Real and Financial Asymmetries in the Euro Area

Abstract

Within the framework of Optimum Currency Area theory, the proper functioning of a currency union presupposes a sufficient degree of similarity of the participating economies or alternative mechanism to make up for a possible lack of similarity. The most recent economic and financial crisis, the European debt crisis and, lately, the COVID-19 pandemic have revealed the deficiencies of the EA in this respect. To successfully accommodate the various shocks, it is crucial to understand how real and financial markets interact and what the differences between euro area economies are. In this thesis I contribute to this understanding along three dimensions. First, I compute country-specific business and financial cycles and study their similarities between countries. I use the cycles to assess the importance of macrofinancial linkages between real and financial markets. Second, I study the impact of symmetric shocks to GDP, the exchange rate and the interest rate on euro area countries’ trade balances and competitiveness. Third, I investigate if migration and the redistribution of taxes have promoted the unconditional and conditional convergence of incomes in Germany. My analysis of business and financial cycles indicates that asymmetries in euro area real and financial markets continue to exist. In particular, the cycle volatility differs across countries, and it significantly and heterogeneously changes over time. I contribute to the literature by analysing how individual EA countries’ (domestic) financial and business cycles are affected by one another as well as their EA equivalents and find that domestic and EA business and financial cycles can explain roughly 50 percent of the domestic business and financial cycle dynamics. I further contribute to the literature by showing that financial cycles include information about risks to future economic growth. For some countries this implies that booming financial cycles translated into continuously declining means, increasing variances and rising recession probabilities of the conditional real GDP distribution in the period leading to the financial crisis. These developments can be interpreted as early signs of an imminent economic crisis. The analysis of symmetric shocks suggests that differences in economic structures and institutions between countries result in heterogenous responses of their trade balances and competitiveness and might add to macroeconomic imbalances between EA economies. I contribute to the literature by differentiating between countries’ intra-EA and extra-EA trade balances and competitiveness. I find that shocks to real GDP are important drivers of EA trade balances and that these shocks significantly affect the competitiveness of individual EA countries. The impact of exchange rate and interest rate movements on trade balances is only temporary. The example of Germany shows that unconditional convergence of incomes within a currency union will likely be a lengthy process even in the presence of migration and fiscal transfer schemes. The impact of both migration and fiscal transfers depends on initial income conditions. Conversely, conditional convergence of incomes between German states is quasi automatic; migration and fiscal variables do not speed up the process. This finding suggests that income differences in the euro area are likely to exist in the longer run.