Olli Rehn
Dr, Member of the Board of Bank of Finland
Lessons of the Crisis for Euro Area Reform
Trinity Economics Forum 2018 in Dublin on 3 February 2018

Lessons of the Crisis for Euro Area Reform

Let me start by thanking you for the invitation to deliver this keynote address at the Trinity Economics Forum, organised by the students. It is a great honour and pleasure to be here today.

On a personal note, it is very easy for a Finn to associate with the Irish people, as our two countries have so much in common. We both spent a long period of our history being ruled by our larger more powerful neighbour. We both suffered great famines before gaining independence. We both experienced a bitter civil war in the context of gaining independence that left deep scars.

And we are both small states in the fringes of Europe. The Finnish sailor who fought in the GPO (General Post Office) in 1916 specifically said he was a champion of “small nations”. He was arrested, like many of the others, but independence followed soon afterwards.

In Finland we have just celebrated the 100th anniversary of our independence, while in Ireland you are in the middle of a whole decade of centenaries. Even after independence, we needed to find ways of living with our larger eastern neighbours. In recent times, this experience has accentuated our importance within the international community, and we both play a solid role in the European Union.

Irish and Finnish soldiers also serve with distinction in the United Nations, keeping peace for example in Lebanon. We frequently hear from our soldiers about the great spirit between the Irish and the Finnish – somehow our national characters seems to be complementary!

Today I would like to focus on lessons we can learn from the crisis for euro area reforms in particular. As former Vice-President of the European Commission responsible for economic and monetary affairs between 2010 and 2014, I was involved with tackling the crisis on a day-to-day basis. As some time has now gone by, it is possible, and indeed desirable, to reflect on the crisis experience.

The debate on the reasons that led to the Euro crisis, and the policy choices made during it, has intensified, not least here in Ireland during recent years. This debate is vital for learning lessons, and for making sure we don’t repeat past mistakes.

Before I move on, I want to emphasise that I am speaking here today in my personal capacity, not on the behalf of the Bank of Finland.

The chronology of the crisis in the euro area and Ireland

Let us start by looking at the path of both euro area and Irish economies in the past 10 years. The euro area economic activity is shown here in this simple but telling chart of real GDP from 2007 onwards.

Slide 2: Level and growth of GDP in the euro area, 2008-2017

The crisis can be divided into 5 stages:

1. The prelude was played out in the US, from where the crisis of financial capitalism initially originated during 2007-2008. In September 2008, the credit crunch culminated first into shortages of liquidity across the global banking system. After the collapse of Lehman Brothers on 15th of September, no bank could feel themselves safe.

Liquidity shortages, combined with falling property prices and the collapse of the construction industry resulted in a sharp deterioration in financial conditions in Ireland. This was followed by a recession due to the near-collapse of two major industries: banking and construction.

As Ireland had a large banking sector, its GDP fell sharply in 2008, somewhat ahead of many of its European peers. To slow down the external outflow of capital and dwindling of deposits, and to resume the banks’ access to funding, the Irish government made a far reaching decision to guarantee both banks’ depositors and their bond holders – nearly all liabilities of the Irish banks.

2. During the second phase of the euro area crisis, between 2009 and 2010, the world economy recovered. Effective global policy coordination, including very substantial monetary and fiscal stimulus packages, also turned growth rates positive in the euro area. The aggregate figure, however, hides substantial difference in economic performance between the member states.

In Ireland, rapidly rising unemployment increased the human costs of the financial crisis, and it meant that many households couldn’t service their mortgages, worsening the value of banks’ loan books. Falling income and increasing expenditure put pressure on public finances on top of the mounting bank losses that the state had committed to cover.
The outbreak of the Greek crisis in 2009-2010 turned the financial crisis into a public debt crisis. The Greek EU-IMF programme was decided in May 2010. Ireland requested conditional financial assistance in November 2010, followed by Portugal in April 2011. Greek, Irish and Portuguese crises did not profoundly damage growth in euro area during 2010 and 2011, as the conditional financial assistance by the EU and the IMF worked to prevent contagion and support stability.

3. While the global economy continued recovering, the third wave of the crisis took it ever more dangerous heights than before. Italy and Spain, two euro area countries with large populations, faced market pressure and very high bond yields between 2011 and 2012. The performance of the euro area started to weaken. The ECB’s rate hikes in 2011 didn’t help. The credit downgrades and simultaneous deleveraging and increase in non-performing loans weakened the lending capacity of banks. As a result, plummeting investment and consumption reduced demand and output.

4. During the fourth stage of the crisis between 2012 and 2013, stabilisation was achieved in the euro area. Confidence was boosted by the creation of the permanent European Stability Mechanism ESM, by the consistent consolidation of public finances in the member states, and by the ECB’s bold actions to prevent contagion in the financial markets. During this period the Eurozone’s economic performance was dualistic: financial markets and public finances stabilised ahead of sustained growth and job creation.

5. Finally, in 2013 the European recovery started to feel some winds of growth beneath its wings. The Irish economy rebounded before the rest of euro area, supported by recovered confidence and job creation. This year will mark the fifth consecutive year of growth for the euro area, and the sixth for Ireland.

To summarise, despite its popular perception as a public debt crisis, the euro area debt crisis had its roots in the balance of payments and macroeconomic imbalances, caused by an increase in public and private debt. In Ireland, in particular, the public debt to GDP ratio was only 25 percent in 2007. The crisis originated in the increase of private debt ‒ massive foreign borrowing by Irish banks ‒ feeding a boom in the construction sector and the real estate market.

Let us now analyse lessons learned from the Irish and euro area crisis. I will focus particularly on those issues that will be relevant for vital reforms in the Eurozone architecture.

Lesson no 1: Significance of financial stability

The first essential lesson of the euro area crisis is the significance of the stability of the financial system. Before the crisis, its importance was underestimated both by politicians as well as institutions.

The crisis experience demonstrates that during the good times when credit flows freely and confidence is high, setting limits, monitoring or building buffers may seem unnecessary as the economy appears invulnerable. But when confidence plummets and volatility increases rapidly, ‘animal sprits’ may take over. In autumn 2010 Ireland experienced animal spirits at first hand, as markets were dragging Ireland’s elected leaders around like dogs on a leash.

The infamous banking guarantee in September 2008 had been broadly welcomed and it was generally felt that some lost confidence had been regained. The Irish decision had been made under the assumption that banks suffered from a temporary liquidity shortage and their balance sheets were essentially on a sound footing.

However, the state guarantee clearly was an insufficient ‘hot-fix’, as it did not address the uncertainty of whether the Irish banks had sufficient amounts of capital. Between 2009 and March 2011 the four successive estimates of the funds needed to recapitalise banks were published, and in each of these, the amount needed was increased from the previous one. These serious attempts to assess the true capitalisation needs of the Irish banks failed to put markets – or the public – at ease.

During the second half of 2010 Irish borrowing costs started to increase rapidly. After the publication of an unfavourable rating assessment for Ireland in August by Standard and Poor’s and the assumed big hole in the public finances, yields increased sharply, both in absolute terms and related to German benchmark bonds.

Slide 3: Bond yields

The negative impact of downgrading and the higher estimates of the cost of bank recapitalisation was intensified by a particular statement by German and French leaders at a summit in the French coastal town of Deauville. What was this meeting about?

During the crisis Germany and France had difficulties to find a common voice in how to tackle the crisis. Germany demanded automatic sanctions to those that breached the stability pact, but the French were against it due to their high debt level. In Deauville, it was agreed that if Germany accepted the watering down of the automatic sanctions, the French, in return, would accept private sector involvement in the agreement of the European Stability Mechanism ESM. There was a clear absence of market literacy when it was declared that this new euro area financial rescue fund, ESM, would require private sector creditors to accept some debt restructuring, or in practical terms, losses.

The Deauville deal sealed Ireland’s fate. The interest rates of Irish bonds exceeded the critical 7 percent mark in October 2010, as private investors exited Irish markets. Meanwhile, the ECB, despite its public praise for Irish reform efforts, and having supported Irish bond markets via the Securities Market Programme, became increasingly concerned over the Irish banks’ dependency on the Eurosystem’s emergency liquidity assistance ELA. Eleven days later it was clarified that the proposed debt restructuring would only be applied to bonds issued after 2013, but the damage had already been done.

Despite the events that followed the “Deauville Doomsday”, in principle I’m not against private sector involvement in debt restructuring – far from it. However, it was dangerous to make spontaneous decisions over private sector involvement in the middle of the crisis.

The ability to dampen market panics, in order to maintain financial stability, is a key lesson from the Irish experiment. In the Irish case, the programme restored credibility, and in summer 2012 the ECB president Draghi used his so-called “big bazooka”, saying that the ECB was ready to do “whatever it takes” to preserve the euro. It turned out to be enough, and as you can see, bond spreads fell rapidly after it.

These “big bazookas” are important, but it would be more efficient if they were not needed in the first place. The solution lies in bolstering financial stability, and in particular, completing the banking union that has been under construction since 2012.

Currently, two of the three building blocks of the banking union are in place: the Single Supervision Mechanism to supervise banks with shared standards, and the Bank Resolution Mechanism to ensure that failing banks are managed in an orderly manner and without costs to taxpayers. What we still need to do is two things.

First, to create a credible fiscal backstop for the bank resolution fund. To prevent banking crises and, if necessary, to resolve them effectively, a contingency arrangement guaranteed by member states is needed as a backstop for crisis resolution. 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 in their construction, at least in the first phase.

Moreover, 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. Key is to have a credible roadmap and concrete action in reducing non-performing loans.

Lesson no 2: Reform of EU and EMU

Completion of the banking union is also a crucial part of the second reform that stems from the lessons of the financial crisis: the necessity to continue reforming the Economic and Monetary Union EMU. After the financial crisis, the euro area went through several reforms, which focused on banking supervision and economic governance.

In the current climate, when the EU is about to lose its third largest present member, one could ask whether the time is right for conducting bold economic or institutional reforms.

In my view the opposite is true. Brexit changes Europe, but its negative ramifications are felt mostly in the UK.

According to the Eurobarometer surveys, Brexit seemingly increased solidarity amongst the other EU member states. This solidarity must be matched with responsibility. In addition to the Banking Union already mentioned, reforms should cover capital markets, not only because the size of the EU’s capital market will shrink as a result of Brexit. Capital markets expand opportunities for SMEs from traditional bank-based funding.

On EMU reform, I found the recent joint policy paper of leading French and German economists, published in January, most relevant; it calls for a constructive rethinking of the inherited national positions on the future development of the EMU.  France has traditionally pursued additional stabilization and risk-sharing mechanisms in the Eurozone. Germany meanwhile tends to underline that the problems in the Eurozone stem rather from misguided domestic policies and calls for rigorous enforcement of fiscal rules and more market discipline.

Going forward, the next reform of the Eurozone should aim at producing a viable win-win synthesis between, on 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. Here I use the quotation marks most deliberately, as these national adjectives are in fact brand names or proxies for two economic philosophies, not “owned” just by the two countries.

Creating a European synthesis means building a solid stability union that emphasizes each member state’s own responsibility, but also recognizes the necessity of joint structures to preserve financial stability. To ensure that each member state is responsible for its own economic policy, the rules and incentives should be designed accordingly. At the same time, there needs to be sufficient joint capacity to preserve financial stability in the face of market turbulence. Moreover, steps towards further sharing of risk should be equally matched by steps to reduce risk. This goes both for public finances and the banking union.

Lesson no 3: Irish flagship recovery demonstrates the importance of flexibility and functionality of real economy

The Eurozone reform brings me to the final broad lesson of the crisis, which is the importance of the real economy, its flexibility and effective, smooth functionality. Growth matters, not least for the citizen but also for making reforms of monetary union possible.

The fact that Ireland lost some control over economic decision making by becoming an EU-IMF programme country was a source of major unease for the Irish electorate. Nevertheless, Ireland has enjoyed political stability, which was a key prerequisite for the recovery.

Today the Irish economy is flourishing again, hopefully more sustainably than during the Celtic Tiger period. Since 2013 Ireland has grown significantly faster than the euro area as whole. There is a rather prominent narrative about the Irish recovery of the crisis that implies that the Irish ‘did their homework’, meaning that after three years of sacrifice the Irish fought their way out of the crisis by implementing the reforms and fiscal consolidation.

During the crisis, multinational companies never abandoned the country. Even though some of the extraordinarily fast growth figures might reflect immaterial transfers of intellectual property, the country has been able to attract a considerable amount of direct foreign investments.

Ireland has been able to boost its competitiveness and diversity its economy from banking and construction. Furthermore, longer term growth prospects have not been dampened down by the reduction in productivity growth that has muted recovery particularly in the UK.

Slide 4: Debt to GDP ratio fallen from 125 percent in 2013 to about 73 percent in 2017

Ireland has benefitted from economic growth in dealing with a high debt burden. Growth helps to reduce the debt-to-GDP ratio. As standards of living increase, the state is able to achieve budgetary surpluses to pay off the debt. In addition, growth increases tax intake, easing public finances still further.

The financial crisis, it has been said, casts a long shadow. Unemployment in Ireland peaked at 15.4 percent in 2013, but has almost halved since then. Nevertheless, many households’ future prospects are dampened by a large debt burden. It is important to ensure that economic recovery benefits the whole nation. Ireland, as well as other countries recovering from the crisis, have to ensure that everyone gets a share when economy improves.

So, why is now the perfect time to reform domestic economies, while not reversing the world’s most successful integration process? Firstly, sustainable growth and improving labour markets are more resilient than before in absorbing short-term costs stemming from reforms. Secondly, the Eurosystem remains committed to achieving its price stability target of inflation close to but below 2 percent. As inflation projections remain below the target, there is no immediate pressure for tightening monetary policy that is currently supporting demand.

Ireland provides, by and large, a sound model of how to turn an economy around from crisis to recovery and growth for countries such as Italy, France and my own country Finland.

We should always try to learn lessons of the crises but also the lessons of the recoveries. The Irish recovery is indeed worth analysing further and deeper, as part of the broader story of the European recovery.

Thank you!

Olli Rehn: Lessons of the crisis for euro area reform. Dublin, 3 Feb 2018 from Suomen Pankki