Will politicians make common breath..? explains Neel Kashkari

Chaos Theory

• Debating a future of inflation vs. deflation is radically new territory for investors. The chaotic nature of the choice facing societies is whipsawing equity markets and dominating bottom-up factors.
• Equity investors seem to be pricing in a combination of outcomes, with the largest weighting going to a goldilocks, mild inflation scenario. But the market’s large daily swings reflect jumps back and forth as investors update the probabilities of very different destinations.

Once per quarter investment professionals from across PIMCO’s global offices gather in Newport Beach for our Economic Forum. These sessions have been the foundation of PIMCO’s investment process for years; we debate and update our short-term and long-term views for the global economy, and, from that, for individual asset classes, such as government bonds, corporate bonds, mortgages and stocks. Last month we gathered for our December Forum and the topic that dominated the discussion, as it has in recent quarters, was the fate of the euro. Will the eurozone break up? Will European governments impose extreme, deflationary austerity to control their deficits? Will the ECB monetize the region’s debts and risk inflation in order to preserve the common currency? 

This is a debate that has raged within PIMCO for quite a while. There is a wide range of opinions, each supported by relevant precedents and sound economic reasoning. Yet despite our intense focus, we don’t know the answer with certainty. 

Here in America we too face a similar question, though markets are not currently demanding an immediate answer. For the last few decades America has fueled its economic growth by borrowing and consuming, and, in doing so, has racked up large, unsustainable debt. Families that take on too much debt must eventually cut spending, either to pay back loans, or at least because banks stop lending them money. They are eventually forced into some combination of austerity and default. But countries with their own currencies have a choice: 1) austerity-induced deflation, or 2) print money and eventually trigger inflation, which makes their debts easier to pay off, while robbing creditors of the real return they were promised. Will we find the political will to cut spending? Or will we continue running large deficits? Will the Federal Reserve resume quantitative easing, in effect monetizing our debts? Will it unintentionally trigger inflation?

Listening to my colleagues make their arguments during the Forum, I was taken back to my days fifteen years ago when I was an engineering graduate student at the University of Illinois. You may wonder what a debate about the global economy has to do with engineering. It reminded me of one of my favorite classes: nonlinear systems – the study of natural and man-made systems that, at times, behave very oddly. Allow me to explain.

Most systems we interact with every day are linear: if you change an input to the system by a small amount, the output will also change by a small amount. Think about driving to work: if you leave your house 10 minutes early, you will usually arrive about 10 minutes early. If you turn up the flame on a stove a little, the pot of water will heat a little faster.

But some systems, under certain conditions, behave very differently. These systems are said to have “sensitive dependence on initial conditions” – very small changes of the inputs can lead to enormous variations of the output. Mathematicians have given these systems the label of being “chaotic” and experts in the field are called “chaoticians.” (The term “chaotician” always struck me as ridiculous. Could you imagine introducing yourself this way?) The weather is the best example of a real-life chaotic system. Predicting the weather beyond a few days is impossible because minor variations lead to large changes in the future. Go back to the driving example: if you leave 10 minutes late, rather than 10 minutes early, you might hit rush hour, and the extra 10 minutes ends up costing you an hour. Chaos theory describes the conditions under which a system changes from linear and smooth to highly nonlinear and violent, where minor changes to the inputs will lead to enormous variations of the output.

Western societies are facing a seemingly minor choice, but that choice will lead to vastly different endpoints for the global economy and for asset prices.

In a “normal” economic environment investors debate a narrow range of outcomes: will the U.S. grow by 2.8% or 3.2%? Will inflation remain at 2.0% or climb to 2.3%? Debating a future of inflation vs. deflation is radically new territory for investors. The chaotic nature of the choice facing societies is whipsawing equity markets and dominating bottom-up factors.

While we don’t know with certainty which path societies will choose, we can identify a few potential outcomes and make reasoned assessments of what they mean for the economy and for equities:

1. Austerity and deflation

Borrowing money to consume allows families and societies to live beyond their means – for a time. Once the debt accumulation has run its course, reality has to set back in. For a family that may mean getting rid of a second car, dining out less often or cuts which are far more painful. It necessarily means consuming less, and to the extent that consumption equates to standard of living, it likely also means a reduced living standard. Societies face a similar challenge. The U.S. and parts of Europe have enjoyed exaggerated living standards enabled by borrowing from our future. Now that creditors are warning us they won’t let this continue forever, governments may reach consensus to cut spending and/or increase taxes to bring budgets into balance. Whatever the mix, by definition this likely means lower economic growth and perhaps a lower level of overall economic activity until debts are worked off and real growth restored. Deflation runs the risk of creating a vicious cycle, where prices fall, causing wages to fall, causing spending to fall, causing prices to fall further. This is a lower risk for a growing population such as in the United States, whereas Japan continues to suffer from such stagnation today. Europe’s demographics are much worse than America’s. The outlook for equities in this environment is negative in the short run and potentially very negative in the long run if a deflationary cycle kicks off. Corporate earnings at some point must be linked to economic growth, and stock prices represent the present value of a future stream of earnings. In a deflationary environment cash will be king – because your purchasing power will increase by just sitting on the sidelines.

2. Explicit default
The scenario of governments not paying back their creditors is extremely unlikely for countries that have their own currencies. Why default on your debt, which would trigger a crisis of confidence in your economy, when you can simply print more money? Of course, unpredictable politics can make the unthinkable possible, as we came dangerously close to seeing this summer with Washington’s debt ceiling debacle. In Europe it is likely some smaller countries, such as Greece, will default on their debt. They simply have taken on more debt than their economies can reasonably hope to pay back. And they don’t have their own currency, so printing drachma is not an option. It is hard to imagine a scenario where an explicit default would be good for equities. Just how bad depends on the size of the country defaulting and the extent of the preparations put in place to minimize the damage. For example, if countries have capitalized their banks to withstand the losses from a Greek default and the ECB funds Italy and Spain so they are not at risk of contagion, the impact to equities should be more muted. An uncontrolled default, or a default of a larger country would be very bad for risk assets and could trigger a deflationary spiral described above.

3. Mild inflation
Mild inflation is the goldilocks scenario: central banks print money to help fund governments while they employ structural reforms to make their economies more competitive and generate long-term growth. Such structural reforms take time to produce results, often many years. Printing money provides governments with that time while, in theory, reducing the sacrifices citizens must make, and the inflation that usually follows makes the fixed debt stock easier to service, because prices (and hence taxes) increase. It often results in a falling currency, which makes exports more competitive. It is easy to see why countries with their own currencies usually choose inflation as the preferred response to overwhelming debt. Although creditors suffer because the purchasing power they were expecting has been reduced, society has to make fewer hard choices and can continue to enjoy its exaggerated standard of living until the pro-growth economic reforms come to the rescue. In a scenario of mild inflation, equities should do well. Prices are contained, the economy functions and corporate profits should continue increasing. Of course, if policymakers do not use this time to implement real economic reforms, which can still be painful for certain constituencies, mild inflation doesn’t solve anything. It just delays the necessary day of reckoning.

4. Runaway inflation
The danger of mild inflation is that it may not remain mild. Inflation is driven by expectations, the collective beliefs of what the future holds that reside in the minds of millions of people. If people expect prices to go up, they will demand higher wages so they can maintain their standard of living. This will increase the cost of labor, pushing the cost of goods higher. A vicious cycle of inflation can take hold as prices climb higher and higher. The U.S. suffered from double-digit inflation in the 1970s, and in an extreme case, Germany suffered from hyper-inflation following World War I. Runaway inflation is devastating because an economy loses its anchor. People are afraid to hold cash because their purchasing power drops rapidly and so they must hoard real assets. Interest rates soar causing investments to plummet. Central bankers are generally afraid of attempting to induce mild inflation for fear they may nudge expectations more than they hoped. Nudging the collective beliefs of millions of people is an inexact science. The Federal Reserve is cautiously experimenting with its expectations-nudging-arsenal with its recent communication innovations. Runaway inflation would be very bad for most risk assets and equities in particular because of the devastating affects on real economic growth and the increases in costs of production and of capital. A loss of faith in paper currencies would mean gold and real assets would likely be king.

5. Miraculous growth
A list of potential solutions to our unsustainable debt load would be incomplete without including a high growth scenario. It is true there could be a major breakthrough in, for example, energy technology that spurs extraordinary economic growth, which would drive tax revenues higher and enable governments to pay down their debt without asking their citizens to give up their exaggerated living standards. In such a scenario, equity returns would likely be very strong, especially for the sector enjoying the innovation. The technology sector in the 1990s was an example. However, such a scenario today is low-probability. We invest based on what we think is likely to happen, rather than what we would like to happen. Policymakers can’t count on a growth miracle and neither can investors. And don’t forget the bumper tax revenues of the 1990s actually led to increased government spending in some cases when politicians wrongly assumed the increased tax revenues would last forever.

While the expected value of two equally possible outcomes, 0 and 1, is 0.5, there is zero chance the outcome will actually be 0.5. It will either be 0 or 1. Based on the level of the stock market today, with a price to earnings ratio of about 13x in the developed world and 11x in the emerging economies, equity investors seem to be pricing in a combination of these outcomes, with the largest weighting going to the goldilocks, mild inflation scenario. But the market’s large daily swings reflect jumps back and forth as investors update the probabilities of these very different destinations.

I believe societies will in the end choose inflation because it is the less painful option for the largest number of its citizens. I am hopeful central banks will be effective in preventing runaway inflation. But it is going to be a long, bumpy journey until the destination becomes clear. This equity market is best for long-term investors who can withstand extended volatility. Day traders beware: chaos is here to stay for the foreseeable future.

Greece blinking Will Italy or Spain barge doors first..?

Europe is doomed and will the world Sink..? Prepare for Dip

Let’s rehash the European situation for those who still don’t get it.

Taken as a whole, the US banking system is leveraged at 13 to 1. Leverage levels at the TBTFs are much much higher… but when you add them in with the 8,100+ other banks in the US, total US bank leverage is 13 to 1.

The European banking system as a whole is nearly twice this at over 25 to 1. That’s the ENTIRE European Banking system leveraged at near Lehman levels (Lehman was 30 to 1 when it collapsed).

To put this into perspective, with a leverage level of 25 to 1, you only need a 4% drop in asset prices to wipe out ALL capital. What are the odds that European bank assets fall 4% in value in the near future?

Now let’s consider TOTAL debt sitting on Financial Institutions’ balance sheets in Europe. The below chart shows this number for financial institutions in several major EU members relative to their country’s 2010 GDP.

Country	Financial Institutions’ Gross Debt as a % of GDP
Portugal	65%
Italy	99%
Ireland	664%
Greece	21%
Spain	113%
UK	735%
France	148%
Germany	95%
EU as a whole	148%

Source: IMF

As you can see, financial institutions in Germany, France, Italy, Spain, the UK, and Ireland are all ticking time bombs. Indeed, taken as a whole, European financial institutions have more debt than Europe’s ENTIRE GDP.

These leverage levels alone position Europe for a full-scale banking collapse on par with Lehman Brothers. Again, I’m talking about Europe’s ENTIRE banking system collapsing.

This is not a question of “if,” it is a question of “when.” And it will very likely happen within the next 10-12 months if not sooner depending on how soon Greece defaults.

The reason that this is guaranteed to happen before the end of 2012 is that a HUGE percentage of European bank debt needs to be rolled over by the end of 2012.

Between now and then…

• French banks need to roll over 30% of their TOTAL debt.
• Spanish banks and Italian banks need to rollover more than 33% of their TOTAL debt.
• German banks need to roll over nearly 40% of their TOTAL debt.
• Irish banks need to roll over almost HALF (50%) of their TOTAL debt.

Good luck with that.

The situation is no better for European Sovereign states themselves, which are facing their own debt roll over issues at a time when investors are rapidly losing their appetite for sovereign debt.

To wit, Spain, Portugal, and Italy have all relied heavily on the ECB to buy their debt at recent auctions. Germany actually just had a failed debt auction this morning.  And in this environment , these nations need to meet the following debt roll over obligations:

	Maturing Debt Plus Budget Deficit as a % of GDP
	2011	2012
Portugal	21.6%	21.0%
Italy	22.8%	23.1%
Ireland	19.5%	18.0%
Greece	24.0%	26.0%
Spain	19.3%	18.7%
UK	15.7%	13.6%
France	20.6%	19.7%
Germany	11.4%	10.5%

And this is just maturing debt that’s due in the near future: it doesn’t include unfunded liabilities.

Jagadeesh Gokhale of the Cato Institute puts the situation as the following, “The average EU country would need to have more than four times (434 percent) its current annual gross domestic product (GDP) in the bank today, earning interest at the government’s borrowing rate, in order to fund current policies indefinitely.”

As I said before, Europe is finished. The region’s entire banking system is insolvent (with few exceptions). European non-financial corporations are running massive debt to equity ratios. And even EU sovereign states require intervention from the ECB just to meet current debt issuance, to say nothing of the huge amount of sovereign debt roll over that is due over the next 14 months.

Again… Europe. Is. Finished.

The Great debt Implosion will hit Europe within the next 14 months and likely much much sooner. When it dues, we will see numerous debt defaults and restructuring on both the corporate and sovereign levels. We’re also very likely going to see significant portions of the European banking system collapse “Lehman-style” along with subsequent HUGE losses of capital.

The impact of this will be global in nature. The EU, taken as a whole, is:

1)   The single largest economy in the world ($16.28 trillion)

2)   Is China’s largest trade partner

3)   Accounts for 21% of US exports

4)   Accounts for $121 billion worth of exports for South America

So if the EU banking system/ economy collapses, the global economy could enter a recession just based on that one issue alone (ignoring the other issues in China, Japan, and the US).

Again, we’re in for a rough rough future in the financial system.

So if you have not already taken steps to prepare for systemic failure, you NEED to do so NOW. We’re literally at most a few months, and very likely just a few weeks from Europe’s banks imploding.

When this happens the entire system could go down. I’m talking about bank holidays, sovereign debt defaults, retirement accounts and pension funds wiped out, even food shortages in some areas.

This will NOT be permanent, nor will we enter some kind of Mad Max apocalypse. But there will be temporary shutdowns of the banking system as they work through this mess. And given that most folks rely almost entirely on their credit cards to survive and haven’t prepared at all, things could indeed get very messy at times.

So you NEED to take steps now to prepare for all of this. This includes having some cash on hand as well as actual physical bullion. It also means stockpiling some food and water.

So if you have not already taken steps to prepare for systemic failure, you NEED to do so NOW. We’re literally at most a few months, and very likely just a few weeks from Europe’s banks imploding.

I’ve already alerted Private Wealth Advisory to 12 CRISIS trades (three for Europe, nine for the US) that will all produce HUGE profits as this mess collapses.

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2) which banks to avoid
3) how much bullion to own
4) how much cash is needed to get through systemic crises
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And more…

I can do the same for you. All you need to do is take out a subscription to my Private Wealth Advisory newsletter.

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Graham SummersSee the report Europe is Doomed

George Soros's 7 Steps to European Banks

My seven-point plan to save the eurozone
George Soros

1) Member states of the eurozone agree on the need for a new treaty creating a common treasury in due course.  They appeal to European Central Bank to co-operate with the European financial stability facility in dealing with the financial crisis in the interim – the ECB to provide liquidity; the EFSF to accept the solvency risks.

2) Accordingly, the EFSF takes over the Greek bonds held by the ECB and the International Monetary Fund.  This will re-establish co-operation between the ECB and eurozone governments and allow a meaningful voluntary reduction in the Greek debt with EFSF participation.

3) The EFSF is then used to guarantee the banking system, not government bonds.  Recapitalisation is postponed but it will still be on a national basis when it occurs.  This is in accordance with the German position and more helpful to France than immediate recapitalisation.

4) In return for the guarantee big banks agree to take instructions from the ECB acting on behalf of governments.  Those who refuse are denied access to the discount window of the ECB.

5) The ECB instructs banks to maintain credit lines and loan portfolios while installing inspectors to control risks banks take for their own account.  This removes one of the main sources of the current credit crunch and reassures financial markets.

6) To deal with the other major problem – the inability of some governments to borrow at reasonable interest rates – the ECB lowers the discount rate, encourages these governments to issue treasury bills and encourages the banks to keep their liquidity in the form of these bills instead of deposits at the ECB.  Any ECB purchases are sterilised by the ECB issuing its own bills.  The solvency risk is guaranteed by the EFSF.  The ECB stops open market purchases.  All this enables countries such as Italy to borrow short-term at very low cost while the ECB is not lending to the governments and not printing money.  The creditor countries can indirectly impose discipline on Italy by controlling how much Rome can borrow in this way.

7) Markets will be impressed by the fact that the authorities are united and have sufficient funds at their disposal.  Soon Italy will be able to borrow in the market at reasonable rates.  Banks can be recapitalised and the eurozone member states can agree on a common fiscal policy in a calmer atmosphere.

Tomorrow and the day after tomorrow: a vision for Europe : Jean-Claude Trichet

Speech by Jean-Claude Trichet, President of the ECB, 

at the Humboldt University,
Berlin, 24 October 2011

Ladies and gentlemen,

It is a great pleasure to be invited to speak here at the Humboldt University this evening. One can only be honoured to be in the university of Hegel, Heinrich Heine and the Nobel prize-winning physicists Albert Einstein and Max Planck – not to mention 27 other laureates. But it is with the ideas of the university’s founder – Wilhelm von Humboldt – that I would like to begin my remarks.

As a Frenchman who has lived in Germany for the past eight years, I note with interest that the mother of the university’s founder – Marie-Elisabeth Colomb – came from a French Huguenot family who also made that eastwards move. Her family had emigrated to Berlin following the Revocation of the Edict of Nantes, a reminder that European integration is a process that has been with us for centuries.

Wilhelm von Humboldt himself was deeply engaged with the question of how to create the conditions for individuals to flourish within a society. His answer involved removing the conditions for mutual harm.

In some ways, this speaks to the challenges of European integration.

The individual Member States of the European Union (EU) also seek to flourish. Their actions are interdependent and can both benefit and damage each other. Removing the potential for mutual harm is essential for collective prosperity.

This dialectic between the individual and the community is at the core of the European project. It is the dialectic between the individual nation states and the community of nations. And it presents some of Europe’s most fundamental challenges.

I would like to reflect today on how to address these challenges – to look forward and offer a perspective of where Europe could go.

In particular, I would like to develop three propositions.

First, while the reasons for European unity have often been presented as deriving from past conflicts and past divisions, forward-looking motivations are in my view decisive.

The unique construction of Europe – with strong local identities and large, integrated markets – is a source of great strength in the new, globalised world we face. It allows Europeans to plant deep roots and build strong communities. At the same time, we can fully benefit from economies of scale and the free flow of trade and investment.

For this reason, European integration is profoundly in the interests of all Member States and deeply connected to their future prosperity.

Second, for Europe to realise fully its future potential, it needs the right rules and the right institutions.

Europe requires a solid form of governance to ensure that the actions of individual countries are oriented towards the common good. Our current arrangements have not yet fully met this standard. They are now being improved. It is a continuous process which will call for Treaty changes if necessary.

As this process will take time, we need to start planning today for the Europe of tomorrow and the Europe of the day after tomorrow.

Third, the underpinning of a more integrated Europe is the emergence of a true European public debate.

As one would say in German, die Schaffung einer europäischen Öffentlichkeit.

Europeans today are highly interconnected via economic and social linkages. Yet our fragmented national public discourse does not necessarily permit citizens to understand fully these connections.

A true European public debate would help us deepen our interest in each other, bridge our linguistic differences and care more about what is happening across our borders.

These are the three main themes on which I will focus tonight.

But before I talk about the Europe of the future, I would like to talk about the Europe of today. To reflect on the relationship between member countries and Europe. And to touch on the challenges we collectively face in tackling the crisis.

1. Europe and Germany

Building deeper union between France and Germany in the service of Europe has been an important theme of my own working life. In this time, I have been profoundly influenced by the German commitment to a stability culture.

In the 1980s, I was seen in my own country as the strongest advocate of the ‘franc fort’ policy. This policy was designed to be part of the modernisation of the French economy through a “competitive disinflation” policy.

In the 1990s, I worked side-by-side with Hans Tietmeyer and Horst Köhler to contribute to the foundations of the euro in the Maastricht Treaty. This work was to ensure that, among other things, the European Central Bank (ECB) would be based on the principles of independence and the pursuit of price stability.

Then in 2003, I had the honour of moving to Frankfurt to become President of this institution.

It was a great personal satisfaction to join an institution that embodied my deep-seated beliefs in central bank independence, price stability and economic discipline.

Over this period I have developed a strong admiration for Germany and its people, and also for the way that Germany conducts its economic policies.

The German economy has often been thought of as the engine of the European economy. But less than 10 years ago, Germany was seen by some observers as the “sick man of Europe”.

Let me cite some books and newspaper articles from that time:

“Can Germany be saved?”, asked one of this country’s most well-known economists in 2003, noting that “Germany provides something of a case study of what not to do in designing a prosperous future”.

“How the mighty are fallen”, said a major international magazine also in 2003, well representing the mainstream economic analysis. "After the German economy was seen as an exemplary model of successful capitalism for decades,” the magazine went on, “ today it is Germany that economists point to with a mixture of contempt and alarm.”

“Vom Meister zum Mittelmaß”, wrote a major German newspaper in 2005, speaking of “absteigende Staaten wie Deutschland, die in ihrer Bedeutung schrumpften und ihren Haushalt nicht in den Griff bekämen. ”

Thankfully, these gloomy forecasts proved mistaken, and today, Germany is in the lead in rebounding from the crisis.

Since the trough of mid-2009, German real GDP has grown by 6.9% compared with the euro area as a whole by 3.8%. Employment in Germany has increased by 2.1%. Exports have grown by 25.6%. This performance is no accident. Neither is it based on cyclical, unsustainable factors. It is the result of sound fiscal policies, permanent attention to unit labour costs, and bold reforms that have been rigorously implemented over a prolonged period. And it sets an example that is very important for the current situation.

First, it demonstrates how sound policies can lead to prosperity within economic and monetary union.

By encouraging industries to embrace the opportunities of globalisation. By maintaining technological excellence. By prioritising cost and price competitiveness. And by ensuring flexibility in the labour market.

Second, it proves that it is possible to regain competitiveness within monetary union.

Germany after the post-unification boom had a very serious competitiveness problem itself. It took a sustained effort to become competitive again.

This gives encouragement to euro area countries that have lost competitiveness and now must regain it. It also underscores the fact that the adjustment effort must begin immediately.

But there is also a third lesson from the German example.

Would the German recovery have been possible without the euro and Germany being in the euro area? Without Germany benefiting from a vast single market of the size of the United States with a highly stable currency?

The German recovery has taken place in the context of the best inflation record achieved by a major central bank for over 50 years. The ECB has delivered an average rate of inflation of 2.0% since beginning operations in 1999. In Germany it is even lower with an average yearly inflation rate of 1.57%.

Such a low rate of inflation over a comparable time period is actually the lowest in Germany for over 50 years. Moreover, expectations of future inflation remain firmly anchored in line with our definition of price stability.

Financial markets and euro area citizens expect the ECB to deliver on its mandate. The German public can rely on our steadfast commitment to do so.

The euro has extended the zone of monetary stability to Germany’s main trading partners in the euro area. As more than 40% of Germany’s exports go to other euro area countries, this is very important for German prosperity. The stability of the euro has also helped German companies remain competitive vis-à-vis the rest of the world.

2. Europe and the crisis

Let me now turn directly to our current challenges. As you are all well aware, we continue to face the most serious economic and financial crisis since World War II. Tackling the crisis has required unprecedented action from public authorities to maintain economic and financial stability.

Inevitably this has produced diverging views. This is not surprising. The euro area is responding to events of historical importance and it naturally takes time to forge consensus on the right way ahead.

But it is very important that people do not misconstrue these debates. They are about policies, not about principles, because in the euro area our principles do not change.

Our principles are the foundations on which we rest. Stability. Responsibility. Independence.

But our policies must adapt. No two crises are the same. It is precisely because we want to defend and reinforce the principles we cherish, that we have to shape our policies appropriately.

I am fully aware that in this country people have genuine concerns about the single currency. They seek assurance that it remains a community of stability. That it is founded on rules and responsibilities. And that the rules are respected and the responsibilities are taken seriously.

I would like to use this occasion to explain the way the Governing Council of the ECB is deciding on monetary policy.

Our standard measure for fulfilling our mandate of maintaining price stability – avoiding both inflation and deflation – is interest rate policy. But effective interest rate policy requires that our policy decisions are transmitted to the real economy. If that is not the case, our monetary policy cannot achieve its objective.

In this transmission, both banks and financial markets play an important role. They are crucial for the financing of the real economy – of firms and households. Yet the crisis has damaged banks and at times severely disrupted the functioning of financial markets.

Addressing these problems needed to be done through non-standard measures. The ECB has decided such measures, for monetary policy reasons, since the very start of the global crisis. It has been offering liquidity to financial institutions at a fixed rate and with full allotment. It has also provided this liquidity over an extended period of time, up to 12 months, so that the euro area banking sector, Germany’s banks included, could continue to be as correct as possible a vehicle for the transmission of our monetary policy.

With additional liquidity demanded by the euro area banks, our balance sheet has expanded during the crisis. But we have been prudent. Our balance sheet has expanded by about 80% since the beginning of the crisis. Only for the sake of comparison the balance sheet of the Federal Reserve increased by about 230%, that of the Bank of England by 205%, and that of the Swiss National Bank by 235%. The crisis hit all of the economies concerned, but you can see that all our non-standard policies have been measured.

Of all our non-standard measures, the policy of full liquidity allotment at fixed rates has been the most important one in my view. Yet it is the bond market interventions that have received the greatest attention, and the most scrutiny.

But just as our measures of enhanced credit support have been necessary to ensure that banks continue to extend credit to the real economy, our bond market interventions have been necessary to help foster a more appropriate transmission of our policies to the real economy. The government bond markets are crucial for our monetary policy transmission. They largely determine the prices of loans and mortgages and thus affect, indirectly, the transmission of monetary policy to all firms and households.

The ECB’s government bond market interventions are not inflationary. Unlike the bond purchase programmes of other major central banks our aim is not to inject additional liquidity. We actually absorb all liquidity injected by these purchases on a regular basis – euro for euro, week by week.

There is no fuelling of money growth in the euro area. M3 growth is less than 3% currently and inflation expectations have remained firmly anchored by all standards.

So let me emphasise this point. It is very important to understand that all the ECB’s policy decisions during the crisis have been made fully in line with our mandate to maintain price stability.

They have been taken in full independence and we have established a solid track record for our independent decisions. Both inflation and inflation expectations in the euro area demonstrate the value of independent deeds, not just words.

Last week in Frankfurt, at the occasion of my official farewell as President of the ECB, Prime Minster Juncker, the longest-serving prime minister in Europe and chair of the Eurogroup, said that discussions of government pressure on the ECB lacked any basis in fact, that such pressure would have been completely futile and that the ECB always acts completely independently.

3. Europe and the future

I have talked about where Europe has come from. Let me turn now to where Europe is going.

When people seek a justification for European integration, there is a tendency to look backwards.

European integration has banished the spectre of war from our continent, is always stressed. European integration has delivered the longest period of peace and prosperity in European history.

This perspective is entirely correct. But it is also incomplete.

There are many more reasons for striving towards “ever closer union” in Europe today than there were in 1945. And these are entirely forward-looking.

65 years ago the distribution of global GDP was such that Europe had only one role model for its single market: the United States of America.

Today, Europe is faced with a new global economy, reconfigured by globalisation and by the emerging economies of Asia and Latin America.

It is a world where economies of scale and networks of innovation matter more than ever. By 2016 – that is, very soon – we can expect the euro area in terms of purchasing power parity to be below the GDP of China and over and above the GDP of India. Together, these two countries would represent around twice the GDP of the euro area.

Over a longer horizon, the entire GDP of the G7 countries will be dwarfed by the rapid development of the systemic emerging economies.

Europe has to cope with a new geo-political landscape very profoundly reshaped by these emerging economies.

And Europe is also faced with new global challenges, such as climate change and migration, where effective solutions are possible only at the European and international levels.

In this new global constellation, European integration – both economic and political – is central to achieving prosperity and influence. For an outward-looking, export-oriented country like Germany, this is profoundly in its interests.

The challenge is to set the correct path for European integration. Getting this right is essential to realise fully our continent’s tremendous potential. Let me therefore lay out a vision for the Europe of tomorrow.

The Europe of tomorrow

The creation of Europe’s economic and monetary union is unique in the history of sovereign states. The euro area constitutes a “society of states” of a completely new type.

Like individuals in a society, euro area countries are both independent and interdependent. They can affect each other both positively and negatively.

Good governance requires that both individual Member States and the institutions of the EU fulfil their responsibilities.

First and foremost, every country in the euro area needs to keep its own house in order.

This means responsible economic policies on behalf of governments and rigorous mutual surveillance of those policies by the Commission and Member States – going beyond the indispensable surveillance of fiscal policies to encompass all aspects of the economy.

In a society, the institutions of law enforcement can ultimately compel a citizen to abide by the rules. In the euro area, our framework based on surveillance and sanctions depends on the willingness of offending states to comply.

I am aware that many observers wonder what can be done if a Member State simply cannot deliver on its promises.

That is why, when I had the deep honour of receiving the Karlspreis, I suggested a new approach to the policing of economic governance.

For countries that lose market access, the current approach of providing aid against strong conditionality is justified. Countries deserve an opportunity to put the situation right themselves and to restore stability.

But as I suggested in Aachen, this approach should have clearly defined limits. A second stage should be envisaged for a country that persistently fails to meet its programme targets.

Under this second stage, euro area authorities would gain a much deeper and more authoritative role in the formulation of that country’s economic policies.

This would move us away from the present concept where all decisions remain in the hands of the country concerned. Instead, it would be not only possible, but in some cases compulsory, for the European authorities to take direct decisions.

Implementing this idea of the second stage would evidently require a Treaty change. It would also imply a new concept of sovereignty. This is necessary given the complex interdependence that exists between euro area countries. And it is ultimately in the interests of all citizens of the euro area.

In my view, it was important to launch such reflections as soon as possible. I am very happy that the European Council, at its meeting yesterday in Brussels, has indicated in its conclusions: “The European Council notes the intention of the Heads of State or Government of the euro area to reflect on further strengthening of economic convergence within the euro area, on improving fiscal discipline and deepening economic union, including exploring the possibility of limited Treaty changes.”

The Europe of the day after tomorrow

Let me now look even further into the future. A vision that can stabilise expectations needs to address not just tomorrow, but also the day after tomorrow. And as it takes time to implement such a vision, we must start thinking about it today.

It is my firm conviction that the Europe of the day after tomorrow will be of an original type – a new type of institutional framework.

In Aachen, on a personal basis, I began to reflect on some elements of this new possible framework.

I asked the question: with a single market, a single currency and a single central bank, would it be too bold to envisage a ministry of finance of the Union?

This European finance ministry would, first, oversee the surveillance of both fiscal policies and competitiveness policies, and when necessary, have responsibility for imposing the “second stage” I just described.

Second, the ministry would perform the typical responsibilities of the executive branches regarding the supervision and regulation of the EU financial sector.

And third, the ministry would represent the euro area in international financial institutions.

Since my Karlspreis address, it seems to me that the case for such an approach has strengthened.

I now hear leaders calling for a Treaty change to create stronger economic governance at the EU level. I hear euro area citizens calling for better supervision of the financial sector. And I know that our partners in the G20 look to Europe as a whole for solutions, not to individual Member States.

Increasingly, it seems that it is not too bold to consider a European finance ministry, but rather too bold not to consider creating such an institution.

This finance ministry would be only one element of the European future institutional framework. Exactly how these new institutions would eventually evolve one cannot say. As Jean Monnet once wrote: « Personne ne peut encore dire aujourd’hui la forme qu’aura l’Europe que nous vivrons demain, car le changement qui naîtra du changement est imprévisible ». ^[1]

We have several federal or confederal institutional frameworks in today’s world. To name only a few, the United States of America, the Federal Republic of Germany and the Swiss Confederation. The European Union is unique in its past history, in its present nature, in its future ambition. It will have to invent its own concept.

But one could imagine that in the future European institutional framework, the Council might evolve into the Senate of the Union, the European Parliament into the lower house, the Commission into the executive and the European Court of Justice into the judiciary – each time for the part of sovereignty that is shared.

And I have no doubt, taking into account the long and proud history of the European countries, that “subsidiarity” will play a major role in the future Europe – very significantly more than in the present models of federation.

As I said, these are personal remarks of a European citizen. The future of Europe is in the hands of its democracies, in the hands of the people of Europe. Our fellow citizens will decide. They are the masters.

In any case, whatever the future institutions of Europe will be, an essential element would be the emergence of a truly pan European public debate. As Europeans we connect deeply with our nations, traditions and histories. These are Europe’s roots. But we also need to extend our branches more widely.

To do this, the Euro area needs media, in the broadest sense of that word, that allow citizens to take a deeper interest each other. Media that provide regular information on events beyond national borders. Media that permit citizens to debate and exchange. And media that are not constrained by language barriers. All we need is a pan European public debate, a gemeinsamer öffentlicher Raum, a débat publique pan-Européen that allows Europeans to appreciate the wider community of which they are part – a community where their interests are increasingly shared and their lives more interdependent than ever before.

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Let me draw to a close.

Twenty years ago, in 1991, my friend Hans Tietmeyer, the former President of the Bundesbank, said that “monetary union is not just a technical matter. It is in itself, to some extent, a political union”.

This condition creates mutual responsibilities.

We see that a challenge in one country can become a challenge for the euro area as a whole. Addressing it requires strong responses from all Member States, including Germany, and from EU institutions.

The global crisis has called into question the overall economic and financial strategy of major advanced economies. All have weaknesses in their economic systems. Not surprisingly, the main weakness for Europe was the nature of its institutional framework – in particular, that its economic and fiscal governance was not commensurate with the interconnectedness of economies sharing a single market and a single currency.

The question is how to confront those obstacles. We should not look back. We must look forward – to the opportunities of Europe for our collective betterment; and to the potential for every country to be stronger and more prosperous in a well-functioning union.

As far as the ECB is concerned, its Governing Council will continue to anchor solidly price stability and confidence in Europe – stability and confidence for 17 countries and 332 million fellow citizens who have decided to unite closely with a single market and a single currency. As Konrad Adenauer said in Aachen 57 years ago: “Gerade wird man die Mahnung verstehen, dass Europa uns heute Schicksalsgemeinschaft ist. Dieses Schicksal zu gestalten ist uns übergeben”. “Above all, people will understand the call: that Europe, for us today, is a community with a common destiny. It’s up to us to shape that destiny”.

Thank you for your attention.