Peter Praet: The financial cycle and real convergence in the euro area
Speech by Mr Peter Praet, Member of the Executive Board 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.
* * *
Ladies and gentlemen1
Thank you for inviting me to address this conference. The latest data confirm that the euro
area on aggregate is proceeding slowly along the path of economic recovery. Yet, a key
issue that faces policymakers today, and that will continue to face them for several years to
come, is how to deal with persistent divergence between national economies. Some euro
area countries are experiencing steady growth, while in others growth remains anaemic.
Some have unemployment rates under 5%, while in others unemployment exceeds 25%.
In the euro area, which is a monetary union but not a formal political union, there are risks if
such divergences remain unaddressed. Without fiscal equalisation mechanisms, real
economic convergence is important to gradually reduce cross-country income gaps, and this
in turn ensures the economic and social cohesion of the single currency. This issue of real
convergence is what I would like to focus on in my remarks today - in particular, why the first
decade of Economic and Monetary Union (EMU) failed to produce real convergence, and
how the euro area can produce a sustainable convergence process going forward.
My main argument is as follows. Economic theory tells us that the introduction of the euro
should have led to real convergence as capital flowed towards so-called "catching-up"
economies where the marginal product of capital was higher. Yet, while capital growth was
indeed higher in catching-up economies, it did not lead to underlying productivity
convergence. In my view this was because two structural and institutional conditions were
missing.
First, there was an incomplete single market in goods and services, and a general lack of
competitive processes in the non-tradable/services sector, which allowed some firms in
socalled catching-up economies to extract excessive rents and distort capital allocation.
Second, there was an incomplete single market in capital, and lack of common approach to
supervision and resolution of banks, which allowed the financial cycle to take hold too
strongly in these countries in the upswing, and limited the potential for risk-sharing between
jurisdictions in the downswing. This "Minsky" cycle in turn masked the underlying lack of
productivity convergence in the pre-crisis period.
The reform process in the euro area today is essentially a process of filling these two
lacunae: improving the functioning of national economies through structural reforms; and
creating a well supervised, integrated financial market through Banking Union. This should
provide the conditions for efficient resource allocation and hence sustainable convergence in
the future.
The illusion of convergence before the crisis
In its simplest form, economic convergence can be understood as the process of narrowing
income gaps between lower and higher income countries, achieved through faster relative
growth in the catching-up economies. According to the standard neoclassical growth model,
convergence should be driven by capital flows towards the lower income countries, which
have low capital-to-output ratios and hence a higher marginal return on capital. An increase
in labour productivity in the catching-up economies would also accelerate convergence, as
capital deepening would empower production in those economies and organisational
processes would gradually reach the standards of efficiency set by more mature regions.
When EMU was launched, the conditions for economic convergence to proceed according to
this model seemed to be present. Nominal interest rates between higher and lower income
countries converged rapidly. Capital flowed towards lower productivity economies where the
marginal product of capital was higher, supported by the elimination of exchange rate risk
within the euro area. For example, from 1999 to 2008 exposures from banks in
higherincome economies towards those in the catching-up economies (Spain, Ireland, Greece and
Portugal) increased more than fivefold. Facilitated by these flows, capital accumulation
accelerated in these countries: from 1999 to 2007 average growth in capital services in
catching-up economies ranged from around 5% to almost 9%, compared with a range of 2%
to 3.5% in more productive economies.
On the surface, these developments appeared to be contributing to convergence: GDP
growth in catching-up economies was generally faster than in higher income economies. Yet,
with hindsight we know that there was no underlying convergence in labour productivity. In
particular, strong capital accumulation in catching-up economies did not translate into faster
total factor productivity (TFP) growth. TFP actually diverged between higher and lower
income countries in this period. In fact, there was a positive correlation between the initial
level of GDP per capita and average TFP growth rates: the highest TFP growth rates were
found in Germany, Austria, Netherlands and Finland. A special case here is Italy, where
initial GDP per capita was high but TFP converged downwards the catching-up economies.
This seems to be because falling real interest rates eased fiscal constraints and reduced the
incentive of governments to focus on structural policies.
In other words, the apparent economic convergence in the pre-crisis period was largely
illusory. There was a cyclical convergence in GDP levels, but it was not structurally
anchored. This poses two questions that can help inform policy choices in the euro area
today: first, why did capital flows not lead to productivity convergence? And second, why did
more observers not see through the illusion of convergence prior to the crisis?
Why did real convergence not happen?
Starting with the question of why TFP in particular did not converge, an important explanation
seems to be that - contrary to the assumptions of the neo-classical growth model - foreign
capital flowing into catching-up economies was allocated to sectors where the marginal
product of capital was low and falling. This implied that capital accumulation was not
associated with technological change and hence TFP growth. Indeed, in the catching-up
economies capital flowed disproportionately into the non-tradable/services sector, which was
in general experiencing significant productivity losses.2 Specifically, capital accumulation was
highest in the construction and real estate sectors, closely followed by retail, transport and
leisure. There seem to be two explanations why this happened.
First, in some sectors the falling marginal product of capital was counterbalanced by rising
profit margins, meaning that total compensation from investing in these sectors remained
high.3 This was principally the result of an incomplete single market and a lack of competition
- for example, in network industries such as utilities and telecommunications - which allowed
incumbent firms to charge excessive rents and distorted price signals. The capturing of rents
by firms in these sectors may have affected productivity growth not only by channelling
resources away from more productive uses, but also by creating a drag on incentives to
become more efficient in other sectors. For example, research has shown that
anticompetitive regulations in upstream sectors such as utilities can curb TFP growth in
downstream sectors.4
Second, specific financial factors also contributed to capital misallocation. In certain sectors
in catching-up economies both the marginal product of capital and profitability were relatively
low - for example, construction and retail - yet capital formation remained elevated. The
explanation for this apparent contradiction seems to have been very loose credit conditions.
This meant that, despite low gross remuneration for enterprises in these sectors, net
remuneration was kept high by low real borrowing costs. In Ireland, for example, from 2003
to 2008 the average real borrowing costs for households (mortgages) was 1.1%, while for
non-financial corporations it was 2.1%. In both cases this averaged 2.8 percentage points
below the nominal cost. As a consequence, and facilitated by insufficiently intrusive banking
supervision, credit volumes also increased steeply, with loans to households growing on
average by 23% per year in the four years before the crisis, and by almost 28% for
nonfinancial corporations. The fact that this credit growth was associated with labour-intensive
sectors such as construction, and hence diverted labour towards these sectors, itself
contributed to the weak performance of productivity.
Another financial factor that may have influenced capital allocation was the type of
crossborder capital flows, which reflected an incomplete single market in capital. According to the
ECB's financial integration indicators, by 2008 there was almost complete integration of euro
area interbank markets, but retail banking remained largely fragmented and cross-border
equity markets were hardly developed at all.5 This meant that the cross-border capital flows
into catching-up countries were mainly debt-based and intermediated through local,
relationship-based banks. Generally speaking, such a financing mode - compared with
equity portfolio investment or direct cross-border lending from foreign banks - tends to favour
incumbent and local firms, and can make bank lending decisions less sensitive to price
signals.6 This may have also supported capital misallocation.
In short, capital flows did not lead to real convergence because the catching-up economies
lacked the appropriate structural and institutional frameworks to allocate those flows
efficiently. In the context of an incomplete single market in goods and services and weak
competitive conditions, profit signals became disconnected from underlying productivity and
diverted capital from more productive uses. And with an incomplete single market in capital
and uneven banking supervision, credit growth became excessive and over-concentrated in
low productivity sectors.
Why did more observers not recognise it?
While weak TFP growth was the subject of academic debate before the crisis, this was
generally seen as a euro area problem, in particular vis-à-vis the United States.7 The general
mood among observers was that the catching-up economies were progressing relatively well,
or at least not markedly worse than others. For example, the European Commission's
EMU@10 Report stated that "three of the four cohesion countries (Spain, Ireland and
Greece) have shown a satisfactory development overall, while only the fourth (Portugal) has
disappointed."8 This leads me to my second question: if this convergence was in fact cyclical
rather than structural, why was it not identified earlier?
My tentative answer would be that observers' assessments were influenced by the financial
cycle, a theme that has echoed in Hyman Minsky's work.9 In retrospect, it seems now that
the early years of the euro were the peak of a much longer financial upswing. This led
observers to overestimate the sustainability of consumption and investment, and to
underestimate the risks of rising private debt levels - and this was true on both sides of the
Atlantic. One explanation for this is that, as the upward phase of the financial cycle can be
very prolonged - according to estimates by BIS scholars, the typical duration of the financial
cycle is around 16 years10 - perceptions of risk and value adjusted upwards. Historical
relationships between asset prices, debt ratios and underlying productivity levels were
deemed no longer to hold. Hence, developments that merely reflected the longer financial
cycle were falsely believed to be structural.
Another explanation is that observers overestimated future productive capacity due to the
effect of the financial cycle on real-time potential growth estimates.11 This in turn could have
led firms' and households to bring forward future consumption and investment into the
present, based on an overestimation of their lifetime income. One way such misperceptions
can arise is if a prolonged credit-driven economic expansion weakens supply constraints and
raises estimates of potential output, making growth appear more structural in nature. In
Spain, for example, the boom in the construction sector raised both domestic participation
rates and immigration levels. The European Commission's latest estimates of potential
growth rates are in the range of 3.2% and 4% for the period 2000-2007, driven mainly by the
increasing labour contribution (adding around 2 percentage points on average per year).
Since 2008, however, the labour contribution has been the largest drag on potential growth,
for example, subtracting more than 2 percentage points from the 2013 estimate.
A final explanation is that observers mistook the significance of inflation differentials within
the euro area. Excess domestic demand combined with low productivity growth should be
reflected in rising prices, and domestic measures of price and wage inflation in the
catchingup economies were indeed running considerably higher than the euro area average on a
cumulative basis. Average annual inflation differentials in the 2002 to 2008 period were in the
range of 0.5 to 1.5 percentage points. However, these developments were not considered
especially alarming by some observers as they were interpreted as reinforcing the theory of
Balassa-Samuelson equalisation. Some also saw inflation differentials as being more
reflective of low inflation in Germany as it went through a phase of wage adjustment. Overall,
this may have led to less concern about the lack of real convergence in productivity levels
than was warranted.
Achieving sustainable convergence
It was only when the financial cycle turned that the unsustainability of economic convergence
became apparent. The majority of countries with relatively strong GDP growth rates prior to
the crisis also experienced a relatively strong downward adjustment, in some cases undoing
much of the welfare gains that were achieved since the launch of the euro. Some might see
this as evidence that the assumptions of the neoclassical growth model need to be qualified
- that absent credit-driven growth, there is no reason to believe that euro area economies
should converge towards similar levels of productivity, or even rates of productivity growth.12
Indeed, endogenous growth models allow for persistent divergences as some forms of
capital exhibit non-diminishing returns.
Yet, I think it is too early to draw such a conclusion. The neo-classical assumptions have not
yet been properly tested, simply because capital did not flow where the marginal return
would have been highest. What the euro area needs, in my view, is to "re-run" the
convergence process, but with the appropriate conditions in place to ensure efficient
allocation of resources, and the right framework to make convergence sustainable. Let me
explain in more detail what that might entail.
To begin with, catching-up economies have to address the immediate after-effects of the
previous misallocation of capital. The pre-crisis inflows into the non-tradable/services sector
were associated with real exchange rate appreciation, rising unit labour costs (ULC) and
increasing dependence on external financing. When the financial cycle turned, however,
capital flows quickly reversed. This reflected the incomplete nature of financial integration
prior to the crisis - based largely based on short-term debt - and in turn unwound the
channels for potential risk sharing within the euro area. A study on risk sharing published in
2008 had found that "monetary union has facilitated risk sharing, although the level of risk
sharing is still much below the level found among U.S. states".13 However, a study using a
similar methodology in 2013 found that risk sharing through capital markets had virtually
collapsed during the crisis.14
With external financing drying up, the catching-up economies faced the risk of a "sudden
stop". They therefore had to pursue both fiscal and structural policies aimed at achieving an
internal devaluation so as to restore external balance. And they have been rather successful:
since 2009 Greece has almost entirely reversed the ULC growth it experienced in the
precrisis period, while good progress has also been made in Spain, Ireland and to a lesser
extent Portugal. All the catching-up economies have also experienced remarkable
improvements in their current accounts15, ranging from an almost 11 percentage points of
GDP correction in Spain to a 16 percentage points of GDP improvement in Greece.
However, while internal devaluation may improve the sustainability of the external position, it
does not in itself produce sustainable convergence. Indeed, there is a risk that, if unit labour
costs (ULC) adjust mainly due to falling wages and the current account closes, policymakers
may lack incentives to address the underlying productivity problem. This may in turn imply
that similar imbalances reappear in the future: the experience of exchange rate devaluations
in the 1990s suggests that adjusting only through relative costs, without lifting productivity,
may not be sustainable. Hence, I see reforms that boost productivity as a cornerstone of a
sustainable convergence process - but which reforms?
The importance of reallocation
Raising TFP is chiefly a function of innovation, technology adoption and reallocation.
Innovation creates new technologies that improve the efficiency of the production process,
adoption helps those technologies to become more widespread, and reallocation helps
capital and labour concentrate in firms where they can be employed most efficiently.
Public policy can and should contribute to innovation and technological spillovers by raising
the quality of human capital and helping incubate research and development, as well
creating a business environment that favours entrepreneurship. However, the benefits in
terms of productivity tend to be felt over a longer time horizon. There may also be a lag
between technology adoption and TFP growth, as optimising the use of new technologies -
in particular information and communication technology - tends to require parallel investment
in intangible capital such as management systems and organisational processes.16 Hence, in
the short- to medium-term, perhaps the most effective role that public policy can play in
boosting TFP is to strengthen the conditions for reallocation to sectors that are already
productive. This is particularly the case in the catching-up economies because, as we saw,
weak TFP growth there was in part driven by misallocation of capital inflows.
Recent firm-level analysis from the Eurosystem's Competitiveness Network provides two
insights that suggest this could be a promising strategy. The first is that the distribution
between the most and least productive firms in individual euro area countries is very large
and skewed. Far from being normally distributed - with many firms centred around the
average performance level - there are a few highly productive firms and many which have
low productivity. The second insight, which applies in particular to Spain, is that the ULC
developments of firms at the bottom and the top of the productivity distribution are dissimilar.
While ULC went up sharply before the crisis for unproductive firms, highly productive firms
did not experience significant ULC growth.17
This implies, first, that there is substantial potential to boost productivity by reallocating
resources both across sectors and within sectors towards the most productive firms; and
second, that reallocation is not dependent on further ULC adjustment among those firms, as
the most productive firms did not experience a significant competitiveness loss. In other
words, productivity gains can be realised in the short- to medium-term independent of
necessary longer term processes such as improving innovation or adopting new technology
- or indeed, completing internal devaluation. Achieving these gains in the euro area today
requires reforms that address both price signals and credit allocation that hinder the pace of
reallocation.
In terms of price signals, I have discussed how before the crisis excessive rents in sheltered
sectors distorted profit signals and encouraged capital misallocation. Hence, ensuring that
capital now flows towards higher TFP firms must involve deepening the single market and
strengthening competitive forces in the non-tradable/services sector. Greater competition will
also support TFP growth through various static and dynamic channels: a recent empirical
study of the impact of competition policy on TFP in twelve OECD countries found a positive
and significant effect.18
So far, catching-up economies have made notable reforms of framework conditions that
increase competition, for example by strengthening competition authorities, reducing
administrative burdens on companies, softening authorisation requirements and ensuring a
fair public procurement process. However, progress in reducing excessive rents in sheltered
goods and services markets has been less impressive, especially in network industries such
as energy, telecommunications and transport. This is partly due to the micro- or
sectorspecific dimension of the reform needs, which imply confronting vested interests inside a
certain sector. Reforms in these sectors are key, not only because they support reallocation,
but also because they immediately increase the competitiveness of the tradable sector by
reducing often onerous input costs. This could in turn strengthen incentives to raise TFP as
the gains would no longer have to be shared with suppliers of intermediate inputs.
Reallocation of capital needs of course to be accompanied by reallocation of labour, and
here price signals are also important. For example, there is some evidence that slower ULC
adjustment in the non-tradable/services sectors in catching-up economies is discouraging
labour from moving to the tradable sector, as wages remain higher in the former. Addressing
this distortion across sectors is the rationale for labour market reforms that strengthen the
link between wage formation and economic conditions. Reforms in this area are now
welladvanced.
However, we must also acknowledge that there may be skill mismatches that prevent
reallocation - especially for workers previously employed in low skill sectors such as
construction - and these are more challenging to address. At the end of 2012, 18% of
workers in the euro area with low education levels were unemployed, compared with only 6%
of highly educated workers. This puts a strong onus on active labour market policies and,
over the longer term, raising educational attainment.
Fixing the financial sector
Improving price signals in these ways is necessary for reallocation to take place in
catchingup economies - but it is not sufficient. For example, in several such countries profit margins
in the tradable sector have increased relative to non-tradables in recent years, yet these
signals have not triggered meaningfully higher investment. Research by the European
Commission suggests that financing constraints are an important factor limiting capital
reallocation in this direction.19 Moreover, there is some evidence that weak bank balance
sheets have retarded the process of "churn" between firms that drives resource reallocation.
One study found that, in the early phase of the crisis, banks that were lowly capitalised were
more likely to maintain credit to less creditworthy borrowers - so-called "ever-greening.20
This type of behaviour inhibits firm exits and reduces the availability of credit for new
entrants.
Addressing these financing constraints has both a short- and a longer-term dimension. The
short-term part concerns dealing with the legacy of the previous financial cycle - that is,
repairing bank balance sheets and reintegrating the euro area's financial markets. This is
necessary so that capital can once more flow "downhill" from higher income to lower income
countries, and so that banks in those countries are sufficiently capitalised to be able to
allocate credit efficiently. The main policy initiative that will support this is the Banking Union
project and, as part of that, the ECB's Comprehensive Assessment. Its aim is to dispel
doubts about asset quality and levels of capital and provisions, and in doing so to accelerate
the process of deleveraging and restructuring in the banking sector that is the inevitable
consequence of a major financial crisis.
Over the longer-term, however, it is important that policy-makers also reflect on the quality of
financial integration in the euro area - that is, the incentive structures in the financial sector
that can lead to inefficient credit allocation, and the channels for sharing risk when financial
crises do arise. Indeed, one criticism we could perhaps make of Optimal Currency Area
theory is that is does not take account of the financial instability that may arise when capital
reallocates across regions, both in terms of inflows and outflows. Banking Union goes some
way towards redressing this, which is why it is essential for the longer term stability of the
euro area.
In terms of improving incentives, the Single Supervisory Mechanism (SSM) should in
principle be better placed to prevent credit misallocation as supervision will be decoupled
from national economic conditions. The shift towards bail-in ability under the new EU
resolution framework should also, over time, increase the quality of scrutiny over allocation
decisions by shareholders and creditors. And by removing supervisory barriers to retail
banking integration, the SSM should provide the pre-conditions for greater foreign entry into
national banking markets, which research suggests could improve capital allocation by
increasing the distance between the main shareholders and management of a bank and the
vested interests in the country where the bank operates.21
These same factors also provide stronger channels for risk-sharing within the euro area. A
more integrated retail banking market would imply that losses from local banking crises
would be shared across multiple jurisdictions, thus acting as a shock absorber as we see, for
example, in the United States. If such losses were still to erode a bank's capital, the new EU
resolution framework will ensure, first, that the costs of bank failure fall mainly on the private
sector rather sovereigns, and second, that they are spread evenly across the euro area
banking sector rather than concentrated in the affected countries. The relevant innovations
here are the minimum requirements for bail-in before sovereign interventions, and the
creation of the Single Resolution Fund for all banks that participate in the SSM.
That said, in my view achieving high quality financial integration must also involve deepening
capital markets in Europe, both to improve the possibilities for market-based debt and equity
financing, and to provide further channels for private risk-sharing. This obviously goes
beyond Banking Union and will not be straight-forward, as it concerns multiple aspects of
national law. But there are practical ways in which progress could be made. To give just one
example, a Securities Law Directive has not been proposed to date, although it was already
recommended in the second report by the Giovannini Group more than ten years ago (in
2003).22
Managing the financial cycle
Facilitating the process of resource reallocation should allow TFP convergence to resume in
catching-up economies, while the structural reforms being undertaken in these economies
should help ensure that efficient resource allocation lasts. However, there is still one question
from the pre-crisis period that I have not addressed: how can we ensure that the
convergence process is not again disrupted by the financial cycle? One would hope that a
better supervised and more diversified financial system will have a smoothing effect on the
financial cycle. Yet, some academics argue that such is the force of the financial cycle that it
is unavoidable that monetary policy will also have to play a central role in "leaning against the
wind". In the euro area, however, the situation is not quite so clear cut.
The ECB's two-pillar strategy does make financial imbalances an important element of our
policy assessment, even when inflation is low. Specifically, the monetary pillar captures the
connection between excess credit and liquidity creation and potential risks to future price
developments, including disruptive asset price booms. And our medium-term orientation
grants us a sufficiently long policy horizon to account for the financial imbalances in our
strategy. In this way, it implicitly incorporates elements of a "leaning against the wind"
approach.
To quote the ECB Monthly Bulletin from April 2005: "[our] approach amounts to a cautious
policy of 'leaning against the wind' of an incipient bubble. The central bank would adopt a
somewhat tighter policy stance in the face of an inflating asset market than it would
otherwise allow if confronted with a similar macroeconomic outlook under more normal
market conditions. It would thus possibly tolerate a certain deviation from its price stability
objective in the shorter term in exchange for enhanced prospects of preserving price and
24
economic stability in the future."23,
Yet, were evidence of financial imbalances to reappear, we would have to reflect carefully on
whether standard monetary policy would be the right tool to use in response. This is for two
reasons. First, there is some uncertainty as to what interest rate path would be required to
prick an emerging credit bubble. Some studies find that in a leverage-driven boom profits are
very sensitive to even small interest rate changes, implying monetary policy could provide a
powerful offset.25 However, other evidence suggests that quite large interest rates
movements would be needed to offset the financial cycle, which would in turn create
collateral damage for the economy and price stability.26
Second, there is still heterogeneity between the financial cycles of individual countries within
the euro area. While it is true that aggregate euro area money and credit growth before the
crisis was high, that growth was concentrated in specific regions. In the catching-up
economies, growth in credit in the pre-crisis period was 10 percentage points higher than in
more productive countries. In such circumstances, it may well be the case that hiking rates at
the aggregate level would be too strong a response for regions that are not subject to
financial exuberance.
The conclusion I draw from this is that standard monetary policy might be the right response
when the financial cycle is rising across sectors and countries. In these circumstances, even
23
See ECB Monthly Bulletin article on "Asset price bubbles and monetary policy", April 2005.
24
It should be noted that at the time this article was written, the idea of using monetary policy to prick asset price
bubbles was alien to much of the theory and practice of central banking. Indeed, in 2006 former Federal
Reserve Governor Don Kohn argued that only if the likelihood and risks of bubbles could be accurately
identified would early intervention by central banks be superior to cleaning up after the bust, adding that "for
my part, I am dubious that any central banker knows enough about the economy to overcome these hurdles"
(see Kohn, D. (2006), "Monetary policy and asset prices", speech at the European Central Bank Colloquium
held in honour of Otmar Issing, 16 March 2006). However, that view has now largely changed across the
central banking community. In particular, the importance of financial stability for price stability is now
selfevident after the crisis, and most central bankers agree that for certain types of financial imbalances monetary
policy may be the only tool that is sufficiently broad-based and powerful.
25
See for example Adrian, T. and H.-S. Shin (2010), "The Changing Nature of Financial Intermediation and the
Financial Crisis of 2007-09", Federal Reserve Bank of New York Staff Reports no. 439, March 2010.
26
See for example Bean, C. et al (2011) "Monetary Policy after the Fall", in Macroeconomic Challenges: The
Decade Ahead, Federal Reserve Bank of Kansas City.
if there was collateral damage, it could be justified for a period of time to offset the danger