This paper by Baxter and Kouparitsas is an ambitious attempt to explore which variables are robust in explaining the correlations of bilateral GDP between countries at business cycle frequencies. Most of the variables turned out to be fragile. The main contribution is to show that countries with large amounts of bilateral trade tend to have robustly higher business cycle correlations. Another interesting finding is that neither currency unions nor industrial structure are robustly related to business cycle correlations.Business cycles - Econometric models

Patrick J. Kehoe

English

Research Papers in Economics

Federal Reserve Bank of Minneapolis
Research Department Staﬀ Report 349
November 2004
Patrick Kehoe’s Comment on “Determinants of Business Cycle
Comovement: A Robust Analysis” by Marianne Baxter and
Michael Kouparitsas
Patrick J. Kehoe∗
Federal Reserve Bank of Minneapolis
a n dU n i v e r s i t yo fM i n n e s o t a
ABSTRACT
This paper by Baxter and Kouparitsas is an ambitious attempt to explore which variables are robust
in explaining the correlations of bilateral GDP between countries at business cycle frequencies. Most
of the variables turned out to be fragile. The main contribution is to show that countries with
large amounts of bilateral trade tend to have robustly higher business cycle correlations. Another
interesting ﬁnding is that neither currency unions nor industrial structure are robustly related to
business cycle correlations.
∗The author wishes to thank the National Science Foundation for support. The views expressed herein are
those of the author and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal
Reserve System.It is a privilege to participate in this conference in honor of Alan Stockman. I will
begin my comments with some remarks about him, and then I will turn to the paper.
1. Remarks about Alan Stockman
I ﬁrst came into contact with Alan’s work in my second year of graduate school in
the early 1980s. At that time I was taking my ﬁrst international macroeconomics course.
For over a month we had been studying the arcane details of the international accounting
system. Many classes were devoted to such questions as, “Suppose that a Thai businessman
buys 100 bags of wheat from Japan but pays for it with shares of General Motors stock that
were valued at $262 it received from a U.S. importer that it recently sent 50 bags of ﬁsh.
Show all of the details of the resulting accounts.” For the next month or so we studied papers
from the 1950s on extending the ISLM model to the open economy. The third part of the
course was about how to use the ISLM model to give policy advice to developing countries.
At this part of the course, just when I was in the middle of deciding between either
dropping out of graduate school or ﬂinging myself into the Charles River, I came across one
of Alan’s papers, “A Theory of Exchange Rate Determination,” Stockman (1980). Reading
that paper rekindled my interest in international economics. Here was a world economy with
actual people in it. These people thought carefully about what they were doing and why.
When you had a world populated with clear-thinking people and governments supplying
money, the question was, What would the exchange rate look like? It was such a refreshing
change from what I had been forced to sit through that I used to read it late at night with
candles and a glass of wine in a kind of ritual to keep away the haunting memories of the
ISLM four-quadrant diagrams.I met Alan soon after graduate school and have known him now for over 20 years.
Alan’s own work has led the way for a whole group of us to take as the starting point for our
work. At a personal level, Alan has always been simultaneously serious about his work and
amusing to talk to about almost any subject. As I know from personal experience, Alan is
very supportive of the young international economists who broke away from the established
reduced-form models and explored new paradigms. One of Alan’s most impressive features
is the amount of time and energy he devotes to his graduate students. Today, I can name
almost a dozen of them who have done very well in the profession. Overall, Alan has been
an inspiring ﬁgure in international macroeconomics, and he has made an indelible mark on
the ﬁeld.
2. Comments on Baxter and Kouparitsas
The paper is an ambitious attempt to document what variables are robust in explaining
the correlations of bilateral GDP between countries at business cycle frequencies. I will begin
by summarizing the authors’ methodology and then discussing their main ﬁndings. They
isolate the business cycle frequencies of output by applying a band pass ﬁlter that essentially
eliminates the contribution of frequencies shorter than 6 quarters and longer than 32 quarters.
They then compute the bilateral correlation of the ﬁltered GDPs and regress these correlations
on a number of variables. They say that a variable is a robust determinant of business cycle
comovement if that variable has a signiﬁcant coeﬃcient when all of the other candidate
explanatory variables have had a chance to “knock that variable out of the equation.” They
apply their robustness analysis to a data set with over 100 countries.
I ﬁnd it quite instructive to look carefully at Figures 1—6. These ﬁgures scatter the
2bilateral correlations of output against six of the candidate explanatory variables along with
the regression line from a univariate regression. As the authors note, the visual impression
is that most of the ﬁgures, especially Figures 2 (Total Trade), 3 (Industrial Similarity), 4
(Similarity of Bilateral Trade), and 6 (Distance), show just a cloud of points. The R2 of most
of these regressions is tiny–under 1% for Figures 2, 4, and 6 and just above 1% for Figure
3. Of course, given that many of these graphs have over 5,000 observations, many of the
regression lines have signiﬁcant coeﬃcients. I was a little surprised as just how dismally most
of these candidate variables performed. The fact that these variables seem to account for so
little, even by themselves, made them not so interesting to build a theory around. That most
of them got “knocked out” by other variables made them even less attractive.
In terms of the tables, the overwhelming impression is that almost all of the variables
are fragile. Indeed, in Tables 4—8, all of the variables are fragile. In Table 1, the top half
indicates that all measures of bilateral trade are robust with no “always included variables.”
The bottom half indicates that once the gravity variables are always included, only the ﬁrst
measure of bilateral trade BT1 is robust. The analysis of the gravity variables in Table
9 indicates that three variables are robust: a measure of distance between countries, an
indicator variable that both countries are developed, and an indicator variable that both
countries are developing.
This paper clearly has a lot of valuable information for business cycle economists.
On the positive side, the main contribution is to show that countries with large amounts of
bilateral trade tend to have robustly higher business cycle correlations. For me, however, the
most interesting part of the paper is the negative part. The two most important ﬁndings are
that i) countries that have higher degrees of industrial similarity do not have robustly higher
3business cycle comovements and ii) countries in a currency union do not have robustly higher
business cycle comovements.
I have two minor comments. First, looking at Figure 1 on Bilateral Trade, I might
be tempted to run this and the subsequent regressions on robustness excluding all countries
with bilateral trade of less than 1%. The rationale, which might be weak, is that if I were
proposing a theory about why countries that traded more might be more correlated than
countries that traded less, I would look for countries that traded some nontrivial amounts
and focus on how the comovements varied as the amounts varied. That is, once countries are
essentially not trading with each other, then whatever variations there are in their business
cycle comovements are essentially just noise in view of a theory that tries to link trade and
comovements. Regardless of how weak this rationale might seem, I would still be interested
in knowing how the regression line varies.
The second comment is a more general one on this robustness methodology. When I
ﬁrst read this paper I thought back to the growth regression literature that often argued that
variable M is important if the researcher cannot knock it out of a regression (in the sense of
making its coeﬃcient insigniﬁcant) by adding in some other variable Z.
The worst of this lot went as follows. A researcher starts by proposing a new theory in
which policy variable M is thought to aﬀect growth y. The researcher then runs regressions
and plays the knock-out game by including variables like investment Z. The problem I had
was that all the stories for how the policy M was supposed to aﬀect growth were channeled
through investment. Thus, I presume that if the researcher had carefully worked out the
theory, the researcher would have been happy to have variable M knocked out by variable
Z (investment). Indeed, if this were not true then it is bad news for the original mechanism
4in which M drives Z, which in turn drives Y . Let me rephrase this. Suppose I generated
data from a model in which much (but not all) of the movements in growth were driven by a
policy variable M, but both this variable and some other unmeasured policy variables worked
through changing investment. I presume I would ﬁnd that the variable M is not robust. But
this result is good news for such a theory–not bad news!
I am most certainly not saying that the current paper has the same problem as these
bad growth regressions did. Rather, I just hope to clarify what implications I think can be
drawn from the results. A careless reading might be that the paper showed that currency
unions have nothing to do with business cycle correlations. Hence, if a country currently
not in a union proceeded to enter one, there is no reason to think that their comovements
would increase. I do not think the evidence in the paper warrants that conclusion. Instead, I
think the paper has a more nuanced interpretation. I think it shows that some variables, like
currency unions or industrial similarity, might aﬀect comovements, but the way they do so is
completely captured by bilateral trade. Hence, once the bilateral trade variable is included it
knocks out both currency unions and industrial similarity. In terms of guiding future theory,
the data suggest that if currency unions are to have an eﬀect on comovements, it is fruitful
to model this eﬀect as coming through bilateral trade and not through some other channel
which is essentially logically divorced from trade.
Overall, I very much enjoyed reading the paper, and I will keep in mind its ﬁndings
for later use.
References
Stockman, Alan C. 1980. A Theory of Exchange Rate Determination, Journal of
5Political Economy 88 (August): 673—98.
6

A Theory of Exchange Rate Determination,

Patrick Kehoe's comment on "Determinants of business cycle comovement: a robust analysis" by Marianne Baxter and Michael Kouparitsas

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Patrick Kehoe's comment on "Determinants of business cycle comovement: a robust analysis" by Marianne Baxter and Michael Kouparitsas

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