Does integration and economic policy coordination promote business cycle synchronization in the EU?

Previous studies have discounted important factors and indirect channels that might contribute to business cycle synchronisation (BCS) in the EU. We estimate the effects of market integration and economic policy coordination on bilateral business cycle correlations over the period 1995–2012 using a simultaneous equations model that takes into account both the endogenous relationships and unveils direct and indirect effects. The results suggest that 1. trade and FDI have a pronounced positive effect on BCS, particularly between incumbent and new EU member countries; 2. rising specialisation does not decouple business cycles; 3. the decline of income disparities in EU 27 contributes to BCS, as converging countries develop stronger trade and FDI linkages; 4. there is strong evidence that poor fiscal discipline of EU member countries is a major impediment of business cycle synchronisation; and 5. the same argument holds true for exchange rate fluctuations that hinder BCS, particularly in EU 15. Since BCS is a fundamental prerequisite and objective in an effective monetary union, the EU has to promote market integration and strengthen the common setting of economic policies.