Erkki Liikanen: The euro, integration and growth
Remarks by Mr Erkki Liikanen, Governor of the Bank of Finland, at the Brussels Economic
Forum 2008 on Economic and Monetary Union in Europe: 10 Years On,
Brussels, 16 May 2008.
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Ladies and Gentlemen,
Ten years of experience have shown that the monetary union has made a tremendous
contribution to the underpinnings for stable growth in the euro area.
The most important channel has been the maintenance of monetary stability, which reduces
distortions and costs caused by price uncertainty. In this respect, the euro has done very well
and this has been reiterated many times today. Rightly so.
I want to discuss other important aspects of growth in the euro area, many of which benefit
from the common currency. I will start by saying a few words about the role of financial
integration in catalyzing financial development. Related to this, I will discuss briefly some
recent studies that show how equal access to financial markets is an important determinant
of competition in the broader economy.
And finally, I will talk about productivity in non-market services; in particular, how improved
productivity in the provision of public services will be indispensable in reconciling sharply
rising old-age dependency with acceptable level public services. The last aspect is
particularly crucial now in Finland, which is the first EU country to face population ageing, but
it will soon been a major issue for the others, too.
But let me start with financial integration.
Financial integration and growth
It is difficult to think of a less opportune time to preach the virtues of financial integration.
Things being as they are, one gets the impression that what global financial markets are
propagating today is not growth, but risks and instability.
The persistent turbulence since last August has demonstrated once again that financial
markets suffer from bipolar tendencies. Overshooting tends to be followed by undershooting.
This time, a period of exuberance and indifference towards risk has been followed by a
period of exaggerated nervousness, risk aversion and distrust.
Once again, there are lots of lessons to be learned for financial institutions, central bankers,
regulators, supervisors. Our vocabulary has been enriched by great many acronyms that
were hardly heard of a year ago, such as ABS, CDO's, SIV's, ABCP's and so on. We are just
starting to form a picture of what this debacle means for policies. Eventually, the storm will
pass, and we will draw some conclusions. Here the recent report of the Financial Stability
Forum, chaired by my Italian colleague Mario Draghi, has made a major contribution.
The issues that we are facing are serious but they must be put in a perspective. Many
countries gradually liberated their capital account and removed credit controls in 1980'ies.
The consequences for the Nordic financial markets were profound. There was a period of
exuberance in the late 1980s, a housing and credit boom, followed by a banking crisis and a
deep depression.
The Nordic experience was not uncommon in those times, when many countries were
liberalising their markets, and it carries some resemblance to what we are experiencing
today. In both cases, advances in financial integration, combined with lack of sophistication
from market participants and policy makers, led to excesses and, eventually, to a costly
correction.
But what is important to bear in mind is that no country experiencing difficulties in those
times, seriously considered reinstating capital controls as a response to the crisis. Although
the pain at the time was real, there simply was no question that the benefits of financial
integration far outweighed any costs of transition.
The rapid growth experienced by Nordic countries including Finland over the last 15 years
would have been simply inconceivable without liberalised financial markets. The cost of
learning was high, but we emerged from the crisis stronger and competitive. And so it is
today. We should recognise and learn from the risks and vulnerabilities that manifest
themselves in the market turmoil. We should design the appropriate policy and regulatory
responses.
But we must not lose sight of the simple fact that the very same financial innovations that
now propagate turmoil also carry the potential of tremendous benefits in terms of lower cost
of finance and better diversification of risks. The challenge is to find the right balance of risks
and rewards. We need better incentive structures. We need better performance from rating
agencies. We need to enhance transparency. The regulators need to pay more attention to
liquidity risks. But still, we cannot design policies that eliminate risks.
The EU has made progress in financial integration. Last year, the ECB and the Commission
each published a report (Financial Integration, ECB 2007; European Financial Integration
Report, EC 2007) on the state of financial integration in the EU. The same issues were
further elaborated in the Commission report EMU@10, released just ahead of this forum.
These reports found that, in markets closely linked to monetary policy, the euro has
catalysed substantial integration. In particular, interbank markets are well integrated - or at
least were, and hopefully will be again, once the turmoil passes - as are government bond
markets and, increasingly, also corporate bond markets.
On the other hand, much remains to be done in other areas. The infrastructure supporting
bond and equity markets is fragmented and hinders competition. And, retail banking
continues to be mainly national.
Even a cursory look at how, say, housing finance works in the EU reveals that EU citizens
face a different reality in different EU countries. Interest rate linkages differ, loan margins
differ, fees differ, collateral requirements differ, and so forth. Not all of these differences are
undesirable; some of them may, for example, reflect quite legitimate variations in attitudes
towards risk.
But it is difficult to avoid the conclusion that not all EU citizens have access to the same level
of financial services. This carries a welfare cost, and that cost is carried by EU citizens in the
form of diminished opportunities to allocate consumption and investment over time.
Ample evidence from various sectors of the economy shows that financial development goes
hand in hand with financial integration. Protected sectors seldom develop. And so it is also in
financial services: it is the pressure of cross-border competition that will motivate innovation
and productivity improvement. The best way to guarantee a high level of financial services
for EU citizens is to remove the remaining obstacles to competition.
Better provision of services is one benefit of financial integration, better diversification of risks
is another. In times of turbulence, domestic orientation of a bank may look like a benefit -
after all, it insulates the bank from trouble originating from abroad. But a purely domestic
institution is highly exposed to country risk; when the crisis hits, it tends to hit hard, as we
found out in the crisis fifteen years ago.
The nature of diversification is that risks materialise more often, but each bank shares a
smaller part of them. Inherently, internationally diversified financial institutions are in a better
position to weather turbulent times. This, of course, provided that we design appropriate
regulatory and supervisory structures that allow holding cross-border institution to the same
prudential standards as domestic institutions.
Going international is one way for a financial institution to diversify risks. Another way is to
securitize and sell those risks. I realise that this may sound like a bad idea these days.
Fundamentally, securitization is an important innovation that carries substantial promise of
better risk management and, ultimately, even better financial stability. It seems obvious that
banks, which generally operate on a rather thin capital cushion, are not the institutions best
equipped to carry the bulk of the systemic risks of housing booms and busts. Why not allow
international investors such as insurance companies, pension funds, sovereign wealth funds
carry part of the risk? There is nothing fundamentally wrong about securitization - it was the
recent complex, structured applications that went wrong.
Besides cheaper funding and better diversification of risks, there is yet another reason why
we should be interested in financial integration and, as a part of it, increased securitization. In
the coming decades, the global population will age. Between now and then, those
approaching retirement will want to save. As a result, there will be an increasing global
demand for financial assets. Those economic areas that are able to generate good-quality
financial assets are going to be the winners in the global allocation of capital and financial
services. Securitization is one important way of generating such assets.
The euro, competition and productivity
As I noted in the beginning, the euro supports growth in various ways. Better anchoring of
inflation expectations creates a more secure foundation for contracts and spending
decisions. Broader home market helps European companies to utilise economies of scale.
And finally, the euro creates a platform for financial integration and development which, in
turn, are important determinants of competition and productivity.
On this last aspect, Rajan & Zingales wrote a couple of years ago a provocative book,
"Saving Capitalism from Capitalists". In the book they examined the various ways in financial
markets spread wealth and opportunity. The message is that the most important function of
financial markets is to promote competition and weaken the power of the incumbent.
Without well-functioning financial markets, economic power is in the hands of those who
have liquid wealth, collateral and connections, not in the hands of those who have ideas.
That is the recipe for stagnation. Financial markets create the opportunities for newcomers to
dislodge the incumbent, to leapfrog them by innovating. Competition increases, monopoly
rents fall, and productivity increases.
If Europe is to accelerate growth potential and promote the Lisbon targets, increased
competition is a necessity. Many are familiar with the study by Bayomi, Laxton and Pesenti
from 2004, which suggests that increasing competition in the euro area to the US level could
boost its output by no less than 12 percent.
Another study, conducted in the Bank of Finland for the Finnish economy, examined the
effects of a general increase in competition both in product markets and in labour markets.
The increase in competition is defined as a reduction of excess rents in these markets by just
a fifth - in other words, monopoly profits in the economy are reduced by 20 percent. This
assumed reduction in rents is rather modest, and the model does not assume the increased
competition to have any effects on the rate of technological change, so the total effect on
output is not huge, only about three percent. But more interestingly, real wages, which
initially fall, as wages are brought closer to the labour market equilibrium, soon rise again,
and end up also three percent above their initial level. Also employment increases by almost
two percent.
These are just model simulations and open to criticism, but the conclusion I draw from this is
the following: Product market reforms, if implemented well, are an important counterweight to
labour market reforms. They can support real wage development at times when labour
market reforms may have negative short-run effects on wages.
Productivity in public services
The single market, the euro, and free trade provide the right framework for the euro area
private sector to flourish and employ in the coming decades. However, for that strategy to
work we need to ensure that there is labour force for the private sector to employ in the
coming decades.
Population ageing of the scale we are facing will exert tremendous demands on the
resources of our economies. These demands are partly financial: the cost of old-age
pensions and health care will increase substantially and will challenge the sustainability of
public finances. To avoid taxes increasing to unsustainable levels, pre-funding is a necessity
in most countries.
Private sector productivity growth may also help, but does not solve the issue. First, pensions
tend reflect wages, through the accrual mathematics and through indexation, so that when
productivity gains boost wages, pensions tend to follow, with a lag, but eventually almost one
to one. And second, when private sector wages increase, so do the wages of health care
professionals on public payrolls. This is the well-known Baumol's disease.
With population ageing, the real demand for public health-care and elderly-care services
increases. So at the same time as working-age population shrinks, the public sector needs to
hoard an increasing number of workers. The labour resources available for the private sector
will diminish from two directions.
This is a challenge for which the response cannot be purely financial. If the economy simply
lacks the labour force to meet the rising demand for health care professionals, no amount of
prefunding can change that. Hence, the other part of the response must be to ease the
physical constraints by increasing productivity in public services.
Increasing productivity in public services is an agreed policy priority in many countries. Still,
experience shows that it is not an easy subject to discuss or to debate. When speaking about
productivity, an economist thinks about more and/or better services from same resources. A
health care professional may think about less personnel per patient, less time available to
respond to individual needs, and longer queues to operations.
To win the case in a debate, we need to have a response to these concerns. One useful
used way to conceptualise the issue is to think in terms of outputs and outcomes of public
services. An output is the actual physical result of action: a consultation with a doctor, a
home visit by a long-term care professional and so forth. Productivity in producing outputs
measures the efficiency of public services.
In contrast, outcomes relate to the ultimate policy goals: better health for the population, safe
and dignified life for the elderly. Productivity in terms of outcomes requires not only that
outputs are produced efficiently, but also that the outputs that are produces are effective in
delivering the desired outcomes.
So why does the debate on productivity tend to raise red flags amongst health care
professionals. It is because there is a general temptation to focus a productivity program
primarily on outputs rather than on outcomes. The reason is simple: First, outputs are
typically far easier to measure than outcomes; second, the link from inputs to outputs tends
to be far easier to establish than the link from inputs to outcomes.
A productivity program that concentrates on outputs may make great leaps in output
productivity, but no gain in terms of outcome productivity, because it promotes outputs that
do not correctly reflect the quality of services. This would be a sad result, indeed, and all too
common. It is what gives productivity a bad name and undermines public support for the
reform of public services.
These concerns need to be taken seriously. We need to resist the temptation to concentrate
only on what can be easily quantified. We have to accept that not all policy goals are easily
measured. Sometimes we may need to rely on information that is qualitative, even anecdotal.
Efficiency in producing outputs is vital for maintaining high quality public services, but we
must never lose sight of the fact that the ultimate policy objectives are defined in terms of
outcomes.
In short, we need to do right things and we must do them well.
Ladies and Gentlemen,
The euro has been a success to an extent few would have predicted ten years ago. Signs
are good that this success will continue - that the euro will continue to underpin price stability
and to promote economic and financial integration in the euro area and beyond.
But to be able to do that, the euro relies on strong political and public support. Population
ageing will present a challenge for that. If the euro area fails to prepare for ageing
appropriately, its economy will suffer, and eventually pressures will mount on monetary
policy: monetary policy will be asked to do something it cannot do. And then continuing the
success story would become much more difficult.
That is why it is so important for us to keep up the momentum in building a public sector that
can weather the pressures of population ageing. It's a long journey, so we have to keep
moving.
Thank you.