Fiscal Policy Stabilisation and the Financial Cycle in the Euro Area

Summary:

This paper examines the impact of the financial cycle on the capacity of the economy to deal with shocks, with a particular focus on fiscal policy in the euro area member states. It starts by measuring national financial cycles and investigating the synchronisation across them as well as their relationship to the medium-term business cycle. It finds that financial cycles tend to be synchronised but their amplitudes differ significantly across countries. Business cycles tend to be positively correlated with the financial cycle, but they usually are smaller. The paper then examines if and how the financial cycle affects international risk-sharing among euro area member states and finds that economic booms and busts are often associated with phases of financial integration and disintegration at the level of the euro area. Such developments are reflected in the degree of international risk-sharing, which turns out to behave pro cyclically. Lastly, the capacity of domestic fiscal policy to smooth asymmetric shocks in the euro area declines dramatically during recessionary phases of the domestic financial cycle. The paper concludes that macro prudential policies are an important tool for preventing excessive swings in the financial cycle, but they should be complemented by a central stabilisation mechanism, which can make both capital markets and fiscal policy more resilient to disruption associated with the financial cycle.

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