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.

“Financial Integration and Firm Performance: Evidence from Foreign Bank Entry in Emerging Markets.” Review of Finance 13, 181–223. 22  The Giovannini Group, Second Report on EU Clearing and Settlement Arrangements, April 2003. 8  BIS central bankers’ speeches  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.