Address by Director of Financial Operations Maurice McGuire at the Colmcille Winter School

‘The euro – re-shaping the architecture’

Introduction

Thank you very much for your invitation to speak here at the Colmcille Winter School on the topic of the origins of the euro and how its future will be secured.

Before discussing the necessary reforms to Economic and Monetary Union, which will be my main focus, I will start with some reflections on how we got to be in the situation that we are now in.

Lessons from the past

There is a long history to the plans for monetary union. These are described in detail in a number of sources, most notably in the recently published book by the historian Harold James on ‘Making the European Monetary Union’ ¹.

With the benefit of hindsight, one central point is now clear, which is that the monetary union, whilst complete as a purely monetary union, lacks other complementary features that are, in fact, essential to its smooth running. My remarks today will centre mainly around two areas, banking supervision and fiscal co-ordination, although a third facet, greater integration and flexibility of the Single Market, is also clearly relevant and I will say a few words on that too. A fourth area, political integration, was also identified by the recently published Report of the Four Presidents ² (the Presidents of the ECB, European Council, European Commission and European Parliament) as another area to be worked upon.

I will not deal with the political aspect in any detail here, but there is one important overall point to be made. While the precise nature of further political integration may not be a key element in the functioning of monetary union and while full-blown political integration is not, I think, strictly speaking necessary, there must be sufficient and on-going political backing for the major advances planned in the first three areas that I have already mentioned. The planned improvements in the banking area, in particular, include the pooling of both responsibilities and also the joint taking on of risks and the financial obligations that follow from that. It may be understandable that there might be a reluctance, for example, to enter into the sharing or mutualisation of potential losses until there is a solid framework of financial supervision in place, but this can be a timing issue only. The principle of sharing both responsibilities and risks has to be fully supported at the political level, if the monetary union is to function smoothly. Similar points can be made about the necessary political backing for increased fiscal co-ordination and further structural reforms.

Some of the early plans for monetary union, and there have been many over the years, did include at least some elements of the missing architecture, particularly in relation to banking union and fiscal surveillance. One can speculate why they were either never put in place or only imperfectly implemented. Perhaps the pooling of sovereignty that was implied by these aspects of the union was too great a step for politicians to take, at least for as long as it seemed unnecessary to do so. While these wider aspects lagged behind, the purely monetary aspect of the European project kept moving ahead. There were probably a number of reasons for this. On a practical level, it seemed possible to make technical progress in this area, although it seems obvious in retrospect that some of the sophisticated technical structures that were set up, such as the Exchange Rate Mechanism (ERM) itself, suffered crises at various points in time that might have pointed to likely difficulties when the permanent locking of exchange rates eventually occurred.

There also seemed to be obvious benefits that a monetary union could deliver. Apart from savings like reduced transaction costs, the formation of a common currency also offered Europeans the prospect of some sort of rival to the US dollar as a reserve currency and held out some of the privileges that went with that. Europe was beginning, even in the 1970s and 1980s, to see that its place in the world was destined to be a smaller one than before and any of the member states on their own, even Germany, were unlikely to be able to rival either the US or, indeed, some of the rising global powers. Second, it seemed to offer a way of dealing with the persistent current account imbalances that had characterised many economies, such as Germany’s persistent surpluses, although it would end up doing so primarily by internalising them in the monetary union. As the monetary union lacked some of the features that we can now identify as evidently ‘missing’ and which are typically present in other monetary unions, this turned out to be problematic, for reasons that I will come back to later. Third, there was probably a general anticipation that simply putting the monetary union in place would be part of a process that would inevitably see the other steps needed to make the union work follow without too much delay. Of course, partly because the monetary union seemed to be working quite successfully in the first six or seven years, the momentum and necessity behind these further changes seemed to lessen and they were effectively left aside.

Of course, there were always doubts expressed on the suitability of the initial euro area for monetary union, perhaps most noticeably by the proponents of the idea that it was not a so-called ‘optimum currency area’, because its business cycles were not fully synchronised and its economic structures were not all that similar. Issues like the differences in labour market functioning were also significant. While studies generally concluded favourably on the issue of an optimum currency area, it was noted that the European Union, as then set up, could not respond to shocks that hit one region and not another with the kind of smoothing mechanisms that were in place in, for example, the United States. The two main problems identified here were the lack of a large common federal budget, which effectively transferred resources across regions and helped to smooth out the impact of region-specific shocks, and labour mobility, which is relatively high in the United States, allowing for a flexible response to the impact of some of these same shocks but was much less so in Europe, given language and other barriers. In Ireland, much of the focus of analysis concerned the advisability or otherwise of entering EMU without the UK.

Less concern seemed to focus on areas that have actually proved to be more problematic during the crisis. The most obvious is the area of financial integration or rather the lack of integration of supervisory and resolution structures. In fact, the initial plans for monetary union included the ECB having banking supervision responsibilities but, in practice, this was never implemented, as many countries, both large and small, were opposed. Interestingly, just because the various actors could not agree, it seems to have been simply left aside, without triggering the idea that this would be a major flaw. The timing of this omission was particularly unfortunate given the looming banking crises both outside and within the monetary union. On an abstract level, financial market integration should be clearly beneficial to all, as financial resources are free to flow to wherever they are most efficiently used. In the early years after monetary union, there was evidence of increased financial market integration taking effect, cross border flows increased and it seemed as if the benefits were being reaped. While this may have been happening to some extent, overall, these flows were not, however, as beneficial as they seemed. We can see now that inflows into the periphery, as it has come to be called, ended up contributing significantly to the overshooting of property markets, price levels and a range of other variables in virtually all of these economies, including our own.

Would a unified supervision structure and an institution with a wider macro financial stability mandate at the level of the euro area necessarily have prevented all of these developments? It is difficult to say. Such structures might have helped to limit the problems but it is not clear that they would have prevented them entirely. Supervisory structures in other countries, such as the US and the UK did not succeed in averting difficulties in those economies, so the jury will probably have to remain out on this issue. What can be said with more certainty is that it would have been easier to deal with a European banking crisis, which is to a large extent what we have been through, if there had been European supervision and bank resolution systems in place.

Fiscal policy co-ordination is a slightly different case. In this instance, the gap in the institutional architecture was more widely recognised. In fact, theoretically, this gap did not exist at all, as mechanisms were put in place to try to limit the impact of spill-over effects from one state’s fiscal policy onto another, through the original Stability and Growth Pact. These rules were, however, not sufficiently wide ranging and not sufficiently enforced to have the desired effect. Limits were breached by both smaller and larger countries. As well as the enforcement problem, there was the issue that unsustainable fiscal developments were not really detected or analysed effectively, as the surveillance mechanisms themselves were not sufficiently robust. That failure came in a number of forms, ranging from simply not having accurate information about developments, most notably in Greece, to a lack of an in-depth analysis. Such an analysis might have revealed that developments in Ireland and Spain and elsewhere, though nominally in line with fiscal limits were, in fact, based on unsustainable developments, such as asset booms and overly narrow tax bases, facilitated to a significant degree by the unregulated financial integration of the euro area.

Apart from these issues of less than perfect information and analysis, were there other reasons why problems were not detected or why people did not see the reason to really strengthen the information gathering and analysis framework? One obvious answer is that everything seemed to be going reasonably well. Growth in the euro area and in the global economy was generally reasonably strong, although Europe still lagged behind the US, but the latter outcome was down to structural and other factors not directly related to the monetary union. Of course, some of the impulses behind this external growth also had their roots in financial sector problems, with asset price bubbles in the two of the euro area’s largest trading partners, the US and the UK, as well as in some other smaller countries outside the monetary union. There was also an internal boost, or an apparent boost from the financial integration, some of it genuine but also involving asset price bubbles within the monetary union. A complicating factor with the identification of some of these problems within the union was that the asset price bubbles in Ireland and elsewhere in the periphery were tangled up with genuine positive impulses to growth from integration.

It is worth spending a minute on this aspect. When Ireland and other peripheral countries entered the process of integration with the core of Europe, a long-term catching up process can be seen as one of the mechanisms that drove developments. This involved a flow of investment to these countries and a gradual rise of incomes and prices to some sort of European average. This catching up effect can generate features like slightly higher inflation or some modest appreciation in house prices but on a sustainable basis. It is sustainable because the productivity levels in these economies are also rising to catch up with the level of output per worker in the core. The trouble with this convergence mechanism is that some of its symptoms, like the slightly higher inflation rate, are not too different from those of an unsustainable credit driven bubble. So, one could plausibly suggest that this slightly higher inflation rate and other developments in the economy were perfectly sustainable and constituted positive developments right up until monetary union and beyond, possibly as late as 2003 in Ireland’s case or thereabouts. From then on, the unsustainable element rapidly took over, as it did elsewhere, but people were slow to recognise the transition and adhered to the myth that strong growth would go on forever – the kind of myth that underpins, and is almost necessary to sustain, the typical bubble.

There were other factors that led to concerns not being as acute as they might have been. For example, some of the normal signalling of problems from external imbalances was blunted by a feeling that current account imbalances no longer mattered, particularly those now subsumed within the monetary union. After all, no one looked at the external balance of regions, so no one considered the current accounts of Andalusia or Bavaria, just like no one looked at imbalances between the various states in the US or within other well established monetary unions. But these imbalances were more of a cause for alarm inside the new monetary union than might have been the case in other monetary unions. First, they were indicators of significant bubbles and disequilibria in some regions of the monetary union partially fuelled by the creation of the monetary union itself and second, the lack of a banking union, a federal budget and other features of other monetary unions were going to make dealing with the bursting of these bubbles much more difficult that would otherwise be the case.

There were warning signs, of course, and not all were ignored. The evolution of unit labour costs on a relative basis was clearly unsustainable with large rises in the periphery against core economies like Germany. Without the possibility of altering exchange rates these competitiveness losses would only be corrected through downward adjustment in wage costs which are always difficult to achieve, especially in countries where the labour market had traditionally been relatively inflexible. These were pointed to by many, including leading central bankers, but there was no apparent response and central bankers themselves did not, in any case, have any tools to address these kinds of country specific issues. By definition, monetary union implied a single monetary policy and in any case, this was not a suitable instrument to spur structural reforms.

Central bankers did, however, have to respond to the crisis when it broke. This they did in a number of ways. Standard monetary policy was loosened with rates falling close to zero, where they remain. The non-standard response included an increase in the flexibility of collateral policy, basically accepting a wider range of assets against which funds would be lent, and interventions in the bond market, like the Securities Market Programme (SMP), initiated with a view to restoring the functioning of the monetary transmission mechanism. While these policies were deployed across the system, the actual result pointed to the divergences that had emerged between the core and periphery. Once it was clear that there were going to be difficulties in the periphery, private funds begin to flow back swiftly to the core. This had to be replaced by central bank lending to support financial institutions in the periphery, resulting in the emergence of high degree of liquidity support in these economies, including Ireland. One of the features reflecting this has been the emergence of the so-called TARGET balances, amounts recorded as intra-Eurosystem liabilities by the constituent National Central Banks of the Eurosystem. These are a symptom of the crisis, not a cause, representing the response of the central banking system to the flows of funds to financial institutions at the centre during times of stress. Interestingly, these may be starting to recede now, as funds begin to flow back towards the periphery, in response to the initiatives taken by the European Central Bank, in particular statements by ECB President Mario Draghi and the announcement of the Outright Monetary Transactions (OMT) programme, a bond buying programme which has been put in place and is yet to be activated, but one which has calmed market fears.

Looking to the future

This latter action and the statement by President Draghi that the ECB will do ‘whatever it takes’ to preserve the euro have proved to be something of a turning point. This is not to say that there will be no more difficulties or that the situation will go back to that which prevailed before. The central task now is about making the system run smoothly by completing the architecture that should have been put in place before monetary union but, for various reasons, was not. The choice, therefore, is between a monetary union that functions smoothly or one that is prone to recurring problems. There may even be a danger that the actions of the ECB in returning a degree of stability to the financial markets will have the paradoxical effect of actually taking off some of the pressure to do what is required to ensure a smooth functioning of the union going forward. As Harold James noted in the book I mentioned earlier, friction between the politicians and the technocrats (of which central bankers were a large component) was a constant feature of shaping the euro in the first place and it has also persisted through the crisis and into the re-shaping of the monetary union. At the moment, however, good progress is being made on the banking union and other aspects, and there appears to be an acceptance on all sides that this important work needs to be completed both urgently and carefully.

What is planned under the various headings? On banking union, the current plans envisage three components to the union. First, there is the supervisory aspect, the so-called Single Supervisory Mechanism (SSM), second, there is a resolution mechanism at a European level and last, there is a European deposit guarantee scheme. The ordering is important here. There is little chance that there will be a mutualisation of the costs of resolution or an exposure to deposit guarantee payments in other member states without the creditor countries, as they are often called, having the assurance that the Single Supervisory Mechanism will give about the condition of the banks first. Then, of course, there is the difficult question of legacy issues, problems that arose because of a combination of flaws in both national supervision and the lack of a suitable European architecture in this area. One could argue that since both of these factors contributed then there is an argument for at least some mutualisation, on the basis that some responsibility also rests with Europe as a whole, for what might be characterised as the initial design flaws of the monetary union.

The plans in the area of banking union are comprehensive and the union that is envisaged, when completed, will be a solid support for monetary union. The plans set out by the European Commission in its statement of 12 September 2012 described a Single Supervisory Mechanism (SSM) that could begin operating in 2013. More recently, however, the European Council decided that the SSM would begin operating in March 2014 or one year after the SSM legislation would come into force. The construction of this mechanism is a large task, however, so building it carefully and ensuring that it is robust should prove to be time well spent in the long run. There needs to be a careful balance here between the centre and member states both in terms of responsibilities and tasks, so that useful local knowledge is combined with the detachment that naturally comes with some distance. The other elements of banking union have to follow in sequence and, although there may be specific issues to be resolved in those areas, the construction of the SSM is both the prerequisite and most complex component in terms of coming up with an overall structure that functions well.

Progress in the fiscal area is harder to assess. Does the union need a large centralised federal budget? Probably not. It would definitely help in responding to shocks but it is not an immediate prospect and the monetary union can function without it. What is definitely required is much better co-ordination and monitoring of member states’ budgets. The various initiatives such as the ‘six pack’ and the ‘two pack’ and the ‘European Semester’, as it is called, do add up to an effective surveillance mechanism, assuming that they are all implemented in a rigorous manner. The need for fiscal policy co-ordination was always recognised in the Stability and Growth Pact (SGP). But this was a mechanism signed up to by politicians at the time, but subsequently conveniently ignored. The danger is of a repeat of this pattern. There are some reasons for being more hopeful on this occasion, the main one being that these changes to the surveillance mechanism are born out of an acute and visible demonstration of why they are needed, whereas the original SGP was largely created in abstraction, considered necessary by some and reluctantly accepted by others but not adhered to in the end. The real test will not be in the short term, of course, but only when benign conditions return and it will be tempting to be more lax in terms of discipline, as the memory of the disasters of the past gradually fades.

Banking union and fiscal co-ordination are the main focus in terms of the missing architecture but there are other areas that require some consideration too. There is ‘enhancing efficiency and growth’ as it is sometimes described. Looked at on a macro-level this is mainly about putting in place structural reforms in economies that allow them to adjust without the exchange rate flexibility of the past. The diverging unit labour costs that I mentioned earlier would have been cured in the past by the expedient of altering the relative value of the currency in which they are denominated – such as an alteration of the currency’s central parity in the ERM or, put simply, a devaluation. Within the monetary union these divergences have to be corrected by other means, either raising the rate of productivity growth above your trading partners or, alternatively, lower or even negative wage inflation. Productivity growth is something that cannot be turned on at will so, in reality, short term adjustments in these relative costs have to largely come through wages.

The degree of labour market flexibility varied greatly across the monetary union before union took place and the evidence is that countries with very different labour market structures did little to align them in the years up to or, indeed, after the introduction of the euro. This was further unfinished business, the significance of which only really came to light during the crisis. These labour market differences, which do not exist in a lot of other monetary unions, would tend to cause problems at the best of times through differing abilities to respond to shocks through internal adjustment as opposed to exchange rate changes. Unfortunately, the impact of the expansion of lending into the periphery that occurred during the early years of monetary union meant that this was no ordinary situation. These flows had the impact of driving up wages in the these regions more than might have happened due to more modest or ordinary economic shocks, while the boom conditions that were experienced meant that there was little apparent need to address issues of labour market flexibility in the short term. Naturally, therefore, they were left unaddressed, resulting in rapid and painful adjustments having to be made during the crisis, an adjustment process that is still on-going.

The overall assessment in this area, however, is that more work will have to be done to adjust labour market and other structures in the various economies to bring them more into line. This will help in maintaining the smooth running of the monetary union going forward. The good news is that if the banking union is completed successfully, then the kind of macro-economic disturbance experienced in the early years of monetary union should not be repeated. Nevertheless, there will always be shocks and this area of structural reforms will be an important part of increasing the robustness of the euro area in the future.

Conclusions

We can clearly see now that, in hindsight, the original construction of the architecture around ‘Economic and Monetary Union’ was flawed. Banking union, in particular, was not seen as being as critical. Part of the reason for this omission, though, was a general problem not confined to the euro area, as too little attention was paid globally to banking and the supervision of banking activity. In the case of monetary union, other areas definitely figured strongly in the plans, especially fiscal co-ordination and, to some extent, the need for structural reforms in individual economies, but these were not seen through properly. In some cases, this was partly linked to the building banking crisis, where the credit boom obscured the need for those pieces of the architecture to be put on a firmer footing.

The future of the euro has certainly been secured in some form. The actions of policy makers, in particular, of the European Central Bank have proved sufficiently effective to essentially remove any probability that the euro itself will not survive. Has a well-designed fully fledged new architecture for a smoothly running monetary union been completely put in place? Not yet is the answer. Comprehensive plans have been drawn up and, in certain areas, such as banking union, a lot of progress has been made but it remains critical to complete the job properly this time. Those of you with experience of small children will recall their typical response to a long car journey. It usually involves asking, sometimes at a very early stage in the journey, ‘are we nearly there yet? In truth, we have a bit to go, we have a good map, but we have to make sure to follow it carefully this time.

Thank you very much for your attention.

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 ¹ James, Harold, ‘Making the European Monetary Union, Harvard university Press, 2012

² Van Rompuy, Herman in collaboration with Jose Manual Barroso, Jean Claude Juncker and Mario Draghi ‘Towards a Genuine Economic and Monetary Union’, European Commission, December 2012