WIREDGOV

Speech by Mario Draghi, President of the ECB,at the European University Institute, Florence, 11 May 2018.

It is a great pleasure for me to be invited by the European University Institute, which in many ways mirrors what the European project is for. It was founded to encourage exchange, cooperation and a common European vision.

Since then, the university has made countless contributions in the fields of economics, law, political science and history. It has often been the meeting point where academic research helps answer the urgent policy questions of the EU.

A decade after the great financial crisis, the euro area looks set to exit more resilient than it entered it. Much of the harm caused by the economic downturn has now been reversed by a consistent period of growth. And some of the institutional and structural factors that exacerbated the crisis have been addressed.

But we know that our Monetary Union is not complete. The crisis revealed some specific fragilities in the euro area’s construction that so far have not been resolved.

To make our Monetary Union more robust against future challenges, we need to address these fragilities.

1. The history of the crisis in the euro area

The crisis took place in five main phases.

The first phase was similar across advanced economies. Most had a financial sector characterised by poor risk management, low capital and liquidity, inadequate corporate governance, and weak supervision and regulation – diluted by many years of excessive optimism in the self-repairing power of markets.

When the Lehman shock hit, banks exposed to toxic US assets ran into difficulties and some were bailed out by their governments.

In the euro area, these banks were mostly located in Germany, France and the Netherlands. Bank bailouts took place on a staggering scale. In 2009, they totalled around 8% of GDP in Germany, 5% in France and 12% in the Netherlands.¹ These bailouts did not greatly affect sovereign borrowing costs, however, thanks largely to the relatively strong fiscal positions of the governments implementing them.

In the second phase, the crisis spread to banks in Spain and Ireland that had similar weaknesses, but were instead overexposed to the collapsing domestic real estate market. Another wave of bank bailouts followed, and some signs of tensions in sovereign debt markets began to appear.

Those tensions were compounded by the third phase, which began when the Greek crisis shattered the impression that public debt was risk-free, triggering a rapid repricing of sovereign risk. To those who saw the crisis as a consequence of moral hazard, this represented a required return of market discipline vis-à-vis sovereigns – a view that was reflected in the Deauville agreement in October 2010.

These events spread contagion to all sovereigns now perceived as vulnerable by financial markets. But they affected most of all those with high public debt levels, a lack of fiscal space, fragile market access and, especially, low growth. Sovereign risk was then transmitted into the domestic banking sector through two channels.

The first was through banks’ direct exposures to their own governments’ bonds.

Between January 2010 and July 2012, banks in Greece, Italy and Portugal incurred aggregate losses on sovereign bonds of vulnerable countries² amounting respectively to 161%, 22% and 36% of their Core Tier 1 capital.³ Regardless of whether these losses directly affected regulatory capital⁴, they had an adverse effect on perceptions of solvency in those national banking systems.

The second channel was via negative confidence effects.

Because the public sector makes up roughly half the economy in many euro area countries, and because of credit rating dynamics, the fear of possible sovereign defaults had a dramatic effect on confidence in the domestic private sector. Any distinction between firms and banks, and between banks with and without high sovereign exposures, disappeared. The general loss of confidence in these countries’ prospects reverberated through the banking sector via a further fall in growth.⁵

In this way, the crisis spread to banks that did not have significant exposures either to US sub-prime assets or to domestic real estate, and therefore had not until then needed to be bailed out. However, governments in these countries found themselves unable to substantially respond to the emerging crisis with public money for the banking sector and countercyclical fiscal policy, due to lack of fiscal space and high debt.

Financial markets then began to fragment along national lines and cross-border funding dried up, exacerbated by defensive risk management by banks and ring-fencing of liquidity by supervisors in the core countries. Lack of liquidity, coupled with capital depletion from domestic losses, precipitated a renewed credit crunch.

Countries were trapped in a “bad equilibrium” caused by the three-way link between sovereigns, banks and domestic firms and households.

Falling credit aggravated the ongoing recession, increased loan losses and further weakened bank balance sheets, which in turn pushed sovereign borrowing costs higher. Fiscal policy, under the pressure of losing market access altogether, took mainly the more expedient route of higher taxes, which led instead to lower growth and therefore renewed market jitters, somewhat defeating its original purpose.

The fourth stage of the crisis was triggered by investors in both Europe and the rest of the world. Faced with a downward growth spiral, many investors reached the conclusion that the only way out for crisis-hit countries, given the institutional design of the euro area, was for them to exit from it. This would, it was believed, allow them to depreciate their currencies and regain monetary sovereignty.

Fearing redenomination into lower-value currencies, investors sold off domestic public and private debt, further widening spreads and exacerbating bad equilibria within vulnerable economies. In 2012, spreads vis-à-vis German ten-year government bonds reached 500 basis points in Italy and 600 basis points in Spain, with even wider spreads in Greece, Portugal and Ireland.

The fifth stage of the crisis then followed: the breakdown in monetary policy transmission across the euro area. Interest rates faced by firms and households in vulnerable countries became increasingly divorced from short-term central bank rates. As those economies represented a third of euro area GDP, this posed a profound threat to price stability.

The ECB responded with its announcement of Outright Monetary Transactions (OMTs), which restored confidence in sovereign bond markets, helped to repair the monetary policy transmission mechanism, and broke the downward spiral. With less of a direct market impact, but fundamental in confirming to the world the strength of our leaders’ commitment to the euro, was the earlier decision to create the banking union and the European Stability Mechanism (ESM).

The long trip back to growth had begun.

The unfolding of the euro area crisis yielded lessons for the financial sector, for individual countries and for the union as a whole. But the unifying theme was the inability of each of these actors to effectively absorb shocks. In some cases, because of their weaknesses, they even amplified those shocks.

Indeed, banks fuelled the build-up of imbalances and then exacerbated the resulting crash. Countries had too low growth potential, limited flexibility to bounce back from the crisis and too little fiscal space to stabilise their economies. And the euro area as a whole was shown to have no public and very little private risk-sharing.

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