The macroeconomic impact of financial fragmentation in the euro area: Which role for credit supply?

This paper studies the macroeconomic impact of financial fragmentation in the euro area by analysing the role of credit supply shocks during the recent pre-crisis, bust, and post-crisis periods. We estimate a time-varying parameter vector autoregression (TVP-VAR) with stochastic volatility à la Primiceri (2005) for euro area countries, and we identify the structural shocks by imposing sign restrictions on impulse response functions based on the theoretical model by Gerali et al. (2010). The results suggest that credit supply shocks have been an important driver of business cycle fluctuations in euro area countries, and that their effects on the economy have generally increased since the recent crisis. More specifically, we find evidence that credit supply shocks contributed positively to output growth during the pre-crisis period and negatively during the downturn in economic activity in 2008-2009 in all the countries considered. In the post-crisis period, by contrast, we observe a strong rise in cross-country heterogeneity, reflecting financial fragmentation in the euro area associated with the sovereign debt crisis and weaker banks' balance sheets. Although this heterogeneity across euro area countries started to decline around 2012, the contribution of credit supply shocks to GDP growth and credit growth remained negative in most euro area countries in mid-2013 (the end of our sample), suggesting that constraints in the supply of credit continued to weaken economic activity.