Linkages between European countries have become more prevalent in the postwar period as a result of the efforts of integrating national markets within Europe. These efforts include the removal of trade barriers, the implementation of the Single European Act in 1986, the Maastricht Treaty in 1992, the introduction of the Single European Market in 1993, the Stability and Growth Pact in 1997, and the creation of the European Monetary Union with a common currency and common monetary policy. An important question is whether these efforts of economic and monetary integration have lead to a higher degree of similarity of European business cycles in recent years.
Such a development is also desirable since the loss of the option of following an independent monetary policy and giving up the value of changing the exchange rate when desired would otherwise constitute a major cost for the EMU countries. These options are especially important if countries are facing asymmetric shocks, in which case exchange rate adjustments and separate monetary policies could help to stabilize nation–specific aggregate fluctuations. A common monetary policy therefore requires that the timing of business cycles is similar among the members of the monetary union. However, even if the timing of business cycles is similar, the magnitude may differ, in which case the intensity of policies may have to be different.
There are theoretical reasons for both the view that economic integration will lead to more synchronized business cycles and the opposite view that increased economic integration will lead to less synchronized business cycles. Kalemli Ozcan, Sørensen and Yosha (2001) argue that increased economic integration leads to better income insurance through greater capital integration which in turn will lead to a more specialized production structure and an increase in trade and therefore less synchronized business cycles. A similar argument has also been proposed by Krugman (1993). Alternatively, it could be argued, as Coe and Helpman (1995) and Frankel and Rose (1998) suggest, that the removal of trade barriers will lead to more trade such that demand shocks are more easily transmitted across national borders. Economic and monetary integration, will according to this view, lead to more symmetry of structural shocks and knowledge and technology spillovers which will lead to a higher degree of synchronization of national business cycles.
Given these theoretical ambiguities over the effects of economic and monetary integration on the behavior of business cycles, empirical evidence must be brought to bear on the issue. Indeed, there are several papers suggesting that business cycles are more synchronized when exchange rate variability is low, see for example Fatás (1997), Artis and Zhang (1997, 1999), Dickerson, Gibson and Tsakalotos (1998) and Rose and Engel (2002). However, there are also papers suggesting the opposite, that business cycles are more synchronized during periods with higher exchange rate volatility, see for example Gerlach (1988), Inklaar and De Haan (2001) and De Haan, Inklaar and Sleijpen (2002). A few authors report evidence suggesting no relationship between exchange rate regime and business cycle synchronization, see Baxter and Stockman (1989) and Sopraseuth (2003). In addition, there seems to be at most only weak evidence supporting the view that increased economic integration leads to a higher degree of synchronization. Indeed, Doyle and Faust (2002) and Kose, Prasad and Terrones (2003) find no strong evidence supporting this idea.
With few exceptions, earlier papers focus on the relationship between exchange rate regimes and the timing of European business cycles disregarding any effects of the magnitude of cycles. This is in part surprising since there is a direct relationship between the correlation and the variance. For example, holding everything else constant, a lower variance would imply a higher correlation coefficient. Dickerson, Gibson and Tsakalotos (1998) find that the magnitude of business cycles in general is lower for core EU countries but they provide no analysis of the relationship between magnitude and exchange rate regimes. Sopraseuth (2003), however, found that the magnitude of European business cycles was unrelated to membership of the EMS.
The purpose of this paper is to shed light on the question whether European business cycles have become more similar as a result of economic and monetary integration. We measure, based on bandpass filtered data, the characteristics of European business cycles analyzing to what extent they have become more synchronized over time and test whether, for example, EU membership and the Single Market program can account for a higher degree of synchronization. We then consider the role of other factors that have received considerable attention in the literature such as differences in fiscal and monetary policy, border effects, and trade intensity. Can these factors explain the lack of full synchronization among European business cycles?
The paper is organized in the following manner. In section 2 we provide a selected overview of the earlier literature focusing on studies of European business cycle behavior and exchange rate regimes. In section 3 we describe the method used to extract the business cycle component from the data and perform a first preliminary analysis of the data. Section 4 contains the empirical analysis. Section 5 summarizes the main findings.
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