Is Germany’s Influence on Austria Waning? Synchronization and Transmission of Cyclical Shocks Gerhard Fenz, This study analyzes the connection between business cycle fluctuations in Germany and Martin Schneider Austria as well as the transmission of German shocks to Austria. Compared to Austria’s links with other countries, the ties between Austria and Germany have loosened in relative terms in recent years; in terms of gross domestic product (GDP), however, a strong and steady increase has been recorded. Static and dynamic correlation measures point to a consistently high level of co-movement between Austria and Germany. While the Austrian economy lagged behind the German economy by one quarter in the 1970s, it now leads the German economy by one quarter. The Austrian economy’s reaction to German shocks equals 0.4 times the German reaction. Monetary policy shocks are transmitted with the greatest impact, while supply and demand shocks trigger a far less pronounced reaction in Austria. Over time, monetary policy shocks have gained slightly in importance, while German demand shocks have become less important. On average across shocks, the transmission effect shows a marginal weakening. The relative importance of Germany and the international environment in explaining the forecast error for Austrian GDP has increased somewhat over time, whereas the domestic contribution to the forecast error has declined. On the whole, it is not possible to identify a decline in Germany’s importance for the Austrian economy. JEL classification: C32, E32, F41 Keywords: business-cycle, synchronization, vector autoregression, shock-identification, transmission. 1 Introduction Brandner and Neusser (1992) exam- As a small and open economy, Aus- ine correlations between Austria and tria is characterized by strong links Germany based on a number of macro- with Germany, its largest neighbor. economic variables. They find a high The ties between the two countries contemporaneous correlation for GDP are the result of their geographical and investment but only a low one for proximity, their common language, a private consumption. Winckler (1993) number of cultural and institutional focuses on the orientation of Austrian similarities as well as a turbulent economic policy toward Germany as common history. Germany has always a cause for the high level of co-move- had a major influence on Austria’s ment, emphasizing the role of the so- economic development. Since the cial partners in wage negotiations as collapse of the communist regimes in well as the role of Austria’s hard the Central and Eastern European currency policy. Hochreiter and countries (CEECs), however, the im- Winckler (1995) examine sector-spe- portance of these countries for the cific shocks in Germany and Austria Austrian economy has surged. from 1973 to 1989, finding no evi- Against this backdrop, the ques- dence of an increase in symmetry be- tion arises as to whether these devel- tween the two countries. Cheung and opments have weakened Germany’s Westermann (1999) analyze Austria’s influence on the development of the relations with Germany using an er- Austrian economy. Various aspects of ror correction model and come to the the business cycle linkages between conclusion that a stable long-term Refereed by: Thomas Url, Austria and Germany have been ana- relationship exists between Austrian WIFO. lyzed in the relevant literature. and German industrial production. 24 ◊ Monetary Policy & the Economy Q2/06 Is Germany’s Influence on Austria Waning? Synchronization and Transmission of Cyclical Shocks The International Monetary Fund 2 Stable International (IMF) examined Austria’s links with Synchronization, Germany and with the CEECs in Weakened Global Shocks a descriptive study (Epstein and Business cycle fluctuations in Ger- Tzanninis, 2005), which identifies a many and Austria are heavily influ- marginal decrease in the correlation enced by global and regional trends in between Austrian and German GDP addition to country-specific charac- and attributes this development to the teristics. For this reason, this section increasing relevance of the CEECs. presents a brief overview of essential The purpose of this study is to facts on the development of interna- examine empirically the influence of tional synchronization in cyclical the German economy on business fluctuations. cycle fluctuations in Austria. We address this research question in sev- 2.1 Decreasing Volatility of Global eral steps: Section 2 provides an in- Shocks troductory overview of the most im- The volatility of business cycle fluc- portant international business cycle tuations in industrialized nations has links. Section 3 then describes the decreased substantially over time. economic relations between Austria Stock and Watson (2003a) show that and Germany, addressing trade flows the standard deviation of GDP growth and direct investment in detail. In in industrialized nations has declined section 4, we proceed to examine the by an average of one third since the connection between business cycle 1960s. More than half of this devel- fluctuations in Austria and its main opment can be attributed to weaker trading partners. In addition to ex- global shocks, while improvements in amining static correlations, we also monetary policy explain only a small evaluate frequency-domain measures. part of the decline in volatility. Struc- Section 5, the main part of the study, tural economic changes such as the deals with the question of how increasing share of services and im- strongly German structural shocks proved inventory management tech- are propagated to Austria. For this niques have also contributed to the purpose, we first identify supply and decline (OECD, 2002). An examina- demand shocks as well as monetary tion of demand components reveals policy shocks using a vector autore- that lower levels of volatility in inven- gression (VAR) model for Germany. tory changes and in private consump- In a second step, we determine the tion are the main factors responsible effects of these shocks on Austria for the lower degree of fluctuations during two periods (1972 to 1989 (Dalsgaard et al., 2002). and 1990 to 2005). In section 6, we analyze the aggregate effects of global, 2.2 Globalization Boosts Interna- German and Austrian shocks on GDP tional Linkages growth in Austria. Section 7 summa- Over the last few decades, barriers to rizes the results and draws a number trade and capital controls have gradu- of relevant conclusions. ally been dismantled, and this has brought about an enormous increase in international trade links as well as highly integrated financial markets. Rapid advances in telecommunica- Monetary Policy & the Economy Q2/06 ◊ 25 Is Germany’s Influence on Austria Waning? Synchronization and Transmission of Cyclical Shocks tions technologies have, inter alia, able empirical evidence indicates that created a situation in which intangible strong growth in financial flows also factors such as confidence spill over reinforces synchronization (Imbs, to other countries more quickly. 2004). However, the effects of these devel- The results of empirical studies opments on the co-movement of which examine the development of economies are theoretically ambigu- synchronization between industrial- ous. On the one hand, stronger inter- ized nations over time are ambiguous, national trade links reinforce the however, as they are sensitive with transmission of demand shocks. De- regard to method, country selection, regulation as well as technological in- the length of observation periods, novations have made it easier for com- etc. However, most of the literature panies to hedge risks and to gain ac- finds evidence of a more or less un- cess to financing. Moreover, consum- changed synchronization between in- ers also have more ways of smoothing dustrialized nations (except in the their consumption. On the other early 1990s3). The apparent paradox hand, if intensified foreign trade is a of stable synchronization coupled result of interindustry specialization, with intensified trade and financial it will bring about higher levels of flows can be explained by a decreasing specialization and thus also asymmet- volatility of global shocks, which has ric reactions to sectoral shocks. Inte- caused country-specific shocks to grated financial markets may bring gain in relative importance. about a concentration of capital flows Synchronization among countries to countries with high productivity in the euro area increased in the growth, thus reducing synchroniza- 1990s, while Anglo-American coun- tion.1 tries (U.S.A., Canada, United King- dom) followed their own pattern of 2.3 Stable Synchronization among economic development.4 Efforts to Industrialized Nations over fulfill the criteria set forth in the Time Maastricht Treaty to create a mone- On the whole, the sharp increase in tary union accounted for a major part international links would justify ex- of the increase in synchronization pectations of higher co-movement in between euro area countries. This international business cycle fluctua- reduced the individual countries’ tions. A large body of empirical liter- freedom to generate country-specific ature deals with this question.2 A fiscal shocks. majority of empirical studies find Table 1 provides an overview of the effect of increasing trade links the determinants of synchronization. on synchronization to be positive The strength of global shocks has a (Frankel and Rose, 1998). The avail- positive effect on synchronization, 1 Imbs (2004) provides