Financial sector repair There is considerable empirical evidence that a strong driver of aggregate productivity growth is “churn” between firms – less productive firms exiting the market and new innovative firms entering, or existing firms reallocating resources to more productive sectors.3 The job of the financial sector is to ensure that credit allocation supports this process. However, what seems to have happened, at least in parts of the euro area, is that banks with weak balance sheets have retarded this process. One recent study found that larger banks have reallocated credit away from riskier firms, preventing new entrants, while smaller banks have engaged in so-called ever-greening of loans, inhibiting firm exits.4 Weak banks also appear to have slowed down sectoral reallocation. To give just one example, despite the recent improvements in cost and price competitiveness in Greece, the sectoral allocation of credits has not substantially shifted towards export-oriented firms.5 This suggests that banks in certain euro area countries are not facilitating sufficiently the shift towards more productive sectors. Financial sector repair therefore has to be at the core of any policy to raise euro area growth potential. And to ensure that lending is directed towards productive activity, in my view there are two policy priorities. The first is to strengthen bank balance sheets – that is, for losses to be properly acknowledged and for adequate recapitalisation to follow.
Here the key issue is to avoid that rising long-term unemployment and structurally low investment create hysteresis effects. The second challenge is how to raise potential growth in a durable way. In line with my broad definition of potential growth, recent research has suggested that pre-crisis estimates may have been overstated by effects linked to the financial cycle.2 In other words, after incorporating information on the unsustainable developments in real interest rates, credit growth and property prices that characterised the 2003–08 period, potential output may have been lower than we thought. A return to the status quo ante may not therefore be enough to restore high levels of sustainable employment. These challenges are interrelated because, to the extent that we can achieve an upward shift in the future growth potential, it will affect growth expectations today. This might induce firms and households to frontload consumption and investment decisions, thus helping lower the risk of hysteresis effects. And vice versa, if there is no prospect of higher growth in the future, we could fall victim to self-fulfilling negative expectations. For this reason, I see policy action on both fronts as urgent. And there are three policy areas that I see as relevant: monetary policy; financial sector repair; and, most importantly, structural reforms. How can we raise potential growth? Monetary policy We know that monetary policy can help buy time for necessary structural measures to be implemented. Going beyond that, it may seem strange to include monetary policy in a discussion of potential growth.