Nemat Shafik: Europe, Toward A More Perfect Union
International Monetary Fund February 15, 2013
During the years that followed the euro’s introduction, financial integration proceeded rapidly and markets and governments hailed it as a sign of success. The widespread belief was that it would benefit both south and north—capital was finally able to flow to where it would best be used and foster real convergence.
But in fact, a lasting convergence in productivity did not materialize across the European Union. Instead, a competitiveness divide emerged. As the financial crisis gripped the euro area in 2010, these and other problems came to the fore.
Three years later, the financial symptoms of the crisis are thankfully receding with a new sense of optimism in markets. But the underlying problems—lack of convergence of productivity and the structural flaws in the architecture of the monetary union—have only been partially addressed. So where do we stand, and what more is needed?
(Not) the right kind of integration
Europe has committed itself to increasingly harmonize legal structures and governance to facilitate the free flow of goods, services, and capital, as well as the free movement of its citizens. Even those European countries that are not part of the European Union, such as Iceland, Norway and Switzerland, share formal ties through pacts and treaties, such as the European Free Trade Agreement.
But if Europe has clearly become more integrated de jure, has it made a difference, de facto, in economic terms? The answer is clearly yes. One simple way of illustrating this is to look at correlations of business cycles between countries.
Figure 1-2, which depict these correlations, show the close links developed between European economies during the past decade. All economies in the European Union—not just euro area member states—are more tightly clustered now than they were.
But integration has many more dimensions. For the 17 euro area members, the introduction of a common currency also meant a common monetary policy and, for a while, the convergence of risk premia. This encouraged capital to shift from the richer north to the poorer south (known as the periphery), and differences in sovereign yields across the euro area narrowed quickly.
But as we now know, the optimism about the use of these funds turned out to be overdone. Domestic productivity in most of the recipient countries did not improve—credit was used to finance current consumption and investment in real estate rather than productive capital.
In fact, there has been little absolute real convergence in the euro area. Those euro area countries that had low per capita incomes in 1999 did not have the highest per capita growth rates.
The newly accessant countries from emerging Europe did better—their per capita incomes seem to be converging faster to northern Europe levels (Figure 3). These economies were in a better position to take advantage of global growth, attract FDI, and strengthened their integration in worldwide supply chains, in particular by building strong links with Germany.
The crisis in the euro zone stems, in large part, from the unwinding of financial integration that occurred in the absence of the necessary accompanying improvements in productivity. As the gaps in growth prospects became apparent, financial markets again began to discriminate among countries that hitherto had enjoyed similar borrowing costs. This resulted in a reversal of capital flows and a fragmentation of the financial system in the euro zone.
That fragmentation has had implications for the monetary policy transmission mechanism. The Target2 system, the mechanism by which national central banks in the euro area borrow from or lend to each other, is a good indicator of financial fragmentation along national borders (Figure 4).