The decision of the euro area's heads of state has reduced the threat of contagion from Greece

Andres Lipstok
Eesti Pank Governor and member of the Governing Council of the European Central Bank

According to Eesti Pank Governor and member of the Governing Council of the European Central Bank Andres Lipstok, the euro area has benefited from the fact that the heads of state reached an agreement on the funding and economic reforms of Greece. This reduces the risk that a drop in confidence in money markets might seriously affect other euro area countries.

The current situation in the euro area's economy varies widely. The economic situation of the euro area as a whole is better than in other major developed economies. However, some euro area countries are struggling with serious debt problems.

During recent weeks, issues of public debt servicing have re-emerged in several euro area countries. In addition to Greece, Ireland and Portugal, the situation has clearly become aggravated in Italy and Spain. Economic recovery in these countries has also remained slower than expected. This has raised the question whether it would be suitable for the euro area's central banks to increase the price of loan capital.

The clearest answer stems from the mandate given to the Eurosystem - the national central banks of the euro area and the European Central Bank. As for the interest rate decisions of the Governing Council of the European Central Bank, we must make these decisions with regard to the entire euro area. More specifically, we make interest rate decisions proceeding from the goal of maintaining the euro area's inflation rate below, but close to, 2 per cent over the medium term.

At the meeting of the Governing Council of the European Central Bank at the beginning of July, we increased the price of loan capital, i.e. interest rates. As a result, the key monetary policy interest rate is now 1.5 per cent. All the Council members agreed that a rise of 0.25 percentage points was essential to guarantee price stability.

The interest rate increase was based on the commonly held opinion that if interest rates stayed the same, inflation in the entire euro area would probably remain over 2 per cent. As a result of the global surge in energy and other commodity prices, inflation in the euro area is currently 2.7 per cent. According to forecasts, high commodity prices continue to affect consumer prices, and as a result, inflation is not expected to drop below 2 per cent in the forthcoming months. The possibility that continuing economic growth in the euro area will start exerting an upward pressure on prices is also quite realistic.

Still, how great is the probability that the problems of some euro area countries will significantly affect the economy of the entire euro area?

Insecurity in financial markets continues to be great and problems in one euro area country may quickly spread to the bond markets of other countries where the situation is also tense.

On the other hand, it must be kept in mind that the gross domestic product of the three most troubled countries - Greece, Ireland and Portugal - comprises only 6 per cent of the euro area's economy. The GDP of Greece, the epicentre of the crisis, amounts to merely 2.5 per cent. Although economic growth in Italy and Spain will remain very low this year, the recovery of the economy in the euro area as a whole is still continuing. Focusing excessively on the situation of struggling countries would entail a threat of price rise acceleration in the entire euro area.

It is essential to emphasise that price stability is an important factor supporting long-term economic growth. Maintaining price stability is the primary duty of the euro area's central banks to the citizens of the euro area. Thus, every euro area country individually considers price stability in the entire euro area an important issue. In the current situation, where insecurity regarding the outlooks of the euro area's economic development is above average, anchoring price rises and related expectations is even more crucial.

So far, the monetary policy used to fulfil the euro area's inflationary goal has been successful. Since the single monetary policy first began to be implemented, prices in the euro area have risen slightly less than 2 per cent.

Moreover, even after the recent increase in key interest rates, monetary policy interest rates still remain very low in historical comparison. In other words, the monetary policy of the euro area's central banks strongly supports the recovery of economic growth.

When interest rates are unusually low, we must carefully assess their impact on the behaviour of the financial sector. Interest rates that remain low for an extended period increase the risk appetite of the financial sector. Higher risk appetite together with optimistic expectations may rapidly lead to excessive loan growth and an increase in the prices of various assets, which will result in the creation of bubbles in the financial sector and the whole economy. The experience of Estonia and many other countries indicates that in such a situation there is not much the governments or the central banks can do. One of the lessons of the recent global financial and economic crisis was the importance of policies, including monetary policy, in preventing such problems.

How does the fate of struggling euro area countries affect monetary policy? The primary impact is related to the fact that the problems have also caused serious issues for the banks in these countries. Considerably stricter terms for involving funds from money markets and obtaining deposits have increased these countries' borrowing from the euro area's central banks.

To continue such borrowing, it is very important that the collaterals given against these loans and the solvency of the commercial banks be guaranteed. If this becomes problematic, finding a solution will be the responsibility of national governments, not of the central banks. Therefore, last week's promise by the euro area's heads of state to offer central banks additional guarantees in relation to the restructuring of Greek public debts, so that we could continue to give monetary policy loans to Greek banks, is very important. The promise of the heads of state that, if necessary, other countries would support Greece in increasing the capital of local banks was also essential.

Regardless of the decision made last week at the euro area's summit on the limited restructuring of the Greek public debt, changing the debt liabilities of struggling countries should be the last resort. Therefore, it is very encouraging that at the summit the heads of state clearly promised that Greece is, in every sense, an exception and that other countries honour their debt liabilities without any additional terms and conditions. I am certain that with strong political will, fulfilling the debt liabilities of all struggling euro area countries is realistic. In both the short and longer term, it would be very disappointing if a pre-emptive solution to public debt repayment problems were to be cavalierly attempted by violating loan contracts.

Today it is very clear that, despite the strong convergence of the economies of euro area countries, their economic growth and development cycles are and will remain different in the future. This applies to the United States of America, for example, where differences in the economic growth of various states are comparable to those of the euro area. The common monetary policy of the euro area must guarantee price stability in the single currency area as a whole. Nevertheless, differences in the economic structure and long-term growth outlooks of the euro area countries mean that in order to maintain economic stability countries must also use financial sector measures and other economic policy instruments.

According to most forecasts, including that of Eesti Pank, Estonia's medium-term economic growth outlooks are currently better than in the euro area on the whole. The experience of Ireland and Spain - these countries witnessed a situation comparable to ours before the global financial crisis - is an impressive example of how rapid growth easily induces imbalances even in the euro area. In such a situation, it is absolutely essential for us to use strong measures if necessary to maintain the stability of the economy.

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