On January 19, the Board of Trustees of the Széll Kálmán Foundation, an organizational member of the Hungarian American Coalition, presented its 2011 award to Professor Sándor Lámfalussy, in recognition of his professional commitment to European financial institutions and his dedication to help Hungary, his native country, over the past 20 years.
Lámfalussy, a citizen of Belgium, was born in Hungary, in 1929 and attended the Benedictine High School in Sopron. He left Hungary in 1949 and received his Ph.D. at Oxford. He began his professional career as economist in 1955, developing expertise in an advisory capacity for international organizations and banks. In 1993, he was named President of the European Monetary Institute in Frankfurt, and charged with constructing the operational framework for a single European monetary policy. For his work, he is widely considered “the father of the Euro.” Lámfalussy has also served as advisor on economic matters to Hungarian governments since 1989.
Thursday’s award ceremony was held at the Hungarian Academy of Sciences, where Ambassador János Csák, creator of the Foundation, summarized Professor Lámfalussy’s achievements for an audience of about 100 guests. The award was presented by Ambassador Csák and Csaba Lantos, the Foundation’s Chairman of the Board of Trustees.
Professor Lámfalussy, after thanking the Foundation for the award, delivered a cautiously optimistic speech, in Hungarian, entitled “Reforming Europe is Underway”. His remarks included a brief analysis of the current crises, followed by a description of European reform initiatives undertaken in recent months, highlighting structural reforms, which in his opinion require priority treatment. The full text of his remarks (in English) is attached to this press release.
The Széll Kálmán Foundation was founded eight years ago to serve as a forum for its membership to conduct social and economic discussions with the involvement of a wide range of experts. The Foundation’s aim is also to provide a forum to creative people who promote and advance Hungary’s interests in the region and in a wider environment.
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Remarks by Alexandre Lamfalussy
Széll Kálmán Foundation
Budapest
January 19, 2012
Ladies and Gentlemen, dear Friends, first things first: let me express my heartfelt gratitude for the great honor you decided to bestow on me. There are two very personal reasons why I feel deeply moved. One is that I have discovered that Kalman Szell spent a few years at the same school I did: the Benedictine “gimnazium” in Sopron. The other is somewhat more complicated. Throughout my successive migrations – from Sopron to Budapest, from Budapest to Brussels, from Brussels to Basel, from Basel to Frankfurt, and by now firmly settled in Ohain (not to mention sabbatical leaves at Yale and in Oxford) -I have tried constantly to respect ethical and professional values despite the need to accept on occasion practical compromises that appeared unavoidable in our multicultural societies. Much to my surprise I realized recently that one and half century ago Kalman Szell acted in conformity with the same principle, but with far greater efficiency than I have ever managed to do.
May I read out to you what he said: “Én azon iskola híve voltam és vagyok, amely elvek fölött tranzakciókat nem ismer … de azt tartja, hogy vannak szituációk, midőn az eljárásban, a részletekben a kompromisszumok terére lépni lehet, és az ország érdekében néha kell, hiszen kompromisszumok láncolatából áll az élet, e törvény alól a közélet sem vonhatja ki magát.”
Now let me turn to a few remarks on the current financial reform initiatives in Europe. For these remarks I propose a title which I want to convey moderate optimism:
“Reforming Europe is under way”.
The complexity of the current crisis
Even if we want just to begin to understand the nature of the challenges facing European policy makers, we have to realize that this crisis has potentially three components which are distinct, but fundamentally interconnected. The first is the banking crisis which came to the surface when on 9 September 2007 the interbank market ceased to function, triggering a historically unprecedented intervention by the Eurosystem. This was beginning to bear fruit when Lehman Brothers went bankrupt, reviving or aggravating the insolvency risks of large segments of the European and US banking systems. The second is the European sovereign debt crisis which erupted with Greece, and has affected unevenly the government debt market of a number of European countries. And the third is the looming recession.
The dominant fact of this situation is the interdependence of these three crisis manifestations. Strangely, this was not always recognized. The radical increase in government debt was not an accident: it was deliberately engineered by the governments to avoid a depression comparable to the one of the nineteen thirties. This indeed has so far been avoided but at the cost of governments losing control over their debt. We now know with hindsight that the increase of the DEBT/GDP ratio has a limit, although even now we can only guess where this limit is.
A similar shortsightedness could be observed during the early spring last year. The shift of debt accumulation away from the private sector’s debt bubble to sovereign debt was greeted with relief by the banks. There was indeed major improvement in the banks’ profit and loss accounts – thanks to the vigorous support to the banks’ interest rate spreads by the continued monetary policy ease – and strikingly generous remuneration schemes. It so happened that in March I attended a major bankers’ conference where I discovered to my surprise that the prevailing mood was “business as usual”. When I took the floor I instantly felt my loss of popularity because I started by insisting that the European banking industry was not yet out of the woods, for the simple reason that our banks were loaded with sovereign debt. And I continued to insist that a sovereign debt crisis could hit the banks in a number of ways – well beyond its primary impact on the sovereign debt portfolios. I concluded that the last thing we needed was returning to “business as usual”. A reminder: this strange mood of optimism died out rather quickly some time in April.
We are now entering the danger zone of a recession. This recession will not necessarily happen, and if it happens might be short and shallow and developments outside Europe may aggravate or attenuate it. But if it does happen, its deleterious effects will aggravate the banking crisis, the impact depending on how deep and long the recession will be. At the same time the governments’ efforts to restore control over their debt will not be made easier, to say the least, by the broad effects of the recession on the fiscal front.
What has been done to break these vicious interactions? Let me sum up in a telegraphic style what I have observed. The record is far from disastrous.
Reform initiatives
Let me begin by focusing on three groups of complementary reform initiatives. The first is the identification and repairing of specific dysfunctions that were instrumental in spreading and deepening the banking crisis. Here is a short reminder: (a) Securitization in general and specifically the “originate and distribute” banking model; (b) The nefarious role played by the CDS (Credit Default Swap) market; (c) The dismal failure of the rating agencies; (d) The breakdown (or the misuse) of the risk management models; (e) The potentially de-stabilizing role of the remuneration schemes; and last but surely not least, the procylicality of our management and accounting systems.
It has not been an easy task to find solutions to these problems. To deal with the CDS story was a particularly hard nut to crack. To reduce systemic risk we now have reached general support for the creation of central clearing counterparts, which will considerably reduce counterparty risk, improve transparency and facilitate risk control. Similarly, it became quickly obvious that the main culprit of securitization going off the rails was Basel I hence the development of Basel II/III. The practical result is that by now officials are discussing implementation details and in some cases are even approaching the implementation stage.
A second, more impressive, result has been the erection of a genuine European financial regulatory and supervisory architecture. This architecture has been designed basically by the “de Larosiere Committee” . It recommended building two new institutional pillars: the European System of Financial Supervision (ESFS) which is composed of three authorities (and not just committees). for banking, insurance and securities markets, and is primarily concerned with micro-prudential and investor protection issues. The second pillar is the European Systemic Risk Board (ESRB), which has been created under the auspices of the European Central Bank and is undertaking macro-prudential supervision and systemic crisis prevention. Here we have two radical institutional innovations, which amount to a quantum jump. Both new institutions have now been operational since the early months of last year.
On the personal level I have good reasons for being reasonably happy with both developments. Why?
As regards the micro-prudential pillar, you may perhaps remember that some time ago (2000/2001) I chaired a Committee of Wise Men on the Regulation of European Securities Markets, which came up with a four level regulatory approach. This has by now been accepted for the whole of the European financial industry, and carries my name as a sort of retribution for my sins. This approach represented and still represents, I believe, a helpful contribution to the process of financial integration in Europe, but it was becoming obvious that it called for further progress. I refer here to the difficulties encountered at Level 3, which is in charge of implementation in individual countries. A difficult mandate, especially when governments have the bad habit of using this last opportunity for trying to prevent the implementation of regulations which have already passed a number if hurdles. Erecting a new pillar endowed with decision making and sanctioning authority has come at the right time.
My second personal reason for satisfaction is that since the dot.com (internet) crisis I was becoming worried about the ability of the European authorities to prevent or handle a major financial crisis. I spelled out my misgivings in October 2004 in a lecture at the Central Bank in Luxembourg under the title “Central Banks and Financial Stability” where I suggested to consider that the European Central Bank is given an operational co-responsibility in the supervision of the thirty-to-forty major banks in Europe whose problems could have directly systemic consequences. I did not expect much support for my suggestion, and I did not get it. The time was not yet ripe for taking into consideration such a “radical” idea. Setting up the European Systemic Risk Board comes as close as politically possible to my 2004 proposal -hence my satisfaction.
Now let me turn to a third reform initiative which has the ambition to make work the E- leg of EMU. This initiative was undertaken a year and a half ago at the request of the Council which asked its newly appointed chairman – Herman van Rompuy – to set up a task force to look into the deficiencies of the “economic” part of the Economic and Monetary Union. This deserves a few minutes of explanation. Let me begin by emphatically stating that, among the Maastricht negotiators, no one ignored what all undergraduates already knew: namely, that the vanishing of exchange rate adjustments as a policy tool required strong economic convergence between the member countries – short of which sooner or later the M-leg of EMU would find itself in an unenviable position. To avoid this happening we had to set up a structure which would facilitate, and if necessary, enforce this convergence.
It is for this reason that it was decided that accession to EMU should be conditional on the member country respecting five criteria – of which the two well-known fiscal criteria. It was also agreed that once accession materializes, the criteria should continue to be observed, although somewhat adjusted and acquiring a new name: the Stability and Growth Pact. After a few years of relatively peaceful development, two sorts of problems finished to undermine the working of the Pact.
One was the basic mistake of focusing (almost) exclusively on the fiscal criteria: debt and deficit. Not that they were unimportant – but they should not have been the only ones. Indeed, the purpose of the “real” convergence process is twofold. Overindebtedness should be avoided, because the risk is monetizing debt, which leads to inflation. But this is not the only evil. In a monetary union you want to avoid major and lasting increases or declines in a member country’s competitive position. To catch the danger or the reality of this happening you have to monitor a number of indicators, of which perhaps the most important are relative unit labour cost indices . The desperate problem of Greece to-day is the combination of a murderous debt burden with the collapse of the country’s competitive position.
The second problem is a simple one, but its solution is not: what is to be done to make the criteria respected? Experience has shown that intergovernmental discussions don’t do the job. It was the two largest member countries – France and the Federal Republic – that simply decided not to respect the Maastricht criteria. Why should then the smaller ones worry? Even worse, when it appeared that the Greek authorities gave wrong figures, no serious consideration was given to sanctions. No wonder: any finance minister will think twice before suggesting sanctions against another minister – he would always keep in mind that the mail might be returned. The route out of this dilemma is not less government, but more and stronger central government. Nation states will surely not vanish} but they will have to accept in well defined areas – they indeed are close to accepting – compromise solutions, of which the most helpful are likely to be the automaticity of sanctions and appropriately adjusted voting procedures. A good example is reverse qualified voting – which means that you need a qualified majority to reject a regulation proposed, after thorough discussion, by the Commission.
We don’t have time (and I don’t have the qualification) to discuss in detail the van Rompuy program, but I am convinced that it is making things move in the right direction. I must confess, however, that I have misgivings about the role played by the UK whose prime minister recently demonstrated his willingness to hamper even the slowest move towards a reinforced EMU.
The elusive structural reforms
Now let me turn to the elusive structural reforms. I have come to believe that among the wide range of reform initiatives the so far neglected structural reforms should receive priority treatment. This, of course, is more easily said than done. There are two reasons for this. On the one hand, such reforms have to be implemented globally – and financial structures vary considerably from country to country and even from one country to another. Just look to the well known differences between Europe and the United States. On the other hand, they touch substantial vested interests, and you can count on the fierce opposition of the beneficiaries of those interests.
Whatever opinion you may have about the desirability and feasibility of the Volcker package, there is no doubt in my mind that the questions to which the package attempted to supply an answer are the right ones. Has the financial sector grown in size beyond a level that would be justified by providing services to the “real” economy? If so, what to do? Has the size of individual banks grown to an extent that makes it hard to bail them out, and perhaps even harder to let them fail? If so, what to do? And what are the merits and feasibility of the narrow bank arguments?
But most importantly, how can we extricate ourselves from the unappealing moral hazard trap? The widespread belief that the systemically important institutions will always be bailed out has devastating consequences: it encourages reckless risk-taking by such institutions, and provides them with an unfair competitive edge over the rest of the financial industry by ensuring cheaper financial resources for them.
To avoid this happening, it has to be made clear that no financial firm, and especially banking firm should count on being protected from failure. But no such statement will appear credible unless ways and means are found to ensure that the absence of a bail-out has no systemically disruptive consequences. Trying to find, and agree globally on such crisis resolution processes should rank very high on the political agenda. While a lot of work has been done in this field by experts, I feel that the topic has not yet caught sufficient attention from our political leaders.
By way of conclusion
I have come to the end of my remarks. I did not want to give you the impression that we are just about getting out of this mess, because we are not. But nor would I want to leave you with the impression that the reform process got stuck. With the exception of the admittedly key structural reforms, I have noted progress, sometimes radical progress in all three areas mentioned in this sketchy survey. I would even venture to say that had these reforms been in place four to five years ago, we might have avoided a good part of the current crisis. Or to put it otherwise: the reforms are moving in the right direction, but in most cases too slowly.
You might also be tempted to argue that while the dominant part of these reforms is supposed to prevent future crises, what we to-day need urgently are decisive policy decisions allowing Europe to get under control the current crisis. You are of course right, but this was not the purpose of my remarks. Not being involved in decision making, I would find preposterous to give publicly lessons to official negotiators. But the present and the future are to some extent interdependent, and not only in the negative sense. In the world of decision makers, dominated by forecasts, when market participants realize that some highly sensitive issues have already been dealt with, they might perhaps get out of their mind that market reactions can go only in one direction. The contemplation of past success might make you believe that there is no fatal impossibility to prevent future success.
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