The world has just experienced unprecedented levels of volatility. While the gyrations were most evident in financial markets, global production and trade were also severely buffeted. At the global level, industrial production fell at the same rate as in the Great Depression, and global trade fell much faster between April 2008 and February 2009 (Eichengreen and O’Rourke 2010 and Baldwin 2009). The economic contraction experienced by some countries could scarcely have been imagined. For example, the German economy, which grew at an average rate of 1.5% a year in the last two decades (with a standard deviation of 1.25%), contracted by 5% in 2009.
While the extreme volatility that the world has recently witnessed could not have been anticipated, it should not have come as a complete surprise. The “Great Moderation” – an extended period of declining output and inflation volatility – was a robustly-established trend in a large number of industrialised nations. However, most of the papers analysing these trends did not factor in the ongoing integration of the global economy; even when considering multiple countries, they have typically dealt with individual country experiences. Did the extended reach of finance and trade not make a difference in global output growth volatility trends?
Stock and Watson (2005) trace the source of the Great Moderation to a fall in common international shocks. However, by 2008 the possibility that “good luck” (milder “shocks” to the economic system) played a role has been generally discounted, with the moderation increasingly attributed to advances in the design and implementation of monetary policy, better inventory management, and financial innovation (Gali and Gambetti, 2009; and Giannone et al. 2008).
New evidence on international spillovers
In recent research, we have expanded this analysis to a much wider set of countries, and a more recent period, given the increasing nature of the world integration (Carare and Mody 2010). We extended the sample of countries from the G7 to 22 OECD economies, and the time span of the analysis from the end of 2002 until the end of 2007. These extensions highlight the significant and growing role of international spillovers.
Our methodology consists of measuring volatility as the time-varying variance of a vector autoregression and decomposing it into various shocks by imposing a certain structure on the regression. The first restriction is that growth in one country is assumed to depend on past growth from all other countries (with a one quarter lag), and on its own past performance (with four quarters lag). The second restriction is that domestic shocks are assumed to have more lasting effects than foreign shocks. “Common international” shocks are assumed to be spreading to all countries contemporaneously, while spillovers are country idiosyncratic shocks that transmit to other countries with a lag. The parameters of the model are estimated using a Gaussian maximum likelihood, and the variance for each shock is calculated using a spectral decomposition. Our paper has three main findings.
- By the mid-1990s, output growth volatility stopped falling in some advanced industrialised countries, and instead the tendency towards output growth volatility began to increase.
The increase in output growth volatility from the mid-1990s was documented in Japan (see for example Bernanke 2004 and Stock and Watson 2005). Another large country apparently experiencing such a trend is Germany. Other countries for which volatility might have increased since mid-1990s are small open economies, e.g. Denmark, Netherlands, Sweden, and Switzerland (Figure 1). The emerging market countries (Korea, Mexico, and Turkey) also experienced an increase in volatility over time, rather than a decline. In fact, in this group of countries there is a noticeable increase in output growth volatility with every financial crisis. Iceland and Ireland also display a pattern of increase volatility since the mid-1990s, similar to the emerging market countries. In countries like Canada, Finland and Norway output growth volatility has decreased, but not as much as for the remaining group of countries in our sample, which continue to display a permanent decline in volatility until the end of the sample: Australia, Austria, Belgium, France, Italy, Spain, and the UK.
- This rebound in output growth volatility was associated with an increased role for spillovers.
Improved domestic policies and structural changes drove down the size of domestic shocks and hence aggregate volatility, but potent though these forces were, the increasingly-interconnected nature of the global economy introduced countervailing tendencies.
- It was not the size of the spillover “shocks” but the sensitivity of countries to these shocks that increased over time.
In a benign global environment, the international transmission also worked in a relatively benign manner. However, with the convergence of several large shocks in 2008 and 2009 – to the financial sectors and to the real economies of several countries – the transmission process added to the rapidity with which the crisis crossed borders and the sense of panic it generated in the past couple of years.
Figure 1. Volatility of real output growth and its main sources
Notes: As in Stock and Watson (2005). We present here just a subset of results, the industrialized countries for which we observe an increase in volatility since mid-1990s. The results for the US are not robust to a change in sample size.
The bottom line represesents the variance of common shocks. The middle line represents the sum of common shocks and spillovers variance, hence the difference between the bottom and the middle line represent spillovers. The top line is the total variance; hence own idiosyncratic shocks are represented here as the difference between the top (total variance) and the middle line. Variances are aggregated using the GDP PPP weight within this group's GDP.
Going one step further, the analysis suggests that the tendency towards greater country alignment through rapid spillovers, since the mid-1990s, was associated with a particular form of trade integration, an acceleration of vertical specialisation (Figure 2). By linking countries in an international supply chain, such trade creates a tighter relationship between a country’s exports and its imports, creating the conditions for swift production spillovers. Our paper is related to the literature on the co-movement of business cycles (e.g. Kose et al. 2008); the nature of globalisation influences the changes in the degree of co-movement.
Figure 2. Role of trade globalisation in the change of spillovers
Source: OECD, WEO, and IMF staff calculations.
Notes: Sample here includes only 18 countries, as data for Vertical Specialization is not available for 1995 for Iceland, Ireland, Mexico, and Switzerland, and for 2000 for Iceland and Mexico. Regression estimated with OLS. t statistics of coefficients
The heightened importance of global linkages starting around the mid-1990s is consistent with results reported by Forbes and Chinn (2004). They find that bilateral trade linkages had become “substantially more important” (p. 720) in explaining the transmission of financial sector shocks through to 1995. Thus, besides their direct impact on output volatility, trade relationships can also have an indirect impact through transmitting financial shocks.
The policy lessons related to this analysis are simple in principle but complex to implement. Imbalances in or shocks experienced by one country have increasingly important implications for other countries. While this observation is widely accepted, our contribution has been to show that the magnitude of the effects underlying global integration is increasing and large. If we are correct in the mechanism identified for the transmission of the shocks – vertical specialisation – the vulnerability is likely to persist. Vertical specialisation is a benign force for global growth and welfare but can turn rapidly to amplify downturns.
Countries responded ex post to the urgency of the recent crisis by coordinating (to varying degrees) financial, monetary, and fiscal policies. Looking ahead, all countries have a stake in the policy stance and approaches of other countries. Recent efforts to achieve greater transparency and coordination of policy on a much larger scale than in the past under the auspices of the G20 and within the European Union are a positive sign. But ultimately, as Obstfeld and Rogoff (2002) point out, the best ex ante coordination is likely to be sensible economic policies followed in a country’s self interest. The outcome of these efforts may depend whether the next crisis threatens another upheaval.
Disclaimer: The views expressed here and in their IMF Working Paper 10/78 are those of the authors and do not necessarily represent those of the IMF or IMF policy.
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Bernanke, Ben (2004), “The Great Moderation”, remarks at the 2004 Eastern Economic Association meetings, Washington DC.
Carare, Alina and Ashoka Mody (2010), Spillovers of Domestic Shocks: Will They Counteract the “Great Moderation?”, International Monetary Fund Working Paper 10/78.
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