Financial Sector and Business Cycles Determinants in the EMU: An Empirical Approach (1996-2011)

Abstract

1. Introduction The frequency and extent of business cycles fluctuations entail significant implications for the real economic activity and the well-being of society. Business cycles volatility reflecting country exposure and vulnerability to shocks, is considered a crucial determining factor for a wide range of economic outcomes including long-run growth (Ramey and Ramey, 1995; Hnatskovsa and Loayza, 2004), welfare (Pallage and Robe, 2003; Barlevy, 2004) and income distribution and poverty (Laursen and Mahajan, 2005; Calderon and Levy-Yeyati, 2009). Notwithstanding there is a subsequent difference between developed and developing economies concerning the level of macroeconomic volatility (Bejan, 2006; Hakura, 2009), there is clear evidence that most advanced economies have experienced a striking decrease in the output volatility over the past 30 years. This period of diminishing volatility starting in the mid 1980s is known as "The Great Moderation" (3). The analysis of the phenomenon has mainly focused on the US economy while there is little evidence for the EMU countries (Gonzalez-Cabanillas and Ruscher, 2008). The ongoing recession started in 2007 has caused volatility to move considerably higher posing concerns on whether the Great Moderation is over or not. According to World Economic Outlook (2005), the determinants of output volatility may be broadly categorized into four groups: namely, the stability of macroeconomic policies in regards of fiscal policy indicators, trade and financial integration, financial sector development, and finally the quality of institutions. Also, other structural characteristics are to be cited autonomously including the volatility of terms of trade and the flexibility of exchange rates. Trade openness is often associated with business cycles fluctuations despite the relationship between openness to trade and business cycle volatility remains ambiguous (Bejan, 2006; Di Giovanni and Levchenko, 2008; Cavallo, 2008; Cavallo and Frankel, 2008). Kose and Yi (2003) suggest that the effects of trade openness on output volatility are strictly related with the emerging patterns specialization and the nature of shocks. Also, the role of fiscal policy in driving business cycles fluctuations and the relationship between fiscal policy variables with output fluctuations are of particular importance (Lane, 2003; Gali and Perotti, 2003; Alesina et al. 2008). Fatas and Mihov (2003) who investigate the impact of discretionary fiscal policy on output volatility and growth, suggest that discretionary fiscal policy increases output volatility which in turn lowers economic growth. Debrun and Kapoor (2010) find that, after accounting for 3 key dimensions of fiscal policy discretionary fiscal policy linked to cyclical conditions does not have a significant effect on output volatility. Structural determinants of business cycles fluctuations are widely investigated. Acemoglu et al. (2003) investigate the effect of institutions on volatility and crises via a number of macroeconomic and microeconomic routes. The empirical results suggest that low quality institutions cause volatility through a variety of micro and macro mediating channels. Gallegati et al. (2004) who examine business cycles characteristics of Mediterranean countries, find that output volatility varies across countries as a result of different stages of development. The relationship between financial sector (openness, integration, development and liberalization) and business cycles volatility has recently received increasing attention among economists. Calderon and Hebbel (2008) find that the impact of financial openness on aggregate volatility is subject to the level of debt-equity ratios in countries under investigation. Higher financial openness is associated with a negligible effect on volatility in countries with high debt-equity ratios. More particularly, the authors argue that the relationship between financial depth measured by the ratio of debt liabilities to GDP and the volatility of output fluctuations appears positive as loan-related liabilities are driven by nominal shocks while the link remains negative in the presence of real shocks (equity-related liabilities). …