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Does integration and economic policy coordination promote business cycle synchronization in the EU?

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Abstract

Previous studies have discounted important factors and indirect channels that might contribute to business cycle synchronization (BCS) in the EU. We estimate the effects of market integration and economic policy coordination on bilateral business cycle correlations over the period 1995–2012 using a simultaneous equations model that takes into accounts both the endogenous relationships and unveils direct and indirect effects. The results suggest that (1) trade and FDI have a pronounced positive effect on BCS, particularly between incumbent and new EU members. (2) Rising specialization does not decouple business cycles. (3) The decline of income disparities in EU27 contributes to BCS, as converging countries develop stronger trade and FDI linkages. (4) There is strong evidence that poor fiscal discipline of EU members is a major impediment of business cycle synchronization. (5) The same argument holds true for exchange rate fluctuations that hinder BCS, particularly in EU15. Since BCS is a fundamental prerequisite and objective in an effective monetary union, the EU has to promote market integration and strengthen the common setting of economic policies.

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Notes

  1. Fidrmuc (2004) and Fontagné and Freudenberg (1999) test explicitly the impact of intra-industry trade to promote BC synchronization.

  2. Studies that use alternative measures of financial integration provide conflicting results. For instance, Jones and Witte (2011) find that financial integration has a significant negative effect on business cycle synchronization between the new member states of the EU and the euro area; Kalemli-Ozcan and Papaioannou (2009) find that a higher degree of financial integration is associated with less synchronized output cycles for a sample of 20 developed countries over the period 1978–2007; Kalemli-Ozcan et al. (2013) based on a panel data set for 18 rich economies over the 1978–2006 period identify a strong negative effect of banking integration on output synchronization, conditional on global shocks and country-pair heterogeneity; Cerqueira and Martins (2009) using data for 20 OECD countries from 1970 to 2002 find a negative and significant effect of financial openness on BCS. On the other hand, Akin (2012) who examines the determinants of real GDP correlations for 51 countries including 27 emerging markets over the period 1970–2008, finds no significant effect on business cycle synchronization on average; a negative effect for developed country pairs, and developed and emerging country pairs; and a positive effect on BCS for emerging markets.

  3. Recently, Canova et al. (2012) examined whether three institutional changes (the Maastricht Treaty, the creation of the ECB and the Euro changeover) affect business cycles in Europe and found that the process of real convergence predates the three institutional changes.

  4. For the system to be identified it is necessary that for each endogenous variable in an equation an equal number of exogenous variables differently from the exogenous in the same equation is present in the other equations. Thus each equation requires a different set of exogenous variables (Wooldridge 2006).

  5. Other authors regard specialization with respect to all economic sectors, e.g. Siedschlag (2010) considers six sectors of the whole economy, Clark and van Wincoop (2001) uses an indicator with eight non-manufacturing and eight manufacturing industries.

  6. As an alternative measure, we have employed a specialization indicator with six industries including both manufacturing and non-manufacturing industries based on data collected from Eurostat. Based on that indicator, specialization is generally less pronounced.

  7. Note that this picture remains very similar with the use of GDP per capita in PPP as the basis of construction of the indicator.

  8. This also explains that, in the recent economic crisis, the Euro area members and in particular the peripheral ones suffered immediately from declining export demand and synchronous output decline.

  9. The result corresponds to Frankel and Rose (1998), who suggest that decreasing exchange rate volatility encourages trade, and argue that this is indicative of the endogeneity between trade and currency areas.

  10. Clark and van Wincoop (2001) use eight manufacturing sectors and eight non-manufacturing branches and Siedschlag (2010) uses six branches of the total economy for the specialization indicator. As mentioned in Sect. 6, we used also an alternative specialization indicator covering six manufacturing and non-manufacturing sectors for robustness checks. In this case we found an insignificant coefficient of specialization. However, the specialization variable based on all sectors of the economy and not only on manufacturing sectors resulted in less clear results in the auxiliary equations and an unsatisfactory fit of the specialization equation.

  11. Clark and van Wincoop (2001) look at the period 1970–1993, Siedschlag (2010) investigates the period 1990–2003.

  12. Dées and Zorell (2012) use the absolute volume of bilateral FDI stocks without relating it to the GDP of the countries involved, as an indication for financial linkages. Since the same volume of FDI can represent either strong FDI linkages existing between small economies, or weak FDI linkages between large economies, this measure is distorted.

  13. The only exception is EA11, wherein we observe a net, albeit small, negative effect of trade on BCS due to the dominance of the negative indirect of trade on BCS via FDI over the direct effect of trade on BCS.

  14. See the debate on the Optimum Currency Area which stresses the need for individual adjustment instrument Mundell 1961 and the debate for real convergence criteria (e.g. Beine and Hecq 1998).

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Acknowledgments

Research for this study has been undertaken as part of the project “The Impact of the Single Market on Cohesion” commissioned by the European Commission, DG Regio. The authors would like to thank Iain Begg, colleagues from the European Commission and participants at the Johannes Kepler University’s Departmental Seminar for helpful suggestions, and the Editor of Empirica, Fritz Breuss, and two anonymous reviewers for their insightful comments on a previous draft of this paper.

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Authors and Affiliations

  1. Department of Economics, Institute for International Economics, Vienna University of Economics and Business, Welthandelsplatz 1, 1020, Vienna, Austria

    N. Antonakakis & G. Tondl

  2. Economics and Finance Subject Group, University of Portsmouth, Portland Street, Portsmouth, PO1 3DE, UK

    N. Antonakakis

  3. Research Institute for European Affairs, Vienna University of Economics and Business, Welthandelsplatz 1, 1020, Vienna, Austria

    G. Tondl

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Correspondence to N. Antonakakis.

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Antonakakis, N., Tondl, G. Does integration and economic policy coordination promote business cycle synchronization in the EU?. Empirica 41, 541–575 (2014). https://doi.org/10.1007/s10663-014-9254-2

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