Lorenzo Bini Smaghi, chair of the board of SNAM and former executive board member of the European Central Bank (ECB), starkly admitted that European authorities had underestimated the effects of the financial crisis on banks, resulting in a “lost half decade.”
In the closing keynote speech of the first day of the European Investment Conference, Bini Smaghi commented that, nevertheless, with a stronger institutional architecture in the form of the banking union, allied with low oil prices and a “weakening in the forces of austerity,” there is room for the eurozone to regain competitiveness. National governments must now undertake the necessary structural reforms to ensure that the loss of output does not become a lost decade, he said.
In diagnosing the state of the eurozone economy, Bini Smaghi observed that on a per capita basis, the eurozone had been growing at the same pace as the United States prior to 2011. Thereafter, per capita growth rates have diverged. Similarly, gross fixed capital formation in the eurozone (a measure of investment) had exceeded levels in the United States prior to 2012 but has since lagged.
Contrary to common perceptions, Bini Smaghi contended that the fiscal policy stance within the eurozone has not been the real problem behind theses divergent growth paths. Indeed, the general government underlying balance as a percentage of GDP has been looser in the eurozone than the United States over this period.
The spike in 10-year government bond yields around 2011 and 2012, however, represented a major shock and was exacerbated by the conditions of the first restructuring of Greek sovereign debt. This changed investor perceptions of what constituted a safe asset (an implied reference to the haircuts imposed on Greek creditors in the first Greek sovereign debt restructuring), according to Bini Smaghi. The policy had a large effect on the financial system, for example, in the form of divergent interest rates and financing conditions between peripheral and core eurozone economies, resulting in financial fragmentation.
Underlining the differing financing conditions within the eurozone, Bini Smaghi further observed that, in nominal terms, interest rates have been higher than the GDP growth rate throughout the eurozone (apart from in Germany). As a result, the rate of refinancing has remained too high, explaining why eurozone economies on the periphery (such as Spain) have struggled to deleverage. Germany, in contrast, has benefitted from an “endogenous QE” (quantitative easing): Only bunds have preserved their risk-free status, resulting in large-scale investor purchases and depression of 10-year yields below the nominal growth rate. This has allowed Germany to make a strong recovery while the rest of the eurozone has lagged.
The same logic also explains why the United States has outperformed the eurozone since 2011/2012: Explicit QE undertaken by the US Federal Reserve has had the same effect of lowering interest rates relative to nominal growth rates.
The corollary of this argument is that the ECB should have undertaken a formal QE program much earlier than it did (it formally began asset purchases in early 2015). Bini Smaghi noted, however, that the institutional architecture did not allow such a program to be undertaken prior to the establishment of the European Stability Mechanism (ESM) and the banking union.
With these reforms now passed, Bini Smaghi said that it was imperative that European authorities complete the reform process, including not only the banking union but also the Capital Markets Union (CMU), an initiative intended to deepen and better integrate Europe’s capital markets. In particular, Bini Smaghi noted that securitization was dead in Europe after 2011 (indeed, a major focus of CMU is to revitalize European securitization markets), whereas securitization has recovered much more quickly in the United States. He stated that it was vital to unfreeze these markets and enable market-based financing to support economic growth, particularly given the reduced lending capacity of banks.
Much remains to be done also at the national level. Bini Smaghi observed that Germany has suffered the least following the crisis, largely a result of its more flexible labor markets, advanced education system, and more open product markets. These are the structural factors that most influence long-term growth, according to Bini Smaghi.
In his concluding remarks, Bini Smaghi returned to the importance of structural reform and acknowledged the limits to what the ECB could achieve. National governments must take this opportunity to implement the necessary reforms to secure sustainable long-term growth, he said.
And as to what the ECB should do next, Bini Smaghi said that the most likely outcome of the ECB’s December policy meeting would be a mixture of a cut in the deposit rate, an extension of the term of QE, and an enlargement of the assets eligible to be purchased under its QE program.
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Photo credit: Harry Richards