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
 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?

3
EA: Towards an Optimum Currency Area (OCA)?

Reached in
OCA criteria
1999? 2007? 2015?

Synchronisation of business cycles

('OCA meta criterion')

Trade integration

Inter-regional labour mobility

Wage flexibility

Mechanisms for fiscal transfers

Financial integration

Political and institutional integration

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

4
While difference in real GDP growth returned to pre-crisis
levels, cyclical differences remain high in the euro area
Real GDP growth rates Output gaps
(dispersion) (dispersion)
5 EA-11 4.0
EA-11
4 Current EA-19 3.5 Current EA-19
4 EA changing
composition 3.0 EA changing
composition
3
2.5
3
2.0
2
1.5
2
1.0
1

1 0.5

0 0.0
1995 2000 2005 2010 2015* 1995 2000 2005 2010 2015*

Note: Dispersion measured as an unweighted standard deviation.

5
 Heterogenous propagation of common shocks
Germany France
10 5

5
0

-5
-5

-10 -10
2000 2005 2010 2000 2005 2010

Portugal Greece
10 15

10
5

5
0
0

-5
-5

-10 -10
2000 2005 2010 2000 2005 2010

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.
6
 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.

7
 Strong nominal convergence pre-EMU; limited further progress
due to weak market pressure and policy complacency

HICP inflation 10-year govt. bond yield Public gross debt / GDP
(dispersion) (dispersion) (dispersion)
8 6
40
7 EA-11
EA-11 5
6 Current EA-19
Current EA-19
35
4 EA changing
5 EA changing
composition
composition

4 3
30

3
2
2 25
1 EA-11
1 Current EA-19
EA changing composition
0 0 20
1995 2000 2005 2010 2015* 1995 2000 2005 2010 1995 2000 2005 2010 2015*
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.
8
 Real convergence: Catching-up process mostly driven
by 'new' euro area Member States
GDP per capita (in PPS) before and after the start of the financial crisis
12 5

4 LT
EE
10 LV LV
(average growth 1999-2007)

(average growth 2008-13)

3
LT SK MT

GDP per capita in PPS

GDP per capita in PPS

DE
8 2
SK EE AT
EL LU excl. 'new'
1 BE
IE EA MS
6 SI FR
CY
ES FI 0 PT
NL excl. 'new'
ITFI NL LU
PT BE SI
4 FR EA MS -1
AT CY ES
MT DE IE
-2
IT
2
all -3 EL all
countries countries
0 -4
0 10 20 30 40 50 0 20 40 60 80
GDP per capita in thousands PPS (1999) GDP per capita in thousands PPS (2008)

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. 9
 No clear real convergence trend across
US States / regions either
Real GDP per capita before and after the start of the financial crisis

4 10

8
(average growth 1999-2007)

(average growth 2008-13)

Real GDP per capita
3 BEA
Real GDP per capita

regions 6

4 BEA
regions US
2
States
2
US
States
0
1

-2

0 -4
0 25 50 75 100 125 150 0 50 100 150 200
Real GDP per capita in thousands (1999) Real GDP per capita in thousands (2008)

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).

10
While unemployment rates converged prior to the crisis,
there is no sign of productivity convergence
Unemployment rate Labour productivity
(dispersion) (dispersion)
7 20

6 18

5 16

4 14

3 12

2 10
EA-11
EA-11
Current EA-19
1 Current EA-19 8
Euro Area changing composition
Euro Area changing composition
0 6

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.
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 After the launch of EMU, capital flowed towards lower
productivity economies, but largely to less productive sectors
Actual current account levels Decomposition of growth in
(2007 and 2014, % of GDP) capital services by sector
(avg. annual contributions 1999-07)
10
2.5

5 Construction
2.0
Real estate activities
0
Services sectors/network
-5
1.5 industries/public utilities

-10 1.0

-15
Current account
0.5
Cyclically-adjusted CA
-20

0.0
-25
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

-0.5
LV EL EE CY PT ES IE SK SI IT FR DE NL ES PT IE EL IT DE FR NL AT BE FI
Source: European Commission (2013): External rebalancing Source: European Commission (2013): Catching-up
in the euro area: progress made and what remains to be, processes in the euro area, Quarterly Report on the Euro
Quarterly Report on the Euro Area, 13(4), p. 30. Area, 12(1), p. 10.
12
 Financial fragmentation hampered the adjustment
process, but has declined in the recent years

Interest rates on loans to non-financial

corporations (dispersion)
14 2

12

1.5
10

8
1
6

4
0.5

0 0
04 05 06 07 08 09 10 11 12 13 14 15

loan volumes (lhs) interest rates (rhs)

Source: ECB.

13
 Labour and product market rigidities contributed to the
non-sustainable real convergence process
Product market rigidities and Changes in ULC and
unemployment rate unemployment rate
20 20

EL EL
15

Change in unemployment rate

15
Change in unemployment rate

10 10

(2009-14)
(2009-14)

ES
ES
5 PT IT
5 IT PT SI
SI NL
NL BE
BE SK
0 IE AT FR
SK 0 FR IE
AT
FI
DE
DE
-5
-5 0 25 50 75 100
0.5 1 1.5 2 2.5
Change in unit labour costs (ULC)
Product market rigidities (2008) (2001-09)

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

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 Convergence to which frontier?
Indicator of
convergence

global
frontier?
EMU
frontier?

Minimum
requirements?

country A EMU
average

country B
country C
time

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 Insufficient real convergence: a problem?

Reduce heterogeneity by reinforcing single market

Heterogeneity can integration, risk-sharing financial market integration
and cross-border labour mobility, whilst allowing for
be costly, but it can
system competition and national idiosyncracies
Economic be overcome by
argument appropriate
Ensure adequate adjustment mechanisms which
adjustment make heterogeneous economies resilient to shocks
mechanisms (asymmetric/common) and respond effectively to
internal and external imbalances

Monetary unions with heterogeneous economies can

A monetary union be sustainable as long as a certain degree of
political cohesion and identity exists, e.g. US,
Political- of heterogeneous
Belgium, Germany
economies depends
economy on political
argument If political cohesion is defined in terms of
cohesion and convergence of economic welfare levels and in
identity the absence of large transfers, the sustainability
of heterogeneous monetary unions is less clear.

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How to strengthen efficient functioning of EMU?

Types of reforms

Reforms to strengthen the

adjustment mechanism Reforms to support
(if actual output deviates potential output
from potential/ if need to (supply-side)
correct imbalances)

Shorter-term impact Medium-term impact

on the economic cycle on the economic trend

Increase sustainable
economic growth

Foster sustainable
real convergence

17
 EMU policy priorities have evolved over time

Potential output
Adjustment mechanism
(supply side)

Minimum harmonisation
approach
Single Market (acquis
EMU in 1999 Limited emphasis communautaire)
Exceptions:(direct) taxation,
labour and social compact,
education, health

Macroeconomic Imbalance
Procedure (MIP)
Institutional Avoid excessive internal and
reforms in external imbalances Limited emphasis
EMU since Still allows for a variety of country-
2011 specific settings
Banking and Capital Market Union

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 Which policy priorities to make EMU work?
Adjustment mechanism
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
Future EMU 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)
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Potential output
(supply side)
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
 Which governance for genuine EMU?

Deepening EMU governance

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?
Future EMU
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

20