Thomas Wieser Director General Austrian Federal Ministry of Finance

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What is an Imbalance? tion of countries, and may have impor- What is a macroeconomic imbalance? tant spillover effects. It has an array of And do macroeconomic imbalances lending instruments at its disposal that matter? Two easy questions. Put them can be utilized if imbalances lead to to an economist and she or he will most capital flows that are inadequate for likely give you an authoritative descrip- satisfying the external financing needs tion or definition of such an imbalance; of a country. The G 20 process has re- and will then proceed to authoritatively discovered this issue in the light of tell you that they either matter enor- global imbalances in current account mously, or not at all. A pattern will positions, and has agreed on a surveil- emerge: first, the definitions or de- lance exercise. scriptions will not be consistent with each other; second: if they matter, then usually abroad. I will start off with a simple definition: a macroeconomic imbalance is the (negative or positive) position of a domestic, external or financial variable in relation to a certain norm. This position may – if uncorrected over time – make the national savings/investment balance so untenable that it self-cor- rects abruptly, thereby causing significant adjustment shocks domestically; in the case of large economies also abroad. Imbalances are caused by economic policies, or by their absence. They are Addressing Potential Imbalances in the Euro Area therefore a lagged indicator of other variables that developed at a pace or in a Within the European Union risks of direction that is not commensurate macroeconomic imbalances were rec- with the overall balanced development ognized in the Treaty. A set of eco- of an economy. At stake therefore is the nomic policy coordination tools was issue of sustainability and liquidity. A designed in order to prevent such dis- deficit or a surplus per se may well be a equilibria; and a balance of payments desirable equilibrium outcome and thus support facility was set up in order to not an imbalance, for instance reflect- assist in overcoming such a crisis. ing an efficient international allocation The design of the euro area as per of capital. the Maastricht Treaty followed the As imbalances influence develop- principles that ments in partner countries they are an – at entry, fulfillment of and adher- important factor in international policy ence to the fiscal, financial, mone- making. At the global level the main tary and exchange rate criteria task of the IMF has been and is focused would guarantee that the relevant on preventing, detecting or mitigating economic parameters that could en- national economic imbalances that may gender imbalances were largely in lead to an unsustainable external posi- balance,

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– market discipline will be sufficient Upon entry into monetary union for nudging the public sector to- and the elimination of exchange rate wards prudence and sustainability risk, risk premia moved downward by prohibiting monetary financing with great speed, by a good 800 basis and a privileged access of the public points for some Member States com- sector to the financial sector, and pared to only a couple of years previ- by a rule on not bailing out Member ously. Subsequent developments of States, rapid credit growth and accelerating – loose economic policy cooperation private indebtedness were undoubtedly and more stringent fiscal policy co- a result of these developments. There is ordination through the relevant a bright side to this, as increased private Treaty Article and (later) the Stabil- sector leverage post-1998 may have had ity and Growth Pact (SGP) would a one-off “convergence euphoria” com- be sufficient for keeping these vari- ponent. ables on track, together with an in- Economic policy cooperation in the dependent monetary policy geared euro area institutionally takes place exclusively towards price stability, (only) in the Eurogroup – the (monthly) – and such was the conviction that no meeting of euro area Finance Minis- imbalances could emerge that no fi- ters, the ECB President and the Com- nancial safety net was designed to missioner responsible for Economic and provide balance of payment support Financial affairs. It is prepared in the to euro area Member States in dif- Economic and Financial Committee/ ficulties. the Eurogroup Working Group. When setting up monetary union the For well over a decade the debates question of asymmetric shocks received were contentious primarily when it wide attention, as this was seen as the came to applying the SGP. Greece ac- weak flank of a monetary union with ceded EMU on a wrong statistical fiscal basis. Nearly ten years ago the Pact faced its first stern test in view of excessive deficits in Germany and France. With the decisive meetings taking place under Italian Presidency the SGP was watered down. Beyond fiscal coordination a moni- toring of overall economic developments takes place; Ireland in 2002/03 actually received a warning for expan- sive fiscal policies fuelling inflation that were considered to be untenable if not corrected. This produced political reactions from the Irish side that were so less than perfect factor mobility across negative that other euro area Member national borders, and autonomous fiscal States were possibly shocked into a pol- policies. The issue of divergent devel- icy of non-interference especially in opments of competitiveness were less non-fiscal policy areas. widely discussed, and seen as a lesser In the meantime financial integra- order problem. tion was proceeding strongly after the adoption of the euro, and cross-border

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capital flows into government debt, – and, finally, that the euro area had a non-tradeable sectors and interbank quasi-coercive policy instrument in markets were significant. The asset the form of the SGP, but no other price increases in the non-tradeable policy tool at its disposal that could sectors (mainly real estate) were ana- realistically be expected to influ- lyzed and discussed extensively, but ence policy behavior of national ac- with the exception of Spain policy reac- tors. As all other policies were tions were muted. And even the Span- firmly anchored in national respon- ish reaction to the real estate develop- sibility, from wage to financial poli- ments did not suffice, as later develop- cies the incentives were skewed ments showed. Stronger reactions were against policy coordination. Policy prevented by domestic interest groups cooperation in and of the euro area or simply due to analytical failure of was firmly confined to the Euro- domestic policy makers. The domestic group meetings of Finance Minis- imbalances were largely seen as consti- ters, and thus reflected the fiscal tuting a problem of the Member State approach to policy coordination as concerned, not of the euro area as a laid down in the Treaty. whole. The build up of negative current ac- Addressing Imbalances in the EU count positions of euro area Member In the European Union of 27 economic States over the last decade was on the policies, even though a matter of com- other hand – with a few exceptions – mon responsibility according to the not seen as critical. By contrast, the Treaty, were in reality not closely coor- drifting apart of competitive positions dinated. ECOFIN work tends to be fo- as measured by diverging relative unit cused on legislative acts required for labor costs was increasingly seen as a completing and deepening the Internal centrifugal issue for the euro area by Market. The Treaty based Economic the European institutions. President Policy Guidelines, beloved by their au- Trichet regularly attempted to con- thors and drafters, are decided upon by vince Finance Ministers that these de- Ministers without substantial discus- velopments were unsustainable, but the sion, and successfully shelved after the Ministers concerned did not act or re- traditional pre-summer decision. Pro- act sufficiently. The reasons for this cess produces papers, not substance, complacency were diverse, but could unless there is a negative externality as- include the following, namely sociated with policy inertia. – that imbalances in a currency area The issue of external imbalances ac- were considered to be self-correct- tually received increasing visibility ing through medium-term nominal amongst policy makers, inter alia in the adjustments that would, admit- context of the ERM II procedures as tedly, take some time to occur (but some new Member States prepared for occur they would – more or less au- or attempted entry into Monetary tomatically – as losses of price com- Union. petitiveness triggered the appropri- The most visible case of imbalances ate price/quantity adjustments), was that of Latvia, where euro area of- – that sovereign risk differentials in a ficials engaged in intensive debates with currency union virtually ceased to the authorities on the causes of their exist and as there was no risk there current account deficit, and appropri- would be no punishment, ate remedies. Seemingly, there were al-

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ways good reasons for the large deficits sector was seen as being a consequence not being a concern – ranging from id- of high growth, and not a cause of over- iosyncratic shocks due to the import of heating and thus unsustainable growth; railway stock to the nearly tautological and increasing contingent liabilities due effect of growth differentials in the to forex exposures were seen as provid- catching up process. In those days ev- ing cheap (long term) finance for pri- ery policy maker could recite Balassa- vate households where domestic capital Samuelson effects even if asleep. markets had no long-term instruments Discussions with many New Mem- available. ber States from 2004 onwards focused In the end, the conditionality in on: balance of payment support programs – External Imbalances: current ac- addressed these issues, but we could count positions and real exchange have gotten there more easily with a rate movements received closest at- higher degree of better policy coordi- tention, international reserve posi- nation and cooperation. tions were hardly ever analyzed; In these programs, the issue of ex- – Financial imbalances: credit growth change rate adjustment was a highly and foreign exchange credit growth contentious one: a traditional approach were addressed, but were inten- would have called for a rapid exchange sively discussed only when the sus- rate adjustment in order to kick start tainability of fiscal and financial po- export activity; with balance sheets sitions in CEE were already at the largely denominated in euro this would forefront of international attention; have bankrupted many domestic credit there was no meaningful ongoing holders, and consequently would have dialogue between supervisors and significantly increased the write off re- macro-economic authorities at the quirements of the banking system European level at an early stage that (widely foreign owned). A mixture of could have contributed to crisis pre- economic interests and analytical dis- vention or mitigation; agreement produced differing policy – Structural weaknesses in product prescriptions, but mainly in favor of ex- and factor markets, linked increas- change rate stability. This required ingly to issues of competitiveness rapid internal devaluations through the – Fiscal imbalances were continu- wage and price mechanism. Ironically, ously monitored, but the policy ad- the countries outside the euro adopted vice of the EU was not taken seri- similar adjustment strategies to those ously by all policy makers to whom within the euro area. The obvious ex- warnings were addressed; a good ception is the UK where we have seen example is Hungary which has re- sterling devalue against the euro area as mained in an excessive deficit pro- the UK attempts to address its external cedure from the outset of its mem- and internal imbalances. bership without major political problems. What Is New in Our Tool Kit, and Increasing external disequilibria due to Why? a loss of competitiveness through As the financial crisis turned more and steadily rising real unit labor costs were more into a sovereign debt crisis for pe- seen by national policy makers as being ripheral euro area economies our as- largely caused by growth differentials; sessment of weaknesses in our toolkit increasing indebtedness of the private evolved. Our understanding of the me-

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chanics of the euro area changed as tegrated financial market with decen- markets also changed their perception tralized fiscal backstops and supervi- of risk differentials within the euro area. sors. Given the “industrial policy” type Progress in our toolkit therefore behavior of national governments to- builds on the (relatively new) fact that wards their financial sectors market within a currency area with decentral- based solutions to financial crisis are ized fiscal policies there is room for dif- more difficult in the EU than in other ferentiated sovereign risk assessments by markets. This in turn has led to access to markets being contingent on in- vestors being convinced of the sustainability of policies. At the outset of monetary union there had been attempts to produce “shadow” market mechanisms in order to discipline Member States into fiscally and financially responsible behavior. Now, we have what we wanted. As some examples showed, quite dramatically, fiscal discipline in the EU and especially in the euro area had not been adequately stringent, thus large economies that have symmetrical leading to inter-temporally unsound responsibilities for financial and fiscal fiscal positions. This was not due to issues. recognition lags (with the one or the other notable exception) but due to the The Safety Net political economy involved in collabor- As already mentioned the euro area did ative decision making and the loss of not have an adequate safety net for market discipline as sovereign risk be- Member States facing external financ- came only a lower-order function of ing constraints until 2010. The com- debt and deficits. plete tale of the debates on whether At the same time the widening of such a mechanism should be based on differentials in competitiveness oc- EU, Community or intergovernmental curred as wage and price developments methods needs to be told separately. were not oriented towards stable (no- After lengthy and very principled tional) real exchange rates within the debates Greece received a loan from euro area. National wage and structural (most of ) the euro area Member States policies need to better reflect this, as well as one from the IMF. The policy which is especially interesting given the conditionality was and is strict, and the autonomy of decision making of policy pricing of the euro area loan was de- actors, especially in the field of wage signed so as to prevent moral hazard, setting. i.e. so as not to incite others to enter And, lastly, the contribution of the such a program. These concerns were financial sector to imbalances shows fairly rapidly seen as naïve. The pricing clearly that financial regulation, but es- has been changed in the meantime. pecially supervision need to be geared Contrary to some expectations more to a highly but not completely in- markets were not convinced by the

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Greek adjustment program that all that proaches to policy failures and prob- needed to be done had been done, and lems, and would ensure that regional spreads continued to remain high for solutions did not cause global imbal- many euro area Member States. In May ances. 2010, after lengthy and politically charged negotiations, the EFSF and Fiscal and Macroeconomic EFSM were set up. These two facilities Surveillance were designed to have a volume of EUR Within the EU, and especially within 440 and 60 billion respectively. Lend- the euro area, a lot of reflection has ing from these two facilities, in con- gone into the design of systems that junction with the IMF, is ongoing for should ensure that a repeat of the fiscal Ireland and Portugal. imbalances of the past decade can be Recognizing that these temporary avoided. A set of 6 legislative acts has facilities did not answer the need for a been agreed on by Ministers, and is permanent and more structured safety presently being negotiated with the net the decision was taken in March European Parliament. These acts should strengthen the SGP by a variety of measures: it should become more difficult to politicize (and thus bring to a halt) an excessive deficit procedure; there should be a higher degree of quasi-automaticity in some of the procedures and sanctions at an earlier stage; not bringing down debt levels at a steady pace towards and under 60% of GDP should give rise to sanctions; and the quality of national fiscal frameworks should be enhanced. Sanctions should be more easily im- posed, and should be gradual in the 2011 to have, as of mid-2013, a perma- sense that Member States should not be nent euro area safety net, the European automatically threatened with the Stability Mechanism. It will dispose of “atomic bomb option” of the highest paid-in capital of EUR 80 billion, and financial sanctions. an overall lending volume of EUR 500 Additionally, the EU has designed a billion. As its predecessors it is ex- macro-economic surveillance process pected to lend in conjunction with the that should detect the emergence of ex- IMF. ternal and internal imbalances at an The latter issue is an important early stage. A wide range of indicators point in the global discussions on re- will be used in an alert mechanism in gional safety nets: whilst it appears in- order to give early warnings. Such creasingly necessary to have regional warnings will be issued to the Member solutions for regional problems it would State concerned, and in the case of be politically and economically coun- excessive imbalances with an invi tation terproductive if they were not all linked to correct the emerging imbalance to a global instrument. This would en- through appropriate policy action. If no sure a hub and spokes system with qual- policy action is taken, sanctions could ity assurance, comparability of ap- be applied. This reflects the lessons

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learned over the last years that a wide stability groups we hope to reduce the range of policies may have area-wide probability of such occurrences by in- destabilizing influences, whilst policy creasing the quality and timeliness of responsibility remains firmly at the na- mutual information across relevant tional level. Producing processes that markets. satisfy both constraints is and will be The myopia of supervisors confined the challenge as we emerge from the to seeing only small parts of important crisis. market developments outside their ju- risdiction was an issue in the crisis. Financial Stability Instruments Through the establishment of the three Within the EU the financial sector is European authorities for banking, in- especially closely interconnected, even surance and securities we hope to though financial integration is incom- achieve better supervisory cooperation, plete and uneven. The growth of cross and a larger and more consistent set of border activities has been pronounced single or very similar rules and prac- over the past two decades as a conse- tices. Over time we will need to move quence of Internal Market legislation, towards a European supervisor, but the and later of the single currency. Imbal- politics of Europe are not ready for this ances in the financial sector have gener- step yet. And then the question of bur- ally been pronounced in industrialized den sharing and back stopping needs to economies in the past years, and espe- be more clearly solved. cially in the EU the process of cleaning Whilst micro-prudential progress up balance sheets is not over yet. Due has been achieved by building on exist- to these strong inter-linkages contagion ing groups, macro-prudential surveil- risks play an important role in Europe. lance in the EU has started from Not so long ago this interconnectedness scratch. The European Systemic Risk was seen as an important stability fac- Board (ESRB) was set up last year, and tor through risk diversification. Both has become operational as of the begin- may be true, though not at the same ning of this year. It is closely associated time. with, but separate from, the ECB. Its A specific feature of the EU finan- function is to detect and warn about cial sector is that due to the dense web emerging imbalances, with a strong fo- of branches and subsidiaries the ques- cus on financial sector imbalances. But tion of fiscal responsibility for banking its surveillance function can obviously sector support is less clear than in other not be confined to the financial sector, parts of the world. Is the home govern- and needs to encompass all those pa- ment “responsible” for all activities of rameters and sectors which could cause its banks? Or is it responsible for activi- such imbalances to emerge. An exam- ties of its banks, including branches ple would be a real estate bubble which, abroad, but not of subsidiaries? Or is it if uncorrected, would cause imbalances only responsible for domestic activities? in the real economy and the financial As the governments of Iceland, the UK sector of the country concerned. And and the Netherlands know, this is more possibly beyond. We will need to work than an academic question! on the inter-linkage of the work of the The issue of burden sharing has still ESRB and the EU’s macroeconomic not been completely clarified, and may imbalance procedure so that they com- never be completely clarified ex ante. plement each other and do not overlap With the introduction of cross border or underlap. We will need to avoid un-

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necessary duplications with the IMF have the processes at the European FSAPs. And we will need to find an ap- level. How do we now get the results? propriate way of channeling advice to As we have seen policy areas well policy makers in a manner that maxi- outside the domain of central bankers mizes the probability that they will act. and Finance Ministers have contributed to existing imbalances. Time and again Does this Suffice? What Are the Finance Ministers return from Brussels Politics of the Longer Run? with advice about their fiscal plans that The EU has reacted impressively so as the Commission and the Council have to decrease the probability of future carefully worked out, and at home they crisis. It has also set up a safety net that do not have an audience. And for the should be available for those Member policy fields that are somewhat re- States that despite all surveillance exer- moved from fiscal policies this holds cises fail to correct their imbalances in even more true. a timely manner. Does this suffice? Better institutions for supervision As set out above a number of new of a European financial sector will be procedures have been set up. They are part of the long term solution, building administered by Finance Ministers, and around a single European supervisor. If in some instances the reports and anal- this is achieved, the financial sector ysis go the Heads of State. But do they will increasingly become a sector which address the root causes of recent imbal- can contribute to European growth ances? with lesser risks of regional instability. The euro area is set up as a decen- Then the vision of risk diversification tralized policy space with a single mon- will have become more of a reality than etary policy. The purpose of many of it is at present. The political and fiscal the new EU policy processes and mea- implications of such a solution are com- sures is to incite nominally (largely) in- plex, and therefore will not come about dependent policy makers to behave in a in the short run. responsible manner, i.e. to ensure the Looking at wage and price develop- sustainability of their policies, and thus ments in a number of Member States it is clear that external constraints have historically played and still play a smaller role in some countries than, say, in Germany or Austria. This is un- derstandable as the diverse national institutions come from a different back- ground of exchange rate policies, and thus a different tradition of wage and price policies. We will therefore need to develop a common understanding of national actors and institutions of what is required in terms of mutually com- patible policies across a large range of policy areas. also share in the responsibility for the It will be necessary that social part- sustainability of the euro area. ners from all Member States share an One element obviously is that we analysis of prospective developments need better national policies. We now of growth, productivity and prices.

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Wage formation and price develop- In short: the euro area needs to be- ments need to have a clearer focus on come a truly political and broadly based stability and sustainability than they policy area. It needs to move beyond have had in the past. In some Member the narrow confines of fiscal coordina- States of the euro area it could be tion and start economic policy coordi- argued that some social partners have nation. The political process needs to not yet joined monetary union. It will be opened up to a larger class of policy be a crucial element of European policy coordination other than monthly making, with an important role for the meetings of finance ministers. There- President of the Euro group to bring fore, guidance but also responsibility about this historic change. of Heads of State must become the Policy makers responsible for struc- norm without micro-management, and tural policies need to understand the with a truly broad based and well role and function of their policy mea- prepared discussion. If this is achieved sures in the context of intra-euro area the euro area will be able to play an imbalances. At present this is still not the portant role at the global level. If this is case. Policy makers responsible for the not achieved, then the processes we design and parametrics of retirement have designed will not suffice to stop policies for example need to under- imbalances emerging in the future stand the euro area aspects of intertem- through an adequate mix of process and poral imbalances. policy.

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