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28 September 2015

VoxEU: Low interest rates, capital flows, and declining productivity in South Europe

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This column presents an alternative perspective on how joining the euro has impacted productivity in southern Europe. It turns out that capital wasn’t allocated efficiently across firms after cheap borrowing at low interest rates, impacting total factor productivity.

The ongoing Greek debt crisis has renewed interest among economists and policymakers in understanding the costs associated with joining the eurozone. It has also generated concerns that countries in Southern Europe could have been better off if they had never joined in the first place. Partly, these concerns arise from the fact that countries in the south were able to borrow at lower interest rates in the run up to and following the introduction of the euro. As creditors deemed these countries less risky than before and as the ECB strengthened its anti-inflationary policy, borrowing rates decreased and these economies experienced large inflows of capital (Feldstein 2012).

While borrowing rates have converged among countries in the eurozone, productivity growth rates have actually diverged. Countries in the South experienced lower productivity growth than other European countries. There is some work suggesting that part of the lower productivity growth in Southern Europe is related to the boom in the construction sector and the shift of resources from traded to non-traded sectors (Reis 2013, Benigno and Fornaro 2014).

In recent work (Gopinath et al. 2015), we highlight an alternative (but complementary) view of how the euro convergence process may have impacted productivity in Southern Europe. We argue that, following the lowering of interest rates, capital was not allocated efficiently across firms in the South. In turn, the misallocation of capital flows generated declines in total factor productivity. [...]

Using our large and representative sample of firms, we find that, in reality, capital was increasingly allocated to less productive firms over time. We also document that firms with higher net worth invested more in physical capital and borrowed more than firms with lower net worth but otherwise similar productivity. The dispersion of the return to capital across firms increased because some productive and high-return firms were constrained from increasing their investment. Total factor productivity declined because capital was allocated inefficiently over time.

[...] An important lesson from our work for economists and policymakers is that capital inflows due to declines in the interest rate may actually impact productivity in a negative way. In an environment with low interest rates, capital can be allocated to less efficient firms if financial markets remain underdeveloped. Financial market imperfections in Southern nations of the Eurozone bear some of the blame for their poor productivity performance.

By lowering interest rates and encouraging an inflow of capital, the adoption of the euro may have been partly responsible for the misallocation of capital and the low productivity observed in the South. While this does not necessarily mean that the adoption of the euro was economically harmful overall, it does highlight one negative consequence through its effect on interest rates when capital markets are relatively underdeveloped. Policymakers concerned with lagging productivity growth in Southern nations would be wise to look for ways to improve the functioning of their financial markets. 

Full article on VoxEU


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