Vítor Constâncio: Growing out of the crisis - is fixing finance enough
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the Annual
Hyman P. Minsky Conference on the State of the US and World Economies, Washington
DC, 10 April 2014.
* * *
Introduction
In the wake of the financial crisis which started in 2008 and two years later evolved into a
sovereign debt crisis, there is little evidence that the European economy will soon be
returning to robust growth.
Risks for growth remain tilted to the downside. Many European countries are facing low
growth prospects and are plagued by record high unemployment, especially among the
young, pointing to a considerable slack in the labour market, lack of demand and subdued
inflationary pressures, which in turn complicate the deleveraging process of sovereigns and
households.
There is now a real but mild recovery going on, and there are, of course, a number of
narratives about what can and should be done to restore growth on the European continent.
Foremost among these is the idea that the economic recovery is hindered by weaknesses in
bank balance sheets, and that if the weak European banks were to be fixed, growth would
inevitably return.
Naturally, policy-makers have been aware of the negative effect that weak bank balance
sheets and deleveraging have had by restricting the normal flow of credit to the economy.
The ECB has gone to great lengths to support the bank lending channel, and we are now
conducting an asset quality review coupled with stress tests to ensure that banks complete
the process of repairing their balance sheets. Furthermore, the banking union, consisting of
genuine supervision and resolution at the European level, will be the most far-reaching
change introduced since the inception of the euro. European countries participating in this
project can rest assured that systemic risks will be better addressed in the future, enhancing
financial stability and boosting the credibility of banks.
Nevertheless, I would like to sound a note of caution and pose two questions about the
benefits of restoring a well-functioning banking sector in Europe, and its contribution to
growth:
• First, how can we take advantage, in terms of growth, of a dynamic and
sophisticated financial industry without running into the risks it tends to create?
• Second, is restoring a well-functioning financial system sufficient for robust
longterm growth?
The first question is important because even though financial intermediation undoubtedly
contributes to economic growth, the crisis has reminded us that finance can breed instability
too, and that the welfare costs of instability can be very high. It is important that we are
aware of the trade-off between growth and stability when designing an institutional
framework for the future in which finance is not excessive.
The second question is even more important, as it refers to the degree to which we can
expect robust financial sector-driven growth in Europe once the banking union becomes
operational and all the problems related to bank balance sheet weaknesses have been
properly addressed. It is my contention that the European economy is gripped by problems
that are more serious than bank deleveraging and also of greater consequence, because it is
not immediately clear how to address them. I will argue that even when bank balance sheets
have been fully repaired, structural problems related to the slowdown in emerging markets,
to weak domestic demand, and to structural phenomena such as the ageing population will
continue to hamper European growth prospects.
Finance and growth: an overview
The empirical literature on finance and growth has accumulated a substantial body of
evidence on the positive relationship between financial development and long-term economic
growth over the past 20 years. From the academic literature, we have learned that countries
with higher levels of financial development grow at a faster rate. Industries which have a
greater need for external finance and face better growth opportunities grow faster in
countries with a higher level of financial development.1 This positive effect has a well-known
microeconomic underpinning: financial deepening alleviates financing constraints at the firm
level, allowing firms to grow by engaging in higher capital investment and R&D investment,
among other things.2 This large body of evidence strongly supports the view that by inducing
a positive resource reallocation and by supporting the creative destruction-driven process of
technological innovation, financial deepening has a transformational effect on the real
economy.
At the same time, the global financial crisis of 2008-09 reminded us of the perils of finance.
Academic research has suggested that financial development does not have a uniformly
positive effect on economic growth, at all levels of financial intermediation. The evidence
points to the fact that there is a threshold beyond which the positive effect of finance on
growth starts petering out.3 A BIS paper puts that threshold at 100% to 150% of GDP.4 There
are different reasons for this concept of a threshold. For example, an excessively large
financial industry can lead to a migration of talented individuals away from productive
sectors.5 Alternatively, as the financial sector grows too large, financial intermediaries can
start taking on excessive risk, and this behaviour can expose the economy to large
macroeconomic contractions.6
In other words, while we know that we need a well-functioning financial sector, we have to
pay attention to its evolution. At reasonable levels, finance is essential for growth, but once it
grows to an excess, the damage it can do can easily wipe out its positive contribution. This is
why we should resist the efforts of the industry to push back on regulatory reform with the
argument that more finance is always good for growth and jobs. Fortunately, we will have
now a leverage ratio that will be an important instrument to control possible excesses of the
1
King, R., and R. Levine, 1993, "Finance and growth: Schumpeter might be right", Quarterly Journal of
Economics 108, 717-7137; Rajan, R. and L. Zingales, 1998, "Financial dependence and growth", American
Economic Review 88, 559-586; Fisman, R., and I. Love, 2007, "Financial dependence and growth revisited",
Journal of the European Economic Association 5, 470-479.
2
Love, I, 2003, "Financial development and financing constraints: Evidence from the structural investment
model", Review of Financial Studies 16, 765-791; Brown, J., Fazzari, S., and M. Petersen, 2009, "Financing
innovation and growth: Cash flow, external equity, and the 1990s R&D boom", Journal of Finance 64,
151-185.
3
Rioja, F., and N. Valev, 2004, "Does one size fit all? A re-examination of the finance and growth relationship",
Journal of Development Economics 74, 429-447; Manganelli, S., and A. Popov, 2013, "Financial dependence,
global growth opportunities, and growth revisited", Economics Letters 120, 123-125.
4
Cecchetti, S. and E. Kharroubi, 2012, "Reassessing the impact of finance on growth", BIS Working
Paper No 38.
5
Tobin, J., 1984, "On the efficiency of the financial system", Lloyds Bank Review 153, 1-15; Philippon, T.,
2010, "Financiers vs. engineers: Should the financial sector be taxed or subsidized", American Economic
Journal: Macroeconomics 2, 158-182.
6
Rajan, R., 2006, "Has finance made the world riskier?", European Financial Management 12, 499-533;
Brunnermeier, M., and Y. Sannikov, 2014, "A macroeconomic model with a financial sector", American
Economic Review 104, 379-421.
financial system, especially if its level will be set above the 3% of the initial proposal as it has
been done recently in the US.
Finance and growth in the post-crisis world
During the financial crisis, financial intermediation in Europe was greatly impaired, and the
recovery in credit supply has been slow at best. Credit standards for loans to enterprises
were reported to have been tightened by a net percentage of around 40% of euro area
banks, on average, in each quarter between the third quarter of 2007 and the second quarter
of 2009. After a period of stabilisation, they started tightening rapidly again in the summer of
2011.7 This process reflects the rapid deleveraging that banks have been engaged in. For
example, just between May 2012 and November 2013, the size of the collective balance
sheet of euro area banks dropped by €3.5 trillion. Households and firms in the euro area
have been strongly affected by this contraction of credit. Over the same period, lending to
non-financial corporations dropped by €361 billion, or 7.5%.
In the light of my discussion of the effect of finance and growth, this is not necessarily an
unnatural development. The euro area financial sector was overextended before the crisis,
with the balance sheets of the euro area's largest banks remaining even today among the
largest in any region of the world. Contraction is the only way to bring the financial sector to a
more "reasonable" size which is relatively more conducive to long-term economic growth. Of
course, we do not fail to recognise that in a recession environment, bank deleveraging
makes policy-makers' goal of encouraging lending to non-financial corporations, and
especially to SMEs (which provide the bulk of employment in Europe), very problematic.
Many countries have in the past experienced boom-bust episodes brought about by some
sort of financial market excess. The three major types of such excess are asset price booms,
credit booms and real estate booms. The recessions that follow any of these episodes are
deeper than standard business cycle contractions; they are even deeper when two of these
excesses take place at the same time; and they are deepest when all three are present.8 The
global financial crisis was preceded by all three, and so the sluggish recovery of the
European economy simply reinforces conventional wisdom.
The resulting state of affairs is a so-called "creditless" recovery in the euro area. Right now
we are witnessing the co-existence of low levels of credit to the private sector and three
consecutive quarters of positive GDP growth. Such creditless recoveries are far from
unusual: one out of five recoveries is "creditless", and output growth during creditless
recoveries tends to be lower than output growth during recoveries when the financial sector
is not impaired. Such recoveries are particularly common after financial crises, and are often
preceded by high levels of private sector indebtedness.9 Nevertheless, it seems that
declining bank credit to the private sector does not necessarily constitute a constraint on
economic recovery once output has bottomed out. Moreover, credit growth and output
growth tend to be uncorrelated in the aftermath of financial crises that were preceded by
credit booms, suggesting that private sector deleveraging does not necessarily pose a threat
to the post-crisis recovery. A recent BIS paper extends earlier evidence for emerging
economies to advanced economies.10 International evidence suggests that recoveries
following financial crises are often not just creditless, but also jobless.11
In other words, following a financial crisis, it is not uncommon to have a recovery without
finance. This is an important observation, and one that is at odds with the conventional
wisdom that finance is indispensable for economic growth. Numerous voices these days urge
European policy-makers to repair the balance sheets of banks so that they can lend again
and in the process jump-start GDP growth. There will be no growth without finance, the
narrative goes, and the fact that the United States has returned to robust economic growth
faster than Europe is to a large degree put down to policy-makers acting quickly to repair the
balance sheets of US banks.
This narrative, while intuitively compelling, is missing two crucial points. The first is that bank
balance sheets in the euro area have to a large degree already been repaired. For instance,
since the onset of the global financial crisis until last year, the top 20 European banks have
increased their capital in absolute amounts net of shares buybacks by 60% more than the
top 20 American banks. As a result, large parts of the sector now fully comply with the
minimum capital requirements under Basel III well ahead of 2018. The remaining weakness
will be addressed in the near future, and once the architecture of the banking union is
operating after our comprehensive assessment of banks' situation, I expect that the
European banking sector will be in a solid shape.
But even if we were to agree that finance is a necessary condition for growth (a conclusion
that is called into question by the prevalence of creditless recoveries), it is far from clear that
finance is a sufficient condition for jump-starting growth in Europe. I will argue that even a
complete rehabilitation of the euro area's banking system (which is well on its way thanks to
the various policy steps related to the banking union) will not guarantee a quick return to high
growth and low unemployment. In fact, the euro area economy faces a number of issues
which are potentially more serious than the damage inflicted by the financial crisis and the
subsequent euro area crisis on the euro area banking sector. These issues are also far more
difficult to address.
Short-run non-financial impediments to growth in Europe
Let me now talk briefly about what I believe are the chief obstacles to growth in the future. I
want first to highlight three short-term impediments in Europe: the slowdown in emerging
markets, the fall in domestic private investment, and weak domestic demand. I will then
move on to longer-term considerations.
In my view, chief among these short-term impediments is the remarkable slowdown in
emerging markets. Take as an example the four BRIC countries (Brazil, Russia, India and
China). While in 2007 these countries grew at an average rate of 9.8%, in 2013 they
managed a rate of growth of only about 4%, on average, the lowest growth rate in more than
a decade if we exclude the crisis in 2009. This was largely due to country-specific factors,
such as excessive investment in China and infrastructure and regulatory bottlenecks in Brazil
and India, to mention just a few. This process is necessarily accompanied by a reduction in
demand for foreign goods, including euro area exports. This is bad news for the euro area,
whose recovery so far has been largely driven by export strength. In addition to structural
issues, there are a number of potential risk factors that have not materialised. For example,
there is a risk of a real estate bubble in Brazil, where house prices have doubled in three
years.
A second important factor is the large drop in domestic private investment following the
onset of the global financial crisis. Between 2007 and 2011, private investment in the then
27 countries of the EU fell by €354 billion, a 15% decline relative to its 2007 level. This
compares with a mere €17 billion (or 0.2%) drop in private consumption. While it is not
unusual for private investment to fall sharply during a contraction in real GDP, its contribution
to the latest contraction in the EU is among the largest on record, and some countries have
seen unprecedented declines (for instance, over the same period private investment declined
by 27% in Spain, by 47% in Greece and by 64% in Ireland). Today, private investment is
almost 20% below a 25-year trend that came to an end with the financial crisis.12
The third important factor is weakness in domestic demand. This is often left out of the
public discourse, but micro evidence suggests that it is a problem that cannot be
underestimated. For example, SMEs interviewed for the ECB's "Survey on the access to
finance of small and medium-sized enterprises in the euro area" have consistently cited
"finding customers" as their most pressing concern. This suggests that euro area
corporations face serious problems on the demand side which seem to be more pressing
than the problems stemming from the bank lending channel. By way of comparison, while in
the latest wave of the survey 24% of euro area SMEs cite demand concerns as the most
limiting factor in their operations, only 16% cite "access to finance" as their most pressing
concern.
Of course, this is not to say that financial sector weaknesses are not important, or that they
are not recognised. The massive Comprehensive Assessment of banks' balance sheets is
proof enough that we take the matter very seriously. My point is rather that while the ongoing
deleveraging in the banking sector certainly plays an important role in the inadequate current
levels of credit supply to the real economy, factors related to the demand side are even more
important. The weak demand outlook combined with slack industrial capacity is the most
important explanation for the drop in private investment during the crisis, and the most
important limiting factor for future investment.
Long-term trends in growth: the global economy
Let me now turn to the other fundamental challenges for growth that lie ahead of us, for the
world economy and, in particular, for the euro area. After almost a decade of relatively
fastpaced economic growth and subdued inflationary pressures in the period preceding the
crisis, the "Goldilocks era", we thought that the potential growth rate of the world economy
could continue along the same trends. The global financial crisis has shaken our certainties
about the sources of global growth, namely: (i) an endless growth of the world population,
global trade and financial integration; (ii) the contribution of emerging markets as a separate
engine of world growth; and finally (iii) the impact of technological progress, largely driven by
the information technology and communication revolution.
Let's assess the solidity of these pillars of global growth, five years after the start of the
global financial crisis.
According to a recent report that has been produced by the Centre for European Policy
Studies (CEPS), the global population may peak by 2030. The negative impact that this has
on future growth has to be weighed against the positive effects stemming from contained
pressures on natural resources and energy. There is evidence that trade globalisation may
have already reached a peak, and the potential for further financial globalisation is likely to
stem mainly from developments in emerging markets.13
The global value of trade as a ratio of world GDP peaked at 64% in 2008, compared with
an average of less than 40% in the 1980s. Over the intervening period, from the 1990s to
2007, the trade volume of goods and services grew, in real terms, at a remarkable pace of
around 7% per year, on average, while it has posted a meagre rate of less than 3% in the
past two years. Overall, according to IMF projections, world trade seems to have stabilised
relative to world GDP around a plateau close to the level reached in 2008.
The financial crisis has been accompanied by a significant retrenchment in cross-border
financial flows, concentrated in particular in banking flows and, to a lesser extent, in
portfolio and FDI flows.14 Across advanced economies, a revival of the boom in financial
integration that we experienced in the first decade of this century is unlikely.15 Nevertheless,
the scope for financial deepening and capital account liberalisation is still large across
emerging markets. This represents an opportunity and, at the same time, a significant
challenge for emerging markets, the second pillar of the growth of the world economy.
Let me then briefly discuss the role played by emerging markets. For the first time, at the end
of last year, emerging markets and developing economies accounted for more than 50% of
world GDP, when measured at purchasing power parity. From now on, it is legitimate to
expect that the value added produced by emerging and developing economies every year
will be larger than that produced by advanced economies. Moreover, emerging markets are
expected to grow at a pace of more than 5% on an annual basis, more than twice the pace of
advanced economies, so that their share in the world economy is bound to grow further.
Can emerging markets represent an independent source of world growth? It is questionable
that this will be the case. Much of the catching-up potential that emerging markets had at the
beginning of the 1990s, in terms of capital accumulation, innovation and employment growth,
has already been realised. Over the medium to long term, the growth path of emerging
markets may remain bumpy, in particular if emerging markets fail to manage the process of
financial and capital account liberalisation or, as in the case of China, the needed
rebalancing from investment to consumption as a main driver of domestic growth.
The third pillar of long-term growth is further technological progress. Recent work by one of
the leading scholars of growth theory, Robert Gordon, offers a particularly downbeat
assessment of the future of innovation. His main tenet is that innovation is not a continuous
process, but a discrete one where waves of inventions are followed by their application and
refinement to extract their full potential. Against this metric, though, the latest ICT revolution,
having generated a rather short-lived increase in productivity, ranks well below previous
industrial revolutions.16
Even if the rate of technological progress were to continue at the same pace of recent years,
according to Gordon, the US economy in any case faces severe "headwinds" due to
demography, education, inequality, globalisation, energy/environmental factors, and the
overhang of consumer and government debt.
Gordon's pessimism seems to have been rather contagious. Late last year, first Paul
Krugman and then Lawrence Summers wondered whether advanced economies were
slipping into a state of "secular stagnation".17 This could be depicted as a condition where the
natural and equilibrium interest rate, the rate equalising desired savings and investment at
full employment, is negative and economies are forced to generate bubbles and an overhang
of private or public debt to support aggregate demand. Research at the BIS shows that,
accounting for the financial cycle - including in particular information on the growth of credit
and property prices - potential output estimates are much lower before the crisis and display
less volatility during the crisis. This can be reconciled with a view reflecting the unsustainable
nature of the pre-crisis financial cycle, leading to a rethinking of the potential output
measurement to include the effects of the financial cycle.18
The main concern is that this potential "secular stagnation" severely curtails the scope for
using traditional policy levers, hampering the growth of advanced economies so that it
remains below potential. On the one hand, the zero lower bound to nominal interest rates
constrains monetary policy; on the other hand, after governments have absorbed the
liabilities of the private sector following the bursting of the bubble and public debts have
swollen, the room for expansionary fiscal policies is severely limited.
Long-term trends in growth: the euro area
Is the euro area at risk of ending up in secular stagnation? Looking ahead, what are then the
growth prospects and challenges for the euro area?
On the back of the fall in capital accumulation and labour utilisation, euro area potential
output growth declined from a level close to 2% in the years preceding the crisis to less than
1% on average between 2008 and 2012. Notably, total factor productivity, which gauges the
efficiency of the use of the factors of production, even though subdued, contributed only
marginally to this decline.19 However, over the medium to long term, cyclical factors dragging
down potential output are expected to fade, with investment recovering through the
normalisation of the credit channel and net immigration, which also has an indirect impact
through an increase in the fertility rate, providing renewed support to the employment
contribution. According to the estimates of the European Commission's Ageing Working
Group, euro area potential output growth is expected to rebound to around 1.5% until 2025,
mainly on the back of a positive contribution from labour input, and then to even out to 1.3%
over the long run.
For the euro area, the main structural challenge is posed by the ageing of the population and
the ensuing decline in the share of the working age population. According to the CEPS report
already mentioned, the European working age population will decline annually by 0.6% until
2030, meaning that the contribution of labour to potential output is projected to become
negative. Potential output is expected to be supported by capital deepening, around half a
percentage point, and, crucially, total factor productivity, assuming that it resumes growing at
an annual pace of close to 1%, the rate prevailing at the beginning of the previous decade.
Unfortunately, since the start of the crisis, euro area total factor productivity growth has
remained subdued, falling behind productivity growth in the United States, where it
rebounded after reaching a trough in 2009. The crisis and the persistent low levels of
capacity utilisation led to a destruction of human capital in those firms and sectors
experiencing the most dramatic downsizing. In the euro area, the greater rigidity of labour
and product market regulation as compared with the United States is likely to have hampered
the needed reallocation of resources towards the most productive sectors. I will come back to
this later; the point I want to make now is that there are downside risks to the long-term
projections for the growth of euro area total factor productivity, unless the euro area
implements reforms that foster innovation, competitiveness and the reallocation of resources
towards the most productive sectors.
What can policy do?
During the financial crisis and the ensuing sovereign debt crisis, policy was mostly focused
on stabilisation. Restoring confidence in the banking system and repairing excessive
indebtedness were the two most pressing concerns, and they were addressed forcefully.
Today, the euro area's economies have largely been stabilised relative to three or five years
ago.
On the basis of current trends, the euro area is facing a medium-term future of stable but low
growth, with unemployment evolving to lower levels in 15 years as a result of a declining
active population. Europe has to react swiftly if it wants to avoid a whole generation being
wasted and sacrificed. Can structural reforms provide a solution in the long run? There is not
much we can do about the ageing of the population because European politics is refusing
immigration and going Malthusian. In this context, can policy address the dual problems of
weak demand and slack industrial capacity?
Regarding demand, only a few countries have financial scope to stimulate consumption and,
more importantly, to increase public investment in a context of very low interest rates. That is
the answer that Bernanke and Blanchard suggest to dispel the risks of secular stagnation.
The reality is nevertheless that Europe as a whole is still pursuing consolidation to achieve a
reduction of debt ratios. In this context, the challenge is to counter the structural impediments
driving potential growth down, above all the negative demographic trends, in a situation in
which the scope and effectiveness of conventional macroeconomic policies is reduced. I will
contend that it is of paramount importance to carry out those structural reforms that may
increase the participation rate of the labour force and lead to a more efficient use of the
factors of production. Reforms aimed at increasing investment and employment in the most
productive sectors are particularly needed at the current juncture.
The preliminary findings of the Eurosystem's CompNet network, which has collected
competitiveness indicators across a huge sample of about 700,000 firms from 11 EU
countries, show a strong heterogeneity of firm labour productivity within and across
countries. The distribution of firms' productivity, or cost structure, is not only very dispersed
but also very asymmetric: there are few champions and a high proportion of low-performance
firms. For policy-makers, this has two major implications. First, when talking about the
competitiveness or productivity of a country, we must look much deeper than simple average
indicators, such as unit labour costs or market shares. The same policy intervention may
produce different results, depending on the initial distribution of firms' productivity, even if
average productivity is the same. Second, the dispersion and skewness of firms' distribution
have important implications for aggregate productivity growth. A recent strand of literature
has shown that aggregate productivity in a country may be lagging behind partly because
inputs are not allocated efficiently across firms or industries. This suggests that there is
significant scope to increase productivity through targeted policies, such as product market
reforms, that facilitate the reallocation of resources across sectors and firms. For instance,
the work of the CompNet network shows that better regulated industries are able to channel
resources more efficiently to the most productive firms. Moreover, it can be shown that the
contribution of the reallocation of resources to productivity growth has been reduced during
the crisis period in some countries, such as Italy and Spain. This evidence may be viewed as
an indicator of structural rigidities which have become binding in the great recession.20
Labour market reforms have also been advocated by many commentators. A widely held
view during the 1990s was that labour market institutions were too rigid and that the common
currency would make reform of these markets even more urgent. In the absence of
countryspecific monetary policy, and with national fiscal policy bound by rules, labour market
flexibility needed to become an important channel of adjustment.21
This is added to the fact that labour mobility across national borders is traditionally low, with
migration responding considerably more slowly to regional labour shocks than in the United
States.22 The crisis itself had a more pernicious and long-lasting effect on the euro area
labour market through the increase in "structural unemployment" and "skills mismatch", with
the unemployment rates of those staying out of work for longer and those with lower skills
increasing more in relation to the average unemployment rate. Participation rates have been
negatively influenced by "discouraged" worker effects.
Pressed against the wall, however, governments have recently acted to provide a legal
framework for more growth. For example, Greece, Portugal and Spain have reformed their
legislation to reduce the burden on firms and to encourage hiring and labour mobility. More
can be done to reduce the corporate labour burden further and to ensure a level playing field
that does not hinder young people and favours insiders. Encouraging a more flexible
governance structure of labour market institutions accompanied by an appropriate social
safety net and active labour policies can also contribute to a reallocation towards more
productive sectors.23
While a well-functioning safety net reduces the short-run consequences of high
unemployment, the fact that so many (in particular young and educated) workers are out of
work today could have serious implications for long-term growth prospects in Europe.
Persistently high unemployment diminishes the economy's ability to cope with more turbulent
economic developments, such as the restructuring from manufacturing to the services
industry, the adoption of new information technologies, and a rapidly changing international
economy.24 It is important to recall that Europe still has a lot of improvements to make in
terms of increasing the segment of the population with a complete tertiary education, a
measure on which we lag well behind the United States and which is so important to foster
total factor productivity.
Policy-makers can tackle the negative long-term consequences by enacting policies aimed at
reducing the negative impact of long-term unemployment on human capital. One such policy
that has proved effective in the past is training. On-the-job training provides workers with
general skills, but especially with the industry-specific skills that are indispensable in today's