Minister Olli Rehn: Lessons learned from the Eurozone Crisis

Ministry of Economic Affairs and Employment 15.4.2016 14.26

Elinkeinoministeri Olli Rehnin puhe Washingtonissa 15.4.2016 (The Peterson Institute for International Economics)

It is a great pleasure to be today here at the Peterson Institute. I have always enjoyed the inspiring talks and side events during the IMF spring meetings. In this spirit I am looking forward to an interesting debate with you.

For both the United States and the European Union, the transatlantic relationship has a crucial role. Our ties are close. We share the common values of democracy, the rule of law, human rights and economic openness. Despite the rise of the BRICS and Asia, the EU-US relationship remains the cornerstone of the world economy and its governance. Concluding the Transatlantic Trade and Investment Partnership will further deepen this bond.  

I understand that from this side of Atlantic it seems that the EU is currently overburdened by numerous crises. And with the refugee crisis, the Brexit threat, the remnants of the Euro crisis, the geopolitics of Russia, Ukraine and Syria, and setbacks of rule of law in some Members States, this perception is not incorrect. On our side of the Atlantic, the Eurosceptics do their best to capitalize on these crises.

However, it is not yet time to declare a premature death of the European Union. We may be short of oxygen for now, but we are totally committed to tackle these crises, one-by-one. And I trust nobody will doubt our determination to do whatever it takes in order to revive the dynamics of economic and political integration in Europe.

Today I will focus on what lessons we can learn from the euro crisis. I do this rather in my capacity as Chair of World Economic Forum’s Council on Public Finance than as Finland’s Minister of Economic Affairs. However, my views are not necessarily contradictionary to those of the Finnish Government.

The debate on the background of the Euro crisis and the policy choices made during it has intensified during the past years.  This debate is necessary, as we must learn lessons from the policy choices made during the crisis years and to make sure that we don’t repeat past mistakes.

This debate should also give an impetus to the reform of the Eurozone, even if it seems that not much has been done since 2014. Whatever the truth, we have to keep in mind the reform agenda, so that the euro area is stronger and better able to face the next crisis, whenever it comes.

Real GDP, euro area

Let us first have a look at the overall trend in real GDP growth in euro area from 2008 to 2015.

- There was a drop of -4.5 % of GDP in 2009, but a recovery during 2010 and 2011. Thus, the Greek and Irish crises did not profoundly damage the growth rate in the Eurozone during this period. The conditional financial assistance by the EU and the IMF worked to contain the contagion.

- But a recession occurred in 2012, cf. the Italian and Spanish crisis during 2011-12. Then, after difficult decisions, in 2013 the recovery started again.  

Now, let’s look at three periods of the crisis - 2008 to 2010, 2011 to 2012 and 2013 to 2015 – and compare the trends in the EU and the US.

GDP growth and fiscal policy: US versus Eurozone

I call the first period “the financial-crisis recession”. Both the US and Eurozone reacted to the first phase with fiscal stimulus. In the case of the US, the stimulus was twice as strong, so it’s not a surprise that growth fell more in the Eurozone than in the US. It seems that the fiscal multipliers behaved “normally” in the early period of the crisis.

Interestingly, it appears that the same mechanism doesn’t apply to the years 2011 and 2012, which I call “the debt-crisis recession”. In 2011, the aggregate fiscal balance was clearly positive and thus, fiscal policy contractionary, in both the US and the Eurozone. While the growth rate was almost the same in US and Eurozone in 2011, it dropped significantly in 2012 in the Eurozone, but not in the US. Moreover, after the first fiscal cliff of 2011, in 2012 the US had even a more contractionary fiscal stance than the Eurozone did.

The euro area economy returned to a path of recovery only in spring 2013, which has continued ever since, even if the recovery has been weak and uneven. There are many factors that enabled the return to recovery by 2013, such as the setting up of the European Stability Mechanism during 2010 to 2012; the commitment of Member States to consolidate their public finances; the decision of the European Central Bank on Outright Monetary Transactions in August 2012. However, this recovery has been weaker than in the US in terms of growth and job creation.

The financial accelerator as a better explanation

It seems that the correlation between aggregate fiscal stance and growth rate weakens in 2011 and 2012. An obvious alternative to a fiscal explanation is either a financial or monetary explanation, or both together.

The period when the euro area growth performance really started to weaken relative to the US – the second half of 2011 – coincides with a widening gap between the long-term interest rates between the Eurozone and the US. Part of that is accounted for by the increase in the ECB policy rates. But a clearly more important factor was the intensification of the Euro debt crisis, especially in Italy and Spain. This was reflected in the significant increases in the spreads between the bond yields of the so-called vulnerable member states, on the one hand, and the Eurozone core countries, on the other hand.

Consequently, I would be less inclined to seek an explanation from the size of the fiscal multiplier for that period, and more inclined to focus on the “financial accelerator”. This concept was developed by Ben Bernanke when he was a scholar of the Great Depression, which was long before he became Chairman of the Federal Reserve. In 2011 and 2012, this factor was actually working in reverse, having turned into a financial decelerator.

The critical difference between the US and the Eurozone was the extent and timing of financial containment. The Eurozone acted slower and with too little financial power when the crisis hit. Meanwhile, the US acted immediately and implemented expansionary monetary policy and fixed the banking and finance system.  The repair of the US banking system was carried out mainly during 2008 and 2009. In contrast, in the Eurozone the financial repair was effectively begun in 2012, and it has not yet been completed.

However, the repair was definitely attempted much earlier, especially with the 2010 bank stress tests. Regrettably, though, these hit the wall of financial nationalism, to use the concept of Nicolas Véron, as there was no supranational institution for banking supervision at the time.  

What lessons can be learnt for the Eurozone reform?

The first conclusion that was drawn by the policy-makers (including myself) already in 2010 was that a convincing financial repair was necessary before the Eurozone could return to a sustainable path of recovery and growth.

This is when we realized it was necessary to build a Banking Union. Currently, two of the three building blocks of the Banking Union are in place (i.e. the Single Supervision Mechanism and the Bank Resolution Mechanism and Fund). Meanwhile, a common deposit guarantee scheme, the missing link, is still pending in the Eurogroup. I believe it will see the light of day, but before that happens, we have to reduce the risks related to it, especially the exposure of banks to the government securities of their “own” sovereigns.

Secondly, we have to be able to look forward and continue the reforms of EMU. In retrospect, the Eurozone debt crisis seems to reflect the crucial point made by the maverick-turned-mainstream economist Hyman Minsky: while stability is destabilizing, the effect can be contained by a proper use of regulation and policy. But even that can never be permanent, and policy will have to continually adjust to new circumstances. As much as the reform of the Eurozone economic governance during 2010 to 2012 was necessary, it was still incomplete. This is why the reconstruction of EMU can’t wait forever.

While the Five EU President's Report of 2015 didn't really go much further than the Commission's Roadmap for EMU in 2012, some ambitious proposals have been presented recently, such as the one by Jens Weidmann and Francois Villeroy de Galhau of Bundesbank and Banque de France, respectively, to create a Eurozone treasury and finance minister.

Yet, knowing the present mood among the European electorates, one may doubt whether there is the political will in the near future to support such a shift of power from national to community level, which would mean a big leap in the centralisation of fiscal policy. And it seems that a silent majority of our citizens suspect – perhaps not without reason - that centralised fiscal policy would lead to a permanent transfer union, which they tend to oppose.

Moreover, initiatives to create a Eurozone fiscal union have usually assumed that a pivotal step towards political integration, or political union, is a necessary condition to underpin its success. However, one may ask whether such a big leap is both possible and necessary.

It took the United States for more than a century and a bitter civil war to create a political union. The Eurozone is hardly at the halfway stop along such road for political integration. And as Barry Eichengreen and Charles Wyplosz argue in their recent article defining four conditions for the survival of the euro, "The euro's existential crisis is likely to be resolved one way or the other long before that destination [political union] is reached."

I tend to agree with them. In the long run, we are all retired - if we were to wait for a political union in order to do the necessary institutional and economic reforms in the euro area, the euro would be dead long before that miracle happens! Besides, laying down the condition that a political union is a necessary condition before advancing substantive reforms in the euro area is actually an excuse of not doing anything.

Instead of reaching to the moon, we should focus on building a real stability union with a strong emphasis on pre-emptive measures for financial stability and on the pursuit of economic reforms. This means focusing on concluding the Banking Union, simplyfying the fiscal rules and putting stronger focus on macroeconomic imbalances and structural reforms in economic governance.

Last but not least, the real economy matters! In other words, we have to do whatever it takes to sustain and strengthen the fragile economic recovery of the euro area. In this regard I see three key elements, une sorte de relance à trois, or a “recovery by three”.

First, the countries like France and Italy (and Finland!) have to commit themselves to a very serious implementation of economic reforms. The experiences of Spain, Ireland and Latvia provide empirical evidence how to pursue reforms in a successful way. 

Second, the ECB has to do everything in monetary policy to combat the deflationary spiral. The crisis and prolonged slow recovery certainly has changed ECB’s monetary policy approach in this regard. Actually, the change in the approach has been so dramatic that one might describe ECB’s evolution as “from a Bundesbank to a Federal Reserve”. 

However, at the same time, the voices that question the policy of cutting rates below zero are strengthening. The idea of a zero rate is to encourage banks to lend more and deliver further stimulus to stagnant economies. But with criticism of negative rate policy growing, central bankers are intensifying the pressure on governments to act more decisively to introduce additional interventionist fiscal policies or enact structural reforms.

Low rates also prevent savers getting the returns they need, potentially forcing consumers to save more, rather than spend and stimulate the economy. While everyone can cut rates, not all currencies can weaken. The situation is new and extremely challenging from a fiscal and monetary policy perspective.

Finally, the surplus economies of the Eurozone – no surprise that I am thinking particularly Germany – should boost domestic demand and domestic investment to support economic activities throughout the entire Eurozone. That would also help to convince other countries to pursue economic reforms.

Dear friends,

As you may see, I don't believe in the extremes. In the case of the Eurozone, it means that doing nothing is really not an alternative, as it would lead to permanent stagnation and finally to an economic and subsequently political dead-end for the euro. But the belief that taking a giant leap forward to political integration as a condition for the euro's survival is also not an alternative. Simply put, this will not happen, and to count on it would be to deceive ourselves and let the euro collapse. The Member States will have to retain the primary responsibility of their economic policies.

Instead, we need pragmatic common sense and really functional solutions. In the medium-to-long term, we may take greater steps towards an economic union, where increased solidarity must always first be matched with increased responsibility. But for now and in the near future, we must focus on the evolution towards a stability union and Banking Union, and on concrete economic reforms to build a solid foundation for sustainable growth and job creation, which really matters to our citizens.

That is also the way to build stronger legitimacy for future steps forward. I am looking forward to an interesting debate now. Thank you!