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Theoretical Background: Income versus Business Cycle Convergence

In the empirical literature, two main strands of literature on convergence can be distinguished, namely studies on (i) income convergence, and on

(ii) business cycle convergence. The former concept is based on neoclassical growth models (see, e.g., Solow, 1956). According to those studies, diminishing returns to capital cause an inverse relationship between a country’s per capita growth rate and its starting level of income per person. In empirical studies, this relationship is commonly tested with regressions following Barro (1991), where the average growth rate of gross domestic product (GDP) per capita is regressed on the initial level of GDP per capita and some additional control variables (e.g. human capital) in various country samples. Thus, income convergence focuses on a long-run setting, which is particularly relevant for emerging market economies. Recent studies on income convergence in Central and Eastern Europe find a pronounced catching-up process in Eastern Europe in the second half of the 1990s as well as the 2000s (Vojinovic and Prochniak, 2009), although the convergence process seems to be rather heterogeneous (Cavenaile and Dubois, 2011).

Figure 10.1 shows the bivariate relationship between initial GDP per capita levels and the cumulative growth rates from 2000-2011 for the 12 initial euro area countries as well as for the eight CESEE economies that joined the EU but not the euro area in this period, and the five EU countries that adopted the euro after the first changeover wave.2 While the link is rather ambiguous across the advanced euro area economies, the catching-up process is quite pronounced for both the later euro area members and the CESEE EU economies: the lower the income per capita in 2000, the higher the cumulative growth rate in the following decade. As shown in the bottom panel of Figure 10.1, the extent of the catching-up process does not seem to be dependent on the size of the economy.

This chapter, however, mainly focuses on the second strand of literature, that is, business cycle convergence in the CESEE region, but also draws certain conclusions concerning the catching-up process and how it has changed during the recent crisis. The concept of business cycle convergence examines whether countries’ short-run fluctuations around long-run trend GDP have become more synchronized. This analysis is particularly relevant for the establishment of a common currency area. In this context, the theory of optimum currency areas (OCA) put forward by Mundell (1961), McKinnon (1963) and Kenen (1969) has proposed a wide range of criteria for the optimality of a region for establishing a currency union, for instance wage and labour market flexibility, trade and financial integration, coordination of fiscal policies, and so on. Generally, the synchronization of business cycles across member states has been proposed to be the ‘meta-criterion’ for the establishment of an optimum currency area. The line of argument is simple: if two countries share the same business cycle,

Income convergence (GDPper capita) in the euro area and in the CESEE region

Figure 10.1 Income convergence (GDPper capita) in the euro area and in the CESEE region

abandoning an independent monetary policy is less costly, as the same monetary stance might be optimal for both countries.

As highlighted by Fidrmuc and Korhonen (2006), the OCA theory was commonly applied after the break-down of the Bretton Woods system to assess the appropriateness of a possible fixed exchange rate for any given country. Subsequently, the OCA theory attracted renewed increased interest before the introduction of the euro, with most empirical studies assessing the correlations of business cycles between Germany and other potential member countries.3 The EU accession by ten countries in 2004,4 followed by the entry of Romania and Bulgaria in 2007, led to a deeper analysis of the new member states and their business cycles. In particular, the membership of several new member states in the exchange rate mechanism II (ERM II) as a required milestone on the road to the euro increased public interest in such studies. Fidrmuc and Korhonen (2006) give a comprehensive review of this literature, with most studies finding a considerably increased synchronization of CESEE countries with the euro area in the run-up to EU accession. Interestingly, the effects of the economic crisis that emerged in 2008 on business cycle synchronization in Europe (and on CESEE countries in particular) have hardly been examined so far, although the often cited heterogeneity in both monetary and fiscal policy in those countries makes a corresponding analysis very interesting.

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