The global economic landscape has shifted dramatically since the mid-1980s. First, there has been a rapid increase in trade and financial linkages across countries. Second, emerging market economies have increasingly become major players and they now account for about a quarter of world output and a major share of global growth. These developments, along with the imminent U.S. recession and concerns about its international spillover effects, have generated a vigorous debate about changes in the patterns of international business cycle comovement. On the one hand, the conventional wisdom suggests that the forces of globalization in recent decades have increased cross-border economic interdependence and led to convergence of business cycle fluctuations. Greater openness to trade and financial flows should make economies more sensitive to external shocks and increase comovement in response to global shocks by widening the channels for these shocks to spill over across countries.
On the other hand, in recent years the impressive growth performance of emerging market economies, especially China and India, seems to have been unaffected by growth slowdowns in a number of industrial countries. This has led to questions about the potency of international channels of business cycle transmission. Some observers have even conjectured that these emerging markets have “decoupled” from industrial economies, in the sense that their business cycle dynamics are no longer tightly linked to industrial country business cycles. These two views of cross-border interdependence have very different implications for the evolution of global business cycles.
What guidance does economic theory offer for discriminating between these two views? Theory delivers rather nuanced predictions about the impact of increased trade and financial linkages on cross-country output comovement. For example, rising financial linkages could result in a higher degree of business cycle comovement via the wealth effects of external shocks. However, they could reduce cross-country output correlations by stimulating specialization of production through the reallocation of capital in a manner consistent with countries’ comparative advantage. Trade linkages generate both demand and supply-side spillovers across countries, which can result in more highly correlated output fluctuations. On the other hand, if stronger trade linkages facilitate increase specialization of production across countries, and if sector specific shocks are dominant, then the degree of comovement of output could fall (see Baxter and Kouparitsas, 2005).
As for other macroeconomic aggregates, the resource-shifting effect in standard business cycle models implies that global integration should reduce investment correlations by shifting capital to and raising investment growth in countries with relatively high productivity growth. By contrast, rising financial integration should increase consumption correlations by enabling more efficient risk sharing. The empirical validity of these (sometimes conflicting) theoretical predictions remains an open issue.
Our objective in this paper is to provide a comprehensive empirical characterization of global business cycle linkages among a large and diverse group of countries. We focus on the following questions: First, what are the major factors driving business cycles in different groups of countries? Are these factors mainly global or are there distinct factors specific to particular groups? Second, how have these factors evolved as the process of globalization has picked up in pace over the past two decades? The answers to these questions have important implications for the debate on the relative merits of the two competing views about whether global business cycles are converging or decoupling.
We extend the research program on global business cycles in several dimensions. First, our study is much more comprehensive than earlier studies as we use a larger dataset (106 countries) with a longer time span (1960-2005). With few exceptions, the existing literature on international business cycles has focused on industrial countries. Given the rising prominence of the emerging markets in the global economy, and particularly in the context of an analysis of international business cycle spillovers, this narrow focus is no longer tenable. Indeed, the current debate about convergence or decoupling is largely about whether and how emerging markets will be affected by the U.S. business cycle. Our use of a large sample of countries allows us to draw a sharp contrast across the different groups of countries in terms of their exposure to the global economy. In addition, the relatively longer time span of the data enables us to consider distinct sub-periods and, in particular, analyze the changes in business cycles that have taken place during the period of globalization (1985-2005) relative to earlier periods.
Second, unlike most existing studies, we specifically consider the roles played by global cycles and distinguish them from cycles common to specific groups of countries—industrial economies, emerging markets, and other developing economies. This distinction between the latter two groups of non-industrial countries turns out to be important for our analysis.
Third, we study the extent of global business cycle comovement in a number of macroeconomic variables rather than solely focusing on output. A key insight from our brief discussion of theory above is that the common practice of measuring business cycles and spillovers based on fluctuations in output can be rather restrictive. Indeed, our approach of using multiple macroeconomic indicators rather than just GDP to characterize business cycles can be traced back to classical scholars of business cycles (Burns and Mitchell, 1946; Zarnowitz, 1992). The NBER also looks at a variety of indicators for determining turning points in U.S. business cycles.
In addition, we employ a set of recently developed econometric tools to analyze these questions. The novel methodology that we implement is based on estimation of a dynamic factor model and is critical for our purposes. Our model enables us to simultaneously capture contemporaneous spillovers of shocks as well as the dynamic propagation of business cycles in a flexible manner, without a priori restrictions on the directions of spillovers or the structure of the propagation mechanism. We decompose macroeconomic fluctuations in national output, consumption, and investment into the following factors: (i) a global factor, which picks up fluctuations that are common across all variables and countries; (ii) three factors specific to each group of countries, which capture fluctuations that are common to all variables and all countries in a given group; (iii) country factors, which are common across all variables in a given country, and (iv) idiosyncratic factors specific to each time series.
The estimated factors reflect elements of commonality of fluctuations in different dimensions of our data. The importance of studying all of these factors in one model is that they obviate problems that could be caused by studying a subset of factors, which could lead to a mischaracterization of commonality. For instance, group-specific factors estimated in a smaller model may simply reflect global factors that are misidentified as being specific to a particular group. Moreover, by including different macroeconomic aggregates, we get better measures of the commonality of fluctuations in overall economic activity. The dynamic factors capture intertemporal cross-correlations among the variables and thereby allow for the effects of propagation and spillovers of shocks to be picked up. This methodology is also useful to analyze how the global and group-specific factors have affected the nature of business cycles within each group of countries over time.
We report a rich set of results about the evolution of global business cycles. Our first major result is that there has been a decline over time in the relative importance of global factors in accounting for business cycle fluctuations in our sample of countries. In other words, there is no evidence of global convergence of business cycles during the recent period of globalization. Even if we use a broader definition of global business cycle convergence by taking the total contribution of all common factors—global and group-specific—there has been little change in overall business cycle synchronicity. This sum has been stable over time because of the substantial increase in the contribution of group-specific factors to business cycles. This brings us to our next interesting result.
During the period of globalization, there has been a modest convergence of business cycles among industrial countries and, separately, among emerging market economies. That is, group-specific factors have become more important than global factors in driving cyclical fluctuations in these two groups of countries. This phenomenon of group-specific business cycle convergence is a robust feature of the data—it is not limited to countries in any particular geographic region and is not a mechanical effect of episodes of crises. The distinction between emerging markets and other developing economies is crucial for uncovering this result. This distinction has become sharper over time as there has been little change in the relative importance of group-specific factors for the latter group, where business cycle fluctuations are largely driven by idiosyncratic factors.
We also find that country-specific factors have become more important for the group of emerging market economies in the recent period of globalization, while they have become less important for industrial economies. The rising comovement among output, consumption and investment in the former group ties in with a recent literature showing that countries with intermediate levels of financial integration—i.e., emerging market economies—have not been able to achieve improved risk sharing during the globalization period (Kose, Prasad and Terrones, 2007). Moreover, the more successful emerging market economies have increasingly depended on domestically-financed investment, rather than relying on foreign capital to boost investment (Gourinchas and Jeanne, 2007; Aizenman et al., 2007; Prasad et al., 2007). On the other hand, countries with high levels of financial integration—mostly industrial countries have been able to use international financial markets to more efficiently share risk and delink consumption and output.
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