no guarantee of political support, for any of its bankers have always prized highly: certainty of mission, certainty of method and certainty of actions. political support. And so in recent years the ECB has had to learn the skills of a political operator as well. The bank First, it no longer has certainty of mission. It is no longer tasked simply with the preservation of could have no better president than , who combines exemplary central banking monetary stability of the euro area, but has acquired some (though not complete) responsibility skills with finely developed political expertise. for financial stability and bank supervision. And it had forced on it a share of the responsibility for the preservation of political stability, in particular the euro area membership of one member Yet even under his astute leadership the guardians of Europe’s single currency have not always state, namely Greece. This is a huge transition. In the process the ECB has lost both its certainty of found it easy to negotiate the right path. It is far too early for the ECB to go back to being purely mission and the position of sole operator within its terms of reference. a technician; its political role is here to stay.

Second, it has lost its certainty of method, moving from the narrower definitions of monetary This points, in the years to come, to further tussles over its actions, and over the true nature of its policy in which interest rates play the biggest role to a much wider definition of monetary policy mandate and its objectives. in which quantitative easing and monetary financing have come into play.

6 THE FUTURE OF THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org 7 How has the policy environment evolved 1 –and what issues remain the same?

he European Central Bank has liquidity into the markets in August 2007 ECB should concentrate on price stability – had to steer a complicated mid- when the first tremors of the trans-Atlantic It is widely accepted that the OMFIF Official Monetary and course during the different phases crisis started to surface. It joined other Financial Institutions Forum the OMFIF e T best a central bank can do in ssay of the five-year-old European sovereign central banks in September 2008 in supporting economic growth Fiscal authority at heart of eMu debt crisis. On the one hand, the ECB coordinated cuts in interest rates in the “ What we should learn from Pierre Werner is providing price stability, which has taken an active line to generate wake of the Lehman Brothers bankruptcy. Yves Mersch, Governor, Banque centrale du Luxembourg here are strong lessons that we need to learn today from the report on economic and is what the European Central Bank Tmonetary union (EMU) issued 40 years ago by Pierre Werner, the Luxembourg prime additional banking liquidity to attempt minister and finance minister. In the wake of the economic and financial turbulence of the has done. During the past three past three years, I strongly support the idea in the 1970 Werner report of an independent EMU needs new European institution for fiscal monitoring and coordination among EMU members. This is structures to provide to restore the monetary transmission But among many reasons for the initial highly relevant to the needs of Europe today as we try to overcome recent uncertainties years the ECB and the and build stronger European governance for the future. much greater policy coordination. We mechanism disrupted by progressive reluctance to take further-reaching An independent fiscal authority would advance the institutional deepening of the monetary were forced to act very fast, boldly area in a way that would follow on from Pierre Werner’s thoughts. His guiding concept need to be more declines in confidence between the measures was belief among policy- was that a single monetary policy would be supported by sound public finances – a ambitious than in the view with which we must concur, given the straitened state of budgetary finances nearly proposals set down and innovatively to ensure their everywhere. creditor and debtor countries. makers that large intra-euro bloc current by the task force of The Werner report called for ever closer economic policy coordination with an agreed finance ministers long term goal of price stability and framework for national budgetary policies and, at the institutional level, it suggested account disequilibria would not impinge a ‘centre of decision for economic policy’. So, transposing his thoughts to the present under Herman Van day, I would propose a formal mechanism for monitoring member states’ budgets with Rompuy. the functioning of the transmission independent assessment to be provided by a Committee of ‘wise persons’. Such a body On the other, particularly as turbulence on monetary union as a whole. This would help in the general efforts to improve quality and reliability of statistics, and reduce the deadlines of assessment procedures and the time-frame for action to curb unwelcome mechanism. The European economy developments. This would necessarily go hand in hand with a stronger Stability and Growth affecting the peripheral countries turned out to be an illusion. Pact, preventing and correcting macroeconomic imbalances at an early stage, and making is now recovering and the tensions enforcement more effective through gradual sanctions on non-compliant euro members. deepened, the ECB has struggled EMU needs new structures to provide much greater policy coordination, and to my mind in financial systems have eased we need to be more ambitious than in the proposals set down by the task force of finance ministers under Herman Van Rompuy, president of the European Union. If the spirit of the against occupying a too high-profile Up to 2008, the ECB believed, too, that Werner report had been better respected in the EMU blueprint decided in the 1990s, then somewhat, although it is still too the structure we have now would be moreNovember stable and resilient. 2010

position in shoring up the euro, for the convergence of long-term interest It is worthwhile dwelling on the circumstances of the Werner report, because they are in early to claim victory. some way comparable to today’s position. The proposals followed an outbreak of currency fear that it would divert pressure from rates among euro members was a force instability in 1968-69 which forced the revaluation of the D-Mark and the devaluation ” of the French franc. These developments demonstrated the weaknesses of the as well as the threats to the common market and specifically the common governments to achieve necessary for stability – contrary to its later view The rise and fall of payments disequilibria in the agriculturaleuro policy.area Current account balances, % of GDP Werner was asked to preside over a committee to design the path to increased economic economic restructuring and reforms. (after 2011) that these circumstances Euro area current accountand monetary deficits, integration for1994 the six founding-2015 members (% of of the European GDP) Economic Community. That report, completed on 8 October 1970, proposed setting up EMU by 15 1980. In fact, the single currency took 20 years beyond this date to become reality, but it The ECB injected large volumes of had led to moral hazard. Among the is worth revisiting the principles of the Werner report, for they are truly visionary.

France Germany GreeceAlthough many ofItaly the proposalsPortugal of the original WernerSpain plan were realised,Netherlands some of the many contentious issues influencing original thoughts were ignored or diluted, which with hindsight appears as a mistake. Of course, the Werner report came about in a different environment when the Union with its KEY POINTS the ECB’s crisis-fighting response was 10 original six members was aiming for a final goal close to a federal Europe. When the euro was eventually introduced in 1999, the number of member states had • Active ECB line to generate controversy over the bank’s bond-buying increased, and it had become clear that there would be no accompanying political union. National sovereignty in economic policymaking was preserved. Recent turbulence highlights the inherent tensions when sovereignty over monetary policy is pooled while additional banking liquidity to attempt move agreed in May 2010 to prop up 5 economic policy remains a national prerogative. to restore the monetary transmission Greece and the other weaker states. 10 www.omfif.org • Struggle against too high-profile a Axel Weber, the Bundesbank president, 0 position in shoring up the euro, for fear publicly opposed the move, sparking a of lowering pressure on governments frosty reaction from Chancellor Angela • Initial misplaced belief among Merkel. -5 policy-makers that large intra-euro bloc current account disequilibria This was one of the reasons why Weber -10 would not impinge on monetary union decided to leave the Bundesbank • Controversy over the ECB 2010 prematurely in 2011 and abandon -15 bond-buying move affected political the earlier plan to take over the ECB decision over Trichet replacement and presidency from Jean-Claude Trichet in -20 leads to Weber departure November that year. 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source:Source: IMF IMF

8 THE FUTURE OF THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org QUESTION 1 9 OMFIF How the euro led to heterogeneity Warning of 'permanent disequilibrium'Official Monetary and – Jacques de Larosière – Financial Institutions Forum Archive insight OMFIF

Official Monetary and Financial Institutions Forum The institutional design of the euro De Larosière pointed to the danger A monthly foray into monetary secrets hidden in archives area has given rise to moral hazard that countries within a monetary newsGlobal analysis A prescient forecast of the euro’s plight and lacked the capacity to engage union could become permanently How de Larosière’s warning of ‘balances in permanent “ “ disequilibrium’ were ignored by Europe’s monetary technocrats credibly in measures to prevent rising uncompetitive and register international effects of heterogeneity he mid-1970s were not happy times for European monetary cooperation. The breakdown Tof the fixed-rate Bretton Woods system in March 1973 was followed by a sharp rise in Euro gave rise to moral hazard S. imbalances. Although there was an payments 'in permanent disequilibrium' the oil price after the Fourth Arab-Israeli war in October 1973. The European Community’s ‘Werner Plan’ (named after the then Luxembourg prime minister) for economic and Peter Praet, Executive Board Member, Europeanhis Central can clearly Bank be seen in the u monetary union (EMU) by 1980 was put on hold as France and Germany reacted in De Larosière’s unseen accumulation of debt in some as a result of durable divergences in traditional, diametrically-opposed fashion to international economic uncertainties. The findings, buried in hen the euro was introduced, many critics claimed that economic and monetary union (EMu) would not work former enacted a drive toward reflation. The latter followed a more orthodox route, under archives for more the leadership of the Bundesbank, to rein in price increases through tighter credit. Wbecause euro area countries’ business cycles and economic structures were not sufficiently similar. But does economic euro area countries, financial markets set productivity and prices. De Larosière's than three decades, integration really need to imply economic uniformity? I do not think so. t Beset by opposing pressures, in July 1975 Jacques de Larosière, director of the French provided a clinically findings, buried in archives for more than Treasury, produced a brilliant analysis of the possible perils of premature introduction of Regional economies are hit by different economic shocks and perform differently owing to their differing economic conditions in such a way that private and monetary union among states that remained economically heterogeneous. He pointed in incisive warning of structures, even over extended periods. At the same time, institutional safeguards are required to ensure that heterogeneous particular to the danger that countries within a monetary union could become permanently the problems that developments do not become self-reinforcing and pose a threat to overall macroeconomic stability. public sector borrowers in those countries 30 years, provided an incisive warning uncompetitive and register international payments ‘in permanent disequilibrium’ as a result eventually hit EMU in of durable divergences in productivity and prices. In the euro area, we have to acknowledge that economic conditions have become increasingly heterogeneous. But this does 2010-11. not imply that a common currency cannot succeed. We need to address the institutional shortcomings and weaknesses of could continue to borrow at the same of the problems that hit EMU in 2010–11 . De Larosière’s findings, buried in archives for more than three decades, provided a EMU to allow the euro area to cope with heterogeneous economic developments and large asymmetric shocks, as is the clinically incisive warning of the problems that eventually hit EMU in 2010-11. Tragically, case in the US. There, too, economic and monetary union did not occur overnight; it was a long process. though perhaps not surprisingly, de Larosière’s scholarly admonitions were ignored by a interest rates as borrowers in countries De Larosière's admonitions were ignored future generation of European economic technocrat once monetary union got under way. Since the introduction of the euro, many of us have been aware of institutional deficiencies, both in terms of the prevention With one or two honourable exceptions, they joined wholeheartedly in the prevailing of imbalances and regarding the management of such imbalances in the event of a crisis. The crisis is now forcing us to belief that, within EMU, balance of payments deficits did not matter because they would address these issues. In doing so, we need to look at how and why imbalances arose in the euro area and how the ECB’s with sounder fiscal and macroeconomic by European economic technocrats… always be financed by an inherent clearing mechanism among member states. As history monetary policy responded to them. subsequently showed, this turned out to be a monumental illusion. Before the financial crisis, euro area countries achieved a very high degree of convergence in financial conditions. At the fundamentals. Financial flows ran from They joined in the belief that, within EMU, Back in the early 1970s, storm clouds resulting from that old hallmark of Europe – a distinct same time, large macroeconomic and financial imbalances were gradually accumulating. With the advent of the euro, lack of uniformity in economic policies – were already building up across the continent. euro area banks were able to trade with one another in a unified money market. Consequently, there was significant France withdrew in January 1974 from Europe’s semi-fixed exchange rate system, the convergence in the interest rates that banks charged households and firms. Indeed, these are necessary conditions for a countries with strong productivity growth balance of payments deficits did not matter Spain European Snake, after the Banque de France’s foreign exchange reserves came under single monetary policy that affects all economic agents in the same way. Italy Ireland heavy pressure. There was general international unease over inflation, which rose to 24% France in Italy, 16% in the UK, 12% in the US and France and 7%. Chart 1: Persistent inflation differentialsGermany – euro area against LuxembourgUS because they would always be financed Greece to those with weak productivity growth, Belgium 20 Cincinnati Netherlands Portugal The French government saw in the growing importance of the D-Mark a problem of a JulyDenver 2012 Austria July 2011 Chicago Kansas City Finland by an inherent clearing mechanism… similar magnitude to the long-running dollar challenge during the Bretton Woods era. The Dallas Minneapolis fuelling a boom based on debt. Boston 15 Houston Pittsburgh Snake had shrunk from a central European Community policy instrument to an informal Cleveland Miami Seattle 20 Detroit mechanism among central banks. In September 1974, President Giscard’s finance minister Philadelphia Atlanta 20 Los Angeles ” San Francisco ” Jean-Pierre Fourcade proposed a ‘European monetary relaunch’ involving a basket of 10 New York Washington D.C. St Louis 15 Community currencies as a new unit of account to counterbalance the D-Mark. However Tampa 15 Germany and other European partners rejected the plan, partly because it would involve 20 5 an unwarranted extension of credit facilities. Spectre of euro exit 10James Bullard Why a non-German became Trichet's successor David Marsh 10– – 15 0 France was desperate to counter a separate initiative for the Swiss franc to join the Snake, 5 as a hard currency substitute for the French franc. De Larosière concluded that revived 5 momentum for EMU could headOMFIF off the threat of a bilateral German-Swiss deal. In a 10 -5 Global investors are dividing Europe Europe has slowly been acclimatising OMFIF Bullet detailed briefing paper for Fourcade and Giscard, de Larosière spelled out France’s fears 0 Official Monetary and 0 of European monetary isolation.GlobalFinancial ‘As one Insight Institutionssees with on present Official Forum discussions Monetary on the reintegration and Financial Institutions 5 -10 once again into member states, a itself to the view that Axel Weber, the of the [French] franc into the Community exchange rate mechanism and on the association In in percentage points, based in1998 based points, percentage in -5 12 of the Swiss franc with this mechanism, this risk is real, involving a group of European -5 10 11 08 09 states with a strong currency and a balance of payments in equilibrium or in surplus.’ 0 06 07 04 05 02 03 sort of market-based disintegration Bundesbank president, will become the -10 00 01 -10 98 99 July-August 2010 in percentage points, based in1998 based points, percentage in -5 Global analysis eCB post would constrain Germany OMFIF 11 12 “ “ 09 10 Official Monetary and 08 of the continent. Much of this can be next head of the European Central Bank… 22 06 07 July-August 2011 Financial Institutions Forum 04 05 uropean crisis Smaller state candidate would suit everyone 02 03 Source: Eurostat, Centre for European Reform. -10 00 01 11 98 99 David Marsh, Co-chairman July - August 2012traced to the increasing realisation that Making Weber ECB president would long shadow of e urope has slowly been acclimatising From the beginning Eitself to the view that a German gaining the No.1 monetary position. – Axel Weber, the Bundesbank No easy solutions in store of the sovereign the European sovereign debt crisis may heavily constrain Germany’s own room Making Weber ECB president would whether the ECB has been diverted president – will become the next head heavily constrain Germany’s own room debt crisis, analysts, of the European Central Bank when from its anti-inflationary duties into the James Bullard, President, Federal Reserve Bank of St. Louis for monetary and political manoeuvre. realm of political bail-outs. policymakers, and be more traumatising and intractable for monetary and political manoeuvre... incumbent Jean-Claude Trichet, former Governor of the Banque de France, As Lagarde correctly says, no-one wants lobal investors are dividing Europe once again into member states, a sort of market- financial market Weber publicly declared on 10 retires in autumn 2011. to make Trichet a lame duck president based disintegration of the continent. The US is growing, but at a sluggish pace. participants have May that he disagreed with the ECB G than previously understood. Exit [from It would be an act of statesmanship for at a fraught time for Europe’s monetary decision earlier that day to start buying Recent data from China suggests a slower pace of growth than might have been expected However, much political wrangling lies craved a simple, decision-making. That’s why it would government bonds from Greece and earlier this year. Commodity prices have fallen to lower levels during recent months in part ahead. [See The OMFIF Essay by John be an act of statesmanship for German other weaker euro members – an in response to the slowing global economy. sharp solution to monetary union] … would suggest the German Chancellor and Nugée, p. 5 – 11]. , Chancellor Angela Merkel and French important adjunct to a €750bn bail- the problem. But the French finance minister, said on President to announce Inflation readings have generally been lower. This constellation of data is causing 9 July she did not rule out Weber as out package by European governments debt problems are now that the decision on the new chief and the International Monetary considerable unease. Much of this can be traced to realisation that the European sovereign use of alternative and presumably much French President Nicolas Sarkozy to Trichet’s successor but pointed out there will be made in summer 2011 – and debt crisis may be more traumatising and intractable than previously understood. unlikely to find quick could be ‘two or three’ candidates. Fund. Weber said the move created that he or she will not come from the ‘considerable risks’ for euro stability solutions. euro area’s largest countries. One of the principal issues facing policymakers inside Europe (and worrying those outside) weaker currencies to pay back external announce that the new chief will not come It is time, though, for the Berlin Weber has been criticised by some is exit from Economic and Monetary Union (EMU). Exit is often portrayed as a crisis event, government to accept that its best The issue has gained in importance as it would suggest the use of alternative and presumably much weaker currencies to pay interests do not necessarily lie in European politicians for allegedly because the ECB and the Bundesbank trying to further his candidature, and back external debt. In this sense it would be a way partially to default, as is always the debt… Markets are reacting by pricing in from the euro area’s largest countries. The have become embroiled in controversy case with surprise inflation and devaluation. Markets are reacting by pricing in some (more discreetly) by some members of probability that such an event could occur, even though the official line is that it cannot. some probability that such an event could ECB and the Bundesbank have become Contents (continued on page 4 ...) EMU was formed from a subset of EU countries, and some countries remain outside, the ECB propels moves towards reform leading example being the UK. Since not all countries joined, it would seem that the Attrition ahead occur, even though the official line is that it embroiled in controversy… Stewart Fleming experiment might have allowed exit from EMU, but it did not. In addition, some European Facing up to EMU’s weakness 3 nations use the euro even though they are not part of EMU. These arrangements give me Renminbi-euro questions pause concerning the meaning of exit. Some countries never joined and others have joined John Nugée ” Clarifying sovereign fund principles 5 Jonathan Fenby, Board of Editors de facto. cannot. Malan Rietveld he People’s ’s announcement of the switch September 2012 Global analysis: July12 2010 The EMU can be viewed as a club, and members enjoy benefits that do not accrue to ” Mooted reshaping at premier fund Tto a ‘flexible’ currency regime and the use of a basket of non-members. The value of being a member was originally to get German credibility on currencies to replace the peg to the dollar resolves far less than 13 monetary policy. Countries choosing not to join calculated that they could run an equally Contagion between banks and state many thought. effective monetary policy to the Germans. The value of club membership was highest for

countries with the least monetary policy credibility. EMU’s initial success was stunning, J.M. Keynes Letter from Heaven 14 While the currency spat is largely conducted between Beijing driving yields on all EMU member debt essentially to German levels. This created a great William Keegan and Washington, the fall-out from the PBoC declaration on 19 environment for investment and stability within EMU. All eyes on inconclusive Dutch 16 June may be felt most keenly in Europe. The Chinese central 10 THE FUTURE OF THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org Roel Janssen bank’s statement said pointedly that flexibility QUESTION means the 1 11 The logic of exit suggests that, if the club is valuable, member countries will not want to Obituary: 18 renminbi could go down as well as up. If the euro continues Peter Walker leave. Survey evidence seems to indicate that these incentives to stay in the club remain Meghnad Desai to slide against the dollar, the chances of Beijing not revaluing strong today. Still, the common refrain that no country can ever be allowed to leave EMU OMFIF Advisory Board 19 but devaluing its currency could become significant. is altering the incentives for nations to take the actions necessary to maintain membership. This is one of the main penalties that in principle should be enforcing the equilibrium 20 OMFIF This document must not be copied As Europe faces a toxic combination of economic austerity and behaviour among the members of the club. Official Monetary and Financial Institutions Forum and is only to be made available a banking crisis, the Chinese are worried about the potential to OMFIF members, prospective for a further euro decline. If that happens, it would not be in The incentive effects for club membership are critical in another way. For countries that members and partner organisations their nature to refrain from remedial action. are already members, taking on country credit risk through mutualisation damages their incentives to remain in the club. They enjoy the benefits of membership, but the calculus could change if they see too many disadvantages from the policies undertaken to keep The Global Retail Banking Summit (continued on page 4 ...) the union together. Countries can, in principle, remain on the outside and also do well, Going for Growth at the Core of International Banking as Sweden has demonstrated. In short, my view is that the incentive effects for a member nd rd country to remain in EMU must be considered very carefully. Policies should be designed 2 - 3 December 2010, London with an eye toward these incentives, and can no longer assume that the political processes will back EMU in all circumstances. Contact Mladina Connolly on +44 (0) 20 3008 4649 or click to find out morewww.omfif.org From the beginning of the sovereign debt crisis, analysts, policymakers, and financial 1 market participants have craved a simple, sharp solution to the problem. But debt problems 8/30/2012 10:02:12 AM are unlikely to find quick solutions. We should expect a long, slow resolution process peppered with bouts of increased financial stress. Still, there is one possibility for a grand bargain that makes some sense and that has been increasingly discussed. www.omfif.org 6

OMFIF 2012-09_08.indd 6 How have euro policy-makers 2 reacted to the crisis?

he single currency was launched Earlier in the European sovereign debt Why Greece should call a referendum – Meghnad Desai OMFIF in 1998−99 with perceived crisis, the ECB concentrated on long-term Official Monetary and As the euro drama descends into Financial Institutions Forum news shortcomings. The lack of a political liquidity injections rather than purchases europe OMFIF Official Monetary and T melodrama and then possibly into How Greece can learn from IcelandFinancial Institutions Forum union to complement monetary union, of government bonds. It deployed its farce, Greece should learn from Concentrate creditors’ minds: hold a referendum and the absence of a fiscal counterparty balance sheet in a different manner and “ Meghnad Desai, Chairman, Advisory Board Iceland… In a referendum, the Icelanders s the euro drama descends into melodrama and then possibly into farce, Greece to the unified central bank, was regarded at a much more sedate pace compared Ashould learn from the example of Iceland, which went bankrupt two years ago. Like voted to renege on the debt… There is a Ireland, Iceland ran into problems with its private banks which built up excessive liabilities by offering above–market interest rates on deposits and then crashed when Lehman Next steps will not by leading figures, from Chancellor with the US Federal Reserve, Bank of Brothers went down. The debt – which were the deposits taken by the banks operating be simple. Jostling lesson for the euro area here. Not every abroad – was left with the Icelandic Treasury. But in a referendum the Icelanders voted to Helmut Kohl downwards, as a handicap, Japan and Bank of England. renege on the debt and forced the creditor countries – mainly the UK and the Netherlands for position are creditor deserves a break. They should – to renegotiate. the European Not being in the euro, Iceland could let its currency depreciate – a painful exercise, but Commission, the to be overcome over time. one that lets individual citizens make their own adjustments to inflation. Now, two years ECB, the Council of have known it was risky to lend to Greece. on, Iceland is on track for annual growth above 2% this year and next after a cumulative Ministers, the Euro- Gradually, in response to a realisation 10% fall in output in 2009 and 2010. Iceland has returned to the international capital markets and can borrow at 5% – a rate the Greeks can only dream of. Group and then, on Let them bear the cost. Greece should hold top, the IMF. The 1991−92 set that monetary union faced an existential There is a lesson for the euro area here. Not every creditor deserves a break. They should have known it was risky to lend to Greece. Let them bear the cost. I believe Greece should a referendum on whether its citizens are hold a referendum on whether its citizens are willing to pay back the debt. That should what appeared to be firm pre-joining threat, the framework was improved. concentrate minds – both in Greece and among the creditor countries – and might make willing to pay back the debt. That should a contribution to resolving the issue. conditions, but it was only after The 2010 'securities market programme' A referendum would certainly be better than the other options that are feared – a revolution or even a military coup. But Greece is used to such shocks – and has a long history of concentrate minds and might make a reneging on its international obligations. The Papandreou government is fast running out Maastricht that the rules for member purchases of Greek and other countries' of options. It’s hoping for respite from privatising many Greece’s assets. But this is a tricky contribution to resolving the issue. political decision for an ostensibly Socialist Party.July Even if the2011 government decides to sell, it states’ economic performance and bonds; the ECB's further 2012 'outright may not get its hands on the money for while. And a fire-sale will be counter-productive. ” The tragedy is that even if Greece eliminates the deficit with great fiscal pain, its debt would only stop rising, not disappear. The debt needs to shrink to at least half its current behaviour after entering the euro were monetary transactions' programme level of 157 % of GDP. Germany went through a decade of austerity after it absorbed the dysfunctional East German economy. The Germans succeeded in pulling through with laid down, in the form of an insufficiently for conditional bond purchases, their economic health restored. That’s why they have no sympathy for the Greeks, who they The ECB's deployment of its balance sheet from 2008think onwardsare lazy, retire too early and pay no taxes. strongly worded 'stability and growth banking union through centralised Central bank assets, national cuurencies Tragedy No. 2 is that the International Monetary Fund has chosen the wrong candidate as managing director to fix the euro crisis. While she was French finance minister, Christine Lagarde’s backers said only a European can heal the euro. This argument is not only pact' that both Germany and France, supervision, and full-scale QE in 2015 racist; it is also wrong. Euro decision-makers including Ms Lagarde have tried to deal with each problem euro country one by one. And one by one they have failed. France and Germany, the euro’s leading powers, have different views. France wishes to tie economies in 2003, failed to respect – a decision were all decided, opportunistically yet into a tighter control grid with budgetary coordination under centralised oversight. For a long time Germany wanted all euro members to be as prudent and fiscally responsible as the Germans. Then it switched priorities to saving German banks with big positions in that was backed by the European laboriously, in reaction to increasing euro area debt. Now German finance minister Wolfgang Schäuble says that he wishes restructuring in the form of write-downs for private bondholders.

Commission. unease. Next steps will not be simple. Jostling for position are the European Commission, the ECB, the Council of Ministers, the Euro-Group and then, on top, the IMF. Schäuble’s resolve on making private creditors pay has been watered down by Chancellor Angela Merkel after meeting President Nicolas Sarkozy. Of course, Greece should never have been allowed to join the euro. But then political considerations demanded maximum membership. Gross KEY POINTS However between 2013 and the start irregularities in Greece’s national accounts were ignored. Now everyone is dancing to the Greek fiddle. Wait for the Greek people to speak. The music may suddenly speed up.y •Maastricht Treaty set what of QE, the central bank’s balance sheet

actually fell – a product of its decision to www.omfif.org appeared to be firm pre-joining 3 conditions tighten credit after autumn 2012. •Post-Maastricht Pact on euro area behaviour not respected by France In its 18th year, and after much strife, the and Germany ECB is now surrounded by an institutional •ECB initially concentrated on long- framework, and benefits from a set of term liquidity injections rather than instruments, with which it might have purchases of government bonds felt comfortable in its infancy. And yet •Full-scale QE in 2015 were all the political consensus supporting it has decided, opportunistically yet become in some cases exceedingly laboriously, in reaction to increasing fraught, with consequences that remain unease unpredictable. Source: FRED, ECB

12 THE FUTURE OF THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org QUESTION 2 13 Why orderly debt restructuring is necessary – Niels Thygesen Why ECB needs a fiscal counterpart –David Green OMFIF OMFIF Official Monetary and Official Monetary and Financial Institutions Forum Financial Institutions Forum The risk of debt restructuring cannot During its first decade, the euro area europe europe be excluded. Euro area policy- managed to skirt round the absence The need for euro area fiscal policy makers say their actions in the spring of a fiscal counterpart to the European Single currency reality requires new machinery “ “ David Green, Financial Reporting Council of 2010 have removed this risk…. But Central Bank, as much through luck Default must be an option for eMu Canadian finance minister, visiting the Governor of the Bank of England when the Keeping open the Aeuro was in the course of creation, expressed puzzlement, based on bitter Canadian should there not be a ‘Plan B’ in the shape as through the ECB’s undoubted skill. experience, that Europe should willingly choose a single currency. Over a diverse economic European Monetary Fund would bring confrontationpossibility that area, he said, the stance of monetary policy tended to be wrong for most regions most of the If and when the Niels Thygesen, Advisory Board individual members time. The common could not restrain a boom in Ontario while simultaneously social disruption of a more permanent crisis management However, the reality of the challenge is staving off recession in British Columbia. Fortunately, he went on to say, the effects were may default is not mitigated by regional economic stabilisation thorough the Canadian federal budget. becomes serious he idea that a member of the euro area could default on its public debt will strike a sign of failure. mechanism – or provisions for ‘orderly enough, with or many as outrageous, yet it may have to be faced. The aim of is to Rather, it is a now plain. It has been uncovered by the During its first decade the euro area managed to skirt round the absence of a fiscal T counterpart to the European Central Bank, as much through luck as through the ECB’s without public or curtail excessive risk-taking by laying individual institutions open to potential insolvency. condition for the undoubted skill. However, the reality of the challenge is now plain. It has finally been Similarly, the possibility of sovereign default is the ultimate warning to governments and private defaults, then debt restructuring’ – to meet the possibility sudden revelation of the true horror of uncovered by the sudden revelation of the true horror of Greece’s unsustainable fiscal the markets against failure to correct unsustainable budgetary policy. Maintaining the system to function intra-euro area fiscal possibility of defaults within economic and monetary union (EMU) is a better option than position. The European authorities have to respond with more solidarity on the fiscal front. properly. How they will do this is not clear, yet they have no choice but, sooner or later, to act. transfer mechanisms active consideration of bail-outs for states such as Greece that get into difficulties over of failure of austerity commitments backed Greece’s unsustainable fiscal position. The excessive borrowing. Bail-outs would fatally upset the delicate balance at the heart of will have to be The other area where the authorities need to respond is in financial supervision. The euro EMU, which in 1999 saw sovereign countries centralise monetary authority, while leaving mobilised. budgetary and other economic policies (largely) in national hands. by hastily improvised financing measures? creates a need for more regionally differentiated approaches, seen in sharp focus in Spain European authorities have to respond with and Ireland. A first challenge for the new European Systemic Risk Board will be to reconcile Some commentators, central bankers and politicians have said that monetary union the decision to adopt a more unified rule book with the requirement for very different cannot survive without political union. The founders of EMU were indeed well aware of …. Adopting the euro gave member more solidarity on the fiscal front. How supervisory responses to the regional consequences of the single interest rate. This is where the special – one might say, lop-sided – nature of the project. They proceeded, because it we will find out how macro-prudential policies can be made to work in practice was the best that could be done at the time. EMU dealt definitively with the long-standing disruptive problem of exchange rate instability. It combined the politically feasible with the countries an escape route from the they will do this is not clear, yet they have Such adjustments are inevitable because the time-honoured safety valve of devaluation is economically adequate. There was no political backing 20 years ago for centralisation of not available, either for Greece or any other member state facing comparable difficulties. authority over taxation and public expenditures, or for intergovernmental transfers. Nor is For Greece to leave the euro would be hugely unpalatable for the Greeks, for economic there any such backing today. discipline imposed by possible currency no choice but, sooner or later, to act. reasons that have often been advanced. However the real reasons why the Greeks (or any other country contemplating departure) are locked in go much further. It is worthwhile recalling these essential facts as we ponder various ideas for financing for crises…. The closer monitoring now being ” weaker states from euro governments, or from a new European Debt Agency or European Let us assume that a country in difficulties wished to restore its former currency at a new Monetary Fund (EMF), as has been suggested by German finance minister Wolfgang rate against the euro. It is simply not possible to know which should be converted Schäuble. An EMF of course could become operational only well after the current crisis. prepared does not make stronger elements into new drachma, new Irish pounds or whatever. It might seem simple to decide that the More importantly, if governments set up an EMF, the intrusion into the debtor’s budgetary assets and liabilities of the Greek authorities should be redenominated as new drachma, policies would be far stronger than in the presentJuly framework 2012 that merely sets guidelines but what about the euro liabilities of a GreekFebruary bank in Frankfurt or New2010 York or Sydney, or for consolidation. The risk of tensions and mutual recriminations would be severe, since of market discipline superfluous. a US bank in Athens or a Greek shipping company in Singapore? the creditors would be individually identifiable and unlikely to agree on the severity of the conditionality for such financing. This would lead towards more political union, but it Would it be the law covering a specific transaction that counted, if that could be agreed? would be much more risky and confrontational than in the past. ” Or would it be the nationality - or the residence - of a debtor? Or would these questions apply to the creditor? For cash, would the new rate apply to the euro coins originally In the context of an EMF, we need to remember that no international framework offers minted in Greece, wherever they were now located? Or to the euro coins circulating in a guarantee against sovereign default. This is the case for conditional lending by the Greece, irrespective of the place where they were struck? ECB Internationalproposals Monetary Fund, as several examplesfor testify, European and as the IMF recognised in policies – Race against time for the euro – Frank Scheidig 2002. While a default could sour political relations, it would be consistent with continued The list of imponderable questions is very long. They would all be contested in courts across participation in EMU; indeed, renewed access to borrowing will be easier with the euro the globe. Splitting the currency so as to devalue arbitrarily a certain proportion of the than without it. At the EU level, the ECB favours We are still waiting for a cure for the world’s euro-denominated assetsOMFIFOMFIF and liabilities is so difficult thatBullet it would be impossible. OMFIF Official Monetary and In Greece’s reaction to the commotion over its excessive debt, there are signsOfficial that Monetarythe and Inescapably, disparities causedGlobal by ‘one size Insight fits all’ intereston Official rates have to Monetarybe handled at anda Financial Institutions Financial Institutions Forum Financial Institutions Forum I combination of monetary pooling combined with continued national fiscal responsibility more streamlined and effective woes of economic and monetary fiscal, not a monetary level. No other significant monetary area is without substantial and n may be starting to work. If the impressive Greek adjustment programme is seen as sufficient powerful fiscal coordination machinery to stand alongside the monetary authority. If and to obviate the need for other governments’ direct ssayparticipation in Greek refinancing, then when the social disruption becomes serious enough, with or without public or private defaults, original model centred on national budgetary sovereignty – though more intensively then intra-euro area fiscal transfer mechanisms will have to be mobilised through something he OMFIF e procedures in the assessment of fiscal union. Necessary steps have been Race against time for the euroSeptember 2012 monitored thant in the past – will have survived for now. “ “ far more far-reaching and robust than the dysfunctional Stability and Growth Pact. Willingness to implement EMU fiscal rules set down in the 1990s under the Stability and developments, and a reversal of the put into place by European governments The euro has delivered very manyBeyond far-reaching ECB benefits. action, But the machinery we to need respond to political will Growth Pact has been gradually eroded. This was partly due to French and German its reality is not yet in place. Franky Scheidig, Deputy Chairman, Advisory Board reluctance to apply the rules themselves around 2003. But the rules remain useful. For a 7 Greatlong time, leap markets may inbe excessively economic tolerant of sovereign creditgovernance risk, but they can change www.omfif.orgburden of proof, making it more difficult to improve euro area decision-making. A 8 www.omfif.orge are still waiting for a cure perspective brutally. EMU can continue to prosper if its members are subject to discipline The May actions Wfor the woes of economic and recession-hit south, could over time from a combination of market forces and policy norms. Keeping open the possibility that monetary union (EMU). Necessary lead to a calming of financial markets. Europeindividual must members learn may defaultlessons is not a ofsign ofspringtime failure. Rather, it succeeded isturbulence a condition forin the for some kind of official financing for for the to overturn start is being made in healing the worst of steps have been put into place by The problem is that, left to their own Lorenzo Binisystem Smaghi, to function Executive properly. Board, y European Central Bank preserving the European governments to improve Spain and conceivably, too, for Italy in devices, the markets will take fright at coming months. integrity of euro area decision-making. A start is the large volume of financing that still in its decisions the assessment of the the intra-EMU economic imbalances. But being made in healing the worst of the e need a leap forward in the governance underlying the economic policies in the the euro area. has to be done for the under-performing The fate of Greece can be expected to intra-EMU economic imbalances. But south in the next few months. member states of the euro area. Whatever is decided for the euro area could However, unless the this is a race against time. dominate Europe’s political calendar, W but the real story focuses on the third conceivably also apply to the rest of the EU, but the discussion among all 27 members Commission. [Other requirements are] this is a race against time. A rebalancing weaknesses that Given the scale of the current and and fourth economies of the euro area. should not water down what is necessary for the euro area. A rebalancing of European capital account imbalances that still were exposed are economies, with the relatively better- The conditionality advanced by the more independence in the collection, of European economies, with the relatively need to be financed, and the sharp European Central Bank is useful and We need to learn the lessons of the springtime turbulence in economic and monetary performing northern economies losing definitely addressed, rise in bond market interest rates for necessary, but beyond that we need union (EMU) – a crisis that had effects spreading far beyond Europe’s borders. On the competitiveness against the necessarily the most heavily exposed countries, political will to put taxpayers’ money eve of the first weekend of May, as the result of worries over the possible default of one or new bouts of verification and assessment of the fiscal better-performing northern economies Italy and Spain, there is no substitute on the table to forestall excessive more EMU members, the global financial system was on the verge of a meltdown similar Conflicting signals from Berlin: ingenuous chaos meets ingenious ambiguity instability may arise. behaviour. to, if not worse than, the one after the failure of Lehman Brothers. Markets would indeed The ebb and flow of bad economic news has wreaked havoc on European yield curves, but the Anglo-(continued on page 8 ...) have collapsed if European leaders had not agreed that weekend to establish a European data and fiscal analysis at the level of the losing competitiveness against the American camp is more riled about conflicting signals from Germany and the lack of decisive steps to end Financial Stability Facility to support countries in difficulty and if the European Central the crisis, writes Michael Burda, Advisory Board, from Berlin. Chancellor Angela Merkel, in contrast, insists Bank had not decided to intervene directly in some securities markets to restore their proper on petit pas and quid pro quos. functioning. Commission, more emphasis on public necessarily recession-hit south, could (continued on page 8...) ContentsContents The actions succeeded in preserving the integrity of the euro area – stopping the speculative Challenges for central banks rout and forcing market participants that had taken short positions against the euro and debt developments, as the Treaty foresees, calming financial markets…. Left to their Banks and the new environment Phil Middleton some sovereign assets to bear losses. However, unless the weaknesses that were exposed 3 LongLong shadowshadow ofof EuropeanEuropean crisiscrisis Michael Lafferty US politics rules are definitely addressed, new bouts of instability may arise. The task force of European 5 finance ministers under EU president Hermann Van Rompuy has the mandate to produce and quasi-automaticity of sanctions in case own devices, the markets will take fright… Structural, social, green JamesJames BullardBullard 6 Beijing may react concrete proposals aimed at closing all the loopholes in the institutional construction of the Cautious approach on growth Angel Gurría 9 euro. Any change in the institutional structure of the euro should start by avoiding three of breaches of the rules. There is no substitute for some kind of official China’sChina's next reform phase Stefan Bielmeier Kishore Mahbubani, Singapore great simplifying assumptions made in the past. 108 Guide to market sentiment LindaLinda YuehYueh he decision by the New York State Department of Financial October 2010 September11 2012 Allan Lane 11 TServices to make public its strictures against the UK bank The first is to think that markets are always right and are able to discipline countries and ” Monetary lawlessness on rise Allan Lane financing. 13 Standard Chartered could spark off similarly heavy-handed their debts. Markets made mistakes in the past in under-pricing risk. They are probably Dutch Socialists to the fore Brendan Brown action by China. doing so again now in over-pricing it. And they will also make mistakes in the future. We 15 Euro money supply boost needed Roel Janssen cannot leave to markets the task of disciplining budgetary policies and inducing member ” 17 17 Benjamin Lawsky, the department’s superintendent, should Debate on stimulus grows sharper Gabriel Stein states to take corrective actions. If we really want to prevent and correct imbalances, in 19 have considered the possibility that his action may encourage OMFIF Advisory Board Darrell Delamaide 19 particular fiscal imbalances, we need stronger institutional mechanisms, across the euro OMFIF Advisory Board Darrell Delamaide Beijing to use its growing economic clout to take similar 24 area and within countries. This means more rules and automatic sanctions. Momentum drops worldwide unilateral action against US banks. THE FUTURE OF THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org 26 QUESTION 2 14 The shift to external lawyers Statistical forecast 15 The second mistake is to think that crises can be prevented altogether. Crises have occurred 29 Lawsky’s decision to go after Standard Chartered appears to in the past and might occur in the future, also because of contagion. We have to be High stakes in euro drama Pooma Kimis 31 have been driven by domestic political considerations, not by prepared for them and be able to manage them efficiently. The third mistake is to think Archive Insight Michael Kaimakliotis the merits of the case. In the US political climate, anyone who 32 that there are easy or ‘orderly’ solutions to crises. Crises are messy, contagious and have Dow’sDow's lesson of past recessions German bond spree stands up to Iran is a hero. The superintendent has enhanced unintended consequences. 34 his reputation. William Keegan 36 The ECB’s proposals to address these issues do not change the fundamental nature of the Additionally, he has undermined the move to create global OMFIF OfficialOfficial MonetaryMonetary andand ThisThis documentdocument mustmust notnot bebe copiedcopied euro area, in particular with respect to budgetary policy, which remains in the hands of Financial Institutions Forum co-operation among financial regulators. Finance is not Financial Institutions Forum andand isis onlyonly toto bebe mademade availableavailable the national authorities. There is no need to have a single budgetary policy. No need for toto OMFIFOMFIF members,members, prospectiveprospective a domestic industry. The only way to regulate it is through a so-called transfer union. However, national budgetary policies have to be conducted in members and partner organisations global norms and processes. However, New York’s unilateral a framework consistent with a single currency. decision has further undermined confidence in American judgments. Significantly, the institutional framework can be strengthened within the current European Treaty, fully exploiting the possibilities of secondary legislation. There is no need for a (continued on page 8 ...) treaty change – and there is also no time. Financial market doubts about the resilience of OMFIF 2012-09_08.indd 1 the system need to be answered quickly. At the EU level, the ECB favours a strengthening 5 www.omfif.org of the fiscal framework geared to five important measures: www.omfif.org 1 More streamlined and effective procedures in the assessment of fiscal developments • 8/30/2012 10:02:06 AM

• Reversal of the burden of proof, making it more difficult for the European Council to overturn in its decisions the assessment of the Commission 3 Why has the ECB expanded supervision?

xtending the ECB’s remit into banking crises could indeed break out in Removing politics from banking supervision – Patrick Honohan banking supervision has been a monetary union, nothing was done until Banking union will go some way to Future of eMu logical extension of its core areas turbulence finally hit home. E removing politics from the enforcement Solidity through detachment of responsibility. But this was held up for of bank supervision. Politics and banking Five hopes for European banking union many years by procedural wrangling After the troubles of the peripheral “ Patrick Honohan, Governor, don’t fit well together but they seem to have am an enthusiastic supporter of banking union in Europe. As we work at breakneck Ispeed to construct what is undoubtedly a most ambitious project, it is worthwhile focusing and, in particular, by opposition from countries intensified post-2009, the on five hopes for what we can achieve from the project. a magnetic attraction for each another. Supervisory Germany, on the grounds that a de facto potential perils of monetary versus My first hope is that banking union will go some way to removing politics from the practice differs enforcement of bank supervision. Politics and banking don’t fit well together but they seem In some circumstances, bankers' political to have a magnetic attraction to each another. In some circumstances, bankers’ political quite significantly in combination of a monetary stability financial stability conflicts started to prominence on the national stage can result in implicit pressures to hesitate or second- Europe. No doubt prominence on the national stage can result guess regulatory action. every supervisory and financial stability mandate would wane. At the same time, the much greater International experience generally shows that the best form of regulation for delivering the agency thinks it does common good is technocratic and wholly insensitive to national, regional or local politics. the job better than in implicit pressures to hesitate or second- That can best be delivered by a regulator that lacks an understanding of, and interest in, present the ECB with a potential conflict danger of toxic contagion between a such politics. Outsiders will often fit this description very well. every other one, but guess regulatory action. International this is impossible. An outside regulator needs to rely on the instinct of the local supervisors for the assembly of compared with its overriding obligation country's banks and the fiscal health relevant information. It is chiefly in making the final decision on regulatory interventions that experience generally shows that the best the need for political distance becomes evident. Indeed, it is not so much in supervision, as to fight inflation. of the home government began to in resolution that these issues become decisive. This points to the need to complement the form of regulation for delivering the common single European supervisory mechanism with a single resolution authority. My second hope is that banking union brings emotional detachment to the process of loom much larger. Depoliticising both supervision. In contrast to the political issues, which will often relate to isolated cases, what good is technocratic and wholly insensitive to I have in mind here is the problem of the waves of euphoria and over-optimism which have Before the 2008–09 financial crisis, supervision and – at a later stage a tendency to sweep through financial systems, often driven by – and driving – property bubbles. If the entire banking system, and the property market gurus, and the beneficiaries national, regional or local politics. of the spin-off economic activity and stock marketApril appreciation 2013 all become cheerleaders Alexandre Lamfalussy – the veteran – banking resolution appeared an ” for the continuation of credit-fuelled bubbles, the regulator may still stand in opposition. All too often, however, the regulator is insufficiently detached. A sneaking suspicion that Belgian central banker who headed attractive proposition. The building blocks of banking union the market may be wrong is weakened or drowned out by the plausible chorus of boosters to which the local regulator is exposed. We must hope that the outsider will embody the the European Monetary Institute, the Integration of different elements of euro-wide scheme scepticismfor supervision, that is natural for all regulators. resolution and (later) deposit guarantees Third, I hope that banking union manages to make use of the diversity of supervisory experience and aptitude across Europe to provide multiple cross-checks on bank forerunner of the ECB, in the 1990s – However, the manifestly unfinished soundness, while not imposing a straitjacket on bank behaviour. This feeling derives from the observation that supervisory practice differs quite significantly in Europe. No doubt Banking union building every supervisory agency thinks it does the job better than every other one, but this is spoke of the benefits of the ECB moving nature of banking union prevented any impossible. At the Central Bank of Ireland, we have recently unveiled a computerised tool blocks (called PRISM) for guiding and recording supervisory engagement. It provides a great into supervision of individual banks. tendency for euro policy-makers to advance especially for dealing in a systematic way with the supervision of financial firms to which an impact factor below the very highest has been applied. However, not least because of policy- rest on their laurels. The ECB’s single We think PRISM embodies much of the accumulated experience (good and bad) Ireland Harmonisedhas gained over the years. I am sure there are aspects that could benefit from a different approach. To be sure, supervisors have been talking to each other in Europe and makers’ complacency about whether supervisory mechanism completed at the Depositinternationally Guarantee for years. Yet there is no agreed supervisory manual. The banking union willSchemes inevitably result in further moves in that direction. The single supervisory mechanism end of 2014, together with the associated will itself embody a single methodology. KEY POINTS A single manual does not mean that banks shall be treated in the same way regardless asset quality review and stress tests of of the macroeconomic context. It means that similar risks should be approached with the •Move into supervision held up for same tools, and stringency, everywhere in the union. individual institutions, put the banking 10 www.omfif.org years by procedural wrangling sector as a whole on to a more healthy •Alexandre Lamfalussy spoke of the footing – contributing to a gradual pick- benefits of ECB supervision up in credit growth from early 2015 as •Danger of toxic contagion between Banking a slow recovery gained momentum. Yet a country’s banks and the fiscal health an old conundrum remained in force. union of the home government loomed Germany and other creditor nations larger after financial crisis continue to oppose a move to full-scale Single Resolution Single Supervisory •The ECB’s end-2014 single Mechanism Mechanism (SSM) banking union, involving pan-European supervisory mechanism, together with (SRM) -> 4 November deposit insurance, on the grounds that the associated asset quality review -> 1 January 2016 2014 this could take place only when (and if) and stress tests, put the banking sector fiscal and political union is completed. on to a more healthy footing Source: ????

16 THE FUTURE OF THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org QUESTION 3 17 Banking union is unfinished– José Manuel González-Páramo Transparency key to restoring confidence– Luis Linde The euro area remains unduly divided, European policy-makers have been Europe & the euro so action is required to put integration working since the end of 2012 on “back on track. In a nutshell: banking “preparing the Single Supervisory Resolute path to banking union union is unfinished. The next step should Mechanism (SSM).... A completely Rigour and transparency key to restoring confidence An end to fragmentation Luis M. Linde, Banco de España

Nevertheless, a credible common backstop be a change in the tre aties to integrate new framework has to be developed Banking union as pathway to deeper integration ithin a year, the European Central should be put in place as soon as possible to keep José Manuel González-Páramo, BBVA WBank will, together with the national the work schedule provides for mapping all intact the credibility of the SRM and the SSM. supervisory authorities, assume broad about the SRM not being able to guide the [emergency] regulations under a European to underpin the supervisory decision- the EU banking institutions. Integrating 17 Having access to liquidity (just as the Federal supervisory competence over the euro area The second element, the balance sheet process. Again, this is misleading. The SRM was national supervision systems (some of them Deposit Insurance Corporation has a credit line banking sector and other EU countries which assessment, will be carried out at a given never meant to deal with that. By law it will not made up by two authorities), along with anking union marks the departure point with the US Treasury) will be essential, especially legislative framework…Steps need to be making process. The ECB will manage and decide to opt in to banking union. point in time and on an accounting basis. have full resolution powers until 2016. The very the ECB, into the SSM is a major challenge. This assessment will be broad and inclusive, of a long journey towards genuine EU during the transition. A transitory solution lies Those credit institutions deemed to be B essence of this recapitalisation process is that it Joint Supervisory Teams (JSTs), consisting of covering credit and market exposures, on integration, but it is not the final destination. with the ESM direct recapitalisation tool but in significant will be directly supervised by supervisors from the ECB and the national must help draw a line between past problems the medium term a more consistent mechanism taken as quickly as possible to enhance oversee the exercise in close co-operation the ECB with the assistance of national and off-balance sheet positions, domestic The existing banking union decided since 2012 authorities, will take care of direct supervision and significant non-domestic exposures. One and the future. In coming years, we will be able would be necessary. supervisory authorities, while the rest of the embodies the most important EU reform since to envisage mutualisation of costs in the context of the significant banks, under the guidance key issue will be the capital threshold used the creation of the euro. It has been pivotal Certainly, the SRB involves a complex system will be indirectly supervised by the of an ECB coordinator. of the SRM. European governance. Banking union with the national authorities and with the ECB through national supervisors. Out of for this exercise, which, in accordance with in underpinning the single currency and decision-making process. But it is the best The ECB plans to devote two Directorates All banks involved in the recapitalisation roughly 6,000 euro area credit institutions, the definitions of the Capital Requirements reversing European fragmentation. design available, given the political constraints. General to this direct supervision of process should be able to cover the capital gap the ECB will directly supervise around 130 Regulation and However, the euro area remains unduly by itself cannot guarantee total financial support of an international consultancy significant banks, DGs I and II. Additionally, Directive IV will take into account the from the markets. If that is not possible, an Completing banking union banks, covering around 85% of total banking divided, so action is required to put integration a DG III will be created to deal with the transitional arrangements and the need for a 8% bail-in will apply. If that is not sufficient, Banking union needs to be completed with assets. back on track. In a nutshell: banking union is indirect supervision of the Less Significant demanding threshold. there will be public support, from the national European policy-makers have been unfinished. The first thing to do is to bring a single deposit guarantee scheme (DGS). This integration. The completion of banking firm. Quality assurance processes will be institutions. Finally, a DG IV will carry out sovereign in the first instance and ultimately working since the end of 2012 on preparing The third element, the stress test, will banking union to its full capacity. This requires was rightly removed from the agenda in late horizontal functions such as supervisory review the major risks of banking groups from the ESM. 2013 to avoid a fatal deadlock in banking union the Single Supervisory Mechanism (SSM). quality assurance, methodology and a lot of work from the technical and the When the results of the AQR stress test were under various scenarios, testing the sensitivity negotiations. But banking union will be neither union must be accompanied by deeper in place at every stage. This exercise has The challenge is to make operational the new standards, enforcement and models approval. management sides to run successfully the new framework agreed by European governments of bank balance sheets to hypothetical released, the direct recapitalisation tool was not credible nor stable if it lacks a strong common Overall, including the Secretariat, the ECB institutional framework. The new set-up needs yet approved. Now it is there, which is good before the ECB assumes its supervisory tasks. external shocks. The assessment will probably to be put into the position, as an urgent priority, safety net. The existing safety net is extremely will need around 1,000 new staff, 750 of them be made with a reference date of December news. That should dispel any doubts about a economic, fiscal and political union. This to be rigorous and transparent, so as fully A new institution has to be created, requiring fragile. It operates with the DGS component directly involved in supervision. 2013 and will be finished in November 2014, of producing beneficial uniformity, efficiency negative financial spiral in the unlikely event considerable recruitment. A completely new and equal treatment of all participants. on a national basis, and with a SRF that will The comprehensive assessment of all banks when its results will be published. that a bank needed public support to bridge its framework has to be developed to underpin that will come under direct ECB supervision In parallel, EU leaders will have to find a way be 100% European only in 2024. Political The ECB will manage and oversee the capital gap. will involve changes in the treaties when to restore confidence in the European the supervisory decision-making process, will consist of three elements: a supervisory to complete the banking union with a common agreement will be challenging. This necessary exercise in close cooperation with the keeping it separated from the ECB’s monetary risk assessment, a balance sheet assessment deposit guarantee scheme and a public backstop. completion requires elements of a fiscal union national authorities and with the support of Single resolution mechanism policy structures. Additionally, before the and a stress test. This will be concluded before This will require high doses of political will. In and hence reform of the European treaties. political conditions are right: a demanding banking sector. an international consultancy firm. Quality The single resolution board will be in charge SSM is fully operational by November next the ECB assumes its supervisory functions in the medium term, further integration is needed, This requirement underlines that the assurance processes will be in place at every of all resolution tasks starting in January 2016. year, the ECB will perform a comprehensive November 2014. including capital market union, fiscal union and February 2015 future of Europe must be met through a assessment of the European banking system. November 2013 stage. This exercise has to be rigorous and During 2015, one SRB priority will be to develop ” The supervisory risk assessment will deepening of European institutions. During but necessary challenge to overcome. transparent, so as fully to restore confidence economic union, all of them underpinned by The transfer of responsibilities from incorporate supervisory judgments on all risk the first resolvability assessment with special the crisis, Europe often acted with urgency, in the European banking sector. ■ due democratic legitimacy. focus on the biggest European institutions. It national authorities to the ECB should be factors, summarising in comparable form all signing intergovernmental agreements such ” a smooth process. The national authorities This is an edited and abridged version of the will also be preparing the single resolution fund potential sources of risk. This risk assessment as on the European Stability Mechanism, have the expertise in the supervision of credit speech delivered at the Economists Meeting in Bank recapitalisation (SRF) which will start functioning by early 2016. will be used for the portfolio selection to The adaptation to the culture and modus the fiscal compact or the SRF. The next step institutions. These bodies, including national Madrid on 21 October. And it will develop coordination guidelines with be undertaken as part of the balance sheet Luis M. Linde is Governor of should be a change in the treaties to integrate central banks, have the necessary information, Banco de España. operandi of the new authorities, both single national resolution authorities, supervisory assessment. Dangersupervisory mechanism of and single undercapitalisation resolution these regulations under – a European Harald legislative Benink Vain hope that banking crisis wouldknowledge and notstaff. happen – Stewart Fleming authorities and third country authorities. framework. Many people see this as a long-term mechanism, will be a tectonic change for most In general terms the financial power of the A rational division of work is required. issue. But steps need to be taken as quickly as The ECB will have the direct oversight of entities. This process will require a big effort for SRF is adequate. However, the lack of a public possible to enhance European governance. significant banks with the cooperation of new authorities and the banks. backstop is a clear weakness especially in a The first test took place with the Asset Banking union by itself cannot guarantee Five years after the Lehman Brothers Another vulnerability was that robust national authorities. The national authorities’ systemic crisis. The €55bn overall capacity of the Quality Review and the associated stress test. total financial integration. The completion of direct supervision of less significant fund has been criticised for being too low. But banking union must be accompanied by deeper institutions will be carried out in harmony The European Central Bank and the European the fund would be used as a private backstop, bankruptcy, European banking systems were not in place to deal with Banking Authority performed well. The exercise economic, fiscal and political union. This is with the ECB, The national authorities will europe OMFIF only after losses equivalent to 8% of total have to comply with regulations, guidelines Official Monetary and was sufficiently sound and transparent, making the only way to end persistent fragmentation. Financial Institutions Forum liabilities have been absorbed internally through This will involve changes in the treaties when and general instructions issued by the ECB. its results credible and robust. a bail-in. This threshold is quite high, and would union seems more urgent than ever. cross-border banking crises. Indeed, eCB propels moves towards reform Stress tests are here to stay. They are a political conditions are right: a demanding but This will not be a two-tier system, but a have been sufficient to cover losses in most of single one with a distribution of tasks. We are key part of theGlobal new Supervisory Review analysis and necessary challenge to overcome. ■ “ “ Central bank seeks to combat the euro’s weaknesses OMFIF the recent banking crises in Europe. The euro area banking system remains banking regulation and supervision remain setting up not a ‘confederation’ but a ‘Union’ Official Monetary and Evaluation Process methodology. The AQR A 5% cap will apply in the use of the fund, Financial Institutions Forum of supervisors under a single European exercise is a one-off procedure that is not meant uropean crisis Stewart Fleming, Board of Contributing Editors making a premature depletion extremely Prof. José Manuel González-Páramo is executive authority. Steered by a High-Level Group on to be repeated at banking union level every year director of BBVA. This is an abridged version of a unlikely. In addition, the fund will be able to undercapitalised, fragile and fragmented. in large part a national prerogative, Supervision, chairedefore by thethe ECBtrans-Atlantic president, crisis struck in 2007, Jean-Claude Trichet used to tell listeners speech delivered at the OMFIF Economists Meeting at unless there is fresh severe turbulence. This raise ex-post contributions and borrow money 15 that the euro had established the same credibility in financial markets as the strongest long shadow of e the Deutsche Bundesbank on 28February January 2015. 2015 B Governor Linde discussing the Spanish economic outlook in Madrid on 21 October point is important: having a comprehensive from third parties on an ex-postFrom basis in thecase beginning of the national currencies it replaced, the Deutsche Mark. assessment as the benchmark for future Well before the No easy solutions in storeof need. In this sense, the inclusionof of the a private sovereign Without instruments to allocate losses of not least because, if bank rescues were exercises can create unnecessary confusion. loan facility is an important step forward. The European Central Bank president knew that, while this was technically true, leading Another source of confusion has to do with GreekNovember crisis 2013 and its James Bullard, President, Federal Reserve Bank of St. Louis debt crisis, analysts, economists and financial market experts had long identified vulnerabilities in the euro’s 25 the recapitalisation of banks that failed the policymakers, and banks to both shareholders and unsecured needed beyond liquidity support, national foundations which cast doubt on the validity of the comparison. On 10 June, in a remarkable aftermath, the EU exercise. Some analysts have shown concern intervention into a politically-charged controversy, the ECB published its own ideas about had begun efforts to lobal investors are dividing Europe once again into member states, a sort of market- financial market how to address some of these sources of weakness. The ECB said its proposals were aimed based disintegration of the continent. The US is growing, but at a sluggish pace. strengthen financial G participants have creditors, taxpayers in the euro area are finance ministries would be the lenders of at changes ‘needed for a sustainable functioning of economic and monetary union.’ Recent data from China suggests a slower pace of growth than might have been expected craved a simple, market regulation. earlier this year. Commodity prices have fallen to lower levels during recent months in part Two particular weaknesses – both well-understood by the euro’s founding fathers – have in response to the slowing global economy. sharp solution to likely to bear the burden of losses. Fiscal last resort. Early efforts to give the ECB been exposed by three years of crises. One is the lack of a fiscal transfer mechanism that the problem. But would have been used to provide support from stronger to weaker countries. This is a Inflation readings have generally been lower. This constellation of data is causing debt problems are capacity to cover these losses is limited a role in supervising cross-border banks commonplace in unitary states, but such a ‘bail-out’ of one euro area member by another is considerable unease. Much of this can be traced to realisation that the European sovereign explicitly forbidden under the treaty creating the single currency. Instead it was hoped that debt crisis may be more traumatising and intractable than previously understood. unlikely to find quick rapid economic convergence and a fiscal discipline mechanism, the Stability and Growth solutions. in the crisis countries. Taxpayers in other were rebuffed in the vain hope that such a Pact, would ensure that bail-outs would not be needed. One of the principal issues facing policymakers inside Europe (and worrying those outside) is exit from Economic and Monetary Union (EMU). Exit is often portrayed as a crisis event, Another vulnerability was that robust systems were not in place to deal with cross-border as it would suggest the use of alternative and presumably much weaker currencies to pay banking crises. Indeed, banking regulation and supervision remain in large part a national back external debt. In this sense it would be a way partially to default, as is always the EU countries are unwilling to pay for a major cross-border or systemic euro area prerogative, not least because, if bank rescues were needed beyond liquidity support, case with surprise inflation and devaluation. Markets are reacting by pricing in some national finance ministries would be the lenders of last resort. The founding fathers blanched probability that such an event could occur, even though the official line is that it cannot. bill running into hundreds of billions of banking crisis would never happen. at the idea that, in a euro crisis, French taxpayers, for example, might be expected to help EMU was formed from a subset of EU countries, and some countries remain outside, the bail out German banks. leading example being the UK. Since not all countries joined, it would seem that the ” experiment might have allowed exit from EMU, but it did not. In addition, some European euros. Early efforts to give the ECB a role in supervising cross-border banks were rebuffed in the nations use the euro even though they are not part of EMU. These arrangements give me vain hope that such a major cross-border or systemic euro area banking crisis would never pause concerning the meaning of exit. Some countries never joined and others have joined ” happen. The trans-Atlantic banking disaster of 2007 exposed these interlocking fiscal and de facto. financial market frailties. The past three years have demonstrated that fiscal discipline October 2013 alone would never be enough to ensure convergenceJuly and stability.2010 Sovereign debt and The EMU can be viewed as a club, and members enjoy benefits that do not accrue to member states’ payments imbalances and competitiveness still matter. non-members. The value of being a member was originally to get German credibility on monetary policy. Countries choosing not to join calculated that they could run an equally The ECB’s proposals aim to address these problems. They call for much tougher surveillance effective monetary policy to the Germans. The value of club membership was highest for of EU budget policies, earlier and tougher implementation of rules, including the application countries with the least monetary policy credibility. EMU’s initial success was stunning, of ‘quasi-automatic’ sanctions such as suspending a member state’s euro area voting rights, driving yields on all EMU member debt essentially to German levels. This created a great more rigorous macro-economic surveillance focused on boosting competitiveness, and a environment for investment and stability within EMU. strengthened crisis management framework. 18 THE FUTURE OF THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org QUESTION 3 19 The logic of exit suggests that, if the club is valuable, member countries will not want to This, the ECB says, should be based on the new €440bn European Financial Stability leave. Survey evidence seems to indicate that these incentives to stay in the club remain Facility, headed by Klaus Regling, a former top German finance ministry, EU Commission strong today. Still, the common refrain that no country can ever be allowed to leave EMU and International Monetary Fund official. Access to the EFSF’s money would be available is altering the incentives for nations to take the actions necessary to maintain membership. only on penal terms. The ECB’s suggestions will feed into a report expected to be This is one of the main penalties that in principle should be enforcing the equilibrium published in October by the increasingly influential Herman van Rompuy, the President of behaviour among the members of the club. the European Council, proposing far-reaching reforms to the economic governance of the EU and the euro area. The incentive effects for club membership are critical in another way. For countries that are already members, taking on country credit risk through mutualisation damages their Well before the Greek crisis and its aftermath, the EU had begun efforts to strengthen incentives to remain in the club. They enjoy the benefits of membership, but the calculus could change if they see too many disadvantages from the policies undertaken to keep financial market regulation. These had been launched in February 2009 by a report by the union together. Countries can, in principle, remain on the outside and also do well, another specialist committee of experts led by Jacques de Larosière. Just how radical the as Sweden has demonstrated. In short, my view is that the incentive effects for a member new banking oversight mechanisms will be, in particular how much authority EU member country to remain in EMU must be considered very carefully. Policies should be designed states will have to surrender to new cross-border EU regulatory authorities, is now being with an eye toward these incentives, and can no longer assume that the political processes contested between and within the European Council and the . y will back EMU in all circumstances.

From the beginning of the sovereign debt crisis, analysts, policymakers, and financial market participants have craved a simple, sharp solution to the problem. But debt problems 8/30/2012 10:02:12 AM are unlikely to find quick solutions. We should expect a long, slow resolution process peppered with bouts of increased financial stress. Still, there is one possibility for a grand www.omfif.org bargain that makes some sense and that has been increasingly discussed. 3 www.omfif.org 6

OMFIF 2012-09_08.indd 6 4 What is the role of quantitative easing?

uch later than the other large experiencing falls in prices as a result of Danger of low inflation – central banks – a delay a savage demand squeeze – a product When inflation is too low, it carries very reflecting the fragmented of austerity programmes, designed to M significant dangers and risks. It makes state of the euro area, and the ECB's reduce debt, that ended up being self- The perils of persistently low inflation real adjustment more complicated. Europe must increase competitiveness as part of recovery consequent lack of a smooth unitary defeating. “ Christian Noyer, Banque de France With low inflation, there is less scope for he situation in the euro area is difficult but decision-making process on such Tnot hopeless. The second quarter of 2013 on the downside, and the need to pursue marked a turning point that put an end to six deleveraging in the public and private downward adjustment in relative prices and consecutive quarters of recession. The euro Prices are still increasing and, most sectors in certain countries is likely to importantly, so are nominal wages. Inflation questions – the ECB started quantitative Behind the German anti-QE aversion area finally saw a return to positive growth, continue weighing on the recovery. As far as with a 0.3% expansion, and this was confirmed expectations remain firmly anchored in real wages … Low inflation makes it difficult unemployment is concerned, although it has positive territory, even in the short-run. in the third quarter with 0.1% growth, and been stabilising for the past few months, the easing only in March 2015. lay concerns that possible losses on again in the fourth quarter with 0.3% growth. Second, low inflation provides economic overall level is still far too high. stimulus by boosting real income. In most to attain low, or negative, real interest Nonetheless, the euro area will have seen In this context, the key question at the a 0.4% contraction over the year 2013, due to parts of the euro area, nominal wages government bond purchases by the heart of debate is: How can we amplify this are downward rigid. Every time inflation a negative growth overhang from the end of recovery? What Europe needs in order to rates, which are necessary in all advanced 2012. The recovery in 2013 was modest and ‘surprises’ on the downside, it creates an strengthen its pace of growth is to improve its unexpected increase in real wages and The QE decision to make monthly ECB’s constituent central banks could unequal across countries. However, this still competitiveness in today’s globalised world. reflects a sharp improvement in the overall purchasing power. On this issue of reforms, the euro area economies. And it increases the risk that the trend, which is continuing and gradually has made considerable progress these last Economic sentiment €60bn purchases of mainly government expose the banks to the need for getting stronger. ECB staff projections foresee few years, especially in those countries with annual real GDP increasing by 1.2% in There is evidence that this mechanism is economy could fall into outright deflation. the biggest competitive lag relative to the rest playing some role by improving economic 2014 and 1.5% in 2015. Compared with the of the region. These countries been plunged bonds, amid constant sniping from recapitalisation through taxpayers. December 2013 euro area staff projections, sentiment and supporting consumption as deeper into crisis than their neighbours. Cost we have seen in the euro area over the past The 2% target is meant to act as a cushion the projection for real GDP growth for 2014 competitiveness, as measured by unit labour has been revised slightly upwards. months.That said, when inflation is too low, it costs, has improved substantially. The same carries very significant dangers and risks. the Bundesbank, was a reaction to It could also open up the path to the nations have shown a strong correction in Europe’s rebound First, it makes real adjustment more against that risk. If this situation persists, it current account balances. complicated. With low inflation, there is Although the strength of the rebound chronically low inflation in the euro long-feared 'transfer union'. Influential With regard to structural reforms, the euro less scope for downward adjustment in varies across countries, it is important to area is moving in the right direction. However, could prove dangerous. highlight the return to positive growth in relative prices and real wages. The euro area it still has a lot of work to do, particularly strongly needs such adjustments in order for area, well below its mandate of keeping Germans have habitually rejected any those countries most affected by the crisis in liberalising goods and services markets, and which are of major importance to the some countries, including France, to regain ” making labourApril markets more2014 flexible, and competitiveness. This would no doubt be euro area: above all of Spain and Italy, where increasing profit margins to enable companies made easier if the overall euro inflation rate annual price rises close to 2%. The permanent transfer of funds to weaker exports have rebounded sharply and are to start investing in innovative technology driving economic activity. stays closer to the ECB definition of price How the ECB lagged in quantitative easing again. This is without doubt the most stability. On a financial level, economists see a important lever for guaranteeing a strong and programme will probably be extended nations. Germany opposition is as significant return to normal in the euro area. Second, low inflation makes it difficult sustainable recovery in the euro area, and one to attain low, or negative, real interest rates, Central bank assets, percentage of GDP Bond markets in periphery countries are that will create jobs. continuing to stabilise and interest rates have which are necessary in all advanced economies beyond September 2016. strong as ever even though, in reality, Central bank assets, (% of nominal GDP) at the current juncture. Finally, low inflation come back down to sustainable levels, with Level of inflation several periphery countries or programme increases the risk that the economy could fall No summary of the euro area situation into outright deflation if and when it is hit by countries recently managing to obtain market would be complete without talking about the to alleviate debt in Greece and other 80 financing at perfectly satisfactory rates. a negative shock. The 2% target is meant to act low level of inflation, which poses a major as a cushion against that risk. That cushion is Similarly, fragmentation within the euro challenge for the euro system, and for the not available at the moment. If this situation Deflation was not, however, a general countries, German taxpayers in coming Bank of Japan Federalarea is decreasing Reserve over time – as shown by BoEeuro area economy as ECBa whole. the decline in liquidity surpluses and Target persists, it could prove dangerous in a very Inflation has been falling recently in all uncertain economic environment. 2 balances. advanced economies.This fall was especially problem, even though some peripheral years will have to face higher taxes and Furthermore, credit dynamics are still To sum up, the situation today calls for 70 marked in the euro area, from 2.7% in 2011 a very careful assessment of the balance of subdued on the whole, due to continuing to 0.8% in February 2014. Let me make a weak demand and bank deleveraging in risks. Precisely because deflation is hard to few points on this. First, low inflation is reverse, even small probabilities should not countries, especially Greece, were lower government spending. response to the new regulations and, in all not deflation. Deflation is a permanent and likelihood, the Asset Quality Review being be neglected and they should be fully factored cumulative process of decrease in the overall into policy-making. conducted by the ECB. price index, fuelled by negative expectations. 60 Overall, and as predicted, we have seen Deflation is especially dangerous because, French economy a trend towards recovery since the middle as the experience of Japan has shown, once KEY POINTS If one takes a closer look at the situation of last year. However, this recovery remains it becomes entrenched, it is very difficult Unfortunately for the ECB, it is still weak and fragile. The risks are still mainly in France, which has its difficulties, recent to stop. From this perspective, there is no indicators have been positive. Growth is •QE decision to make monthly deflation today in the euro area. expected to be a bit below euro area average ensnared in financial wrangling over 50 in 2014, at just below 1% compared with 1.2% €60bn purchases of mainly Greece – as a large direct and indirect April 2014 government bonds was a reaction to 11 creditor, as a bank supervisor, and also 40 chronically low inflation as the arbiter of whether, and for how •Influential Germans have habitually long, Greece should continue to benefit 30 rejected any permanent transfer of from emergency liquidity assistance to funds to weaker nations keep its banks afloat. Despite the €86bn 20 •ECB still ensnared in financial loan package agreed for Greece in wrangling over Greece – as a large August, it is still not entirely excluded that 10 direct and indirect creditor, and as a the ECB will make losses on Greek debt bank supervisor holdings – which would affect the entire 0 •QE likely to be extended beyond QE programme. 2016 as a result of low inflation 2008 2009 2010 2011 2012 2013 2014 2015 Source:Source: ??? FRED, ECB

20 THE FUTURE OF THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org QUESTION 3 21 OMFIF Bullet Global Insight on Official Monetary and FinancialI Institutionsn

Abe relies on BoJ arm-twisting January 2013 Growth plans aimed at securing power in upper house Shumpei Takemori, Advisory Board hinzo Abe, the new Japanese Sprime minister, is relying on Bank would be the last major poll for three of Japan (BoJ) arm-twisting and big years, would enable the prime minister public spending measures amounting as planned in December. Enacting the to pursue pet projects like rewriting the measure depends on Japan’s economic to Y11tn to provide sufficient Japanese constitution. momentum to win crucial elections condition in the second quarter of 2013. In the event of a major slump, the in the upper house of the Japanese Abe has little substance to offer. parliament this summer. Government would probably decide to His growth strategy was patched withdraw the tax increase. together at the last minute before Following victory for his Liberal the December election. He appears Since 2005, the life expectancy of a Democratic Party (LDP) in December’s confident of the success of his magic lower house elections, Abe needs to Japanese prime minister has been less formula: pressure on the Bank of Japan than a year. The ‘pro-growth’ LDP in fact secure a majority in the upper house, governor to raise its inflation target and too, to prevent politics becoming utterly has a miserable record. For 18 years print more money. These short-term when it was in power, from 1990 to dysfunctional – the painful experience measures will have long-term effects, he had as prime minister in 2006. Victory 2007, Japan’s average nominal growth notably by determining whether or was a mere 0.8%. (In real terms, growth Transfer union a 'perversion' of solidarity ECB measures 'brilliant confidencein the uppertrick' house election, whichMeghnad not the government can increase Desai the – – was slightly over 1%, because Japan has consumption tax rate from 5% to 8% OMFIF launches Year of the Luso-Economy and Focus onbeen Renminbi plagued by indeflation.) 2013 OMFIF is launching the Year of the Luso-Economy in 2013 to recognise the importance (continued on page 12 ...) The demand that the stronger countries Among largely toothless institutions, of the nine Portuguese-speaking nations in Europe, Latin America, Africa and Asia for world development and finance. One of the highlights will be a large roundtable meeting in Brasilia jointly hosted by Banco Central do Brasil and OMFIF on 17-18 June. OMFIF should, in pursuit of the common the European Central Bank (ECB) is is also intensifying its focus on the internationalisation of the renminbi. SEE ARTICLES ON P. 6-9, 12 & 34-35. interest, support the weaker ones is showing decisiveness. Its proposal of Contents euro begins its 13th year OMFIF ” ” Euro adjustment progress Official Monetary and Euro misery Financial Institutions Forum a perversion of 'financial solidarity'. In bailing out countries if they asked for help Support for bank separation Kirsten Lommatzsch 3 Tackling renminbi expansion Michael Lafferty Brilliant ECB proposal 5 fact, this is the opposite. It would establish was a brilliant confidence trick. No country China share set to rise Kelvin Lau and Stephen Green Meghnad Desai, Advisory Board Moment of truth postponed 6 Top 10 forecasts for 2013 Gary Smith The present scenario 8 Survival of euro is at stake a revenue-sharing system under which would be likely to ask … it would indicate Why we must heed monetary threat Michael Kaimakliotis he euro area came near to breaking up in 2012 or does not come as a 10 Tat least ejecting Greece. Various dire threats were Paradoxical consequences of Basel III Gabriel Stein issued; elections were held which threatened the worst. Otmar Issing, former Chief Economist, European Central Bank surprise. … At the 13 Constraints on Scotland Moorad Choudhry In the end misery was given renewed support. It is likely outset, and also after imbalances generated by macroeconomic that bankruptcy was imminent. Markets 16 Preparing for the worst Brian Quinn to be endless. he news from Athens came as a shock to the political and financial market community. the start, politics Christopher Tugendhat 18 When the new Greek government announced in autumn 2009 that the public sector budget Great step forward for the euro Greece will take the poisoned chalice and drink it. A whole T failed to create the divergence would be financed by forced would act faster than the ECB and hence Ruud Lubbers, Paul van Seters 20 deficit had risen to 13% of GDP (a figure subsequently revised to 15%), compared with the Nuanced view of Fed target generation of Greek youth will have their lives blighted. 21 previously estimated 3%, the correction did much more than simply amplify scepticism about right conditions The End is Nigh, or is it? Darrell Delamaide Among a large number of largely toothless institutions, 22 the European Central Bank (ECB) is the only one showing Greek statistics. The scale of the fiscal disaster sparked concerns about whether the country for EMU to work transfers from less well-off countries that no country has made an application. Yet Archive Insight: Why no one heeded FrederickBundesbank Hopson warnings could remain a permanent member of economic and monetary union (EMU). 28 decisiveness. Its proposal of bailing out countries if they optimally. Year of the Luso-Economy asked for help was a brilliant confidence trick. 32 These worries spread, too, to other EMU members. A highly inappropriate terminology play by the rules to countries with higher the expectation that they may do so has Year for living dangerously Edward Longhurst-Pierce came into play, speaking of ‘contagion’, as if the other ‘patients’ had not long ago 34 No country would be likely to ask for such help as it would William Keegan indicate to the markets that bankruptcy was imminent. displayed similar, though weaker, symptoms of the same disease. Greece has certainly 36 been an exceptional case. But it also demonstrated – as if we needed fresh evidence living standards following unsound fiscal buoyed markets. The ECB is a 'class act' Markets would act faster than the ECB and hence no country – some of the general shortcomings that have grown up since EMU started, which has made an application. Yet the expectation that they may have contributed in large measure to the threatening circumstances we have now at do so has buoyed markets. the beginning of the 13th year of the single currency. Sadly, I cannot say that the policies. Transfer payments that are neither and knows a trick or two. But how long (continued on page 12 ...) scenario we face now has come in any way as a surprise. Among the past setbacks, we have to list violations of the Stability and Growth Pact as well as persistent differences in member countries’ unit labour costs, resulting in serious loss of competitiveness in economically nor socially justified become can the conjuring trick last? In the longer www.omfif.org different member states. This was a crisis that in many ways had been pre-announced; 1 the seeds were sown some time ago. necessary in a misaligned monetary union run, prospects are dim for the euro area… EMU started out as an exceptional construct. In contrast with what we might term a ‘normal’ historical development, in EMU the borders of money and states did not coincide. The 11 with an inadequate framework of rules that What is needed is a euro-wide tax which founder members, now 17 with the entry of Estonia on 1 January, in no way represent a politically unified entirety. But they form Januarya single currency, the euro,2011 run by one central January 2013 bank, the European Central Bank (ECB), entrusted with ensuring price stability in the euro rewards rather than punishes violators. could be used for transfer payments. area, with a one-size-fits-all monetary policy. At the outset, and also after the start, politics failed to create the right conditions for it to work optimally. ” ” With entry into monetary union, conditions for individual countries changed significantly. Countries that had registered higher inflation in the past were suddenly able, under the Needumbrella offor a common stablefresh currency, to enjoy measures lower interest rates – a luxury they could – Franco Bassanini & Edoardo Reviglio Creditors get ready to pay – David Marsh & John Plender previously experience only through hearsay. Among other things, this created a construction boom in some countries. This development, though initially desirable in some cases, soon gave way to unsustainable overheating. The European Central Bank's targeted The firepower assembled to shore OMFIFOMFIF Bullet Monetary policy could not compensate for failings in individual countries, since policy had to be set for the euro area as a whole. To correct inappropriate developments in individual Official Monetary and 2010 Global Insight on Official Monetary and Financial Institutions countries, economic policies should have been adjusted at a national level, for2009 example Financial Institutions Forum In 2008 long-term refinancing operations up economic and monetary union 2007 101.6 though fiscal policies, which after all were still a national 2006responsibility. Such 106.9measures Europe & the euro 2005 104.3 could have been activated at an earlier stage2004 to mitigate the boom.103.6 91.1 2003 101.4 94.4 2002 100.2 91.4 2001 101.4 89.3 122.8 (TLTROs), a line of liquidity earmarked demonstrates that euro area creditors, Competitive positions:2000 relative unit98.7 labour costs 90.1 126.6 1999 95.9 94.1 124.5 94.0 98.9 120.6 111.1 October 2012 95.2 98.8 117.7 113.0 100.0 94.4 116.7 114.0 “ “ euro creditors get ready to pay 92.1 115.3 111.8 96.7 France 93.4 110.8 107.9 91.1 for medium-term bank financing, were well led by Germany, are getting ready to do 100.0 101.3 105.3 95.3 97. 3 103.0 109.4 Germany 95.8 99.2 106.1 Unlike 1920s, this time Germany’s the creditor 100.0 93.5 103.7 91.0 104.9 Italy 90.0 100.2 100.0 103.3 received by the markets. There is broad what they always do in debt restructurings: David Marsh and John Plender 99.6 Spain 102.3 Following100.0 in Draghi’s footsteps battery of firepower assembled to UK Cassa Depositi e Prestiti Ashore up economic and monetary The stand-off between EMU surplus and InstitutionsNote: Competitiveness-weighted should take relative a unit lead labour costsfrom in the manufactoringECB easing sector in dollar measures terms. consensus on the need to boost investment… pay up mighty sums to ensure peace union (EMU) demonstrates that euro deficit states partly resembles a rerun Competitiveness weights take into account the structure of competition in both export and import markets of area creditors, led by Germany, are how the illusion of creditor power is Franco Bassaninithe manufacturing and sectorEdoardo of 42 countries. Reviglio, An increase in the index indicates a real effective appreciation and of the moral and economic arguments progressively being stripped away. a corresponding deteriorationEIB president of the competitive and his position.predecessor Philippe getting ready to do what they always This approach requires new financing tools, and harmony. The ECB’s initiative to about Germany’s payment of post-First The same is true for the plan, still in Maystadt, as well as from an influential do in the case of debt restructurings: Source: OECD Economic Outlook 88 database. World War reparations. This time, its early stages, of quadrupling EMU group of MEPs, it was generally received pay up mighty sums to ensure peace he European Central Bank’s 5 June Germany is creditor, not debtor. Just as governments’ permanent rescue fund, www.omfif.orgwith scepticism. This reflected general belief as well as a more favourable regulatory buy weaker countries bonds through and harmony. measures were well8 received by German reparations were not paid in the European Stability Mechanism, T that Bundesbank resistance would have been the 1920s, it seems unlikely that, 90 the markets, which saw the action as a to €2tn through extra infusions of aid difficult to overcome. It is significant that, Whether or not Germany, as well as years later, EMU debtors will have to useful contribution to renewing growth money. two years later, the ECB governing council, framework. Until now, Europe has the 'outright monetary transactions' the other big creditors, Netherlands, pay anything like the full amount of and reducing the cost of money. The including the Bundesbank president, gave the Finland and Austria, really will their obligations. differentials between government bonds of TLRTOs unanimous approval. sanction large flows of funds to the Buttressed by constant Germanic the euro area core countries and those of the witnessed mainly words rather than actions. programme, hotly opposed by the cash-strapped debtors will be one of affirmations on financial orthodoxy, peripheral countries narrowed following the European Central Bank in Frankfurt The European Central Bank’s initiative EMU’s prevailing wisdom is that the ECB measures Europe’s major questions, not simply to buy weaker countries bonds through announcement. However we should point out some Further risks flow from the possibility that in the campaign towards next autumn’s burden of adjustment falls exclusively There has been a broad consensus for Now the ECB has made the first step. Mario Bundesbank, illustrates how the illusion of the so-called Outright Monetary on the debtors, who are all subject to differences between our 2012 proposal and the the banks will use the measures to indulge German general election. some time on the need to boost medium- Transactions programme, hotly supposedly strict conditionality on bail- ECB measures, which could have a negative further in ‘carry trades’ (funding purchases to long-term investment as a key route to opposed by the Bundesbank, illustrates out packages. impact on their effectiveness. The first of relatively high-yielding government Draghi, the ECB president, once again is creditor power is being stripped away. The Insights into 2012 Greek debt restructuring and past episodes of world hyperinflation renewing growth and competitiveness in concerns the scope of the financing. The ECB bonds). Against a background of low banking The October 2012 Bulletin contains insights into two sets of circumstances of seminal importance for world economics. Italy and Europe as a whole. This approach (continued on page 10...) decision excludes infrastructure investments profitability, banks face the temptation of These are the landmark Greek restructuring of 2012 – by far the biggest sovereign bankruptcy in history – and past requires new financing tools, as well as a more (project finance, public private partnerships improving their returns on equity using such doing everything he can to promote growth. same is true for the plan for quadrupling episodes of world hyperinflation, compiled in a unique table. The articles are respectively by Philip Wood, Head favourable regulatory framework. Until now, and so on). It is not clear why this is so. On trades rather than by restarting profitable Europe has witnessed mainly words rather of Allen & Overy Global Law Intelligence Unit, and Steve H. Hanke and Nicholas Krus from The Johns Hopkins average, ‘investment grade’ infrastructure loans to enterprises. than actions. Now the ECB has made the first University. S projects have lower risk profiles than many It is difficult to say what the effects of Other European institutions need to follow in EMU governments' permanent rescue fund, ee ARtICleS O step. Mario Draghi, the ECB president, once n HYPeRIn corporate risks, and Europe is in great need of these measures will be. Much depends on the FlAtIOn, P. 11-13, An again is doing everything he can to promote D GRee infrastructure finance. response from the credit system and from Contents Ce, P. 20-27. growth. Other European institutions need to Second, the duration is limited to four his footsteps. the European Stability Mechanism. companies. The Italian government could follow in his footsteps. years,July which is quite2014 short for the medium- Faustian pact over money October 2012 The most significant innovation centres on however play an important accompanying term financing of business investments, and role in mitigating risks and reducing the ” ” Inflation risks under control Debt wave the targeted long-term refinancing operations 3 a very short time indeed for the financing of banks’ capital absorption, thus encouraging (TLTROs), a line of liquidity earmarked for Tracking world hyperinflation Gabriel Stein infrastructure projects. them to participate in the operation. 6 Corporates lead way medium-term bank financing to the real An extension to seven years (or What Europe can learn from Asia Steve H. Hanke economy This provides funds of up to €400bn alternatively a system under which a three- 11 Victoria Harling, Investec Government guarantees The eternal euro debate Prasarn Trairatvorakul at low cost (currently 0.25%). year loan could be automatically renewed for The TLRTO loans (particularly those made 14 The money will be supplied in two Harold James orporate bond issues from emerging market economies so a further three under certain conditions), as to smaller enterprises) could, for example, be BankNotes - The Fed operations,THE FUTUREin September OF and THEDecember. EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org 16 far this year have risen to a record $214bn,QUESTION already above4 22 we proposed, could be decisive in unblocking backed by government guarantees provided Darrell Delamaide C 23 Banks that can prove they have increased Bankruptcy that changed world the previous full-year high of $211bn in 2010 and well ahead large numbers of investment projects now on by the Central Guarantee Fund (which could 18 lending to the real economy will be able to Philip Wood of year-to-date emerging market sovereign issuance of $67bn. hold. subsequently be recapitalised further, if No European federation in view draw down additional sums between March Third, the timing is hardly propitious. 20 Asian issuers, particularly from Hong Kong and China, have necessary, with resources from the structural OMFIF Advisory Board Frits Bolkestein 2015 and June 2016. been the most prolific ($80bn), followed by Latin American When we made our proposal, Europe had funds). An alternative, for operations not 28 All the TLTROs will mature in September companies ($65bn). endured two years of scarce liquidity and falling within the scope of the , 30 2018. According to estimates by Morgan Shoring up the structures tight credit rationing. would be to use Caissa Depositi e Prestiti, Ruud Lubbers & Paul Stanley, Italian banks could draw down Today, there is plentiful liquidity on the Following the first two waves of emerging market debt (EMD) – which would in turn backed by a government €75bn, leading to a potential reduction of 20 When action by ECB is not enough van Seters 33 market. The problem is, if anything, risk and guarantee. Plainly, a guarantee covering 60- sovereign borrowing first in dollars and then in local currencies to 40 basis points on the average cost of loans capital absorption. Other potential problems 65% of the risk (no more, to avoid moral Unconventional becomes standard Statistical forecasts – investors are now riding corporate debt as the ‘third wave’ in to small and medium-sized enterprises. will perhaps require technical solutions. 34 the development of emerging market debt. This is an attractive hazard) would have a significant impact on The Keegan commentary Stefan Bielmeier There is a risk that the resources unleashed by the burden of the capital ratios imposed under 35 new way of harnessing the structural investment benefits An unconventional measure William Keegan the ECB resources will end up financing not the latest Basel III rules. This would promote OMFIF of emerging markets. The rise in corporate EMD reflects The idea behind the TLTROs is Official Monetary and This document must not be copied 36 smaller businesses, which have the greatest credit supply to the real economy and bring Financial Institutions Forum and is only to be made available companies’ efforts to replace traditional bank loans by funding fundamentally correct. Two years ago, in May need for them, but mostly large and medium- about a more orderly process for the overall to OMFIF members, prospective in public debt, with the latter now relatively attractive thanks to 2012 writing in Il Sole 24 Ore, we proposed members and partner organisations sized companies. deleveraging that Europe still needs. ■ quantitative easing and bank deleveraging. a rather similar unconventional measure, This in turn could interfere with the 25 Franco Bassanini is Chairman and Edoardo Reviglio referred to as very long-term refinancing smooth working of a European corporate July - August 2014 is Chief Economist at Cassa Depositi e Prestiti. (continued on page 10 ...) operation (VLTRO), to counter the credit bond market that is undergoing healthy crunch and stimulate investment. We growth, and is making its own contribution repeated this proposal in autumn 2012 at a to reducing credit spreads. www.omfif.org (EIB) conference 1 in Luxembourg. Although the proposal found ready support from Werner Hoyer, the News

How can EMU be restructured? Redrawing the euro’s contours 5 Thorough overhaul needed for Eurosystem Michael Burda, Advisory Board egitimate argument surrounds how steps towards much-neededconomic economic and monetary union Redrawingas their government and the private euro's sectors credit contours policy across the– euroMichael area. Burda much restructuring is required. One coordination. Ewas always a grand gamble. It were already overextended. Restricting The logical remedy is a redesign of established the European Central Bank creditAn flows overhaul to Greek ofbanks the and Eurosystem other the ECB is in a fashion similar to the US News central aspect is to put back the (ECB) for a region that was not a state. lenders would have slowed aggregate Federal Reserve system. The regional L The ECB is a trans-European institution demandrequired, and the including deterioration a redrawingof Federal Reserve Banks represent largeRedrawing the euro’s contours 'economic' in economic and monetary Redrawing the contours of the ECB with governmental duties that does not competitivenessof ECB central already emerging.banks' boundaries.stretches of territory that reach beyondThorough overhaul needed for Eurosystem union. Incontestably, the political climate system along US Federal Reserve-stylerepresent any government in particular. the borders of US states and sometimesMichael Burda, Advisory Board “ conomic and monetary union Re-politicisationThe one-interest rate ofpolicy monetary praised policyeven divide them. Ewas always a grand gamble. It as their government and private sectors has changed since the eruption of the lines represents one of the more visionary established the European Central Bank were already overextended. Restricting credit policy across the euro area. The euro’s founding fathers did not by Jean-Claude Trichet, then ECB (ECB) for a region that was not a state. credit flows to Greek banks and other poses a risk for economic integration as The ECB is a trans-European institution The logical remedy is a redesign of anticipate all the ramifications. In president, sent exactly the wrong signal Balance of payments problems lenders would have slowed aggregate the ECB in a fashion similar to the US Greek turbulence in 2010, underlining ideas for restructuring; this surely requires with governmental duties that does not demand and the deterioration of represent any government in particular. Federal Reserve system. The regional particular, every expansion of the euro wellto the as markets. for money Once markets and got credit wise policy.and competitiveness The misalignments competitiveness already emerging. Federal Reserve Banks represent large that even relatively small economies can (but could also help to define) a more stretches of territory that reach beyond The euro’s founding fathers did not The one-interest rate policy praised area has led to an automatic enlargement to what was going on, governments between Federal Reserveanticipate districts all the ramifications.do In the borders of US states and sometimes remedy is a system like the US Federal by Jean-Claude Trichet, then ECB even divide them. make a difference to aggregate levels of fundamental decision on politicalof the central union. bank council, without that had previously been able to occur, but they are apoliticalparticular, every andexpansion of the euro president, sent exactly the wrong signal area has led to an automatic enlargement to the markets. Once markets got wise of the central bank council, without Balance of payments problems taking account of increased complexity Reserve.borrow on Thethe regionalsame conditions Feds asrepresent immune from the pressures of state to what was going on, governments and competitiveness misalignments confidence and output. The euro system is already charging in taking account of increased complexity that had previously been able to of governance and monetary policy- between Federal Reserve districts do of governance and monetary policy- Germany saw a drastic deterioration in legislatures. borrow on the same conditions as occur, but they are apolitical and territory that reach over internal US state making, including funding conditions Germany saw a drastic deterioration in for governments and refinancing of immune from the pressures of state the direction of more joint making,surveillance including funding conditions their creditworthiness. By then, it was their creditworthiness. By then, it was legislatures. for governments and refinancing of borders.too late: after Balance the adjustment, of payments the ECB Theproblems map shows one possiblecommercial model banks. for too late: after the adjustment, the ECB became so preoccupied with shoring The map shows one possible model for Simply going back to the starting and monitoring of individual countries' To overcome these deep-seated up the financial health of the system commercial banks. became so preoccupied with shoring repartitioning the euro areagovernance monetary problems, a thoroughgoing repartitioning the euro area monetary that it was unable to apply haircuts to authority along the lines of the EU and competitiveness misalignments overhaul of the Eurosystem is required, any single country. blocks and reimposing Maastricht-style fiscal and general economic policies. up the financial health of the system authority along the linesincluding of a redrawingthe EUof the boundaries NUTS-2 regions used for statistical of the central banks that make up the analysis. Such an ECB redrawing, To overcome these deep-seated betweenthat it was unableFed districts to apply haircutsdo occur, to NUTS-2 but they regions used for statistical The repoliticisation of monetary cutting across national frontiers, ECB’s constituency. A possible plan is policy poses a significant risk for discipline is clearly not enough. Yet shown on the map on this page. would help reestablish a neutral and governance problems, a thoroughgoing any single country. analysis. Such an ECB redrawing, economic integration as well as for politically independent allocation of are apolitical and immune from state a neutral (country-blind) money and a bedrock of future policy is member EMU membership by the largeroverhaul non-euroof the Eurosystem is required, cutting across nationalAdjustment frontiers,in a monetary union is April 2014 money and credit. painful – as developments in the The Burda Plan for repartitioning the euro(continued area on page 20..) including a redrawing of the boundaries legislatureThe repoliticisation pressures. of monetary would help reestablishEuropean a neutral periphery makeand clear – so it is countries' commitment to budgetary states has been postponed for years if paramount to prevent such misalignments of the central banks that make up the policy poses a significant risk for politically independentfrom allocation arising in the first place.of Despite ” these warnings, European politicians rigour and introduction of labour not decades. Managing theECB’s relationship constituency. A possible plan is economic integration as well as for money and credit. insisted on setting up a system with fundamental flaws. A common monetary shown on the map on this page. Newa neutral contours (country-blind) for the ECBmoney and (continuedpolicy must on be page formulated 20..) above and market and product reforms to make between 'ins' and 'outs' will require beyond individual national concerns. Yet regions could look like this, using the model of thebecause US the Federal national euro centralReserve banks The Burda Plan for repartitioning the euro areahave much to say about ECB monetary markets more flexible and thus more considerable finesse. Adjustment in a monetary union is policy – in fact, they own the ECB – they pose source of significant risk. This redrawing of the ECB, based on EU regions, painful – as developments in the One example is their well-recognised susceptible to the potential benefits reluctance to impose ‘haircuts’ on the European periphery make clear – so it is value of collateral used by memberintentionally cuts across national frontiers of the country private banks for funding their of the single currency. Without doubt, The ECB, through its diverseparamount liquidity to prevent such misalignments lending activities. larger countries. from arising in the first place. Despite EMU has accomplished some important injections and hints of guarantees for This is one of the few natural brakes onIt would help re-establish a neutral and politically these warnings, European politicians government borrowing, especially when it is driven by reckless fiscal policy. In independent allocation of money and credit. countries' debt, has shoredinsisted up the on systemsetting up a system with this sense, the ECB should have applied that brake much earlier. By any normalThe number of board members representing the KEY POINTS fundamental flaws. A common monetary reckoning, Greek banks should have at times of adversity, allowing time faced this constraint already in 2003-04,districts could be based on population or GDP per •Bedrock of future policy is policy must be formulated above and for more thoroughgoing amendmentsbeyond individual national concerns. Yet 18 www.omfif.org capita. commitment to budgetary rigour requiring political consent.because the national euro central banks The governing bodies of the new ECB would re- •Redrawing the contours of the ECB have much to say about ECB monetary ceive democratic legitimation from the Europe- policy – in fact, they own the ECB – an Parliament upon nomination by national au- system along US Federal Reserve- Alongside a political restructuring,they pose sourcewe of significant risk. thorities. Smaller countries would benefit from a style lines represents one of the One example is their well-recognised reduction in the natural hegemony of the larger will also see a debt restructuring.reluctance Asto impose ‘haircuts’ on the member states. more visionary ideas for euro area value of collateral used by member a quid pro quo for more control over The legacy of the defective status quo − the TAR- restructuring country private banks for funding their individual member's finances,lending creditoractivities. GET2 accounts on national central bank balance •ECB, through its diverse liquidity nations are getting ready to transfer large sheets − could be reapportioned to the new ECB injections and hints of guarantees for This is one of the few natural brakes on districts on a pro rata basis. sums of money to weaker governmentstates, whether borrowing, especially when countries' debt, has shored up the overtly through permanentit funding is driven by reckless fiscal policy. In system at times of adversity this sense, the ECB should have applied mechanisms, or more clandestinelythat brake much earlier. By any normal •Alongside a political restructuring, through debt relief. reckoning, Greek banks should have we will also see a debt restructuring faced this constraint already in 2003-04, Source: Michael Burda 18 www.omfif.org 24 THE FUTURE OF THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org QUESTION 5 25 Balance between liability and control – Jens Weidmann Avoiding divisions with non-euro states – OMFIFOMFIF Bullet The current framework should be European leaders' crisis resolution GlobalOfficial InsightMonetary on and Official Monetary and Financial Institutions Financial Institutions Forum In strengthened… This comprises efforts will be futile if Europe becomes uropean economy OMFIF e Official Monetary and a macroeconomic surveillance divided between those inside and December 2011 Financial Institutions Forum “ “ Why europe must stand united procedure and tighter restrictions for outside the single currency. As an EU Preserving single market is main priority A more stable euro framework Marek Belka, President, Increasing resilience fiscal policy… It would continue to be member not part of EMU, Poland remains uropean leaders’ efforts at resolving Question marks remain over way forwardto future shocks Ethe euro crisis will be futile if, at its Entering the euro was supposed to hour of need, Europe becomes divided Jens Weidmann, President, Deutsche Bundesbank necessitates further bring its members sustainable growth Second, in combating tough policy up to member states to lower deficit and strongly committed to joining. But we will between those inside and outside the by lowering credit costs and facilitating single currency. As an EU member issues, there is nothing wrong with these were developments which the improvements to access to a common market. These not part of economic and monetary sustained, sensible gradualism. For he crisis has exposed the weaknesses of monetary union. Some member states assumptions have been unveiled as this means the foundation must regulation and union (EMU), Poland remains strongly example, Polish experience in lifting experienced severe unsound developments in their financial system, their national debt ratios… Furthermore, the financial do so only after the euro area has shown illusions, but the goals remain valid. T financial supervision. committed to joining the single currency capital controls step by step avoided financial policies or their economic structures. in coming years. But we will do so excessive outflows or inflows and institutional framework both failed to prevent and underestimated in terms of their impact. If properly designed, Poland’s experience in doing its cushioned social acceptance. In and banking system would have to be it has learned its lessons… Europe must only after the euro area has shown it homework without undue reliance the foundation of monetary policy proved to be too weak. a crisis resolution has learned its lessons and restored a another field, some states now in EMU be strengthened and deepened so that the euro area remains a stability union and once on others contains precepts for other reversed their fiscal deficits in the mid- instrument, such sense of shared purpose. countries undergoing economic again engenders confidence. made much more robust… The increase do more than ensure that such calamitous 1990s in a rush to meet the Maastricht as the ESM, could transition. First, European countries deadlines. Fiscal consolidation was Europe must do more than take must recognise the importance of We need clarity how this objective should be achieved. This refers to the depth of intended anything but durable. Steadiness over provide a vital steps to ensure that such calamitous self-help. Poland profits greatly from integration and on any concomitant transfer of responsibilities from the national to the time would have been better. in joint liability threatens to overstretch circumstances never reoccur. It must find circumstances never re-occur. It must European trade as well as counter- European level. We must find a coherent framework that clearly allocates responsibilities. contribution. find ways of rekindling growth, without cyclical receipts from EU structural funds This requires political consensus which in turn makes necessary the approval of the public Third, fiscal soundness is a priority. It which much of what Europe has and the Cohesion Fund. But it also has for the design of the treaties and constitutions. the existing institutional framework. We ways of rekindling growth… Allowing achieved will be lost. Allowing divisions is paramount to set a ceiling for public to rely on its own efforts. Poland is a debt, as Poland did in 1997, along with between EMU members and non- relatively small open economy, yet we In principle, there are two approaches to achieving a stable monetary union. First, the members, separating countries such as pre-emptive thresholds, the breaching are large enough to absorb negative of which automatically triggers member states could return to the principles stipulated in the Maastricht treaty and in are reaching a degree of mutualisation divisions between EMU members and Poland from Europe’s mainstream and external shocks, at least partially. their current constitutions. Emphasis must be put on both sides of individual responsibility, sub-dividing the single market would sanctions. Such measures alone do Inflation and the public deficit are still not guarantee fiscal stability, but they whereby the member states make their own decisions and bear the consequences harm euro members themselves. too high, but in recent years Poland themselves. of risks that goes well ahead of the non-members, separating countries such as are higly important in underpinning had a sustainable external position. domestic discipline. The guiding principles here are national sovereignty and subsidiarity. In this option, fiscal Contents (continued on page 4 ...) and economic policy would remain chiefly a national responsibility, as does the stability possibilities for control and intervention Poland from Europe's mainstream and sub- of national banking and financial systems. Strong incentives would be in place for member Wellink reveals ECB wrangling Roel Janssen Vatican views states to pursue stability-oriented policies: a strict overall policy framework and interest rate premiums on these countries’ capital market debt that reflect the soundness of public – posing an acute threat to the balance dividing the single market would harm euro Firewall becomes wall of fire Michael Kaimakliotis 3 Dragooning Draghi finances. In such a scenario, there is no place Julyfor a system 2012 of far-reaching joint liability. It’s the politics, stupid! December 2011 5 Darrell Delamaide between liability and control. members themselves. Europe’s second chance Meghnad Desai To implement this approach, the current framework should be strengthened by intensifying 7 crisis prevention measures further. This comprises, in particular, a macroeconomic Spain rediscovers its identity Ruud Lubbers he head of the Vatican Bank, Ettore Gotti Tedeschi, has surveillance procedure, as it is just being established, and tighter restrictions for fiscal ” ” 8 Tadded his voice to calls for the European Central Bank to Shy technocrat with thankless task Pawel Kowalewski 9 policy, including improved monitoring and implementation. become lender of last resort in the European sovereign debt Banknotes - The Fed Stewart Fleming 10 crisis, and specifically backing joint euro area bonds. It would continue to be up to member states to lower deficit and debt ratios, enabling Why Iceland is not Greece Jón SigurgeirssonDarrell Delamaide A newpublic finances reality to absorb macroeconomic in shocks the without endangering making a state’s solvency. Laurens Jan Brinkhorst How the euro must cope with diversity – Jacques12 DelorsWhile German chancellor Angela Merkel, daughter of a – OMFIF Advisory Board 15 Lutheran pastor, may be able to resist the admonitions of Furthermore, the financial and banking system would have to be made much more robust Why ECB will have to intervene the Holy See, the Vatican may expect that new Italian ECB 16 president Mario Draghi could pay them more heed. The to limit contagion despite ever closer financial ties. Increasing resilience to future shocks Towards multi-polar currencies Stefan Bielmeier 19 necessitates further improvements to regulation and financial supervision. If properly It has become a commonplace to Another vulnerability was that I believed latest calls by Tedeschi (whose name means ‘German’ in Britain’s open euro questionOMFIF Paddy AshdownVítor Constâncio 21 Italian) come on the heels of a Vatican document in October designed, a crisis resolution instrument, such as the ESM, could provide a vital contributionOMFIF Official Monetary and to stabilisation. Official Monetary and Cameron meets his WaterlooFinancial William Institutions KeeganForum 23 that stirred up controversy because it calls for a reform of the Financial Institutions Forum emphasise the mismatch between a in co-operation and I was wrong… The the22 futureinternational financial of e systemM uin the interests of the common Breaking the vicious circle Niels Thygesen At present, I see the danger that the increase in joint liability threatens to overstretch the good of humanity. Intriguingly, Tedeschi is a declared follower of Friedrich Hayek and liberal economics, who had a long existing institutional framework. We are reaching a degree of mutualisation of risks that OMFIF This document must not be copied 24 career in Italian and international banking before coming to goes well ahead of the possibilities for necessary control and intervention – posing an common currency at the European single market with the single currency Official Monetary and Financial Institutions Forum escapingand is only to be made available thethe helmstranglehold of the Institute for Public Works, the official name of acute threat to the balance between liability and control. to OMFIF members, prospective “ “ members and partner organisations the Vatican Bank, in 2009. ECB, too, was partly responsible for the crisis Because of this tendency, we have to consider an alternative to a ‘return to Maastricht’. This level and the preservation of national had given rise to an increasingly large alternative is the transition to a true fiscal union, now the subject of intense debate. This Jacques Delors, Founding President, Notre Europe (continued on page 4 ...) idea is not new. This issue was a topic of debate at the Bundesbank long before monetary independence over economic policies. diversification, specialisation of production, conomic and Monetary Union (EMU) is in a very difficult situation. The euro’s problems union was established. www.omfif.org A new reality in the making Eovershadow the problems of the Union, to the despair of European parliamentarians 1 Changing bad who would also like us to talk about the European budget, environmental policy, energy, The concept of a ‘fiscal union’ is difficult to pin down and can take a number of forms. If Euro doomsayers are being proved wrong However, new political climate is to the benefit of countries such as Germany, the common agricultural policy and many other subjects concerning our foreign policy. it is adequately structured, a fiscal union can be the cornerstone of a habitscoherent institutionalcannot The fire is Laurensframework Jan Brinkhorst for monetary , Advisory union. Board happen overnight. smouldering, but EMU is in a stranglehold. On the one hand there is the fire still smouldering on the financial www.omfif.org But a quiet revolution beginning to emerge. European countries and to the detriment of others. We know markets, and this is the main argument for those who wish to impose the fiscal compact, we must not keep it 8 hroughout the European sovereign debt crisis a large chorus of doomsayers (mainly has taken place, they have no other argument. On the other hand, there is the risk of stagnation which, burning. It is tragic Teconomists) has predicted the fall of the euro, its division in a neuro and a zeuro, and despite deep-seated have become much more interdependent. now the strength of Germany… I am apart from its dire consequences – unemployment, inequality, poverty – confirms, sadly, and irresponsible other dramatic consequences, all leading to the end of the European Union in its present Europe’s relative decline compared with the rest relative to the world as a whole. form. None of this has happened, because the political nature of the euro project for the resistance to change when Spain tries future destiny of Europe has not been properly understood. in most European The completion of the internal market and appalled when I hear economists talking I do not have a miracle cure. I simply support an approach which endeavours to resolve theto reduce its contradiction between two elements: how to reconcile the necessary economic restructuring, It has become a commonplace to emphasise the mismatch between a common currency at countries. demanded by those whom we call ‘the markets’, and the need to restore confidence in budget deficit, is the European level and the preservation of national independence over economic policies. the creation of the euro have considerably about comparable competitiveness as if it Europe, in its dynamism, in its growth and in its ability to create jobs, which in itself is the unable to reach However, we are seeing a steep decline in financial market tensions. A new political synonym for reduction of inequality. the figure decided climate is beginning to emerge. The crisis has not yet been fully overcome, but the markets have become considerably more cautious in betting against the euro. accelerated this process. Changing bad were possible to club together in the same The fire is smouldering, but we must not keep it burning. It is tragic and irresponsible when by technocrats Spain, under a right-wing government, tries to reduce its budget deficit but is unable to and immediately a Why has this occurred? The EU has always grown as a result of crises – and the present reach the figure decided by technocrats. Immediately a government leader and a member one has been exceptional in its depth and impact. We are therefore going through a habits cannot happen overnight. But a model Germany, Portugal and Greece… of the Commission publicly sound alarm bells, at the risk of reactivating market anxieties. government leader crucial phase. It has taken some time before this new reality (beyond economics) has sunk Such attitudes are appalling and irresponsible. We must be aware that risk exists but and a member of the in with national political leaders. Hence the prevarications and endless hesitations of the avoid fuelling it by such reflections, which, essentially are merely a way of salving our past two years. At the same time, the debt crisis has made clear that the European Union quiet revolution has taken place… The Can [Europe] live with diversity, or will it consciences. Spain is making a huge effort. Casting aspersions is tantamount to fanning Commission publicly is not an abstract idea, but affects our daily life. the flames. sound alarm bells.

After the eruption of the Greek crisis two years ago, many in Europe believed this was a European Central Bank, in its courageous, have to accept the implicit domination of The recent call by European socialist leaders on ways out of the crisis marks the beginning matter for Greece to resolve and that no one else was involved. Now there is recognition of an offensive of social democracy in the broadest sense of the term. Social democracy is that European countries have become much more interdependent. The completion of the independent role channelling liquidity to Germany and its rules? reacting to our current situation by speaking on behalf of its fundamental values, with the internal market, also in finance, and the creation of the euro have considerably accelerated aim of reinforcing a united Europe. This is what is at stake. One key part of the approach this process. Benjamin Franklin’s words – March‘If we do not hang 2012 together, we will all hang is to inaugurate what the document calls ‘a socialistJune reform that 2012 could constitute the basis separately’ – are apt here. banks, has taken the lead. ” of a new call to European citizens’. It will take two years of patient and focused work. This sense of co-responsibility has only been grudgingly accepted. The reality of ” A wake-up call is essential. It is not simply a question of changing Europe. Each country interdependence hit most leaders almost by surprise. But it is this common experience that must do what is necessary. I regret to say that today social dialogue is absent and lacks has pushed the EU, and in particular the euro countries, towards more integration, as seen substance. That frustrates me, because social dialogue is, along with the parliamentary in the signing of the fiscal pact on budgetary discipline in Brussels on 1 March. There is system, one of the cornerstones of democracy. Moreover, the most successful countries are a strong accent on growth and jobs, but the leaders recognise that the best platform for those that have been capable of associating the forces of capital and labour with their 26 THEgrowth FUTURE is to restore OFstability. THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org reforms, as is the case in Austria and Germany. QUESTION 5 27

Changing bad habits cannot happen overnight. But a quiet revolution has taken place, What are the lessons from the past? First of all, let us take the Single Act. In a few months’ despite deep-seated resistance to change in most European countries. This beings stronger time we are going to celebrate the 20th anniversary of the Single Market and, some argue, surveillance of national budgets and deficits, more common rules on banks, and the it is the alpha and the omega. I don’t believe that is true. It was simply necessary. The boosting of rescue mechanisms through the provisional EFSF and the permanent ESM. The Single Market was founded on three notions: competition which stimulates, cooperation European Central Bank, in its courageous, independent role channelling liquidity to banks, which strengthens and solidarity which unites. has taken the lead in overcoming national reflexes. Two years ago, this was unthinkable. Then, there are the international causes of the crisis affecting the euro. Of course, it is easy But there is more. Europeanisation is becoming the answer to globalization. German for the US Treasury secretary to talk about the euro crisis, forgetting his own deficit and the chancellor Angela Merkel, in a speech at Davos in January, made the point that Germany, domination of the dollar. But the international causes of the euro crisis still exist. These are, as the strongest economy and largest country of the EU, represents no more than 1% of of course, linked to the excesses of financial ideology. I will quote you a single sentence the world population and the EU as a whole not more than 7%. The message is clear. that shocked me when I was talking to a leading French banker, who said to me: ‘Jacques European countries individually are unable to cope with the growing challenges of the new Delors, you understand nothing, the creation of value is essential.’ I asked him: ‘And what powers of the 21st century, let alone to shape the structures of a more sustainable and is the creation of value?’ I asked him. I did not wait for his answer, as I already knew it: it safer world. is the increase in stock market prices. 15 Most countries on the European continent, through common hardships, but also murderous March 2012 14 www.omfif.org confrontations in the past century, are beginning to see the inevitability of more, not less Europe, as a way of maintaining, not weakening, their national identity. The larger countries say that only through more European commonalty will their voices continue to be heard in the world of tomorrow. Chancellor Merkel’s Davos speech was a clear signal of a new reality in the making. y 6 How do policy-makers see the future?

common view is that, if monetary after earning it. France and Italy, on the Why Europe needs political union – Gerhard Schröder OMFIF Official Monetary and union is to prosper and survive, other hand, argue that pooling of fiscal Financial Institutions Forum I favour the proposal of [Jean-Claude] the OMFIF Interview a stronger political framework, and financial strength should come in A Juncker to introduce common Euro bonds. Wanted: political union for euro indeed the vaunted 'political union', the early stages of a process culminating If you want to keep the EU and EMU Ex-German Chancellor favours Luxembourger for ECB is required to complete the monetary in political union – in essence, a re- “ Gerhard Schröder, former German Chancellor Gerhard Schröder, the former German Chancellor who presided over the introduction of within it as a central element, then common the euro in 1999, calls for more German funds and guarantees to bail out the troubled architecture. run of the old 'economists versus members of monetary union, coupled with tougher action on economic governance and bond issues represent a form of compensation moves to political union for the euro ‘core’. Chancellor Merkel should have acted monetarists' argument that figured in A man well known for his hard-headed and unsentimental stance on the euro, Schröder – for member states’ abandonment of exchange who now plays no role in day-to-day politics – neatly encapsulates the various dilemmas earlier, which would facing his successor Angela Merkel. Interviewed in his Hanover law office, Schröder lays have saved a lot of Germany, France and Italy would all early controversies over monetary union down a marker for the future leadership of the European Central Bank by stating baldly rate flexibility. Rather than denying this, the that it should pass not to a German but to a representative of the smallest and wealthiest money. Six weeks agree on the longer-term goal, but in the 1960s and 1970s. 'Halfway house' EU state, Luxembourg. were wasted. German government should simply accept Marsh: What could Germany have done better in handling the euro crisis? disagree on the stepping stones needed proposals suggest some shared liability Schröder: Greece should have been helped earlier. It was clear for quite some time that this is the logic of the single currency… that Greece would need funding. In substance the Government was right to involve the to reach it. The orthodox German line is through joint borrowing to spread out International Monetary Fund. I know the processes in the European Council. You get a decision only if these are linked to firm conditions and there is pressure from outside. we can and must now finally talk about However, Chancellor Merkel should have acted earlier, which would have saved a lot of that political union, including a formal and lower capital market costs, with money. Six weeks were wasted. things that matter in EMU. You can’t avoid fiscal transfer mechanism (whether elements of conditionality. Marsh: Do you see positive signs from the crisis? the conclusion: we have to organise a federal Schröder: The crisis offers a chance to analyse from the start of economic and monetary union (EMU) what things were done right, and which were wrong. I was initially sceptical through joint-liability bank guarantee about the single currency, partly for factual reasons; I was a supporter of the ‘coronation Europe for members of EMU... even if this is a theory’, according to which a monetary union should come only at the end of a long process and resolution schemes or permanent Once again, as with the birth of the euro of convergence. Naturally, another reason for my stance reflected electoral factors. terrible idea for the UK. February 2011 funding of weaker states) should come in 1998−99, today's framework is a A Chancellor whose reforms set a model for neighbours that are now struggling ” OMFIF commentary chröder is one of only three only at the end of a programme of repair compromise. It contains elements of both Sformer German Chancellors still because of the economic reforms he Euro area unemployment projected to stabilise at roughlyalive. (The othersdouble are Helmut Schmidt,US and UK levels brought in under ‘Agenda 2010’ in energy partnership between the two still intellectually active although Unemployment rate, 1999-2015 (% of2003. total Schröder andlabour many others see force)powerful states flanking Poland. He and reform. fiscal and transfer union (through the wheelchair-bound at the age of Unemployment rate 1999-2019 (projected) as % of total labour force these successful efforts to restructure is an independent director of TNK- 92, and Helmut Kohl, 80, who is the German economy – in which he BP, the Russian oil company in which incapacitated and seldom appears in 14 was powerfully aided by larger and BP has a stake, and he advises fund-like European Stability Mechanism public.) Aged a sprightly 66, Schröder smaller businesses across the country Swiss publishing house Ringier on concentrates on a business career and Euro area Japan UK– as paving the wayUS for the eventual international political issues. his young family partly inherited from German upswing. These reforms The Bundesbank and other conservatives at the centre of member states' rescue his fourth marriage. also set a model for other countries He predicted before he became in Europe now struggling with huge chancellor in November 1998 that After seven years of heading a coalition problems of lagging competitiveness the euro would increase Germany’s aver that previously-foundering euro programmes) and the Maastricht-style between his Social Democratic Party against a redynamised Germany. dominance in Europe – a forecast (SPD) and the ecologist Green party 12 that has proven remarkably accurate. between 1998 and 2005, Schröder states should achieve this prize only stick-by-the-rules approach that lays Schröder’s closeness to business During his chancellorship, he was has sparked controversy by his marked his time as Chancellor. After involved in several bruising clashes closeness to Russia and particularly leaving office, he became chairman with the European Central Bank with president-turned-prime minister down that member states cannot be of the board of the Russian-German over the Stability and Growth Pact, Vladimir Putin. But he is still accorded pipeline company Nordstream which which Jean-Claude Trichet, the ECB a good deal of respect, above all KEY POINTS has raised hackles particularly among president, regularly accuses him of bailed out, and could default on their the as setting up a privileged undermining – a charge he briskly, 10 but not entirely convincingly, denies. •Germany says political union, debts. 8 www.omfif.org including fiscal transfer mechanism, should come only at the end of a With a tenacity that seems to have 8 programme of repair and reform increased with the separation of •France and Italy argue that pooling monetary union into debtor and creditor of fiscal and financial strength should nations, different parts of the euro area 6 come in the early stages of a process stick to their traditional points of view, culminating in political union for cultural as well as economic reasons; •Compromise with elements of reconciling these diverse, sometimes 4 both fiscal and transfer union and contradictory, positions is the task for Maastricht-style approach coming years. • Reconciling diverse positions is task 2 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 for coming years Source:Source: IMF IMF

28 THE FUTURE OF THE EUROPEAN CENTRAL BANK www.omfif.org www.omfif.org QUESTION 6 29 OMFIF Bullet OfficialGlobal MonetaryInsight on and Official Monetary and Financial Institutions Financial Institutions Forum In

ssay Special iSSue: the criSiS of the euroJanuary 2011 the OMFIF e There is no need for OMFIF Europe to reinvent Way out of the e Official Monetary and Financial Institutions Forum the wheel. We can uropean impasse learn from IMF Parallel currency solution could resolve problems experience. Michael Butler, former UK Permanent Representative, European Community • More independence in the collection, verification and assessment of the fiscal data and he way out of the impasse over fiscal analysis at the level of the Commission TEconomic and Monetary Union (EMU) after the dollar. And we would allow the is to create a parallel currency system weaker countries of Europe to regain need for support packages which may • More emphasis on public debt developments, as the Treaty foresees in Europe. Uncompetitive countries some measure of competitiveness by would retain the euro for appropriate be too onerous for the taxpayers of establishing units of account in the Germany and other creditor countries. Quasi-automaticity of sanctions in case of breaches of the rules, including the provision transactions at home and abroad, • old national currencies, bank accounts At the root of the difficulties is the lack of both so-called procedural and financial sanctions but they would also recreate national denominated in national currency to be of competitiveness of southern and currencies, which would take part in a used for trading purposes. managed float against the euro. western peripheral economies. Over the One reason for the urgency is that the interconnections created by the single currency first decade of the euro, Germany has have transformed what appeared to be a relatively limited problem affecting the Greek A solution along these lines is needed virtuously succeeded in holding down economy, which represents less than 3% of euro area GDP, into a systemic issue. This We would effectively have the best of because EMU is beset by numerous both worlds. We would maintain the euro its costs and improving its productivity, explains why, as markets started to doubt Greek solvency, the speculative positions aimed problems including excessive debts while other member countries have at minimisingNeed losses or maximising for profits associatedpermanent with such an event also affected theEuropean fund – John Nugée Transparency key to restoring confidenceas an important factor of integration– in Wolfgangand budget deficits, lack of confidence Schäuble Europe and the second world currency not followed such rigorous policies valuation of other sovereign assets and of the euro itself. in some countries’ ability to avoid and have progressively faced losses of default, some weak banks, and the competitiveness by up to 20%. The creation of the EFSF ultimately averted financial collapse. The question now is how to Europe should set up a permanent Permanent crisis management requires Issing warns on ‘basic design flaw’ over euro and says crisis is no surprise create a management mechanism that avoids crises without creating moral hazard. This Otmar Issing, former chief economist of the European Central Bank, is warning that European(continued politicians on page 4 ...) is not a new issue. It has been dealt with by the International Monetary Fund and consists are endangering the euro’s survival. He says the euro crisis ‘does not come as a surprise’. He terms as a of attaching strong conditions on structural and fiscal policies for financial support for a European fund that would borrow in not only euro members’ solidarity, ‘basic design flaw’ that member countries could not be relied upon to enact appropriate economic policies. country in difficulty. ‘The present seemingly unstoppable process towards further financial transfers will generate tensions... The longer this process is characterised by unsound conduct of individual member countries, the more these There is no need for Europe to reinvent the wheel. We can learn from IMF experience. the collective name of the euro states but also, when debt restructuring is tensions will endanger the existence of EMU.’ History shows that countries are not particularly keen to get financial support from the urope FOR F Fund, precisely because of its tough conditions. “ “ ull ARtICle BY O t MAR ISSInG See P.8-13 and use the proceeds to lend …to the necessary, participation of private sector Contents Permanent fund for e Mechanism basically working well Rate discipline individual governments. This could evolve creditors. Such a condition helps to combat Wolfgang Schäuble The euro’s best friend 3

Strengthening the continent’s fiscal governance Jonathan Fenby Merits of squeeze from the European Financial Stability speculative excesses on the financial Profiting from monetary uncertainty 5 Wolfgang Schäuble, Finance Minister John Nugée, Deputy Chairman, Advisory Board Frank Scheidig Moment of truth postponed 7 he mechanism within EMU generating higher interest rate spreads for troubled countries such as Ireland and Greece he measures enacted in spring this year to counter Europe’s sovereign debt crisis are impressive and extensive – Facility. It could be called the European markets. This requires more stringent Otmar Issing T but they represent only a temporary solution, buying time for a more permanent and far-reaching arrangement. Germany faces Doppelmark danger 8 has shown ‘fundamental merit’, according to Wolfgang T Laurent Fabius Schäuble, the German finance minister. Such an arrangement will have to include a much greater and more formal degree of fiscal integration among euro An error of understanding 14 members. Fiscal Solidarity Fund. An annual meeting rules for financial market participants AndréOMFIF Szász Schäuble BULLETIN writes, ‘As a result of investors’ perceptions of the Keynes’ Clearing Union in Europe 17 Official Monetary andrisks caused in Greece by excessively high public debt and in What form should this take? On the one hand, authoritative voices such as Niels Thygesen have argued [OMFIF September ErikGlobal Holm Insight on Official Monetary and Financial Institutions Bulletin, p.8] for market discipline to rein in spendthrift governments. Indeed, the extreme lack of market discipline in 2003- of finance ministers would agree the and products, as well as improved Mirage of Keynesian advantage Financial Institutions22 Ireland Forum by negative developments in the banking sector, interest rates on these two countries’ debt rose significantly. Neither 2007 (when Greek bonds traded only a few basis points over German bonds) contributed to an environment in which less Meghnad Desai financially responsible governments aggressively expanded their fiscal spending. borrowing limit of the Fund and the national and European financial market Healey’s EMS view vindicated 25 country could cope with the increases in borrowing costs and William Keegan ensuing loss of confidence without assistance from abroad,

On the other hand, now that the market has realised that not all EU sovereign credits are of equal standing, there is a definite OMFIF Advisory Board 26 which was forthcoming as a result of European solidarity. September 2011 sense – especially in Brussels and Frankfurt – that they have overreacted. Such thinking lies behind the natural desire of other Europe’s debtThis assistance lessons was made conditional from on the adoption 1930s of individual limits that countries can borrow supervision. Better coordination of national 28 far-reaching economic restructuring... Because the existing states to help those facing what many see as unwarranted market attack. OMFIF This document must not be copied Official Monetary and and is only to be made available mechanism … has basically worked well, there is no reason Financial Institutions Forum Austerity and taxation expose democratic deficit How should the EU address this? Market discipline is necessary, and should not be evaded completely (as for example would from it. Bonds issued by the Fund should be financial, budgetary, economic and social to OMFIF members, prospective for replacing it with a Community-wide pooling of interest rate members and partner organisations be the consequence of a joint-and-several liability for all state debts or a blanket EU-level guarantee). But equally, markets John Nugee, Deputy Chairman,risk, as the Advisoryproposal to Board create Eurobonds would entail.’ y FOR F cannot be allowed a free rein to punish weaker states unjustifiably harshly. ull ARtICle BY WO n the realm of international lFGAnG SCHÄu more liquid and a better credit than bonds policies [is needed]… The more such efforts Ble See P.3 Increasingly, there are calls for fiscal co-ordination at the policy formation stage. Dominique Strauss-Kahn, the managing Imoney, 2011 brings two notable These episodes are reminders of the director of the IMF, called in a speech in Brussels in September for a central fiscal authority to set EU member(continued states’ on page fiscal 7 ...) anniversaries. It is 40 years since the parallels for Europe’s present crisis www.omfif.org We do have alternatives1 to crushing stances and allocate resources from a central budget. issued by any single state. succeed, the more the European Central US ended the dollar’s convertibility of national solvency and excessive into gold by closing the ‘gold window’ austerity. But the current path in Europe, government debt. And they perhaps in which the political leadership imposes While this might be a step too far towards federalism at this juncture, there is a clear requirement for a mechanism in August 1971. Precisely twice as long ” provide important lessons for today’s hardship with neither explanation, nor simultaneously to co-ordinate Europe’s fiscal policies, strengthen the sanctions element of the Stability and Growth Pact Bank will be able to concentrate on its ago, the UK did the same for its own policy-makers. We are not doomed to discussion, nor consent, risks repeating (SGP), and remove the SGP’s Achilles Heel, namely that its limits can be broken more or less with impunity. currency when Britain left the gold re-run the 1930s. We can learn from October 2010 standard in September 1931. January 2011 some of the blackest periods of Europe’s mandate of monetary stability. that dreadful decade, as our forefathers recent history. These are lessons we did 50 year ago. must heed. www.omfif.org Stark departure throws European Central Bank into new turmoil 6 ” (continued on page 4 ...) The surprise announcement on 9 September that European Central Bank board member Jürgen Stark is leaving the bank over differences on the ECB’s sovereign bond purchase programme brings economic integration in Europe into a new phase of turbulence. How Europe will change – John Kornblum Long and painful road ahead – Gill Marcus SEE ARTICLES ON ECB FUTURE ON P. 7-11 Zeti expounds ‘transformation that will reshape the world’ The will be Ordinary people are bearing the brunt Governor Zeti Akhtar Aziz of Bank Negara Malaysia explains ‘a major global transformation at an unprecedented scale and speed’ – the shift in economic power to the East. ‘The pervasive nature of this transformative change is the result of mutually reinforcing global shifts – economic, financial and monetary, In resolved one way or another. While of the consequences of the crisis. These with far-reaching implications. The realignment is a structural transformation of historical significance that will reshape the world.’ FOR FULL ARTICLE BY GOVERNOR ZETI SEE P. 19-20 February 2011 OMFIF we cannot predict the outcome, we social and the social consequences Contents OMFIF Bullet Battle ahead for Atlantic United Official Monetary and “ “ Global Insight on Official Monetary and Financial Institutions Time to downgrade S&P John Kornblum Financial Institutions Forum can be sure that, when it is over, the are becoming increasingly apparent 3 Leadership test More euro funds will calm markets Darrell Delamaide 5 Saving Europe, not the euro Frank Scheidig Painful path ahead European Union as we have known and disturbing with a growing structural 7 Monetary hands tied everywhere Hans-Olaf Henkel Gill Marcus, S. African Reserve Bank 8 Michael Kaimakliotis eMu changes will be global it during the past half a century will unemployment problem, particularly EMU proposals remind us of history he inability of the leadership of the euro area economies to fear of thermonuclear war. European 9 South Africa’s vulnerability Niels Thygesen Tagree on a credible and durable solution for the region has Germany leads path to new Europeanleaders hadgovernance lost the habit of thinking 10 undermined support not only for the leaders but also for the and planning strategically. ‘Building Age of Wisdom takes time Peter Bruce have ceased to exist. This will lead to a among the youth in some countries and, 12 whole euro project, according to Gill Marcus, Governor of the John C. Kornblum, Advisoryrelatively Board new democratic systems of Europe’ was virtually their only goal. IMF gets it right on Mexico Meghnad Desai South African Reserve Bank. countries such as Greece, Portugal and Only after 1990 were European 13 Spain bear the political and social burden Steve Hanke he European debt crisis will be societies slowly but steadily exposed to Sovereign issue for LIbya of months, if not years, of declining fundamental change in the way European in some instances, civil unrest. As austerity 14 In an address to the August OMFIF meeting at the South resolved one way or another. While the full force of global change. Germany China’s problems amid the growth Malan Rietveld African Reserve Bank in Pretoria, Governor Marcus said the T standards of living? On the other hand, has done better than most, because it 15 we cannot predict the outcome, we Jonathan Fenby poor outlook was compounded by the ‘damaging’ US debt will the richer, more successful euro is more developed, but also because and North American partners deal with programmes bite further, we are likely to Noda faces yen pressure can be sure that, when it is over, the members be willing to subsidise the 16 ceiling debate and the American ratings downgrade. European Union as we have known it had the discipline and the incentive Why renminbi should go global Junko Nishioka poorer-performing countries? to make important changes. The 17 it during the past half a century will An end to western dominance Songzuo Xiang Pointing out that recessions involving financial crises took longer challenges of reunification ultimately each other… All of this has the makings of see more scenes [of social disturbance]… 18 have ceased to exist. This will lead All of this has the makings of a major to work through, she said ‘significant financial commitments’ proved positive by pushing Germany Little leeway for monetary policy Zeti Akhtar Aziz to a fundamental change in the way 19 would be needed to head off a new growth slowdown. ‘These restructuring in Europe’s political and towards modernisation rather than European and North American partners social systems, in a delayed result of Ring-fencing in UK - but not yet Gill Marcus need to be big enough to put a stake in the ground.’ However, deal with each other across the Atlantic simply imposing a financial burden as a major restructuring in Europe’s political There has to be action, but the room for 24 because of the monetary and fiscal firepower already the 1989 fall of the Berlin Wall. Pre- most Germans still(continued seem to onbelieve. page 12 ...) Riots, leaks and back-stabbing Michael Lafferty and globally. 1989 Europe was a protected island of 35 expended, she admitted that room for action was limited. William Keegan ‘There is a long, painful path ahead for all of us.’ y relative prosperity shielded from global and social systems, in a delayed result of action is limited. Any measures taken 36 Myriad questions abound. They are as pressures by American protection and FOR FULL ARTICLE BY GOVERNOR MARCUS SEE P.24-25 much about politics and national culture the self-censorship engendered by the as about economics. Are austerity and the 1989 fall of the Berlin Wall. are likely to entail significant financial budget cutting the right solutions for www.omfif.org underperforming economies? Can the 1 Schröder indicates central banking shake-up by calling for Luxembourger to run ECB ” commitments…There is a long, painful path Gerhard Schröder, the former German Chancellor, has paved the way for a possibleeR Sshake-upee P. 8-15. in European central banking by calling for a Luxembourger ttoH GheadeRHARD the European SCHRÖD Central Bank. His eW WI statement may strengthen the likelihood thatnte YvesRVI Mersch, governor of the Luxembourg central bank, will ahead for all of us. be favoured. Schröder says Germany should support common ‘Euro bonds’ to pool European debt and increase guarantees to Februaryimprove availability of the 2011EFSF bail-out fund for hard-up European states. ‘This September 2011 would be a signal to the markets.’ FOR I Dollar shifts ” US role in decline 3 Ousmène Mandeng Contents Michael Kaimakliotis 5 Mariela Méndez Prado 6 he unrest in Egypt has provided a reminder of the role of Debt fault-lines split the world the dollar in the international economy. On the one hand, 30 THE FUTURE OF THEMalan EUROPEAN Rietveld CENTRALT BANK www.omfif.org www.omfif.org QUESTION 6 31 Euro lessons for the sucre 8 mounting political uncertainty in Northern Africa and the Gerhard Schröder 16 Middle East is likely to underpin its ‘haven’ status. On the New South Africa challenges loom other hand, markets have shown an appropriate amount of Michael Lafferty Wanted: political union for euro 17 differentiation and contagion has been limited. Steve H. Hanke Stand-alone future beckons 18 There appears a general consensus – shared even by some Darrell Delamaide 21 thinkers in the US – that the dollar’s share in the world Zero sum game for US policy monetary system will necessarily diminish in coming years. Stefan Bielmeier Dangers of policy ‘groupthink’ 22 Certainly this is the view of the Chinese leadership. Frederick Hopson Lesser of two evils 23 One way to institutionalise and control this trend would be William Keegan for central banks to undertake to make allocations of a The Year of the Dollar beckons 24 certain portion of their foreign exchange (continuedreserves, onsay page 10% 7 ...) Keynesian returns to the fray of the total, to emerging market currencies over the next five 1 years. This would be a major step to world monetary reform. This document must not be copied www.omfif.org OMFIF Advisory Board and is only to be made available to OMFIF members, prospective OMFIF members and partner organisations Official Monetary and Financial Institutions Forum About OMFIF

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