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,  4  Bourlès et al (2010), “Do product market reforms in upstream sectors curb productivity growth? Panel data evidence for OECD countries”, NBER Working Paper 16520, November 2010.

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,  12  The most widely used concepts in applied work are those of β-convergence (faster productivity growth, exhibited by countries with lower productivity levels) and σ-convergence (decreasing cross-country dispersion in productivity levels). 13  Demyanyk, Y. et al (2008), “Risk sharing and portfolio allocation in EMU”, DG ECFIN Economic Papers 334, July 2008. 14  Kalemli-Ozcan, S. et al (2013), “Debt crises and risk sharing: the role of markets versus sovereigns”, CEPR Discussion Paper no. 9541, July 2013. 15  Including capital transfers (e.g. EU funds). BIS central bankers’ speeches  5  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.