Business Cycle Accounting for Peripheral European Economies

Published date01 November 2016
Date01 November 2016
Petre Caraiani*
Using the Business Cycle Accounting methodology, this paper analyzes the
dynamics of the EMU-periphery economies before and during what was called
the sovereign debt crisis. TFP dynamics and the labor wedge explain most of the
dynamics before and during the crisis. The bond wedge, corresponding to the risk
premium, made a low contribution, moving counter-cyclically. The capital wedge
made a modest contribution to the fall in output during the crisis. Additional evi-
dence links the dynamics of the TFP and the labor wedge with changes in the
interest rates and a spike in import prices at the onset of the crisis, correspond-
ing to the general mechanisms of the large capital inflows, in the wake of the
introduction of the Euro, followed by sudden stops.
Following the effects of the Great Recession, the macroeconomic dynamics of
the so-called EMU-periphery economies (hereafter PIGS economies, as they
best known, or less offensively GIPS economies, i.e. Greece, Ireland, Portugal
and Spain) have attracted a lot of attention. Previously seen as success stories
of rapid economic development, they are now viewed as deeply concerning.
However, the academic literature is still limited with respect to the causes of
the deep recessions in these economies.
In this paper, I propose using the business cycle accounting (BCA) frame-
work to study the dynamics of these economies. Originally proposed by Chari
et al. (2007), this approach analyzes business cycles by considering a prototyp-
ical model characterized by a number of wedges (in the original paper, TFP,
labor, investment and government wedge), which potentially cover a number
of more detailed models. The purpose of a business cycle accounting exercise
*Romanian Academy
This research was supported by a grant from the CERGE-EI Foundation under a program
of the Global Development Network. All opinions expressed are those of the author and
have not been endorsed by CERGE-EI or the GDN.
Many thanks to Mario Holzner and Jeong Byeongju for their insightful comments which
very much helped in refining this paper. I also thank Marek Kapicka and the other partici-
pants at the CERGE workshop for the research grants awarded in the RRC 13 competition
in August 2013.
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12119, Vol. 63, No. 5, November 2016
©2016 Scottish Economic Society.
is thus to uncover the main wedges that drive business cycles, although this
identification is not unique, as different detailed models can lead to the same
This framework was applied to a variety of cases, starting with the case
studies in the original paper, namely the Great Depression in the United
States and the recession in United States in the early 1980s. Later case studies
include the early 1980 recession in the United Kingdom (see Kersting, 2008)
or the Great Depression in Japan (see Saijo, 2008). A common note of these
studies is that the TFP and the labor wedge are the most important drivers of
the business cycle.
More recently, research has expanded to deal with small open economies,
typically by considering that households optimally choose to hold debt/foreign
bonds with an associated wedge. This bond/debt wedge usually reflects the
international risk associated with the bonds. One of the first studies in this
direction is due to Lama (2011), who applied an extension of the BCA
methodology to small open economies in Latin America. Otsu (2010) did simi-
lar work by studying the crisis in the late 1990s in East Asia using the busi-
ness cycle accounting framework. However, most of this research also
identifies the TFP and the labor wedge as the most important factors in the
business cycle dynamics of the different small open economies studied. At the
same time, it must be pointed out that these identified wedges could and
should correspond to different detailed models as compared to the wedges
identified, for example, for the United States.
A few recent studies have also addressed the issue of how the identified
wedges differ for various types of economies. One of them (Cho and Doblas-
Madrid, 2013) identified a more significant role for investment wedges in
South-East Asian economies as compared to Western economies.
As this paper aims at applying the BCA approach to the pre-crisis and cri-
sis period in the PIGS economies, it proposes to answer the following research
questions. The first looks at which type of wedges were the main drivers of
the recent crisis in the PIGS. A second pertinent question refers to what kind
of detailed model could have produced the actual dynamics of the wedges
(that is, a well-specified model, having different kinds of frictions and able to
reproduce the corresponding dynamics of the wedges in the prototype model).
Some studies were carried on these particular economies, but either they
came too soon to address the post-2008 crisis, like Cavalcanti (2007) or
Ahearne et al. (2006), or they focused on particular economies or only used a
closed economy approach, like Iskrev (2013) or L
opez and Garcia (2014).
Using an open economy business cycles account framework, this paper
finds that the TFP and the labor wedge can explain most of the dynamics of
output in these economies, both before and after the crisis. I also find that
possible detailed models that capture the changes in the interest rates faced by
these economies and in the import prices can explain the role of these two
wedges. The labor wedge can be explained through the working capital con-
straint. An additional analysis of the Portuguese slump between 2000 and
2007 suggests the misallocation of resources acting through TFP as a potential
Scottish Journal of Political Economy
©2016 Scottish Economic Society

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT