Dr. Olli Rehn
Deputy Governor of the Bank of Finland
European Economics and Financial Centre
London, 24 May 2018
The Euro Area Economy: On the Road of Recovery and Reform?
Ladies and Gentlemen,
Let me first thank the European Economics and Financial Centre for the invitation to join you here in the financial capital of Europe today. London is and will remain a financial powerhouse. We euro area central bankers need to engage with market participants and academia – and European Economics and Financial Centre provides opportunities to bring them together to share knowledge and develop ideas. I am therefore glad to share with you today some thoughts on two issues and to listen to your views on them. I will start with the state of the European economy and then discuss euro area reform.
Euro area economy
The euro area economy has now been growing for over five years, as seen in Figure 1.
Figure 1: Level of euro area GDP and forecast (ppt slide)
Equally important, growth remains broadly based across sectors and also across the Member States. The ECB’s latest forecast from March foresees growth to be 2.4% this year and 1.9% in 2019. Euro area GDP reached its pre-crisis level in 2015.
This includes, however, somewhat different country-specific paths. German output, for example, already reached its pre-crisis level in 2010. Meanwhile, Italian output is still smaller than before the crisis, although it has recently returned to the path of recovery and growth.
The euro area’s stronger performance in output and growth has also paved the way for positive labour markets trends. Euro area aggregate unemployment fell to 8.5% in March 2018 as can be seen in Figure 2.
Figure 2: Euro area unemployment rates (ppt slide)
Moreover, the unemployment rate is trending down in almost all Member States (see Figure 3). The German unemployment rate has dropped to a record low of 3.4%, whereas unemployment remains relatively high in the countries that suffered most from the financial crisis; for example in Italy it is down to 11% from around 14%.
Figure 3: EU unemployment rates (ppt slide), Source: Eurostat
Overall, there was a strong expansion in the euro area economy in 2017. Short-term indicators, however, suggest that the pace of growth has cooled somewhat in early 2018. Some of this could be explained by temporary factors – such as the cold winter – but recent data points to some moderation in the pace of economic growth from the high rates observed at the end of 2017. Nevertheless, the overall economic outlook for the euro area is strong, supported by favourable financial conditions, a strong labour market and steady income growth.
There is, however, a certain discrepancy or even mismatch between the currently strong economic fundamentals in the euro area economy, on one hand, and the surrounding political uncertainty on the other. In a nutshell, growth in the medium-term could be quite solid and sustainable, unless the possible political risks derail it.
So far, European financial markets have been quite resilient to geopolitical events, sanctions and tariff threats, emerging market jitters and political events in the euro area. Significantly improved and stronger economic fundamentals and the ECB’s measures have helped to contain the impact of these negative shocks.
But complacency on the part of the authorities, including us central bankers and market participants, should not be allowed to creep in. Excessive exuberance in the markets should be avoided, as valuation ratios in global financial markets are approaching high levels, although we do not see excessive credit growth in Europe for the moment.
The recent rise in Italian government bond yields needs to be taken seriously – see Figure 4.
Figure 4: Italian and German 10-year bond yields and spread (ppt slide)
The recent rise in yields in Italy has been in the scale of 60 bp in relation to the German Bunds. While still relatively limited, its signal should be taken seriously: markets are indicating that they are anxious about the medium-term impact on growth and public finances of the measures put forward in the negotiations to form a government in Italy.
Getting ready for Brexit
Speaking here in London I probably cannot avoid discussing Brexit, even though it is not my favourite topic. As you can probably guess from my background, I respect, but regret, the UK’s decision to leave the EU. Now both of us must not reminisce about the past, but focus on the future given the rather lousy cards we have been dealt with.
We should try to work together on both sides of the channel towards a solution that minimises the damage caused by the UK leaving the Single Market. The solution needs to respect the integrity, level playing field and financial stability of the Single Market, and the will of the UK people. There are accordingly evident constraints to possible solutions. In any case, trade cannot be as frictionless outside the Customs Union and the Single Market as within them.
Aside from trade, Brexit’s impact on the banking system and financial markets is obviously something I keep observing as a central banker. As I mentioned at the beginning, the UK forms a key part of the European financial markets. It is likely to remain a key financial hub despite it cannot become the centre of the Capital Markets Union.
At the same time, we must recognise that some things are likely to change as a result of Brexit. I do not want to prejudge the outcome of the negotiations on the future trade arrangements and, in particular, as it concerns financial services. These discussions are still at an early stage. The withdrawal agreement, too, which contains the transition period, is not yet ratified since important issues still remain open.
I would therefore urge market participants to make prudent arrangements to be able to continue serving their customers smoothly from the day one after the UK leaves the EU – in all scenarios, including one with no transition or passporting. If these arrangements involve setting up new entities in the EU or channelling more activity via existing EU entities, it is worth noting that the Single Supervisory Mechanism, which is responsible for the Banking Union, has been clear that this increased activity cannot be done using empty shell entities. According to SSM guidance, authorisation applications for the new entities should be initiated as soon as possible, at the latest by mid-2018.
For new and existing entities to qualify for a banking licence in the Banking Union, meaningful and commensurate resources compared to overall activities must be located in the Banking Union. The SSM has communicated that the ECB and national supervisors may allow more time for banks to meet certain supervisory expectations regarding their local risk management capabilities and governance structures, and to move to an adequate and balanced business organisation within the euro area. Finally, market participants should also prepare for the continuity of financial contracts.
With proper preparation by market participants and authorities, the risk that access to wholesale and retail financial services would be materially restricted for the euro area economy appears limited, as indicated by the ECB in its financial stability review. The impact on financial services is likely to be reflected more in the cost of financial services and in costs for financial institutions than in a reduction in the availability of services.
The ECB’s monetary policy
Despite the recent recovery, euro area inflation has remained below its historical average for a prolonged period of time. Measures of underlying inflation remain subdued and have yet to show convincing signs of a sustained upward trend. This has been puzzling and has inspired economists to identify several different explanations for the persistently low inflation.
Figure 5: Euro area inflation rate (ppt slide), Source: Eurostat
Without going into a detailed list of these explanations, it is a fact that the financial and debt crisis that the euro area recently faced was exceptionally deep and persistent, which has had an impact on inflation expectations. However, the latest estimates of excess capacities point to a closing output gap. This, together with the ECB's accommodative monetary policy, is expected to lead to a gradual pick-up in inflation rates. The ECB’s recent forecast expects euro area annual inflation to reach 1.7% on average in 2020.
In fact, despite the massive unconventional measures in the past decade by the leading central banks, the advanced economies have suffered from a persistently low inflation, or ‘low-flation’. In 2013-14 in the euro area there was also a serious danger of deflation. The latter threat was successfully combatted by the ECB’s decisive action in 2014-15, and the spectre of deflation subsequently disappeared. But the rate of inflation has continued to be low in a very persistent manner, even though growth has picked up. Core inflation in 2014-17 was barely at 1%, while the ECB’s price stability target is “below but close to 2% in the medium-term”.
Economists and central bankers all over the developed world keep on analysing the reasons for the persistently low inflation. Some have blamed “secular stagnation” for this phenomenon, implying that the natural rate of interest is very low due to both cyclical and structural reasons, such as low productivity growth and/or population ageing. Others have even gone as far as to maintain that the Phillips curve (i.e. the correlation between unemployment and inflation, see Figure 6) has lost its relevance. In my view, the Phillips curve has not disappeared anywhere, but the impact of improving employment on expected rise of inflation has been delayed, for both cyclical and structural reasons.
Figure 6: Unemployment and inflation in the euro area (ppt slide)
The main culprit for the continuously low inflation can be found in the combination of the remaining ‘slack’ or still untapped economic potential (for long, relatively high unemployment) and the long shadow of the global financial and euro area debt crisis. The wage demands have not really picked up, since many unemployed have only recently found jobs; since part-time employees prefer to work more hours before asking for wage increases; since many outside the labour force return to it thanks to improving economy; and since immigration may keep supply of labour up and thus curb wage pressures.
In early 2018, however, there were signs in the US that inflation has finally been picking up (partly because of energy price increases). Moreover, in Germany IG Metall, the Metal Workers’ Union (the usual wage leader) and Ver.di, the public sector workers and civil servants Union secured significant wage increases and shorter working time. We may thereby assume that the inflation rate will pick up in the medium-term. A normalisation of monetary policy in the euro area is therefore looming on the horizon, even though not yet around the corner – and wisely so. It will be a stepwise, gradual normalisation.
Having said that, the normalisation of monetary policy will not mean that otherwise we would return to the pre-2008 ‘old normal’ context of unsustainable boom. Instead, as a result of the root-and-branch reforms in financial regulation and supervision, the emergence of macro-prudential policies and the substantial evolution in monetary policy, we justifiably talk about a new equilibrium that is able to deliver financial stability, sustainable growth and sound job creation.
I am delighted to return to the Governing Council meetings. I used to represent the European Commission between 2010 and 2014 in the Governing Council, speaking on economic policy, fiscal policies and structural reforms, but without the voting right – next time I expect my colleagues to let me speak on monetary policy, as well! I look forward to participating in the monetary policy debate for the first time on 26 July. Meanwhile, let me recap where we stand today.
The ECB Governing Council reiterated on 26 April that an ample degree of monetary stimulus remains necessary, so that underlying inflation pressures will continue to build up and support headline inflation developments over the medium term. The Governing Council rightly stressed the paramount importance of patience, persistence and prudence in its monetary policy-making.
The path to a gradual and sequential phasing out of our non-standard measures has been clearly outlined by the Governing Council as part of its forward guidance. The sequencing is as follows:
- First, the ECB intends to continue net asset purchases, at the current monthly pace of €30 billion until the end of September 2018, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.
- After the end of the net asset purchases, the Governing Council expects them to remain at their present levels for an extended period of time, and well past the horizon of our net asset purchases.
- After the end of the net asset purchases, the Eurosystem will continue to reinvest the principal payments from maturing securities purchased under the asset purchase programme for an extended period of time, and in any case for as long as necessary.
- Finally, one should not forget the targeted long-term refinancing operations i.e. TLTRO-II programme and our standard refinancing operations that will be conducted on a fixed-rate full allotment. The last one of the TLTRO-II operations is set to run until March 2021. These TLTRO-IIs provide over 700bn of affordable funding to banks at rates as low of as -0.4%.
Euro area reform
Next, I will share some views on completing the Banking Union and reinforcing the ESM. I focus today on these two issues in the interests of time, but we should not forget that there is also still a lot of work to be done in undertaking structural reforms in member states, developing the Capital Markets Union, revising fiscal rules and developing fiscal stabilisers.
Completing the Banking Union
Completing the Banking Union is crucial for the stability of the European banking system, and the prime priority of euro area reform. The crisis revealed serious weaknesses in the institutional structure of euro area. It revealed especially how financial stability concerns – in particular the stability of the banking system and of the government bond markets – were neglected when the euro area was created.
Significant progress has been made since 2012. The Single Supervisory Mechanism and the Single Resolution Mechanism have been set up. At the same time, the financial stability of the euro area has improved. The capital, leverage and funding positions of euro area banks have strengthened. Figure 7 shows the improvement in capital.
Figure 7: Euro area banks’ capital positions are strengthening (ppt slide)
However, the work to strengthen the euro area financial system and to increase stability must continue. In this respect, priority should be given to strengthening the resolution and deposit guarantee schemes.
First, we need a fiscal backstop to the Single Resolution Fund, the privately financed resolution tool of the Single Resolution Mechanism. Such a fiscal backstop is important in order to give solid credibility to the commitment of the SRM to resolve, wind up or reorganise failing banks, quickly and effectively. The backstop would be a reserve instrument, activated only if the Single Resolution Fund becomes temporarily short of the resources required for its tasks, even after the owners and eligible creditors of failing banks have borne the losses allocated to them.
Financially, the backstop could operate as a credit line in the reformed European Stability Mechanism. It should be fiscally neutral, so that, over time, the Single Resolution Fund and ultimately the banking industry itself would replenish any funds drawn from it.
The firepower of the ESM could give the Single Resolution Fund the tools to tackle liquidity concerns. One idea is that the ESM could provide its bonds to liquidity-constrained banks emerging from resolution. Thus far, ESM bonds have been used for the recapitalisation of banks in program countries. Lending ESM bonds to banks emerging from resolution would allow them to use these bonds as collateral in market transactions. ESM bonds are also eligible collateral in our monetary policy operations.
The liquidity tool for resolution could be developed as part of the fiscal backstop arrangement for the Single Resolution Fund, as also endorsed by the ECB in its opinion on the proposal for a Council Regulation on the establishment of the European Monetary Fund.
Second, we need a common deposit guarantee scheme, the ultimate objective of which is to prevent bank runs. A bank run is usually caused by lack of confidence in a single bank or in a banking system. The stronger and more credible the deposit guarantee scheme is, the less likely it is that it will have to be used.
A common European deposit insurance scheme would significantly increase the stability of the euro area banking system compared with the current situation in which national funds are responsible for the deposit guarantee. The goal should be that confidence in the secured bank deposits is equally strong throughout the euro area.
The completion of the banking union can be enhanced by reducing risks in the euro area banking system. Significant progress has already been made, as the level of non-performing loans (NPLs) has decreased from 7% to below 5% in the euro area. In Italy, which has the largest volume of NPLs, their share has been brought down from 16% to 11% in two years 2016-2017.
It is important that the PM-designate Giuseppe Conte has underlined the European commitment of Italy – as far as the completion of the banking union and the necessary financial repair is concerned, this can be proven by keeping up the positive trend in the reduction of NPLs, which has been maintained in the past two years.
In addition, Europe’s financial firewall, the European Stability Mechanism, should be developed further by reinforcing its capacity to take decisions and extending its toolbox with a more workable and effective precautionary credit instrument.
In the event that the euro area faces excessive market turbulence, the ESM should be able to take rapid, effective decisions to help stabilise the situation. For a precautionary credit instrument, a pertinent benchmark is provided by the IMF’s Flexible Credit Line (FCL), which was successfully used during the crisis by three countries: Colombia, Mexico and Poland, as a crisis-prevention instrument against market turbulence. None of the three countries had to draw on these lines, as the FCL provided an effective backstop for these countries and strengthened market confidence during the time of elevated risks.
There are other proposals on the table as well. One is to change the name of the ESM to European Monetary Fund, EMF. Would this be justified? To my mind, the nameplate is less important than the substantive improvements in the functioning of the ESM. In my view, the primary reform of the ESM now needed is to enhance its concrete functionality and capacity to act in cases of market turbulence.
By way of conclusion, let me refer to the importance of ownership by Member States and policy learning in developing the euro area.
The early 20th century film-maker Groucho Marx was famous for quipping that he would refuse to join any club that would have him as a member. Sometimes during the crisis as Commissioner I got the feeling that the euro area member states were indeed thinking like Groucho Marx, behaving rather as outsiders than as members. Their sense of common ownership of the European project – be it the fiscal rules, economic reforms, the stability mechanism, or the then still nascent Banking Union – was sometimes rather limited.
But to be fair, there was a lot of policy learning by most of us who were responsible for policy-making in the euro area, as assumed by theories of muddling through or incrementalism. Over time, the ownership by euro area member states developed in a better direction, and in 2012 it facilitated the decisive moves in the European Council and the ECB Governing Council. It was indeed an evolutionary learning process, in which the decision-makers gradually realised that the concerns of financial stability and thus the union’s future were in fact even more important than the concerns of moral hazard, without belittling the importance of the latter.
The starting point for any consequential and effective reform of the euro area is therefore quite simple: Since the euro area member states are committed to their membership in the common project, it is better for each and every member state that the euro area functions well and effectively in every respect. In other words, each and every member state should have every reason to support a solid, robust foundation of the euro area that can withstand economic headwinds and support sustained growth.
There is no use in getting nostalgic over the bygone 1990s by repeating the Clash 1980 classic “should I stay or should I go?” – at least outside “London calling” – for an umpteenth time.
Instead, we should look to the future and work to ensure that the euro has a solid architecture to support economically and ecologically sustainable and employment-friendly growth in the economies of all member states.
And that’s why we’d better actively proceed in setting the directions of European reform in anticipation of preventing the next crisis in the euro area before it has even started.
Thank you very much for your attention!
 The preliminary flash estimate on the GDP growth rate for the first quarter of 2018 was 0.4%, while in the last quarter of 2017 the growth rate was 0.7% from the previous quarter.
 See the speech by Vice-President Valdis Dombrovskis at City Week in London on 24 April 2018: http://europa.eu/rapid/press-release_SPEECH-18-3523_en.htm
See also the Speech by Michel Barnier at the Eurofi High-level Seminar in Sofia on 26 April 2018:
 For the SSM view on relocation of financial services to the euro area from the UK, see Brexit: Booking models and “empty shells” on 14 February 2018:
For the SSM view on preparing for Brexit and supervision during the transition period, see Brexit: impact of a potential transition period on 16 May 2018: https://www.bankingsupervision.europa.eu/press/publications/newsletter/2018/html/ssm.nl180516.en.html
 For the analysis, see the ECB Financial Stability Review, November 2017: https://www.ecb.europa.eu/pub/pdf/other/ecb.financialstabilityreview201711.en.pdf?7a775eed7ede9aee35acd83d2052a198
 For a thorough review of the discussion, see Constâncio, V. (2017) ‘Understanding and overcoming low inflation’, Remarks at the Conference on ‘Understanding inflation: lessons from the past, lessons for the future?’, Frankfurt am Main on 21 and 22 September 2017:
And Yellen, J. (2017) ‘Inflation, Uncertainty, and Monetary Policy’, Remarks at the ‘Prospects for Growth: Reassessing the Fundamentals’ 59th Annual Meeting of the National Association for Business Economics on 26 September 2017:
See also Kortela, Oinonen & Vilmi (2018) ‘Reports of the Phillips curve’s death are greatly exaggerated’, Bank of Finland Bulletin 1/2018:
 The main refinancing operations and the three-month longer-term refinancing operations will continue to be done as fixed rate tender procedures with full allotment for as long as necessary, and at least until the end of the last reserve maintenance period of 2019.
 For a comprehensive analysis by the ECB on completing the banking union and establishing the capital markets union see financial integration in Europe, May 2018:
See also the ECB Occasional Paper titled: Completing the Banking Union with a European Deposit Insurance Scheme: who is afraid of cross-subsidisation? ECB Occasional Paper Series No 208 / April 2018: http://www.ecb.europa.eu/pub/pdf/scpops/ecb.op208.en.pdf?557c7f15bddfac62f842fd08920b1e6e
 See also the ECB opinion on a proposal for a regulation on the establishment of the European Monetary Fund: