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 economic stability in the future.”23, 24 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.

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.