Member of the Board of Bank of Finland
Appearance of Olli Rehn before the Parliamentary Committee of Inquiry into the Spanish crisis and the Spanish financial sector assistance programme
Madrid, 2 November 2017
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Appearance of Olli Rehn before the Parliamentary Committee of Inquiry into the Spanish crisis and the Spanish financial sector assistance programme
Distinguished Speaker Ana María Pastor Julián,
Honourable Members of Congreso de los Diputados
Let me first thank you for the invitation to appear before this Parliamentary Committee of Inquiry into the Financial Crisis in Spain and the Financial Sector Program.
I have been asked to give testimony on the different dimensions of the financial crisis in Spain and the financial sector reform program, as a former Vice-President of the European Commission responsible for economic and monetary affairs. In my presentation, I will set the Spanish crisis into its context of the Eurozone crisis and focus on three main issues:
first, on the causes of the financial and economic crisis in Spain (on this, I can be relatively brief, since the causes are rather well-known by now, and I can broadly agree with Deputy Director-General Servaas Deroose of DG ECFIN who appeared here earlier today);second, on the remedies and decisions related to the financial sector program and its policy outcomes by looking at the progress in economic recovery;and third, on the lessons that can and should be learnt from the Spanish crisis as well as the wider Eurozone crisis for reforming the Economic and Monetary Union.
Before dwelling into substance, I need to make two reservations: first, my term responsible for economic and monetary affairs covered the years 2010-14, so I will focus on that period; second, I am speaking in my personal capacity, not on behalf of the Bank of Finland.
II. THE CONTEXT: THE EUROZONE CRISIS
For a start, it is useful to look at the overall evolution of the Eurozone economy in the last decade, seen below from the simple but telling perspective of real GDP in the Eurozone in 2008-2017.
The Eurozone debt crisis evolved in various stages and was an adjacent to the financial crisis, which started in 2007-8 in the United States and became a global one in 2008-9. In Europe, the global financial crisis turned into a debt crisis – which is often perceived as a public debt crisis, but actually was at its root a balance of payment crisis, or a crisis of macroeconomic imbalances, caused by the increase in both private and public debt, in the Spanish case mostly private debt, especially related to the boom in the construction sector and the real estate market.
Essentially, the crisis was a classic story of boom and bust, the accumulation of large economic and financial imbalances, unwinding of those imbalances and dealing with the consequences of these unwindings.
The strength of the housing boom was intensified by several factors: mortgage interest rates fell a lot, making mortgages extremely cheap. Banks used securitization intensively. As the crises hit, the property developers were left with thousands of unsold and even unfinished properties and a piles of debt.
The most intense period of the Eurozone crisis was between 2010 and 2013. The chronology of the crisis can be divided into five stages:
1. As a prologue, the global financial crisis in 2007-9, which hit the Eurozone hard and reduced its GDP by the dramatic 4.5 percent. However, by effective global policy coordination, very substantial monetary and fiscal stimulus packages were agreed, which helped the world economy to recover in the course of 2009-10. Yet, the unemployment rate in the Eurozone jumped in two years of the financial crisis by 2.5 percentage points, i.e. from 7.5% in mid-2007 to 10.0% in end-20091. This led to large structural unemployment and thus to deep social and human scars in Europe.
2. The outbreak of the Greek crisis and the pressing, improvised debt crisis management in 2009-10, with Greece at its epicenter. The Greek program was decided in May 2010. Soon after, Ireland (in November 2010) and Portugal (in April 2011) had to request a conditional financial assistance program, too. The EU was caught off-guard by the debt crisis, without any viable financial stability tools at its disposal, and with the weight of the global financial crisis still on its shoulders. However, at this stage it was still mostly a matter of small states, and thanks to the new tools that were created (particularly the reform of economic governance through the so-called six-pack legislation, as well as the European Financial Stability Mechanism and European Financial Stability Facility, or the EFSM and EFSF), the small states' bushfires were successfully prevented from turning to continent-wide forest fires.
3. The Italian and Spanish crises of 2011-12, which constituted a creeping, protracted confidence crisis and even more dangerous stage than the first one. Both countries faced immense market pressure and very high bond yields, which led to credit rating downgrades and threatened the sustainable service of their public debt. Even France was touched by these headwinds. The credit downgrades and the simultaneous deleveraging and increase of non-performing loans in the banking sector had negative ramifications to the lending capacity of these countries' banks. This in turn led to a decline in private lending to enterprises, especially SMEs, and became a form of a liquidity trap.
4. The stabilization was reached after strenuous efforts in 2012-13, with the combination of the re-instated credibility of fiscal policy by the member states, the creation of the permanent European Stability Mechanism and the ECB's bold action to contain the contagion in the financial markets. During these years, the rebalancing of the Eurozone economy gathered pace, especially in the countries that had had large current account deficits. But its economic performance was dualistic: the financial markets and public finances stabilized first, while sustained growth and job creation only recovered with delay, from spring 2013 on.
5. The stage of recovery and growth was reached in 2013 and has since been going on. Yet, the recovery was for many years fragile and haunted by deflationary dangers, geopolitical tensions and governance weaknesses. In 2016-17 the Eurozone growth however accelerated, and its per capita growth was stronger than that of the United States. In 2018, the Eurozone will be growing for the fifth year in row. Inflation is still under control – or rather, below the price stability target which should be reached in a sustainable manner – and this reduces pressures for rapid reactions in monetary policy that could slow down the growth rate.
III. FINANCIAL SECTOR PROGRAMME
In July 2012, the Eurogroup decided on a conditional financial assistance program for Spain which implied granting a maximum of 100 billion euros of loans for bank recapitalization to Spain. A program seeking to reform the banking sector was approved in July. The program included a first-aid reserve of 30 billion euros.
Something had been learned in crisis management by 2012. For once, the Eurogroup and the Commission worked closely in tandem and decided to overshoot rather than undershoot, which was crucial for the credibility of the Spanish rescue operation and for the financial stability of the Eurozone. This was decisive to show that we were finally – if not ahead – but at least not behind the curve.
The markets took our commitment to effectively recapitalize the Spanish banking sector very seriously, as the maximum figure 100 billion euros was assumed to be clearly above the expected needs.
In the end, Spain used only around 41 billion of the financial sector assistance programme of 100 billion.
I can say we worked very well with the respective Spanish Governments.
Moreover, the competent preparation by the Spanish authorities, not least by the central bank,Banco de España, was crucial for the success of the Spanish program. This was substantially aided by the high-quality work of the Commission mission team, led by Deputy Director-General Servaas Deroose.
IV. IMPRESSIVE RECOVERY IN SPAIN
We should try to learn lessons of the crises but also the lessons of the recoveries. The recovery in Spain has been impressive.
• Once the GDP started to grow, the rate of growth has been strong (slide 4)
• The competitiveness has improved in terms of unit labour costs (slide 5)
• The deleveraging of the Spanish corporate sector has been painful (slide 6)
• Corporate borrowing does not decline anymore (slide 7)
• The loan quality has improved in terms of the share of non-performing exposures (slide 8)
• The amount and share of housing-related doubtful is steeply declining (slide 9)
Against this backdrop, it is more than warranted to properly analyse the lessons learnt from the Eurozone debt crisis. Generals, as the saying goes, are always preparing for the previous war. Maybe so, but, the euro area debt crisis has provided a wealth of lessons of general application.
Based on the crisis experience, I see the following three lessons as key issues for rebuilding the EMU:
1. Financial stability was grossly neglected before the crisis, and this should now be corrected by completing the banking union.
Based on my experience in the fire brigade during the debt crisis, stability of the financial system is crucially important for the macro-economy, i.e. for sustainable growth and employment. The nadir – or rather, the worst rock-bottom – of the crisis followed the worst phase of market turbulence, which raged untamed until the European Stability Mechanism was put in place and the ECB had launched its unconventional monetary policy measures as the lender of last resort.
As Daniel Gros has noted, financial stability proved to be the "neglected stepchild" of the Maastricht Treaty. As a result, we Europeans paid a bitter price in the form of a double-dip recession in 2008–2012 and suffered years of high unemployment.
Against this backdrop, the near-term focus should be kept on finalisation of the banking union. Our goal should be a strong banking union based on the bail-in principle, which means that the private sector, the owners and the investors, should bear losses for bank failures before taxpayers.
What we still need to do is two things. First, to create a credible fiscal backstop for the bank resolution fund. Second, to build a common European Deposit Insurance Scheme. To be politically feasible, these remaining elements will require convincing measures of risk reduction, and possibly some co-insurance features, at least in the first phase.
Legacy bank problems at the national level should not be shifted on to the euro-area level. Member states should work out the legacy problems on their own. This is what recent solutions to winding up troubled banks have sought to achieve.
2. For the sake of financial stability, and also to prevent future crises, the EMU needs a lender of last resort and an effective financial stability mechanism, which it now has, but can be further developed.
That's why we must recognize the critical importance of the function of the lender of last resort – both for solvent sovereigns and for solvent financial institutions in the case of market panic. In practice, this means that any jurisdiction, including the Eurozone, must possess a financial stabilization mechanism, or a big bazooka (in the popular language and financial journalism), so that a central bank, a separate stability fund, or both, have the tools to come to the rescue in a crisis and subdue even a major market panic. It is needed proactively and permanently to pre-empt them. One of the lessons of the crisis is that prevention is always better than correction.
The ESM can be further developed by e.g. reinforcing its capacity to take decisions and extending its toolbox with a more effective and workable precautionary credit instrument.
3. In building the stability union, the main responsibility for economic policies should rest with the member states, while this responsibility should be balanced with the insurance provided by common structures, especially as regards ensuring financial stability.
Going forward – further and maybe deeper as well – we have the Commission's policy paper, the initiative of the French President and the non-paper of the German Ministry of Finance on the table. None of these alone can carry the day. Therefore, the next reform of the Eurozone architecture should aim at producing a plausible, viable synthesis between, on the one hand, the core principles of "German" economic philosophy, which calls for properly tuned incentives and rules, and those of "French" economic philosophy, which emphasizes insurance and stabilization – I would call this a European synthesis or Spanish and Finnish, why not! Here I use the quotation marks deliberately, as these national adjectives are only labels for two economic philosophies, not owned just by the two countries.
I found the joint contribution of 15 French and German leading economists, published in September, most relevant in this regard, with its call for a constructive rethinking and re-consideration of the inherited national positions on the question of the future development of the EMU.
That means building a solid stability union which emphasizes each member state's own responsibility and joint structures to preserve financial stability. The second principle is that there needs to be sufficient capacity for joint Eurozone action to preserve financial stability in case of market turbulence. Moreover, it is essential that steps towards further sharing of risk are equally matched by steps to reduce risk. This goes both for public finances and the banking union.
The euro area will not become a federation or transfer union, but neither will it break up just because of not becoming one. In any case, its architecture must be further reinforced, and there is a third way by combining risk reduction and risk sharing.
The dichotomy of 'federation or death' has been put forward too often, and frequently for propaganda reasons. It is fake news, and has no factual basis. The euro area will not survive by simply becoming a federation or transfer union, but neither will it break up just because of not becoming one. Life is seldom black-and-white.
Instead, there is a third way – we need both a sense of direction and a sense of realism. The essential guiding principle in reforming the Eurozone economic governance is that we must work to ensure financial stability through co-insurance and risk sharing, while any step towards increased solidarity and merger of economic risk should be combined with increased responsibility and economic sustainability.
The most promising and, to my mind, preferable option for the Eurozone reform is to strengthen such a stability union in which the Member States' own responsibility for sustainable economic growth and employment, on one hand, and the common economic policy co-ordination with its insurance coverage of joint structures providing risk management, on the other hand, are in balance.
I wish we can work together with the "Congreso de los Diputados" for such a genuinely European outcome.
Thank you for your attention.
1Eurostat, Euro area unemployment at 9.1%. Press release 2 March 2017. See: http://ec.europa.eu/eurostat/documents/2995521/7895735/3-02032017-AP-EN.pdf/8a73cf73-2bb5-44e4-9494-3dfa39427469