European Commissioner for Economic and Monetary Policy
Conference EEAG Report on the European Economy
Ladies and Gentlemen,
Let me start by thanking the European Economic Advisory Group as well as Bruegel, for inviting me to this conference. In these difficult and highly uncertain times, it is useful to exchange views on the economic situation and discuss policy options.
With this in mind, I must congratulate the CESifo/EEAG for producing another very interesting and timely report. Economic forecasting is not the easiest task at the best of times. The speed and unpredictability with which the crisis has unfolded over the last months makes it particularly difficult to predict what lies ahead for the European economy. Nevertheless, we can all agree that 2009 will be a difficult and painful year.
This is clearly the worst financial crisis since 1929. It is also complex. Its origins lie both in macroeconomic failings - through the compression of interest rates and the build up of huge global imbalances – and in serious shortcomings in the financial sector, including the systemic failure of financial regulation and supervision to properly identify and manage risks in international financial markets.
There will be an ongoing debate about what exactly went wrong and putting right those failings will be the focus of our efforts over the next years. However, right now the central challenge we face is to contain the immediate crisis and implement policies for recovery.
Last autumn, when Lehman Brothers collapsed and the banking sector was driven to crisis point, Europe was quick to react, putting in place a comprehensive recovery plan.
The ECB, together with central banks around the world, aggressively lowered interest rates and expanded its range of collateral. Governments launched substantial rescue packages for the financial sector, including state-backed guarantees for bank liabilities and capital injections into financial institutions. In total 17 Member States have announced schemes and to date and 16 plans have been approved by the Commission. Consequently we have avoided a second Lehman Brothers, we have managed to stabilise the banking sector and we have seen some improvement in interbank lending.
At the same time, it became clear that a fiscal stimulus for the economy would be necessary. Investment and consumption was in free fall and monetary policy was running out of room for further easing. For this reason, the European Commission proposed last November a massive, coordinated fiscal stimulus for the European economy that was endorsed by all Heads of State and Government.
The latest outlook for the global and European economies confirms that we were right to move fast. In the intervening months, economic situation has deteriorated rapidly.
We are now facing the worst annual synchronised global economic downturn since the great depression. Industrial production has virtually collapsed and world trade is falling faster than anyone would have expected.
All G7 economies are now in recession and the Commission forecasts global growth to be a mere ½% in 2009. To add to the difficulties, no region is taking up the slack created by the slowdown in the advanced economies. Growth is slowing sharply in emerging markets, which are being hit by decreasing demand from the US and Europe.
In Europe, the economic situation is grave. The euro area has been in recession since the second quarter of 2008 and the contraction accelerated further in the final quarter of last year by -1.5% quarter-over-quarter.
We share the view of the EEAG that the European economy will continue to shrink in the first half of this year, although we forecast GDP to fall by 1.9% this year – which is slightly more pessimistic than the figure in the report presented today. In light of the most recent data concerning industrial production, industrial new orders, I fear that our forecast may turn out to be more realistic.
However, there is light at the end of the tunnel. The bold action – financial, monetary and fiscal - taken under the European Recovery Plan should begin to curb the fall in activity and put a floor under the downturn this year. As a result, we should see a gradual recovery for the European economy at the end of 2009, and this is echoed by the IMF forecasts and the EEAG's own outlook.
But this scenario depends to a great extent on the swift and continued implementation of the recovery plan.
First and foremost, this means repairing the damage in the financial sector. The crisis has its roots in the financial system and the recession is being transmitted to the real economy very rapidly through financial channels.
Our actions so far have, as I said, stabilised financial markets. Interbank lending rates and spreads have steadily declined over the last couple of months.
However, markets are far from back to normal. Banks continue to report losses. Sovereign bond spreads have widened which reflects the transfer of risk from the private to the public sector.
Most worrying of all, there is mounting evidence that credit markets are not working properly. The latest ECB data shows an overall decline in credit to the private sector and we are hearing more and more reports of households and businesses finding it difficult to obtain financing.
This is a very real concern because if credit cannot flow properly, it is equal to cutting the oxygen supply to the economy. There can be no recovery without it. Even the best devised fiscal stimulus package is unlikely to be effective if the normal functioning of credit markets is not restored.
One of the main reasons for this blockage in credit channels is continued uncertainty about the valuation and location of impaired assets in the financial system. These include the 'toxic assets' linked to the sub-prime mortgage market in the US, but not only those. As the crisis has evolved, an ever-wider range of assets have become impaired. Indeed, the crisis has now reached the point where the real economy is harming the banks, not just the other way around.
A broad consensus is now forming in Europe that we will need to move fast and introduce some form of asset relief to complement the measures already in place. Many countries are now looking seriously at the options on the table. Some are considering the possibility of setting up a 'bad bank' to absorb the impaired assets, others an insurance scheme.
However, less important than the model that each Member State chooses, is the fact that all programs should abide by a set of common principles. This is crucially important to ensure that we maintain a level playing field among banks.
For this reason, today we are publishing guidelines on asset relief produced by the ECB and the Commission. These set a clear framework for assessing which assets are eligible for treatment and for their valuation. The Commission has tried to adopt a flexible approach in order to be able to cope with the different situations across Member States. This means that action should not necessarily be limited to subprime related assets but could also cover more typical affected by the current economic difficulties.
We also advise Member States on how to value impaired assets. This is a difficult task, especially when dealing with complex financial instruments. The general principle is that in the absence of correctly functioning markets, the valuation of the assets should be carried out with reference to their real economic value. The Commission will promote ex ante coordination of valuation methodologies where possible and establish an independent ex-post review in order to help evaluate the techniques applied by Member States.
It is clear that after the huge amounts of public money already poured into the banking sector, it will not be easy explaining to taxpayers why we need to do more. If asset relief for banks is to achieve sufficient public acceptance, it is essential that the banking sector is seen to provide an adequate quid quo pro. This cannot just be limited to restrictions on executive pay. It must also include a commitment to maintaining lending to the real economy and to carry out appropriate restructuring.
We are not rushing into any decisions that have not been carefully thought through and their impact assessed. But we do need to act soon. Measures to cleanse bank balance sheets can have a powerful effect to boost confidence and re-start lending. And they will be crucial if we want to see the full impact of fiscal stimulus measures.
This brings me to the second immediate priority for recovery, which is to implement as quickly and as fully as possible the announced measures to support household consumption and public and private investment.
Progress so far has been good. Taken together, the discretionary budgetary measures planned for 2009 and 2010, plus the role of the automatic stabilisers and any additional budgetary measures are estimated to total between 3 and 4% of the EU's GDP. On the 4th March, the Commission will publish a stock take of the recovery plan, including the budgetary measures taken so far and will update these figures.
The Commission proposed a coordinated stimulus of 1.5% for the EU on average, but it should be differentiated according to Member States budgetary starting positions. This has largely been the case. Those member states with room for manoeuvre are doing more, while those without have generally not adopted stimulus plans. We also stipulated that any fiscal stimulus should be timely, targeted and temporary and I am pleased to say that these principles have been broadly respected.
There were two key rationale for the '3 Ts', as these principles have become known. The first was to ensure that any measures to support demand would have maximum effect. The second was to make certain that fiscal stimulus plans could eventually be reversed. We need to fight the recession in the short term, while not jeopardising the medium term credibility of government budgets.
The downturn, interventions in the banking sector and stimulus measures are all taking their toll on public finances. The government deficit is projected to reach 4.8% of the EU GDP in 2010, its highest level in 15 years.
So it is vitally important that we look ahead and plan an exit strategy for the end of the crisis. This is why I have called on Member States to develop concrete strategies for reversing deficits and debts when growth returns, to consolidate public finances and to advance towards a close to balance position.
In this respect, the Stability and Growth Pact is a major asset that can help us devise a clear, predictable and credible strategy for rolling back deficits and debts.
I have heard some say that the severity of the recession means that the Pact is no longer relevant. This is wrong. The reality is that to overcome the crisis, to maintain the confidence of citizens in the capacity of public authorities to preserve a sustainable position in their public finances in the medium to long term, we need to implement the pact.
The impact of the budgetary measures and automatic stabilizers on the public debt ratio risks placing a huge burden on future generations. But by drawing on the flexibility that was introduced in the Pact when it was reformed in 2005, we can combine the fiscal stimulus in the short term with a sustainable position of our public finances in the long term.
This morning the Commission adopted opinions on the second batch of Member States' Stability and Convergence Programmes – the documents in which countries detail their budgetary plans for the next five years. Six countries foresee deficits above 3% of GDP and therefore, in accordance with the Treaty, the Commission has adopted excessive deficit reports under Article 104.3.
In the second half of March we will adopt recommendations for the correction of these excessive deficits and propose deadlines for their adjustment which will be discussed at the informal Council of EU finance ministers in April.
In forming our recommendations, we will use the full flexibility embedded in the Pact. This means that we will take into account the economic situation, the impact of any fiscal stimulus measures on budgets and how countries are planning to reverse these once the recession is over. In this way we can ensure an adequate pace for the correction of excessive deficits.
I want to stress that the Pact is not about sanctions; is about peer pressure and support for sound policies. It is about anchoring credibility for member states public finances – and that is particularly pertinent when we consider widening spreads and the pressure that some countries are being placed under by the markets.
The SGP remains the cornerstone of our fiscal framework; this was reaffirmed by EU leaders in December. We will implement it in a judicious and intelligent way and in doing so, we will help to safeguard the credibility of government budgets and the long-term sustainability of public finances for generations come.
Finally, before I finish, let me just mention the ongoing efforts for financial sector reform both at the EU and global levels. These efforts are vital to safeguard stability in the long term and ensure that a crisis of this scale cannot occur in the future.
At EU level we have brought forward a package of measures over the last year to improve the transparency and regulatory gaps in EU financial markets. We are now examining executive pay, assessing the role of hedge funds and reviewing codes and national regulation for private equity to identify any gaps that need to be addressed by EU legislation.
We are also now seriously looking at resolving the issue of European supervisory arrangements. The crisis has thrown into sharp focus the weaknesses of the present arrangements in cross border supervision. There is no question that we can continue to accept the status quo of largely national based regulators for our highly integrated financial markets.
Hence the proposals published today by the High Level Group chaired by Jacques de Larosière couldn't come any sooner. The report puts forward some ambitious proposals which, overall, are to be welcomed. Of course, before we can respond in detail we will need to evaluate the substance of the proposals, in consultation with the European Parliament, the level 3 committees and the ECB. However, we are determined to move quickly. We need to push on with substantial reforms in this area, which is why the Commission will give its first response already on the 4th March in our communication to prepare the spring European Council.
Even as we advance at EU level, we know that reforms will only be truly effective if coordinated internationally. The various working groups of the G20 have been working hard on the Action Plan agreed at the summit in Washington last November. With the second G20 summit just over a month away, we are at pains to maintain the broad consensus and the high level of ambition on regulatory and supervisory reform of the international financial system.
Ladies and Gentlemen, let me conclude.
The crisis that began in financial markets has transformed the outlook for the European and global economy. 2009 is set to be an extremely difficult year as citizens and businesses around the world feel the strain. The responsibilities for policy makers are great and the stakes are high. However, we are drawing on a powerful set of economic instruments to fight this crisis. I believe that if we can implement the right measures in the short term, especially repairing credit channels, while keeping an appropriate medium term perspective for macroeconomic policy making, then we can set the European economy back onto a path of strong and sustainable growth.