Federal policies and local economies: Europe and the US

This paper establishes stylized facts on regional output fluctuations in Europe and the US. Moreover, it proposes a measure of the potential output target of the future European central bank, estimates the potential variance stabilization of a fiscal federation and constructs a regional map of the potential beneficiaries of monetary and fiscal federal policies. The econometric model is an extention of the dynamic factor model a la Sargent and Sims (1977. In: Sims, C.A. (Ed.), New Methods in Business Research. Federal Reserve Bank of Minneapolis) where we introduce an intermediate-level shock, which is common to all regions (counties) in each country (state), but it is not common to Europe (US) as a whole. We build on Forni and Reichlin (1996. Empirical Economics, Long-Run Economic Growth (special issue) 21 (1996) 27-42. Review of Economic Studies 65 (1998) 453-473) to propose an estimation method which exploits the large cross-sectional dimension of our data set. Our analysis shows that (i) Europe has a level of integration similar to that of the US and that national shocks are not a sizeable source of fluctuations: around 75% of output variance is explained by global and purely local dynamics; (ii) Europe, unlike the US, has no traditional business cycle; (iii) the core of the most integrated regions in Europe does not have national boundaries;(iv) the future European Central Bank has a potential stabilization target of about 18% of total output fluctuations; (v) a fiscal federation, if implemented, could have a smoothing effect on output in addition to what done by national fiscal policy, which accounts also for about 18% of total output fluctuations. (C) 2001 Elsevier Science B.V. All rights reserved. JEL classification: C51; E32; O30.