Draghi Says ECB Bias Allows for Rate Cuts (Transcript)

European Central Bank President Mario Draghi speaks about the euro area’s economy and the central bank’s guidance and policy.

Draghi speaks at the Economic Club of New York.

(This is not a legal transcript. Bloomberg LP cannot guarantee its accuracy.)

MARIO DRAGHI, PRESIDENT, EUROPEAN CENTRAL BANK: I would like to take the opportunity to talk about simply what’s happening in Europe right now. The euro area as a whole is undergoing a process of fundamental reform. The overarching objective is to lay the foundation for recovery and more jobs, foster financial stability and fiscal sustainability, and enhance international competitiveness for the benefits of all parts of the economy and wider society.

Reform will be a lengthy process, but while it is far from complete, perhaps for the first time in many years we are seeing signs of significant progress. National policymakers in Europe are able to focus a little less on short-term difficulties and a little more on their longer-term responsibilities to strengthen the resilience of their domestic economies while developing their growth potential.

And the monetary policy that we at the European Central Bank are implementing will accompany the reform process by maintaining the degree of accommodation that is most appropriate, given our economic outlook and the risks that surround it.

So let me start with a quick review of the current situation and of the outlook for the economy.

Recent data basically support our baseline outlook of a nascent economic recovery over the coming months. Following six quarters of negative output growth, euro area GDP rose by 0.3 percent in the second quarter of this year. Taken together, this data, with incoming information confirmed the growth outlook that the ECB staff produced last September and, as a matter of fact, had been producing all throughout this year. So we see this projection - these projection see real GDP shrinking by 0.4 percent this year and positive growth rate of 1 percent for 2014.

But, as you can easily conclude from these numbers, the pace of recovery is going to be subdued, uneven, and to some extent fragile, being exposed to many risks. It’s uneven across countries for as long as it’s meaningful for us to look into the future. The unemployment rate, currently standing at 12.1 percent, remains unacceptably high, and the risks around the outlook continue to be tilted on the downside.

In keeping with the broad-based weakness in aggregate demand, underlying price pressures remain subdued, as well. Annual euro area headline inflation is projected to reach 1.5 percent this year and, next year, 1.3 percent. These levels are historically very moderate and remain in the lower part of the range of values that the ECB’s Governing Council has identified as consistent with our quantitative definition of price stability, namely that inflation has to be close, but below 2 percent.

That said, inflation expectations continue to be firmly anchored in line with our aim of maintaining inflation rates at the level I said before. And the risks to the outlook for price developments are, in spite of everything, still expected to be broadly balanced.

Finally, monetary and, in particular, credit dynamics remain weak. The annual growth rate of loans to the private sector has remained well in the negative territory, and the pace of contraction of loan - of lending has actually accelerated over the recent period. Certainly, weak loan dynamics can largely be explained by the current stage of the business cycle, but we have to be attentive to alleviate structural and supply-side factor that may hamper credit provision.

The significant improvement in the funding situation of banks since the summer of 2012 has partly offset supply-side restrictions, but it will - it will be some time before the more permissive funding conditions faced by many banks will be turned into an active spur for credit creation.

Against this background, let’s ask, how should policymakers respond to this still fragile macroeconomic recovery? We need a three-pronged strategy. First, monetary policy has to remain consistently supportive of the baseline outlook and mitigate the risks that surround it. Our price stability mandate is sufficiently precise to keep us concentrated on that mission. But preserving monetary accommodation is a necessary, but not sufficient condition for the recovery to take hold.

A second essential ingredient is that countries continue the adjustment of their domestic policies in a way that removes structural impediments to their economic potential and fosters long-term financial - fiscal sustainability. Monetary accommodation can accompany and facilitate such regime shift in economic policy, but we know it can never replace it.

Third, and equally important, Europe has to continue the reform process in its banking sector. Sound finance is part and parcel of a dynamic economy, and banks remain a major conduit of finance, especially in the euro area. Hence, we must establish conditions that align incentives of individual financial institutions with those of the society.

Let me start with monetary policy. As you know, our treaty clearly gives priority to price stability as our primary objective. Within this disciplining framework, we tailor our policy response to the challenges that we face. In response to the events of the last six years, we’ve taken swift and resolute action. We cut the main policy rates to record lows. We provided funding support to euro area banks over long time horizons, first time in three years, and we counteracted and removed unwarranted fears of a breakup of the euro area last year.

In July this year, we again expanded our toolkit to protect the nascent recovery from the risk that it could be choked off prematurely by an unwelcome restriction in monetary conditions. To that effect, the Governing Council adopted explicit communication on how it expects its key interest rates to evolve in the future. In particular, we have communicated our expectation that the key interest rates will remain at present or lower level for an extended period of time.

This expectation is based on our assessment that the subdued inflation outlook extends - will extend in the medium term, given the broad-based weakness in the real economy and subdued monetary dynamics.

What was the rationale for adopting our forward guidance, our type of forward guidance? In June and July, we observed substantial volatility in money market rates. The pricing of term interbank credit in the money market - the first stage of the transmission of monetary policy to the broader economy - had become increasingly divorced from euro area fundamentals.

Markets tended to overreact to news that was either not directly relevant to the euro area macroeconomic outlook or simply confirmed our baseline scenario. Against this background, our forward guidance aimed at better aligning money market conditions with our policy intentions.

In interpreting our forward guidance, there are three essential elements. First, it acknowledges the scope for further cuts in our key interest rates. In other words, the adoption of forward guidance does not imply that we have reached the effective lower bound.

Indeed, the opposite is the case. The Governing Council has unanimously agreed to incorporate an easing bias into our forward guidance that explicitly provides for the possibility of further rate reductions, should the volatility in money market conditions return to the levels observed in early summer.

Second, our forward guidance is specifically tailored to the ECB’s mandate and our monetary policy strategy. The path of the policy rates remains conditional on the outlook for inflation, and it will be reviewed over time against our analytical framework.

This means that we assess whether the medium-term outlook for inflation remains subdued against two types of metrics, first, economic indicators pointing to persistent slack in the real economy; second, monetary indicators pointing to persistent subdued dynamics in money and credit.

The third element of our forward guidance is that, by confirming our policy framework, it refocuses attention on what matters most for our monetary policy, namely the medium-term inflation outlook in the euro area. On our side, it induces the sort of prudent language in communicating about the economy and the type of balanced and steady response to economic news that is needed in exceptional circumstances in which we currently have to steer our monetary policy course.

The observed decline in market uncertainty about future short-term rates indicates that our forward guidance has helped to anchor market expectations. Going forward, we will carefully assess developments in money markets and liquidity conditions. And we have to ensure that interest rate expectations remain firmly anchored around a path that does not add to downside risks for the recovery.

Thus, our monetary policy stance will continue to be geared towards maintaining the accommodative stance and providing support of the economic recovery. But preserving, as I said before, preserving monetary policy accommodation is not sufficient in itself for the recovery to become self-sustaining.

And this leads me to the second element of the policy response: repairing the fiscal and structural problems that hold back individual euro area countries. A painful lesson from the last few years is that we all underestimated the destructive potential that myopic national policies could exert on the euro area’s collective body and on the world as a whole.

It’s time to remove the institutional shortcomings that allowed imbalances to build up in the national economies and escalate into systemic threats in the first place.

In the euro area, two such shortcomings were particularly consequential. First, the E.U. - European Union - fiscal rules were weakly enforced and, as such, incapable of promoting prudent fiscal policies at times of favorable economic conditions, so between the year 2000-year 2007. Second, there was no mechanism to prevent and correct macroeconomic imbalances within the E.U.

The result was an incentive vacuum. Rather than exploiting the advantages of monetary union for modernizing their domestic economies, several countries simply delayed all the necessary adjustments. And the elimination of exchange rate fluctuations and the leveling-off of the spreads in sovereign borrowing costs that preceded the crisis deactivated the market forces that previously had disciplined macroeconomic policies at countries’ level.

European policymakers are now addressing these issues. Due to a recent strengthening of the E.U. fiscal rules, member states now face stronger incentives to adopt sound budgetary policies. Namely, there are provisions that are now being inserted in the national constitutions to the extent that the budgets must be balanced.

Moreover, a new macroeconomic imbalances procedure has been established at European Union level. It does require governments to adopt competitiveness-enhancing policies and tackle potential sources of financial instability in their economies.

Reflecting this reform momentum at the European level, governments are tackling imbalances in their domestic economies. They are implementing reforms to reverse the misguided policies of the past and to create sustainable long-term growth. Progress is steady, and the data increasingly show that the right direction has started.

Euro area countries have cut their fiscal deficit ratios by half since the peak in 2009. Excluding interest payments, euro area member countries on the aggregate are expected to run a small surplus by the end of this year. This is clearly in contrast to other industrial economies, such as the U.S. or Japan, which last year still recorded primary deficits of 6 percent and 8 percent of GDP, respectively.

We are also seeing some noteworthy improvements in competitiveness and external positions. The countries under full E.U.-IMF programs, like Spain, like Portugal, like Ireland, like Greece, have seen their unit labor costs fall by more than 10 percent since 2008 relative to the euro area average. Their current accounts have improved by around 8 percent of GDP since then.

In short, there is progress towards more solid economic fundamentals in the euro area. But, of course, it’s necessary that the current momentum of reform be maintained to reach greater stability.

Finally, a sustainable recovery requires healthy financial institutions. We’ve seen much progress in the banking sector of the euro area. Since the beginning of the financial crisis in 2007, euro area banks have raised around 225 billion euros of fresh capital, and another 275 billion has been injected by governments. All in all, this amounts to more than 5 percent of euro area GDP.

As a result, the average Core Tier 1 ratio of the largest euro area banks currently stands well above 11 percent and the majority of euro area banks already comply with the minimum capital requirements of the fully implemented Basel III framework.

Furthermore, in countries under financial assistance, which are the countries I mentioned before, under financial assistance programs - Spain, especially - problematic legacy assets have been removed from banks’ balance sheets to ensure that they will no longer curb banks’ lending to profitable businesses.

More progress is on its way in terms of the institutional architecture. Europe’s Economic and Monetary Union will be complemented by a European banking union.

Last month - last month, the European Parliament cleared the way for the single supervisory mechanism, which tasks the ECB with overseeing major parts of the European banking system.

By placing this responsibility with an independent institution at European level, the new supervisory mechanism will allow for more stringent and consistent supervision. This will ultimately afford an earlier identification of financial risk, in both individual institutions and the financial sector as a whole.

Looking forward, two objectives need to be addressed. First - and I think that’s the most important one - we need to create full transparency about the risks that are present in banks’ balance sheets. And, second, we need to align investors’ incentives with those of society.

A comprehensive balance sheet assessment will be a crucial preparatory step before we begin our new supervisory task in the fall of next year. This will serve to strengthen transparency and to mitigate the risk of the possible emergence in the early days of operations of the new supervisory mechanism. There’s going to be a major exercise of a balance sheet assessment, the objective of which must be to convince the private sector that it pays to put money in the banking industry. I think that’s the key objective. So for this reason, transparency is the main consideration that we have to keep in mind.

Now, this balance sheet assessment is formed by three components: a risk assessment; an asset quality review; and, finally, a stress test. The - two be as transparent as possible, we envisage a process which is going to be run not only by national supervisors, but by four actors, the ECB from Frankfurt, the national supervisors, also other national supervisors will be part of the joint inspection teams, and, finally, third-party private sector advisers.

So the three elements - risk assessment, asset quality review, and a stress test - will ensure a comprehensive assessment that will identify the remaining risks on banks’ balance sheets.

To strengthen incentives, the institutional architecture will also be augmented - I’ve spoken so far about the single supervisory mechanism, the single supervisor in the euro area, but there’s also going to be a single resolution mechanism, like equivalent to your FDIC. As a first step to overcoming the existing problem, harmonized rules and procedures for bank recovery and resolution are being developed at a European level. And this - this new way of European rules should be implemented at a national level quickly.

But to ensure a fully consistent and effective application of these rules, their implementation should be placed within the remit of an independent authority that reinforces the new supervisory framework at a European level.

So there will be a single resolution mechanism that will execute bank resolution in a timely and impartial manner and formulates its decisions from a clear, encompassing European perspective.

So by enhancing transparency and resolution, the combination of the single supervisory mechanism and the single resolution mechanism we hope will help Europe return to a situation in which investment decisions will be based on business prospects and not on geographical location.

Let me conclude. As I said, the recovery remains in its infancy. Given the prolonged build-up of macroeconomic imbalances in the past, we have to be prepared for a protracted process in the future.

Yet we should also not exaggerate the euro area’s challenges. For example, while the unemployment rate has increased more in euro area than in the United States during the crisis, the employment rate in the U.S. has fallen further than in the euro area, which makes the two figures hardly comparably.

Moreover, the euro area has a strategy to return to sustainable growth and employment, and that strategy is actually being executed. What is essential is that all policymakers play their part to stay the course. The rewards that will result from the reform of our economic institutions cannot be overestimated.

Thank you for your attention.

(APPLAUSE)

Thank you.

MODERATOR: Thank you very much, Mario, for that very comprehensive and insightful speech. I’d now like to introduce the two members who will conduct our question-and-answer session, Bob Hormats, the former undersecretary of state for economic growth, energy and the environment, and now with Kissinger Associates, and John Lipsky, a distinguished visiting scholar at Johns Hopkins University and the former acting managing director of the IMF.

If you in the audience have any questions, you can e-mail them to questions@econclubny.org. That’s questions@econclubny.org, and our president, Jan Hopkins, will read them.

Bob, you have the first question.

BOB HORMATS, FORMER UNDERSECRETARY OF STATE FOR ECONOMIC GROWTH, ENERGY AND THE ENVIRONMENT: Thank you very much (OFF-MIKE) to the New York Economic Club and welcome back to New York. I would be remiss if I did not begin on the note that everyone is talking about, I think particularly in Washington, but throughout the country, and that is the ongoing debate over the government shutdown and the debt ceiling. As you know, these issues have enormous impact not only on the American economy, but on the global economy.

And, therefore, I would request from your perspective if you could take a look at this from an international point of view, and particularly what the implications would be if Washington failed to reach an agreement on a constructive and sustainable solution to this problem, not one that simply kicks the can down the road or leads to a default in the current environment, but one that just is simply not able to address the kind of fundamental challenges that we face as a country on broader fiscal policy issues, what would the global impact be?

And the second is, what do global markets and other countries look to the United States to do to strengthen our long-term fiscal sustainability? As you know, this debate has been swirling for some time around the debt issue, the deficit issue, not just in the immediate sense, but over the next 10 to 15 years. The CBO has just done a report on that.

So I’d be interested on your thoughts on what happens to global markets if this is not dealt with in an effective way in near term, but also what kinds of measures the United States needs to do to put ourselves on a more sustainable basis and renew confidence in the dollar and in the U.S.’s financial markets?

DRAGHI: Well, thanks, Bob. I’m not sure I’m actually the best person to answer this question.

(LAUGHTER)

But - so I hope you’ll forgive any naive statement on my side.

HORMATS: You’re better than most in Washington, Mario, so please proceed.

(LAUGHTER)

DRAGHI: First, let me say that the - let me give you just an outside perspective, as I said, as someone who’s not especially informed about this issue. But I think the world still does not believe that the United States will not find a way out of this. There is complete misbelief that finally some agreement will be found. So that’s the first part.

Second, there are two types of - at least two types of situations that we have to keep in mind. First is an agreement is found, but late, and there may be an accident in between. Clearly, the market’s response will depend on what type of accident, whether it’s - it depends very much what sort of nonpayment happens. And there are different consequences on the markets, depending on whether it’s bonds or it’s not bonds.

The second situation is one where this standoff lasts several months or several weeks. In that case, it’s probably safe to say that this could be - could cause severe damage to the U.S. economy and to the world economy. So that’s the - I think the answer.

Now, I can’t comment on the last part, namely what sort of agreement is more likely to be found. It’s quite clear that longstanding agreements will have - will contain an element of stability for both the U.S. economy and the world economy, and it’s also quite obvious that if you have a short-term agreement will be less stable, will produce less stability.

But I think the - this is, in a sense, must be clear to all of you. And the key thing now is where an agreement will be found or a way out will be - will be - will be achieved.

On the second question, I mean, what the U.S. government should do to ensure long-run fiscal sustainability? I think the - it’s, again, a very, very complicated question, but it is quite clear that the financial crisis has produced a debt and a deficit level that is not sustainable through time. It’s also quite clear that fiscal retrenchment has - fiscal consolidation has different speeds in different parts of the world.

In Europe, it’s been very fast. And in some cases, it was absolutely necessary, and I can say more about this later, to do it fast, and has produced a contraction, in some cases, a severe contraction. In U.S., the consolidation is proceeding.

And the other way to get out of a situation which is unsustainable is to grow more. So to grow is equally important as to consolidate. And I’m confident that this is well understood here. Thank you.

MODERATOR: John?

JOHN LIPSKY, FORMER ACTING MANAGING DIRECTOR OF THE IMF: Thank you. And congratulations on that thoughtful address.

DRAGHI: Thank you.

LIPSKY: More broadly, congratulations on the wonderful job you and your colleagues in Frankfurt and around the European Central Banks have done meeting the challenges. I think the size of this audience reflects the interest here in the European project, but also recent events have underscored our interest in the success of European economic monetary union, and I hope you can convey that back home.

DRAGHI: Thanks, John.

LIPSKY: I think when you get to Washington, you will find another hot topic, the conduct of unconventional monetary policy, and you can see that recent events in - here in the United States and our markets underscore that, as well. The implementation of unconventional policy has involved the implementation of new and more instruments. In the case of the ECB, beyond the traditional discount and repo facilities, and the long-term repurchase operations, the OMT, the outright monetary transactions, the ELA, and now, more recently, forward guidance.

How do you decide what - how to implement this mix of instruments, given the traditional idea that you should match instruments to targets? How has this - how do you decide which of these instruments to use? And has it - has the proliferation of instruments made it more difficult to gauge the stance and overall impact of monetary policy?

And, finally, how do you meet the challenges of effectively communicating this much more complex array of monetary instruments?

DRAGHI: Thanks, John. Well, thank you for your kind words. Just these days, one doesn’t happen to be flattered that often, so -

(LAUGHTER)

Thanks. The three instruments you mentioned, the long-term refinancing operations that we started at the end of 2011 and - for the first time, this means that, for the first time, the ECB was opening a what we call fixed-rate full allotment, namely a credit line at policy rates without any penalty for all the banks that would apply. And it was a three-year horizon. The ECB had done it for at most one year, with a horizon of at most one year.

Now, that addressed a specific problem, which was the - the fragmentation of the financial markets of the euro area. By the end of 2011, when the data of credit and money, any monetary, any credit data, was showing a dramatic drop in the last - it started - it all started, really, midyear, but it was - became dramatically visible by November and December. So that’s why, in two months, we cut rates twice, and we did the LTROs.

And we are convinced that, in so doing, we avoided major accidents in the banking system. The reason was, frankly, all other source of funding had dried up, and deposits were vastly migrating to safe haven places, like Germany, from the rest of the European Union.

So that helped to cope with that - with that problem, with that objective, at least, and I think we’ve reached the objective. And it worked. It worked also in terms of rates, volatility, stock markets, any index had a positive reaction, but it didn’t last. Three months down the road, the euro area was seen at risk, and there were many people, many investors - also on this side of the Atlantic - which were believing that the euro will not survive, and they had taken significant positions on the short side.

And so the OMT - the response that the ECB within its mandate would do whatever it takes to preserve the euro, to make - so it was a positive commitment to the objective - the immediate objective, of course, to defy, to - I would say to destroy self-fulfilling expectations of disruptive scenarios for the euro, and it was a positive commitment to a higher, I would say, political objective, is to make sure that the euro is irreversible. And it worked.

Now we, in a much more stable situation, we saw interest rates going - by the way, between July 2012 and a month ago, we saw interest rates further going down all over, fragmentation gradually being reduced. By the way, fragmentation on the funding side is by and large disappeared as far as deposits are concerned.

What we do every month, every month, we look at how deposits in the banking system grow in different parts of the euro area. And then we calculate a dispersion index. And this index is now at the same level it was in 2007. So as far as that component of funding, fragmentation is gone.

But on the lending side, we still have problems. And so the last thing we want is the short-term money market rates start behaving in a way that would threaten our recovery. And that’s why we issued our specific, peculiar forward guidance. It’s different. It’s different from the one you have here. It’s different from the one that Bank of England has. Certainly very different from what Japan has.

Why is that? Well, we are simpler folks.

(LAUGHTER)

That’s the answer. We - and I’ll tell you why, because we don’t have - we don’t buy assets. We don’t buy government bonds. We don’t buy gilts. We don’t - we - our interest rates have not reached - as I was saying in the statement before - have not reached the zero level or the lower bound.

So there was the different situation. Our mandate is clear. It speaks only about price stability. So the issue was, then, are we going to be quantitative or qualitative? Again, being in the specific institutional context, we thought that the - well, there were many reasons for being qualitative, but especially that the world is such an uncertain place that we wouldn’t feel like binding ourselves to a specific figure, and the thing that we say is that basically our medium-term outlook about inflation has to be such and such for our forward guidance to remain in place, which is what it is today, namely subdued and weak.

The intention was not to change our reaction function. Our intention was to clarify our reaction function. And - now so the question is, did it work? There are various metrics. One is, were we successful at keeping interest rates at the level we want to keep the short-term interest rates? And the answer was, yes, for some time. And then they fluctuated, but still in a corridor that is by and large acceptable.

The second point is that the forward guidance has been clearly successful in reducing the volatility. And the third is that it’s been clearly successful in reducing the sensitivity of interest rates to news that have nothing to do with the fundamentals of the euro area economy. I mean, if the euro area economy recovers, you would expect an increase in interest rates, but if it doesn’t, then you would not. So all in all, we will stay with that.

Thank you.

LIPSKY: Thank you very much.

HORMATS: Mario, you’ve spoken eloquently here and in many speeches in the past on the importance of structural reforms in Europe regard product and labor markets, to improve competitiveness, increasing adjustment capabilities, and achieving higher growth rates. And as you’ve pointed out in your speech today, some improvements have actually taken place, in fact, in some countries, considerable improvements have taken place with respect to reducing current account deficits - some are now in surplus - major changes in the positive realm.

I wonder if you could dig a little bit deeper and identify what the future priorities should be. You’ve talked about the need to keep up the momentum. Could you be a little bit more specific about what areas you think need to be focused on in the future to sustain momentum? And particularly, what types of measures have proved so far to be most successful or most promising? Because different countries, as you correctly pointed out, have instituted different kinds of reforms.

Which are those that seem to be the most promising and most successful? And are countries in Europe learning from one another to try to figure out what works and what doesn’t under, in some cases, very similar circumstances, others, obviously, different from one to the other? But where are we going? What should the priorities be? And where do you see the most room for optimism in this area?

DRAGHI: Thanks, Bob. Let me just step back and go to, say, 2009, in just the - just the aftermath of the - of the most violent period of the crisis. In many of - in many governments of the so-called stressed countries in the euro area, what happened was that budget deficits levels and debt levels were unsustainable. And markets were clearly saying so.

So the governments in power at that time had to face a very urgent situation, and they had to go fast about repairing these budgets. And when you have to decide very fast on how to fix your budget, the easiest things that everybody does is - is basically raise taxes. Taxes were raised significantly everywhere in a part of the world where taxes are already very high, so that some countries reached something like 50 percent and plus of GDP in terms of tax incidence on the economy.

The second thing was to cut investment expenditure, capital expenditure, because that’s easy, simply cancel investments. Now, all this produced a recession. And no wonder. Now there is more time, and what countries now ought to think about is just the other way around, namely cut taxes, bring them back to sort of what used to be a normal historical level, to recreate the incentive for private investment, and also cut expenditure.

Now, when you go to cut expenditure, I think you know very well in this country, it’s the same probably, it’s not easy, because you have to change legislation which has been (inaudible) often for many, many years. And that’s where the structural reforms come into place. And there is a broad range of structural reforms that can be done by the public sector in - as far as government expenditure is concerned, some countries need a new pension reform. Other countries need different - much better control over their - some of them are federal, and they have no - well, they have very little control over their single regions’ budgets, so they have to enforce that. Each country has its own manual.

And then you have the reforms that simply free the individual initiative for the individual entrepreneurship, and these are reforms that deal with competition, especially in the product markets. If you need to wait six months, nine months before you can open a shop and - so, you know, I mean, just you give up. If you have to bear substantial costs for having a license, if it’s too high, you give up, and so on and so forth.

And, second, you - structural reforms that would directly affect the labor market. The labor market situation is a special one, because what happened is - well, first of all, you look at the labor market in Europe now and you see that in some countries they had all - most of them had a serious crisis, comparable. Most of them have higher levels of unemployment, but in some of them, you have a very high level of youth unemployment on top of having a high level of unemployment, and you ask why.

And the reasons are, by and large, two. In the early part of the year 2000, these countries had - wanted to make their labor markets more flexible, but they didn’t want to hurt the people who were already working. So they wanted to introduce flexibility leaving everything else constant. So what they did was to introduce flexibility only for the young entrants.

That translated into these young people being hired only with short-term, very short-term contracts, three, six months, even one month in one country. And this situation went on and on and on until the crisis struck. And then, of course, the first jobs to be cut were these people. And so you have millions of young unemployed.

The second reason is basically that, in some countries, you have educational systems that simply do not produce the skills necessary for these young people to find a job. And that’s an even - if I may say - more serious and longer-term problem.

So the labor market has to be addressed by all countries in their different ways, and the - there are countries - like Spain, for example - who have started to reform the labor market, and you can see that it works, because, for example, the unit labor cost in Spain had dropped much more than in other countries. In some countries, for example, in spite of having 13 percent, 14 percent of unemployment, you still see nominal wages going up more than the European average, which means, basically, you have lots of people unemployed and the ones who are protected getting higher and higher wages. So you see that there is clearly need to address this issue.

MODERATOR: John?

LIPSKY: Thank you. As you mentioned, and as - as is underscored in the IMF’s World Economic Outlook and Global Financial Stability Report that were both published earlier this week, that the banking system, that weakness - capital weakness, fragmentation, and corporate debt overhangs in the eurozone are leading to higher borrowing costs for corporate borrowers, adding to systematic fragility and helping to induce the deleveraging, the decline in bank lending that you had discussed, and that the IMF agrees with your analysis that progress on banking union is central to strengthening the financial sector, especially in the banking sector, in the eurozone economy, where, as we all know, bank lending is dramatically more important as a relative source of funding than, for example, in the U.S. economy.

You have described a very important set of actions that will be forthcoming in the next few months, the risk assessment, the asset quality review, and the stress test. And in the near term, that is going to produce potentially a need for even further capital raising on the part of some institutions.

Now, there’s been a broad agreement that that - where capital needs to be raised, it should come, first, from retainer needs, second, from private sources, third, from national governments, and, fourth, from the new European stability - stabilization mechanisms, bank recapitalization facility.

Who is going to have the power to decide what banks are going to have to do and which source of capital they will have to make use of? Is it going to be the ECB as the new single supervisor, national governments, or the European Commission, or who?

DRAGHI: Now, you’re absolutely right. I just have to correct on only one small point. The ESM, the European stability mechanism, will not be able to recapitalize banks directly until the single supervisory mechanism will be in place. So it’s very unlikely that they will be - that they will - could actually finance anything at this stage - or, I mean, at the end of - at the end of next year.

But other than that, your description is absolutely right. And that’s why the asset quality review is so important. The banks will have - some banks may have to raise capital. I have no idea whether to expect major disasters or not. Certainly, what is positive is that, in view of this exercise, ahead of this exercise, all banks and supervisors, national supervisors are actually reacting very, very strongly everywhere, either convincing banks to raise more capital, forcing a very high level of provisions in many parts of the area, so it’s quite - this is quite good, because it’s conducive a better situation. But certainly we’ll have to see exactly what’s - how things stand.

And that’s why - that’s why these four actors’ participation to the exercise is so important, because transparency is the key thing. And the - by and large, people outside Europe are convinced that, if there is no more transparency, it’s very unlikely that they can actually invest in the banking system.

Now, the - what are the prospects for raising capital? From what we see today, the situation is not - is not bad. We’ve seen - in the last month-and-a-half, we’ve seen several banks capable of raising capital. So the market prospects are way better than they were on the occasion on the last stress test two years ago. Also, the sovereign bond market, by and large, is more stable than it was two years ago.

Who’s going to decide this? There are two different - two different assessments. The supervisor will be - the ECB - will be responsible for the assessment of whether a certain bank is viable or it’s not viable. And then there will be another authority which will decide what to do. They can decide to sell, merge, close, liquidate, resolve, different actions.

Suppose it’s not viable. In this process, as you said, first, ordinary capital will be exhausted, and then a series of creditors, according to a pecking order, which has been defined by the European Commission as a law. It’s - the rules of the bail-in have been defined by the European level.

And then, at the end of this - and I insisted a lot - in having a precise commitment by the national governments to play - to have in place the, say, national backstops of public money, not with the idea that it’s going to be necessary - maybe it’s not necessarily - but it’s absolutely important to let markets and people know that in case it were necessary, it’s there.

It also, frankly, says something about the - I would say the clarity of our exercise, because people might think, if there is no backstop money, then the exercise would be more lenient in order to avoid, to use taxpayers’ money. And this commitment, which is, by the way, enshrined in a solemn sentence by the European leaders, is now sort of going down to more operational level, and very likely in the next few weeks we’ll have a precise statement about that.

So who’s going to decide about whether to use public money? In the end, it’s the national government, because the single resolution authority will not be in place very likely by the time we finish with this exercise. But the rules are, I would say, overall consistent, because they have been fixed at the European level by legislation.

LIPSKY: Thank you very much.

DRAGHI: Thank you.

***END OF TRANSCRIPT***

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