27 February 2014

ECFIN Economic Brief: Financing the real economy

This article addresses the relationship between the real economy and the financial sector, asking the question: to what extent does the crisis in the financial sector cast a shadow on economic activity?

In the aftermath of the economic and financial crisis, policymaking became more geared towards structural reforms to support the process of economic recovery, steered at the EU level through the reinforced economic governance. While there are encouraging signs that an economic recovery is underway in Europe, growth prospects are modest and further reforms remain necessary in order to restore productivity and reach the Europe 2020 targets. Priorities for the EU include, inter alia, restoring normal lending to the economy and promoting growth and competitiveness for today and tomorrow. 

This article addresses the relationship between the real economy and the financial sector, asking the question: to what extent does the crisis in the financial sector cast a shadow on economic activity? The purpose here is to explore how bank lending can affect the real economy, and how distress in financial institutions has influenced bank lending to firms. To better understand this complex issue, a multi-faceted approach is adopted, and the relationship is examined from a firm-, sector-, and macrolevel perspective.

The main findings can be summarised as follows:

• First, market entry and exit of firms (firm dynamics) is necessary for an efficient allocation of resources. Limited access to finance can frustrate business dynamics, thereby impeding resources to flow from low-productive to high-productive firms, leading to lower allocative efficiency.
• Second, access to finance difficulties have a negative impact on a firm's productivity level, and thereby on its chances to become an exporter.
• Third, access to finance difficulties reduce investments, also in export-oriented sectors where profitability has improved, thus negatively affecting the repair of imbalances
  in vulnerable Member States.
• Fourth, for those sectors that rely on outside financing the adverse growth impact of the crisis was mitigated in countries with more developed financial markets.
• Finally, survey data reveals that firms face less access to finance difficulties in countries with a healthier financial sector.

Policy efforts to revitalise competitiveness are of paramount importance to absorb the productive sources in the form of people and capital that have become idle during the crisis. A failure to do so will result in nontrivial social and economic costs, and permanent damage in the form of depreciated human capital due to prolonged spells of unemployment. Intensified competition through market entry would lead to welfare gains for consumers in terms of lower prices and/or increased quality of goods and services.

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