Convergence and divergence in the euro area

Servaas DEROOSE

Deputy Director-General European Commission, DG Economic and Financial Affairs

21st Dubrovnik Economic Conference 8 June 2015

Outline

1. What is the issue?

2. Review of convergence trends in EA

3. Looking ahead: EA – united in how much real divergence/heterogeneity?

2

3

What is the issue?

• What type of convergence?

o OCA and the synchronisation of business cycles

o Nominal convergence

o Real convergence

• Convergence to which frontier?

• Insufficient real convergence – would it be a problem?

• What policies/institutions to address the issue?

EA: Towards an Optimum Currency Area (OCA)?

Note: Green / orange / red stand for 'fulfilled' / 'partly fulfilled' / 'not fulfilled'.

4

Synchronisation of business cycles ('OCA meta criterion')

OCA criteria Reached in

Political and institutional integration

Trade integration

Inter-regional labour mobility

Wage flexibility

Mechanisms for fiscal transfers

Financial integration

1999? 2007? 2015?

5

While difference in real GDP growth returned to pre-crisis levels, cyclical differences remain high in the euro area

Real GDP growth rates

(dispersion)

Output gaps

(dispersion)

Note: Dispersion measured as an unweighted standard deviation.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

1995 2000 2005 2010 2015*

EA-11

Current EA-19

EA changing

composition

0

1

1

2

2

3

3

4

4

5

1995 2000 2005 2010 2015*

EA-11

Current EA-19

EA changing

composition

6

Heterogenous propagation of common shocks

Note: Charts show the findings of a BVAR model conditional on the observed EA-12 GDP per capita. Shades of orange/yellow show the distribution of the conditional forecasts of a BVAR model in levels, excluding the lower and higher 5% quantiles. Solid blue line: the median of the distribution of the conditional forecasts in the BVAR in differences. Green line : actual values.

Source: European Commission (2015): Business cycle synchronisation in the euro area, Quarterly Report on the Euro Area, forthcoming.

Germany

2000 2005 2010-10

-5

0

5

10France

2000 2005 2010-10

-5

0

5

Portugal

2000 2005 2010-10

-5

0

5

10Greece

2000 2005 2010-10

-5

0

5

10

15

7

Euro area growth correlations are uneven, but no less than among US states

Source: Goldman Sachs (2014): What makes a monetary union work?, Global Economics Paper: 224.

8

Strong nominal convergence pre-EMU; limited further progress due to weak market pressure and policy complacency

HICP inflation

(dispersion)

10-year govt. bond yield (dispersion)

Public gross debt / GDP

(dispersion)

0

1

2

3

4

5

6

1995 2000 2005 2010

EA-11

Current EA-19

EA changing

composition

20

25

30

35

40

1995 2000 2005 2010 2015*

EA-11

Current EA-19

EA changing composition

Note: Dispersion measured as an unweighted standard deviation. "*" indicates projected values. HICP inflation measured as y-o-y growth rate of the HICP index. 10-year nominal govt. bond yield. Public gross debt in line with EDP definition based on ESA 2010.

Source: Ameco.

0

1

2

3

4

5

6

7

8

1995 2000 2005 2010 2015*

EA-11

Current EA-19

EA changing

composition

9

Real convergence: Catching-up process mostly driven by 'new' euro area Member States

Note: Countries which were in 1999 (left chart) and in 2008 (right chart) not members of the euro area are highlighted in red.

The black regression line is based on the full sample of countries, the blue one excludes the 'new' euro area Member States, which are highlighted in red.

Source: Eurostat.

GDP per capita (in PPS) before and after the start of the financial crisis

AT

BE

EE

FI

FR DE

EL IE

IT

LU

NL PT

SK

SI

ES CY

LV

LT

MT

0

2

4

6

8

10

12

0 10 20 30 40 50

GD

P p

er

capita in P

PS

(avera

ge g

row

th 1

999-2

007)

GDP per capita in thousands PPS (1999)

excl. 'new' EA MS

all countries

AT BE

EE

FI

FR

DE

EL

IE

IT LU NL PT

SK

SI ES CY

LV LT

MT

-4

-3

-2

-1

0

1

2

3

4

5

0 20 40 60 80

GD

P p

er

capita in P

PS

(avera

ge g

row

th 2

008-1

3)

GDP per capita in thousands PPS (2008)

excl. 'new' EA MS

all countries

10

No clear real convergence trend across US States / regions either

Note: Blue entries relate to U.S. States, red entries to BEA regions. Real GDP per capita in thousand USD.

Source: U.S. Department of Commerce. Bureau of Economic Analysis (BEA).

Real GDP per capita before and after the start of the financial crisis

0

1

2

3

4

0 25 50 75 100 125 150

Real G

DP p

er

capita

(a

vera

ge g

row

th 1

999-2

007)

Real GDP per capita in thousands (1999)

US States

BEA regions

-4

-2

0

2

4

6

8

10

0 50 100 150 200

Real G

DP p

er

capita

(avera

ge g

row

th 2

008-1

3)

Real GDP per capita in thousands (2008)

US States

BEA regions

11

Unemployment rate

(dispersion)

Labour productivity

(dispersion)

0

1

2

3

4

5

6

7

EA-11

Current EA-19

Euro Area changing composition6

8

10

12

14

16

18

20

EA-11

Current EA-19

Euro Area changing composition

Note: Dispersion measured as an unweighted standard deviation. Total unemployment rate in line with Eurostat definition. Labour productivity measured as GDP at 2010 reference levels per hour worked. "*" indicates projected values.

Source: Ameco.

While unemployment rates converged prior to the crisis, there is no sign of productivity convergence

12

After the launch of EMU, capital flowed towards lower productivity economies, but largely to less productive sectors

Actual current account levels

(2007 and 2014, % of GDP)

Decomposition of growth in capital services by sector

(avg. annual contributions 1999-07)

Source: European Commission (2013): Catching-up processes in the euro area, Quarterly Report on the Euro Area, 12(1), p. 10.

Source: European Commission (2013): External rebalancing in the euro area: progress made and what remains to be, Quarterly Report on the Euro Area, 13(4), p. 30.

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

ES PT IE EL IT DE FR NL AT BE FI

Construction

Real estate activities

Services sectors/networkindustries/public utilities

-25

-20

-15

-10

-5

0

5

10

2007

2014

2007

2014

2007

2014

2007

2014

2007

2014

2007

2014

2007

2014

2007

2014

2007

2014

2007

2014

2007

2014

2007

2014

2007

2014

LV EL EE CY PT ES IE SK SI IT FR DE NL

Current account

Cyclically-adjusted CA

13

Financial fragmentation hampered the adjustment process, but has declined in the recent years

Interest rates on loans to non-financial corporations (dispersion)

Source: ECB.

0

0.5

1

1.5

2

0

2

4

6

8

10

12

14

04 05 06 07 08 09 10 11 12 13 14 15

loan volumes (lhs) interest rates (rhs)

14

Labour and product market rigidities contributed to the non-sustainable real convergence process

Product market rigidities and

unemployment rate

Changes in ULC and unemployment rate

Source: All indicators taken from Ameco except for the product market rigidity measure, which comes from the OECD.

BE

DE

IE

EL

ES

FR

IT

NL

AT

PT SI

SK FI

-5

0

5

10

15

20

0.5 1 1.5 2 2.5

Change in u

nem

plo

ym

ent

rate

(2009-1

4)

Product market rigidities (2008)

BE

DE

IE

EL

ES

FR

IT

NL

AT

PT SI

SK

-5

0

5

10

15

20

0 25 50 75 100

Change in u

nem

plo

ym

ent

rate

(2

009-1

4)

Change in unit labour costs (ULC) (2001-09)

15

Convergence to which frontier?

EMU frontier?

time

global frontier?

EMU average

Indicator of convergence

country B country C

country A

Minimum requirements?

16

Heterogeneity can be costly, but it can

be overcome by appropriate adjustment mechanisms

Insufficient real convergence: a problem?

Reduce heterogeneity by reinforcing single market integration, risk-sharing financial market integration and cross-border labour mobility, whilst allowing for

system competition and national idiosyncracies

Ensure adequate adjustment mechanisms which make heterogeneous economies resilient to shocks (asymmetric/common) and respond effectively to

internal and external imbalances

Economic argument

Political-economy argument

A monetary union of heterogeneous

economies depends on political

cohesion and identity

Monetary unions with heterogeneous economies can be sustainable as long as a certain degree of

political cohesion and identity exists, e.g. US, Belgium, Germany

If political cohesion is defined in terms of convergence of economic welfare levels and in the absence of large transfers, the sustainability

of heterogeneous monetary unions is less clear.

17

Types of reforms

Reforms to support potential output

(supply-side)

How to strengthen efficient functioning of EMU?

Shorter-term impact on the economic cycle

Medium-term impact on the economic trend

Increase sustainable economic growth

Foster sustainable real convergence

Reforms to strengthen the adjustment mechanism

(if actual output deviates from potential/ if need to

correct imbalances)

18

EMU policy priorities have evolved over time

Potential output

(supply side) Adjustment mechanism

EMU in 1999

Minimum harmonisation approach

• Single Market (acquis communautaire)

• Exceptions:(direct) taxation, labour and social compact, education, health

Limited emphasis

Institutional reforms in EMU since

2011

Limited emphasis

Macroeconomic Imbalance Procedure (MIP)

• Avoid excessive internal and external imbalances

• Still allows for a variety of country-specific settings

Banking and Capital Market Union

19

Which policy priorities to make EMU work?

Potential output

(supply side) Adjustment mechanism

Future EMU

• Prioritise the removal of medium-term bottlenecks to potential growth in the European Semester process

• Exploit the full potential of the Single Market as a key instrument to foster growth and convergence, with a focus on services and the digital economy

• Boost productive investment to support the sustainability of long-term growth

• Re-kindle catching-up convergence with a focus on Member States where catching-up has stalled

• Strengthen national adjustment and shock-absorption capacities by pursuing rigorous reforms in product and labour markets, including removing barriers to labour mobility

• Promote sustainable financial integration and reduce fragmentation by completing Banking Union

• Diversify corporate funding sources by implementing Capital Market Union

• Assure full play of strong fiscal automatic stabilisers by creating national fiscal buffers and adequate aggregate EA fiscal stance, aligned with the monetary stance (policy mix)

• Prevent harmful imbalances by consistent monitoring and corrective action (MIP/EIP)

20

Which governance for genuine EMU?

Deepening EMU governance

Future EMU

• Centralise or de-centralise EMU governance?

— Estalish an EMU Treasury/Debt Management Office, with EA-wide taxing and borrowing powers?

— Or, de-centralise fiscal responsibility by re-instating the no-bailout clause, in conjunction with a EA sovereign insolvency framework?

• Move from a rules-based to an institutions-based approach?

— Develop institutions with appropriate mandates within which they can act flexibly?

• Develop a limited EA fiscal capacity in the form of EU Unemployment Insurance scheme or EA Emergency Facility?

• Introduce systemtic stress-testing of national security systems to establish adequate floors and minimum efficiency standards for social safety nets?

• Create independent Productivity Councils at the national level to monitor trends in competitiveness , productivity and convergence?

• Monitor and benchmark national shock absorption and adjustment capacities?

• Establish minimum requirements for structural reforms?

— Labour markets, e.g. full portability of pension rights and enhanced recognition of qualifications

— Product markets, e.g. strengthening national competition authorities