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Financial cycles in Europe: dynamics, synchronicity and implications for business cycles and macroeconomic imbalances

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Abstract

Using dynamic factor models and state-space techniques we quantify financial cycles for twenty European countries over the period 1960Q1–2015Q4 capturing imbalances across credit, housing, bond and equity markets. The paper documents the existence of slow-moving and persistent financial cycles, as well as cross-country synchronicity patterns in Europe. Spillover analysis points at the significant role the global financial cycle and the regional European financial cycle play in shaping national financial market dynamics. Quarterly Bayesian panel VAR estimations suggest that financial cycles influence business cycles and public debt dynamics, with stronger shock transmission observed in the euro area and systemic European economies.

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Data availibility

The data that support the findings of this study are available from the author upon request, except for subscription-only data from Haver Analytics. The author would like to thank Nadya Heger for excellent statistical support, as well as the participants of the 16th Euroframe, AMEF 2019, ERFIN 2020 conferences, and two anonymous referees for valuable comments. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author, and do not necessarily reflect the views of the World Bank, the Executive Directors of the World Bank, or the governments they represent.

Notes

  1. The paper is well-aligned with this literature also with regard to the dynamic factor approach utilized to derive supranational financial cycles based on the data for multiple countries and financial markets.

  2. The studies similar in certain aspects are Ha et al. (2020) and Comunale (2022). However, Ha et al. (2020) investigate only G-7 economies and do not analyze implications for current account and public debt. Differing from Comunale (2017), we estimate financial cycles as a dynamic factor based on price, quantity and risk characteristics of four financial segments (in contrast to a measure based only on private credit) and analyze a broader sample, including non-EU countries.

  3. See, for instance, Aikman et al. (2015), Claessens et al. (2012), Schularick and Taylor (2012).

  4. In particular, it is shown using a full-panel scatterplot of business cycle measures and charts for the dynamics of selected countries with longer data availability that, in fact, alternative statistical filters—the Baxter-King (BK) and the Hodrick-Prescott (HP) filters—yield very similar results and are strongly correlated.

  5. The variables are standardized (demeaned and divided by their sample standard deviation) to ensure their variances contribute to the variance of the estimated latent factor symmetrically, regardless of their measurement scale and historical volatility.

  6. One may also formulate a hierarchical model incorporating segment-specific, aggregate country-level, and regional factors in a single system. However, this would need a strongly balanced panel rather than a broader unbalanced sample for which the financial cycles are estimated individually, while only those countries with longer series form a strongly balanced sample to estimate the regional financial cycles. In addition, technically this may not be feasible for a sample with heterogeneous composition of input financial market series and contraints on the signs of factor loadings at each step. Furthermore, constructing a hierarchical factor model would yield “net” national financial cycles, i.e. financial cycles purged from common regional and global factor, while the analysis focuses on the dynamics of “gross” financial cycles and then discusses the role of the common factor (regional and global) in shaping their dynamics.

  7. The magnitudes of predictive margins are challenging to interpret directly given that both variables do not have a direct interpretation for the full sample, as the financial cycle index does not have a global interpretable scale, while credit-to-GDP is expressed as a deviation from trend and the magnitudes differ across countries. However, one may interpret the magnitudes in relation to the range and distribution of both series, which, inter alia, can be inferred from the scatterplot in Fig. 3, panel e)

  8. Estimations are done via the BEAR toolbox by Dieppe et al. (2016).

  9. Estimations with the Minnesota prior produced similar results.

  10. A one-standard deviation shock corresponds to a change in FC by 0.2. As noted above, financial cycle indices are standardized, which allows to interpret FC changes in terms of the number of standard deviations from the (country-specific) historical mean. These can then be related to the known financial distress episodes as benchmarks—see Fig. 2. Generally, systemic financial market events are associated with FC fluctuations of at least one standard deviation.

  11. An alternative measure computed for robustness, Pearson’s correlation, is reported in Appendix Figure A3.

  12. Country composition for version 1: AUT, SWE, DEU, FRA, CHE, GBR, ITA; version 2: AUT, SWE, DEU, FRA, CHE, GBR, ITA, BEL, ESP, NOR, HUN, NLD. The country composition is based entirely on the length of the financial cycle series.

  13. The global financial cycle index is obtained from Adarov (2020), which estimates it using a similar dynamic factor model based on a global sample of countries.

  14. Additional estimations are carried out based on a broader sample of 12 countries (CHE, GBR, DEU, NLD, ESP, FRA, ITA, SWE, AUT, NOR, BEL and HUN). However, in this case the time span shrinks to 1993Q2–2012Q2. The preference thus is given to the estimates based on the longer period, albeit both cases yield similar results.

  15. The Minnesota prior yields very similar results—available on request.

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Acknowledgements

Support from the Austrian National Bank’s Anniversary Fund is gratefully acknowledged (research Grant No.17044). The research was conducted while the author was at the wiiw.

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  1. The World Bank, 1818 H Street, NW Washington, DC, 20433, USA

    Amat Adarov

  2. Vienna Institute for International Economic Studies wiiw, Rahlgasse 3, 1060, Vienna, Austria

    Amat Adarov

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Adarov, A. Financial cycles in Europe: dynamics, synchronicity and implications for business cycles and macroeconomic imbalances. Empirica 50, 551–583 (2023). https://doi.org/10.1007/s10663-022-09566-5

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