The most important transmission channels of US business activity are trade, financial market connectivity, the correlation of market volatilities and the globalization of economic expectations. In an increasingly global world economy, this plethora of transmission channels might be expected to result in an increasingly synchronous business cycle pattern in both economic blocs. Our study reveals that that correlation is greatest on the premise of a two-quarter lead for the US economy on the euro area. What does come as a surprise, though, is the slight reduction in correlation in the recent past, between 2001 and 2006, (correlation coefficient 0.65) versus the previous period 1995-2000 (correlation coefficient 0.72).
Has Europe moved out of the American economic slipstream?
We achieve a similar result when we estimate growth in the euro area by entering US growth and another two potential determinants of the business cycle – the change in the price of oil and in the term structure of interest rates in the euro area – into a multiple regression equation. For the period 1995-2006 the three explanatory variables are assured at a significance level of 90 %. However, for the partial periods 1995 to 2000 and 2000 to 2006 this approach produces rather different results. Whereas in the earlier period the elasticity of European economic growth with respect to American growth worked out at 0.64, it fell to a not-significant 0.15 in the more recent period.
The European business cycle has therefore tended to show less synchronicity in recent years than in the second half of the 1990s. But this is only really surprising at first glance. European economic integration has made extremely rapid advances since the mid-1990s Enlarging the EU through the addition of twelve central and east European countries has also broadened the economic area and raised its potential. All this indicates that factors specific to the region are shaping the European business cycle more strongly than before. Viewed in this light, the lesser co-movement with the US economic cycle in recent years is understandable. Nor is it surprising in this context that the cooling in business activity in America since the middle of last year has not put an end to the economic rebound in Europe, particularly since the fallout on the financial markets – the second major avenue of transmission – has so far been minimal.
But even in the future, matters would look different in the event of a severe US recession, which would in all probability deal a hefty blow to the financial markets. In this case, and notwithstanding Europe’s closer economic integration, the European business cycle would presumably be hard hit. In the course of this the correlation in economic growth between the two areas would probably increase significantly again.