Lorenzo Bini Smaghi: Real and nominal convergence - policy challenges
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the Conference on European Economic Integration 2007, Currency and
Competitiveness, Austrian National Bank, Vienna, 20 November 2007.
* * *
1. Introduction1
Ladies and gentlemen,
It is a real pleasure for me to speak to you today at this conference.
As you know, the Maastricht Treaty - and in this respect the Reform Treaty has not changed
anything - says very little on the real economy, aside from the fact that growth and
employment are an objective of the Union. The articles contained in the monetary chapters of
the Treaty all refer to nominal variables, be they monetary policy or inflation, and so does the
section that describes the criteria and procedure for the adoption of the euro. This does not
mean, though, that the underlying developments in the real economy are unimportant. In
fact, there is a burgeoning literature on the impact that the euro has had on the convergence
of the member economies. Among such a wide range of academic contributions, let me refer
in particular to papers presented at a conference organised by the ECB in June 2005, which
provide evidence of the changes brought about by the euro with respect to trade integration,
structural reforms, financial integration, business cycle synchronisation and inflation
differentials.2 I will not dwell on those topics today, but will certainly refer to the literature in
addressing the specific issue of convergence towards the euro area.
As I just mentioned, the criteria for adopting the euro refer to nominal variables - the inflation
rate, the long-term interest rate and the exchange rate - and to the budget deficit and debt
ratios. Is this a problem? Should the Treaty have been drafted differently? I will argue to the
contrary. However, while it is wrong to suggest that the adoption of the euro solves all
problems, it is equally wrong to suggest that real convergence does not pose considerable
challenges in the path towards the adoption of the euro. The key policy message is that
these challenges can be addressed as long as one is aware of them and explicitly takes
them into consideration. Hiding the issues does not help. It might actually backfire if and
when difficulties arise as people might be inclined to think that the root of all problems lies
with the euro and its early adoption, rather than inappropriate policy actions in other fields.
This is not just a hypothesis. It's what we observe every day, even within the euro area, with
politicians claiming that Europe and the euro are to blame for their lack of success.
In my speech today, I would like to consider the case of countries which are converging in
real and nominal terms towards the euro area.3 Can both processes take place in parallel?
What are the challenges? How can monetary, fiscal and structural policies best tackle them?
Let me also emphasise that the issue is relevant not only for the countries concerned but
also for the whole of the European Union, in light of the existing strong economic ties. For
example, the trade share of the new EU Member States, excluding Slovenia, is 18% for
Germany, 9% for France and 12% for Italy. These share are comparable to that of the US
and more important than China. Links through financial and foreign direct investment are
also equally, if not more, important. Of course, the euro area is also very important for the
New EU member states, representing 62% of their external trade. It is not far-fetched to say
that to some extent we are "all in the same boat".
I will structure my remarks in two parts. I will first propose an analytical framework to examine
the issue in a systematic way. I will then discuss some examples within the euro area.
Finally, I will try to draw some policy lessons from both theory and experience.
2. Analytical framework
Let me start by laying out a framework to interpret real and nominal economic convergence.
2.1 Structural forces driving convergence, real appreciation and external deficits
Let us take two hypothetical countries, an advanced one, which I'll call for simplicity West,
and one that is emerging and catching up, named East. Real economic convergence should
imply a higher marginal return on capital in East compared with West, due to the fact that
capital is scarcer and due to decreasing returns on capital accumulation. In a closed
economy, this translates into a higher real equilibrium interest rate in East compared with
West. In a world with full financial integration, we would observe large capital flows from
West to East. Since people in East expect to be richer tomorrow and want to smooth
consumption over time, they will borrow, the more so the higher the expected economic
growth rate.
This phenomenon will not happen if there are financial frictions and borrowing constraints in
East which prevent the real interest rate from rising or the borrowing demand from being
satisfied. In that case we might even observe that the flow of capital is reversed, from East to
West. This is the so-called Lucas paradox; it's what we are currently observing, for example,
in some eastern Asian economies, notably in China, and what we saw in western Europe in
the 1950s and 1960s. In central and eastern European countries, there does not seem to be
such a paradox. There are, by and large, no borrowing constraints as countries are bound by
what is called the acquis communautaire, in other words, all the laws and agreements,
including the treaties that apply in the EU. Perhaps what is more important, they have
implemented banking sector reforms that have led to an increase in banking competition.4 So
in the case of the European Union the theory works.
Another element of the theory which seems to be working to some extent is the
BalassaSamuelson effect, which contributes to a real exchange rate appreciation in East.5 The real
exchange rate appreciation associated with real convergence can obviously happen in two
ways (or a combination of them): first, with a stable nominal exchange rate and high inflation,
as in Japan in the postwar period up to the early 1970s; second, with an appreciating
nominal exchange rate and stable low inflation, as in Japan in the subsequent period up to
the early 1990s. I will not dwell on the choice of the exchange rate regime in my speech
today, apart from noting that the second channel of real appreciation is obviously precluded
after a country joins the monetary union.
2.2 "Disequilibrium" real appreciation
While the theory suggests that real appreciation and balance of payments deficits are the
natural consequences of real convergence, it does not follow that any such appreciation or
deficit is justified in size. Real appreciation and external deficits may become excessive as a
result of inappropriate policies and/or excessively optimistic expectations by economic
agents.6 Conceptually, this is no different from bubbles and busts in asset prices, which may
be initially triggered by a real, fundamental reason (such as higher productivity growth or
monetary policy shocks) but may then be inflated disproportionately by excessive
selffulfilling expectations.
In our example of East converging to West, the above risk may materialise when investor
exuberance in East, supported by expectations of rapid economic and monetary integration,
generates excess demand and inflationary pressures. Risk premia in East may be
excessively squeezed,7 leading to asset price misalignments (e.g. in housing) and
overindebtedness in a context of still abundant global liquidity and strong risk appetite. Irrational
optimism on the side of wage earners can add to the risk. Such a scenario represents an
"out-of-equilibrium" real appreciation, leading to an overshooting that is typically observed in
boom-and-bust cycles. There is abundant literature on this phenomenon.
The key question is what to do to avoid such a scenario.
2.3 Adjustment in a monetary union
Let's consider first the case of a monetary union which, as I mentioned previously, puts a
constraint on real exchange rate movements or, more precisely, a constraint on
competitiveness within the union. Let us go back to the idea that the expected real marginal
product of capital is higher in East. If the nominal exchange rate is fixed and there is
sufficient capital mobility within the union, capital inflows in East must be accompanied by a
combination of (i) balance of payments deficits, and (ii) higher inflation. This should gradually
be reversed as the real convergence process runs its course and the excess return on
investment opportunities is absorbed.
What is the adjustment mechanism? If inflation rises above the average, the country loses
competitiveness and this has, over time, a dampening impact on inflation. The point can be
illustrated clearly using an open economy Phillips curve where the real exchange rate
appears as a determinant of inflation.8 What effect prevails, and at what speed, depends on
the relative importance of the two channels in the Phillips curve. Ceteris paribus, the more
integrated and flexible a country, the likelier it will be that the forces of convergence prevail
over those of divergence. Research shows that in the euro area the competitiveness channel
works satisfactorily and that, abstracting from trends related to Balassa-Samuelson effects,
deviations from PPP are mean-reverting. According to this research, the adjustment in the
euro area is actually found to be quicker in Economic and Monetary Union than in regions of
the United States.9 However, more research is needed on this important issue; moreover,
the situation is clearly different across countries, depending on the degree of integration and
flexibility.
Due consideration should be given to the fact that the adjustment channels might be
impaired in some cases. If nominal and real rigidities as well as financial frictions are limiting
the scope for relative price changes, or weakening the expenditure-switching role of relative
inflation differentials, the convergence process in a monetary union could be rather bumpy.
This may occur, for example, if the massive inflow of capital and exceptionally low risk
premia are rapidly reversed and followed by an equally large outflow as the adjustment takes
place and as risks are re-appreciated .
It is important to recognise that membership of a monetary union increases the likelihood of
excessively low risk premia and a pro-cyclical behaviour of real interest rates, which might
temporarily slow down or even destabilise the structural adjustment process. Indeed, within a
monetary union, forces exerting upward pressures on inflation tend to become self-sustained
and more likely to give rise to an abrupt adjustment. Since the nominal interest rate is fixed at
the union level, any shock bringing inflation above the union average will reduce the real
interest rate and fuel further inflationary pressures, in a self-reinforcing mechanism.10
In a boom-and-bust scenario, such as the one I have described, which is a real risk in a
monetary union or with a fixed exchange rate regime, policy-makers undoubtedly face the
very difficult challenge of having to avoid an overheating of the economy in the face of
surging capital inflows and rapid credit growth. Monetary policy would be the ideal instrument
to tackle such a problem but it is simply not available. Actually, monetary policy makes things
even worse for East, because it is set by West with a view to ensuring price stability in West
itself. Given the convergence process and the required higher rate of growth of productivity
and income in East, as compared with West, the monetary policy set by West is too
expansionary for East. As an illustration, a 4% interest rate might be appropriate for an
economy growing at a steady state rate of 2% and with 2% inflation - I'm giving these
numbers for purely illustrative reasons - but is certainly not appropriate for an economy
growing in real terms at 6% or more, as required by the catching-up process. As the
inflationary pressures arise in East, the monetary policy becomes pro-cyclical, further
destabilising the economy and making the adjustment more abrupt later on.
The recent financial turbulence in the United States and Europe has shown the dangers of
keeping interest rates too low, compared with the economy's underlying rate of productivity
and income growth, for a prolonged period of time. When I raised the issue myself, about two
years ago, I noted that there was still very little literature on this issue.11 Some progress has
been made, but the issue is still not sufficiently recognised in academic and policy fora.
Indeed, when one looks at the current situation in many emerging market economies, one
cannot but be struck by the huge gap between these two variables which, in my view, is the
sign of a major distortion in the allocation of resources that might lead to future abrupt
12
adjustment.
Fiscal policy can be activated to attenuate the inflationary pressures arising from the
monetary stimulus, but the size of the fiscal restraint might have to be quite ample. Banking
supervision and related prudential measures could also be implemented to limit credit
expansion. Their quantitative impact is of course uncertain, especially in an environment of
full capital mobility. Capital controls might be applied to contain inflows, but they are not
allowed in the EU.
2.4 Summing up
What can we learn from all this? Let me recap the reasoning in three main developments that
can be expected from real convergence in a monetary union:
•
First, real convergence may entail a higher return on capital for some time in the
catching-up country and a substantial appreciation of the real exchange rate, which
is to be considered, to some extent, as an equilibrium phenomenon and a natural
consequence of real catching-up dynamics.
• Second, within a monetary union or with a fixed exchange rate system, the
appreciation of the real exchange rate may take place through a higher inflation rate.
•
Third, as a consequence of the above, the inflationary process associated with the
real exchange appreciation may fuel an inflationary spiral that entails an
overshooting of inflation and a boom-and-bust cycle. In this context, nominal
convergence is not consistent with the continuation of real convergence and might
imply large adjustment costs.
How can these last developments be avoided?
The key word is flexibility. Let me elaborate on this. First, there must be flexibility in the wage
and price adjustment setting. Since the process of real convergence requires significant
movements in the real exchange rate and since in a monetary union the nominal exchange
rate cannot be used as an adjustment tool, it is of paramount importance that prices can
move quickly in the required direction. A key aspect is thus wage formation. Movements in
the real exchange rates must be rapidly reflected in movements of real wages - in the
opposite direction (!) - in order to preserve the competitiveness of the economy. We do have
some evidence that some new Member States score quite well in terms of labour market
flexibility.13
However, the situation is not the same across countries.
Movements in the real exchange rate should, and will, bring about demand shifts between
tradable and non-tradable goods and more generally between different sectors of the
economy. In the era of globalisation, this cannot only be described as a problem for EU
countries. In fact, membership of the EU and of the monetary union can be characterised as
a "regional globalisation" due to the trade-enhancing effects of the euro.14 It is of great
importance that the economy is flexible and able to reallocate physical and human capital
across different production locations. The ability to shift production seamlessly from the less
competitive to the more competitive sectors is a hallmark of countries dealing successfully
with globalisation. It is also true for success in the monetary union.
A study of the administrative burdens in the new EU Member States on the basis of
indicators published by the Fraser Institute shows that the business environment has
significantly improved in those states over the past few years.15 However, on average in
2004 it had still not reached the average level of the euro area countries and there remained
significant differences between the new EU Member States. Another indicator, the OECD's
country score index on barriers to trade and investments, shows an overall decline from 1998
to 2003 both in the euro area and in the four largest EU new Member States, but on average,
they remain higher in the latter. This would suggest that more needs to be done to make the
economies of the New Member States more flexible so that they can respond to the
challenges they face in the process of real and nominal convergence.
3. Some interesting examples
Let us now see how the conceptual framework that I have just described works out in
practice.
3.1 Some stylised facts
Let me consider the experiences of countries that are already in the euro area. This might
teach us something useful about the challenges that the new Member States may face in
converging towards the euro adoption. In 1995, i.e. a few years before the launch of the
euro, there were a handful of countries with a real GDP per capita significantly below the
euro area average: Greece, at 65%, Spain, at 79%, Portugal, at 65%, and Ireland, at 89%. If
we look at the new Member States (data for 2006), we see a range of between 34%
(Romania and Bulgaria) and 72% (Czech Republic) of euro area GDP per capita. For some
of these countries, we are already in a situation similar to that of the countries catching up
with the euro area in 1995; currently, the Czech Republic already has a higher income per
capita than Portugal and is very close to Greece and Slovenia.16 For some other countries,
however, and notably for Bulgaria and Romania, the degree of the required catching-up is
nowhere near to the income gap for the original euro area members. We are therefore in a
new situation here.
A stylised fact in the adoption of the euro in 1999 was that the convergence of nominal
interest rates was accompanied by the convergence of the real interest rate.17 The real
interest rate of previously high-inflation countries such as Greece, Spain, Italy and Ireland fell
substantially as these countries were able to slash inflation and exchange rate risk premia. In
Italy, for example, the real short-term interest rate fell from over 5% in the nine years before
the euro to 1% in the nine years thereafter. Nevertheless, convergence has not been
completed. This is related to persistent inflation differentials among the euro area countries,
which has been the subject of quite some attention in the literature.18 Higher-inflation
countries, such as Spain and Ireland, have experienced systematically lower (and in the Irish
case often negative) real interest rates than lower-inflation countries such as Germany,
despite their higher (potential) growth.
In theory, as I said earlier, the self-sustaining nature of real interest rates in the different
countries of a monetary union can fuel divergences within the union. But these forces are
partly countered by the loss of competitiveness, which has a dampening effect on inflation. If
you want to see the glass half empty, you could argue that this second force has not yet
been strong enough to prevent persistent inflation differentials across countries. I prefer to
see the glass half full by noting that inflation differentials within the euro area have remained
at a relatively low level, fully comparable with divergence among US regions and well below
the cross-country variation seen before the mid-1990s. This observation is also true when we
look at business cycle fluctuations, which appear to be quite synchronised within the euro
area. This is not to say - of course - that the differences between real interest rates across
countries are of no concern.
3.2 Ireland v Portugal
In the remainder of my speech, let me focus on two extremely different performances within
the euro area: Ireland and Portugal. Real GDP per capita in Ireland was 89% of the euro
area average in 1995, but was already above the average in 1998. Between 1998 and 2006,
real income per capita increased by almost 25 percentage points, to reach 131% of the euro
area average in 2006, which is the second highest after Luxembourg. (Based on these
numbers, it is surprising how many people still speak of Ireland as a catching-up economy).
As for Portugal, its income per capita was 65% of the euro area average in 1995, a figure
which has changed little in over a decade (it was 67% in 1998 and 68% in 2006). The bottom
line is that real per capita income in the two countries was not very different in the early
1990s but became twice as large in Ireland by 2006. How could that happen?
The answer to this question may well matter since Ireland and Portugal in 1995 were in a
situation not unlike that of some new Member States now (though, as we have seen, for
some of them the starting point is significantly lower).19 One approach to understanding the
difference can be found in growth accounting exercises. The stellar growth performance of
Ireland was not just due to higher labour and capital input but also, and mainly, due to labour
productivity growth, which has been close to 3% per year since the introduction of the euro
and, according to available estimates, almost entirely due to growth in total factor productivity
(TFP). In Portugal, growth in labour productivity has been less than 1% per year on average,
reflecting subdued TFP growth.
In the decade before joining the euro area both Portugal and Ireland went through a boom,
with annual average GDP growth rates at 2.8% and 6.7%, respectively (1990-1998). This
strong growth masked substantive differences. While fiscal policy was pro-cyclical in
Portugal, reinforcing domestic demand pressures, it was much more disciplined in Ireland.
While growth in unit labour costs and HICP inflation was high in Portugal (7.6% and 6.2% on
average between 1990 and 1998, respectively), cost and price pressures remained
contained in Ireland (1.4% and 2.3%, respectively). Competitiveness was hurt in Portugal,
resulting in a rising current account deficit (to 8.9% of GDP in 1999), while competitiveness
was relatively well preserved in Ireland and the current account position broadly neutral
(0.3% of GDP in 1999). Thus, the longer-term track record before joining monetary union
regarding low inflationary pressures and a balanced current account was impressive in
Ireland. This shows that even very rapid catching-up does not need to be associated with
high inflation or large imbalances.
After the euro changeover - between 2000 and 2003 - a sharp downward adjustment
occurred in Portugal as consumption and investment slowed considerably. Competitiveness
problems and the need to improve the fiscal position added to the downturn. Annual real
GDP growth in Portugal in the period 1999-2006 averaged 1.7%. In Ireland, real output
growth continued instead at a strong pace (at 6.5% on average) in this period and the fiscal
balance was in slight surplus. Following the slowdown in activity, ULC growth and inflation
pressures diminished in Portugal (to 3.1% and 3.0% on average, respectively), while they
gradually picked up in Ireland (3.2% and 3.5%, respectively, on average) in the period 1999-
2006. Since 1999, the Portuguese economy has not succeeded in improving its
competitiveness and its sizeable current account deficit remains.
In principle, one could imagine that stronger productivity growth should contribute to
containing unit labour costs, making Ireland more competitive than Portugal. This is true, but
not in the most obvious sense. If one computes unit labour costs in Ireland and Portugal,
numbers are approximately the same. However, export performance has been much
stronger in Ireland than in Portugal, which has resulted in a trade surplus in the balance of
payments (against a large deficit in Portugal). The large profit outflows in the factor income
account in Ireland negatively affect the current account position. In 2006, the current account
stood at -4.2% of GDP in Ireland, against -9.9% of GDP in Portugal. What has happened?
Quite simply, cost competitiveness is not the only determinant of competitiveness. Shifting
production to higher value-added sectors is as important as keeping unit labour costs under
control, if not more. There is evidence that Ireland and Portugal have been competing in
quite different products and markets in the past decade, with the latter country being subject
to stronger competitive pressures from new Member States and emerging market
economies.
To a large extent, the divergence can be traced back to the key structural features of the two
economies. The first is a different degree of flexibility. Indicators of product and market
regulation, compiled by the OECD, signal significantly more rigidity in Portugal than in
Ireland; the same is true for other measures of market friendliness such as the World Bank's
Doing Business index.20 Another crucial difference is in the availability of physical and human
capital, as evidenced by the discrepancy in educational attainment of the labour force, R&D
expenditure, penetration of information technology, etc. Ireland has also benefited, in part,
from the removal of the exchange rate risk after the adoption of the euro, which has favoured
large FDI inflows (though countries like Portugal should have benefited from this as well).
Labour market and wage and price flexibility have contributed to preventing inflation from
rising excessively and becoming entrenched and ultimately unsustainable for the country's
competitiveness.
Another interesting and telling difference between Ireland and Portugal has been in the field
of fiscal policy. Public debt, public expenditure and budget deficits have all been significantly
lower in Ireland than in the rest of the euro area, noticeably so when compared with Portugal.
This shows that the discretionary use of fiscal policy is hardly a recipe for stimulating growth,
especially when the "fiscal house" is not in order.
At the same time, one should not be complacent about developments in Ireland. Several
years of very low and even negative real interest rates, coupled with buoyant growth, may
have led some sectors of the economy, and the housing market in particular, to levels which
are unsustainable over the medium term. We still do not know of policies that have been
reliably deployed to prevent the risk of misallocation of capital in an environment of very low
real interest rates. Only time will tell. Moreover, the success of Ireland, a small country with
little more than four million inhabitants, may not be easily replicated elsewhere, especially in
larger countries. Nonetheless, it shows that equally flexible and dynamic economies in the
east could do just as well if they were to join the euro area.
To sum up, the differences between Ireland and Portugal are not so much in the behaviour of
the real exchange rate and in standard measures of cost competitiveness. The Irish example
shows that it is possible to prosper in the monetary union while having a higher potential
growth rate than the rest of the union. This does not need to be "paid" in terms of divergent
or explosive inflationary outcomes and / or in unsustainable competitiveness for the country.
The Portuguese example, in contrast, provides a stark warning that entering the monetary
union per se does not guarantee a satisfactory growth performance. In order to obtain the full
benefits of monetary union, the appropriate economic structures and national policies have to
be in place.
4. Conclusion
Ladies and Gentlemen, let me conclude. Economic and monetary union should never be
considered as a final destination, but only as a departure point. Joining the euro area is not,
in itself, a recipe for economic success. Countries need to be well equipped in order to thrive
in it. The recipes for success are known: flexibility in the wage and price formation process,
flexibility in the production structure, human and physical capital, dynamism. These features
are not very different from those that are needed anyway in an era of globalisation, but
participation in EMU makes them even more compelling. Real convergence is therefore not,
per se, an impediment to joining the monetary union. Nonetheless, there is no doubt that real
convergence creates some challenges of its own that need to be properly addressed by
policy-makers before joining a monetary union. Not doing so will lead to both economic and
political problems.
The recent experience of Slovenia, which adopted the euro on 1 January this year, is a
confirmation of what I just said. The economy is growing fast and inflationary pressures are
mounting, with the latest numbers exceeding 5%. Monetary policy evidently cannot cure this
problem. On the other hand, fiscal policy in Slovenia is too lax, out of line with what would be
required for macroeconomic stabilisation. Deregulation of the product and labour markets
has not yet been completed. Wages are growing faster than productivity, in particular in the
public sector. The risks of a boom-and-bust cycle are looming.
In the face of this worrying scenario, what is the reaction of the policy authorities? Very
predictable: they blame the euro for the price increases.21 "Déjà vu all over again": Whenever
things go wrong in a country, the policy-makers blame Europe.
It's obviously not the right response, and it won't help the Slovenian people understand
where the problems lie. Whether Slovenia will turn out to be more like Ireland than Portugal
in the next few years depends entirely on Slovenia. And this will be true for any new member
of the euro area.
Thank you for your attention.
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