Working Paper Series. The Political Economy under Monetary. a Difference? No 956 / November by Marcel Fratzscher and Livio Stracca

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1 Working Paper Series No 956 / The Poliical Economy under Moneary Union Has he Euro Made a Difference? by Marcel Frazscher and Livio Sracca

2 WORKING PAPER SERIES NO 956 / NOVEMBER 2008 THE POLITICAL ECONOMY UNDER MONETARY UNION HAS THE EURO MADE A DIFFERENCE? 1 by Marcel Frazscher and Livio Sracca 2 In 2008 all publicaions feaure a moif aken from he 10 banknoe. This paper can be downloaded wihou charge from hp:// or from he Social Science Research Nework elecronic library a hp://ssrn.com/absrac_id= Paper prepared for he 48h Panel of Economic Policy. We would like o hank he edior in charge of his paper, Philippe Marin, and hree anonymous referees for commens. The views expressed in his paper are hose of he auhors and do no necessarily reflec hose of he European Cenral Bank. 2 European Cenral Bank, Kaisersrasse 29, D Frankfur am Main, Germany; marcel.frazscher@ecb.europa.eu and livio.sracca@ecb.europa.eu

3 European Cenral Bank, 2008 Address Kaisersrasse Frankfur am Main, Germany Posal address Posfach Frankfur am Main, Germany Telephone Websie hp:// Fax All righs reserved. Any reproducion, publicaion and reprin in he form of a differen publicaion, wheher prined or produced elecronically, in whole or in par, is permied only wih he explici wrien auhorisaion of he or he auhor(s). The views expressed in his paper do no necessarily reflec hose of he European Cenral Bank. The saemen of purpose for he Working Paper Series is available from he websie, hp:// eu/pub/scienific/wps/dae/hml/index. en.hml ISSN (prin) ISSN (online)

4 CONTENTS Absrac 4 Non-echnical summary 5 1 Inroducion 7 2 Daa Poliical news Sock marke daa and oher variables 12 3 The ransmission of poliical shocks on sock markes and EMU The role of EMU Baseline resuls 14 4 The role of economic policy and insiuions 18 5 Conclusions and policy implicaions 21 References 23 Appendix 26 European Cenral Bank Working Paper Series 45 3

5 Absrac Economic and Moneary Union (EMU) has ransformed Europe and has creaed an inegraed pan-european economy. Much research has focused on undersanding his inegraion process and wha benefis and coss i enails. This paper idenifies a poliical economy channel of EMU as he moneary union implies ha member saes had o ransfer or a leas curail heir policy auonomy in several areas, such as moneary policy and fiscal policy. The paper shows ha EMU has helped reduce he impac of poliical shocks on he domesic economy of member saes bu magnified he ransmission of poliical shocks wihin he euro area. Equally imporanly, economies wih a weaker rack record in erms of economic and insiuional qualiy exhibied a significanly higher sensiiviy o domesic poliical shocks before EMU, bu no hereafer. While his may enail ha EMU has brough benefis o counries wih a weaker economic and insiuional sabiliy by insulaing hem from adverse poliical developmens a home, a poenial drawback is ha i may provide weaker marke discipline for domesic poliical sabiliy. Keywords: EMU, poliical economy, poliical news, moneary policy, fiscal policy, sock markes, ransmission. JEL Classificaion: F31; F33; G14. 4

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27 APPENDIX Table A.1: Counry sample euro area non-euro area Ausria Ireland Bulgaria Lavia Slovak Rep. Belgium Ialy Cyprus Lihuania Slovenia Finland Luxembourg Czech Rep. Mala Sweden France Neherlands Denmark Poland Swizerland Germany Porugal Esonia Romania UK Greece Spain Hungary Russia Ukraine Table A.2: Summary of idenified shocks Toal All 213 Euro area 99 Pre-EMU 38 Pos-EMU 61 Non - euro area 114 Pre-EMU 35 Pos-EMU 79 26

28 Table A.3: Definiions and sources of deerminans Variable Definiion Source Elecions Parliamenary and presidenial elecions, daes Elecions Guide (hp:// guide.org/); Execuive changes ouside elecions Oher relevan poliical evens and naural caasrophes Governance indicaors Resignaion of he governmen and / or of he chief execuive Daes for major erroris aacks and violence, naural caasrophes, wars, poliical scandals various measures for he qualiy of counries' insiuions and governance Various news agencies; mainly BBC news Various news agencies; Bekaer and Harvey(2004) Kaufman e al. (2007) Sock price indices Daily equiy marke reurns, in local currency MSCI, Bloomberg Cenral bank ransparency insiuional measure of various sub-componens for a cenral bank's ransparency, available for 1998 and 2006 Crowe and Meade (2008) Cenral bank independence insiuional measure of various sub-componens for a cenral bank's independence from poliical influence, available for and 2003 Crowe and Meade (2008) Growh Annual real GDP growh WEO Inflaion Annual CPI inflaion rae WEO Inflaion volailiy 5-year sandard deviaion of CPI inflaion WEO Fiscal balance General governmen balance o GDP raio WEO Governmen deb Governmen deb o GDP raio WEO Sock marke cap. Sock marke capialisaion o GDP raio MSCI, Bloomberg Financial openness Sock of porfolio invesmen asses plus liabiliies o IMF GDP raio Trade openness Expors plus impors of goods and services o GDP raio WEO Table A.4: Examples of poliical news Even Counry affeced Dae Kaprun fire, 155 die Ausria 11/09/00 Whie March Belgium 20/10/96 Suicide of Pierre Beregovoy France 01/05/93 SPD loses elecion in Norh-Rhine Wesfalia Germany 22/05/05 Aack on US embassy in Ahens Greece 11/01/07 Murder of judge Giovanni Falcone Ialy 23/05/92 Murder of poliician Foryun Neherlands 06/05/02 Presiden Sampaio calls for early elecions Porugal 30/11/04 Madrid bombings Spain 11/03/04 Shipwreck of Esonia, deah of >500 Swedes Sweden 28/09/94 Crash of Swissair 111 Swizerland 02/09/98 Scandal over leak of Iraq-relaed documens Unied Kingdom 18/09/04 27

29 Table A.5: Summary saisics of deerminans Mean Sd. Dev. Min Max Inflaion Inflaion volailiy Fiscal balance Governmen deb Sock marke cap Financial openness Trade openness Poliical sabiliy Governmen effeciveness Governmen accounabiliy Regulaory qualiy Rule of law Enforcemen of conracs Table A.6: Correlaions across deerminans Inflaion Inflaion volailiy Fiscal balance Govern. deb Sock mk cap. Financial openness Trade openness Poliical sabiliy Gov. effeciv. Gov. accoun. Regula. qualiy Rule of law Inflaion 1 Inflaion volailiy Fiscal balance Governmen deb Sock marke cap Financial openness Trade openness Poliical sabiliy Gov. effeciveness Gov. accounab Regulaory qualiy Rule of law Enforcemen

30 Figure 1: Mean and dispersion of inflaion and growh across euro area counries CPI Inflaion CPI Inflaion volailiy percen sd. deviaion percen sd. deviaion GDP Growh GDP Growh volailiy percen sd. deviaion percen sd. deviaion Mean (lhs) Dispersion (rhs). Noes: The figures show he unweighed average (in percen) and he dispersion (measured as he annual sandard deviaion) across he 12 euro area counries, for CPI inflaion, GDP growh and boh of heir volailiies (measured as he 5-year moving sandard deviaion). 29

31 Figure 2: Mean and dispersion of fiscal balance and governmen deb across euro area counries Fiscal balance o GDP Governmen deb o GDP percen sd. deviaion percen sd. deviaion Mean (lhs) Dispersion (rhs) Noes: The figures show he unweighed average (in percen) and he dispersion (measured as he annual sandard deviaion) across he 12 euro area counries, for he fiscal balance o GDP raion and he governmen deb o GDP raio. 30

32 Figure 3: Time-varying equiy marke responses o shocks euro area counries versus non-euro area counries A. Equiy marke response o domesic shocks Euro area Non-euro area B. Equiy marke response o euro area shocks Euro area Non-euro area Noes: The figure show he equiy marke response of he 12 euro area counries and he 18 non-euro area counries o domesic shocks (Panel A) and o shocks in oher euro area counries (Panel B), using recursive panel esimaions by adding one year of daa sequenially. The model specificaion is ha of equaion (1): = α + β S + ω Z + (1) r ε where r are he daily equiy reurns, S=[S dom,s ea,s nea ] is a vecor of he hree ypes of shocks and Z is a vecor of conrols. 31

33 Figure 4: Time-varying responses euro area core versus periphery A. Equiy marke response o domesic shocks response coefficien Euro area core Euro area periphery B. Equiy marke response o euro area shocks response coefficien Euro area core Euro area periphery Noes: The figures show he equiy marke response of he euro area core counries versus he periphery counries o domesic shocks (Panel A) and shocks in oher euro area counries (Panel B), using recursive panel esimaions. The model specificaion is ha of equaion (1): r α + β S + ω Z + ε = (1) where r are he daily equiy reurns, S=[S dom,s ea,s nea ] is a vecor of he hree ypes of shocks and Z is a vecor of conrols, only ha he panel is spli ino wo counry samples. 32

34 Figure 5: Time-varying heerogeneiy in equiy marke responses o shocks euro area counries sd. deviaion Domesic shocks Euro area shocks Noes: The figure show he dispersion measured as he annual sandard deviaion across he response coefficiens in he equiy marke responses across he euro area 12 counries o domesic shocks and o shocks in oher euro area counries, using recursive esimaions for each counry separaely, using a model specificaion akin o ha of equaion (1): r α + β S + ω Z + ε = (1) only ha here he model is esimaed separaely for each euro area counry. 33

35 Figure 6: World Bank indicaor for poliical sabiliy in seleced counry groups Euro area periphery Oher European counries Euro area core EU New Member Saes ouside he euro area Noes: The figure shows he indicaor for Poliical Sabiliy and Absence of Violence in he seleced counry groups. A higher reading of he indicaor implies a more poliically sable counry. The indicaor measures, iner alia, percepions of he likelihood ha he governmen will be desabilised or overhrown by unconsiuional or violen means, including domesic violence and errorism. See Kaufmann e al. (2007) for furher explanaions. New EU Member Saes ouside he euro area include Poland, he Czech Republic, Hungary, Romania, Bulgaria, Lavia, Esonia, and Lihuania. 34

36 Table 1: Baseline resuls ransmission of shocks o domesic equiy markes coef. s.e. coef. s.e. A. EMU effec: (S * D * EA i ) Euro area counries - pre-1999: 1 + Domesic ** Domesic *** Euro area ** Euro area *** Non - euro area Non - euro area *** B. Pos-99 common effec: (S * D ) Euro area counries - pos-1999: Domesic Domesic *** Euro area Euro area *** Non - euro area Non - euro area *** C. Euro area-specific effec: (S * EA i ) Non-euro area counries - pre-1999: 1 Domesic Domesic *** Euro area Euro area *** Non - euro area Non - euro area *** D. Common overall effec: S Non-euro area counries - pos-1999: 1 + Domesic *** Domesic *** Euro area *** Euro area *** Non - euro area *** Non - euro area * Counries Obs. R^2 Benchmark Overall effecs Noes: The able shows he effec of shocks from various origins (domesic, euro area, non euro area) on equiy markes, using he difference-in-difference specificaion of equaion (2): r S 99 D 99 EA i ( S * D ) ( S * EA ) ( S * D * EA ) Z i 1 99 i (2) where EA i = 1 for a euro area counry and zero oherwise, and D = 1 for he period since The lef-hand panel shows he individual coefficiens of (2); he righ-hand panel gives he overall effecs of shocks for differen counry groups and periods. The OLS esimaor akes ino accoun clusering across residuals by counry. ***, **, and * indicaes saisical significance a he 1%, 5%, and 10% levels, respecively. 35

37 Table 2: Robusness alernaive EMU break dae, counry sample and ime sample EMU-break 1997 Europe 27 All days Absolue reurns Banking reurns (1) (2) (3) (4) (5) coef. s.e. coef. s.e. coef. s.e. coef. s.e. coef. s.e. A. EMU effec: (S * D * EA i ) Domesic ** ** ** ** ** Euro area ** *** ** Non - euro area * B. Pos-99 common effec: (S * D ) Domesic Euro area * *** Non - euro area ** * C. Euro area-specific effec: (S * EA i ) Domesic * Euro area Non - euro area D. Common overall effec: S Domesic *** *** *** *** *** Euro area *** *** *** *** *** Non - euro area *** *** *** ** Counries Obs R^ ws he effec of shocks from various origins on equiy markes, using he difference-in-difference specificaion of equaion (2): r 1 1 S 2 D 99 EA ( S * D ) ( S * EA ) ( S * D * EA ) Z for a euro area counry and zero oherwise, and D = 1 for he period since Model (1) replaces he dummy for he beginning of EMU in 1 MU saring in Model (2) uses a reduced counry sample ha excludes he hree old EU members Denmark, Sweden and UK. Model (3) us ion, i.e. no only hose wih shocks bu also days when no shock occurred in any of he 30 counries in he sample. Model (4) uses absolue reur s, while (5) akes reurns of financial secor equiy indices as dependen variable. The OLS esimaor akes ino accoun clusering across residuals b indicaes saisical significance a he 1%, 5%, and 10% levels, respecively. i, i, i, i, i i i, i i, i, 36

38 Table 3: Robusness ess conrol for risk aversion, moneary policy shocks and macro shocks A. EMU effec: (S * D * EA i ) Benchmark wih all conrols wih VIX & in. raes wih macro news (1) (2) (3) (4) coef. s.e. coef. s.e. coef. s.e. coef. s.e. Domesic ** * ** * Euro area ** ** ** ** Non - euro area Conrols: 1. VIX ** ** EA ineres raes *** *** US & EA macro news: US news Indusrial producion *** *** ISM - NAPM Nonfarm payroll Unemploymen * Consumer confidence Trade balance ** *** Advance GDP * * CPI PPI * Housing sars Reail sales * * Workweek *** *** Euro area news CPI Ger Trade balance Ger Curren accoun Fra Consumer confid. Fra GDP Ia *** *** CPI euro area. *** *** GDP euro area Reail sales euro area *** *** Unemploymen euro area Cy. Obs. R^ Noes: The able shows he effec of shocks from various origins on equiy markes, while conrolling for risk aversion, moneary policy shocks and various US and euro area macro news in he vecor Z, based on equaion (2): r S 99 D 99 EA i ( S * D ) ( S * EA ) ( S * D * EA ) Z i 1 99 i (2) where EA i = 1 for a euro area counry and zero oherwise, and D = 1 for he period since The OLS esimaor akes ino accoun clusering across residuals by counry. ***, **, and * indicaes saisical significance a he 1%, 5%, and 10% levels, respecively. 37

39 Table 4: The role of moneary policy performance Deerminan X : Inflaion Inflaion volailiy (1) (2) (3) (4) coef. s.e. coef. s.e. coef. s.e. coef. s.e. EMU effec: Domesic *** Euro area *** Non - euro area Euro area counries - pre-1999: 3 + Domesic *** Euro area *** Non - euro area ** Euro area counries - pos-1999: Domesic ** Euro area Non - euro area Non-euro area counries - pre-1999: 3 Domesic Euro area * * *** Non - euro area ** ** Non-euro area counries - pos-1999: 3 + Domesic *** Euro area *** Non - euro area ** Counries Obs. R^ Noes: The able shows he effec of shocks, ineraced wih policy proxies X, for (1) and (3) based on equaion (3): r S 99 D 99 EA i ( S * D ) ( S * EA ) ( S * X ) Z i 3 (3) and for (2) and (4) based on equaion (4): r S D ( S 1 ( S 1 ( S 1 1 * D * D * D * X 99 ) ( S 2 i EA ) ( S * EA ) ( S 3 i * EA ) ( S 2 2 i * EA * D i * X * X i ) * EA * X ) ) Z (4) where Z includes he linear effecs of X. The OLS esimaor akes ino accoun clusering across residuals by counry. ***, **, and * indicaes saisical significance a he 1%, 5%, and 10% levels, respecively. 38

40 Table 5: The role of fiscal policy Deerminan X : Fiscal balance Governmen deb (1) (2) (3) (4) coef. s.e. coef. s.e. coef. s.e. coef. s.e. EMU effec: Domesic * Euro area * Non - euro area *** Euro area counries - pre-1999: 3 + Domesic ** Euro area Non - euro area Euro area counries - pos-1999: Domesic ** Euro area ** Non - euro area * Non-euro area counries - pre-1999: 3 Domesic *** *** Euro area ** Non - euro area * Non-euro area counries - pos-1999: 3 + Domesic * *** Euro area *** Non - euro area ** Counries Obs. R^ Noes: See Table 4. 39

41 Table 6: The role of financial openness and rade openness Deerminan X : Sock marke capialisaion Financial openness Trade openness (1) (2) (3) (4) (5) (6) coef. s.e. coef. s.e. coef. s.e. coef. s.e. coef. s.e. coef. s.e. EMU effec: Domesic ** ** Euro area Non - euro area ** Euro area counries - pre-1999: 3 + Domesic * Euro area * Non - euro area Euro area counries - pos-1999: Domesic *** *** Euro area ** Non - euro area *** Non-euro area counries - pre-1999: 3 Domesic * Euro area *** *** *** Non - euro area *** ** Non-euro area counries - pos-1999: 3 + Domesic *** *** Euro area ** ** Non - euro area ** * Counries Obs. R^ Noes: See Table 4. 40

42 Table 7: The role of insiuions Deerminan X : Poliical sabiliy Governmen effeciveness Governmen accounabiliy (1) (2) (3) (4) (5) (6) coef. s.e. coef. s.e. coef. s.e. coef. s.e. coef. s.e. coef. s.e. EMU effec: Domesic *** *** *** Euro area Non - euro area Euro area counries - pre-1999: 3 + Domesic ** *** *** Euro area ** ** *** Non - euro area ** ** *** Euro area counries - pos-1999: Domesic Euro area Non - euro area Non-euro area counries - pre-1999: 3 Domesic *** *** *** * Euro area ** Non - euro area Non-euro area counries - pos-1999: 3 + Domesic *** *** *** Euro area ** *** Non - euro area *** Counries Obs. R^ (con.) 41

43 Table 7: The role of insiuions (coninued) Deerminan X : Regulaory qualiy Rule of law Enforcemen of conracs (7) (8) (9) (10) (11) (12) coef. s.e. coef. s.e. coef. s.e. coef. s.e. coef. s.e. coef. s.e. EMU effec: Domesic *** *** *** Euro area Non - euro area Euro area counries - pre-1999: 3 + Domesic ** *** * Euro area ** ** ** Non - euro area ** ** ** Euro area counries - pos-1999: Domesic * Euro area Non - euro area Non-euro area counries - pre-1999: 3 Domesic *** * *** Euro area *** Non - euro area Non-euro area counries - pos-1999: 3 + Domesic *** *** *** Euro area *** *** ** Non - euro area ** ** Counries Obs. R^ Noes: See Table 4. 42

44 Table 8: Robusness alernaive saring poin for EMU Deerminan X : Inflaion Governmen deb Poliical sabiliy (1) (2) (3) (4) (5) (6) coef. s.e. coef. s.e. coef. s.e. coef. s.e. coef. s.e. coef. s.e. EMU effec: Domesic *** * *** Euro area * Non - euro area * Euro area counries - pre-1997: 3 + Domesic *** ** Euro area *** * ** Non - euro area *** ** Euro area counries - pos-1997: Domesic Euro area * Non - euro area Non-euro area counries - pre-1997: 3 Domesic *** *** *** Euro area Non - euro area Non-euro area counries - pos-1997: 3 + Domesic *** ** Euro area *** * Non - euro area *** Counries Obs. R^ Noes: See Table 4, only ha he break poin D is shifed o 1 January 1997 for all counries in he sample. 43

45 Table 9: Robusness muliple deerminans: conrolling for financial openness Deerminan X : Inflaion Governmen deb Poliical sabiliy (1) (2) (3) (4) (5) (6) coef. s.e. coef. s.e. coef. s.e. coef. s.e. coef. s.e. coef. s.e. EMU effec: Domesic ** * *** Euro area * Non - euro area Euro area counries - pre-1997: 3 + Domesic *** * Euro area *** * Non - euro area *** * Euro area counries - pos-1997: Domesic Euro area Non - euro area Non-euro area counries - pre-1997: 3 Domesic ** Euro area Non - euro area Non-euro area counries - pos-1997: 3 + Domesic *** *** Euro area *** * Non - euro area *** ** Counries Obs. R^ Noes: See Table 4, only ha for he esimaions for his able all models conrol, in a linear and a non-linear way, for he degree of financial marke openness based on sock marke capialisaion as shown in Table 6. 44

46 European Cenral Bank Working Paper Series For a complee lis of Working Papers published by he, please visi he s websie (hp:// 923 Resusciaing he wage channel in models wih unemploymen flucuaions by K. Chrisoffel and K. Kueser, Augus Governmen spending volailiy and he size of naions by D. Furceri and M. Poplawski Ribeiro, Augus Flow on conjuncural informaion and forecas of euro area economic aciviy by K. Drechsel and L. Maurin, Augus Euro area money demand and inernaional porfolio allocaion: a conribuion o assessing risks o price sabiliy by R. A. De Sanis, C. A. Favero and B. Roffia, Augus Moneary sabilisaion in a currency union of small open economies by M. Sánchez, Augus Corporae ax compeiion and he decline of public invesmen by P. Gomes and F. Pouge, Augus Real convergence in Cenral and Easern European EU Member Saes: which role for exchange rae volailiy? by O. Arraibel, D. Furceri and R. Marin, Sepember Sicky informaion Phillips curves: European evidence by J. Döpke, J. Dovern, U. Frische and J. Slacalek, Sepember Inernaional sock reurn comovemens by G. Bekaer, R. J. Hodrick and X. Zhang, Sepember How does compeiion affec efficiency and soundness in banking? New empirical evidence by K. Schaeck and M. Čihák, Sepember Impor price dynamics in major advanced economies and heerogeneiy in exchange rae pass-hrough by S. Dées, M. Burger and N. Paren, Sepember Bank mergers and lending relaionships by J. Monoriol-Garriga, Sepember Fiscal policies, he curren accoun and Ricardian equivalence by C. Nickel and I. Vanseenkise, Sepember Sparse and sable Markowiz porfolios by J. Brodie, I. Daubechies, C. De Mol, D. Giannone and I. Loris, Sepember Should quarerly governmen finance saisics be used for fiscal surveillance in Europe? by D. J. Pedregal and J. J. Pérez, Sepember Channels of inernaional risk-sharing: capial gains versus income flows by T. Bracke and M. Schmiz, Sepember An applicaion of index numbers heory o ineres raes by J. Huerga and L. Seklacova, Sepember The effec of durable goods and ICT on euro area produciviy growh? by J. Jalava and I. K. Kavonius, Sepember The euro s influence upon rade: Rose effec versus border effec by G. Cafiso, Sepember

47 942 Towards a moneary policy evaluaion framework by S. Adjemian, M. Darracq Pariès and S. Moyen, Sepember The impac of financial posiion on invesmen: an analysis for non-financial corporaions in he euro area by C. Marinez-Carrascal and A. Ferrando, Sepember The New Area-Wide Model of he euro area: a micro-founded open-economy model for forecasing and policy analysis by K. Chrisoffel, G. Coenen and A. Warne, Ocober Wage and price dynamics in Porugal by C. Robalo Marques, Ocober Macroeconomic adjusmen o moneary union by G. Fagan and V. Gaspar, Ocober Foreign-currency bonds: currency choice and he role of uncovered and covered ineres pariy by M. M. Habib and M. Joy, Ocober Clusering echniques applied o oulier deecion of financial marke series using a moving window filering algorihm by J. M. Puigver Guiérrez and J. Foriana Gregor Ocober Shor-erm forecass of euro area GDP growh by E. Angelin G. Camba-Méndez, D. Giannone, L. Reichlin and G. Rünsler, Ocober Is forecasing wih large models informaive? Assessing he role of judgemen in macroeconomic forecass by R. Mesre and P. McAdam, Ocober Exchange rae pass-hrough in he global economy: he role of emerging marke economies by M. Bussière and T. Pelonen, Ocober How successful is he G7 in managing exchange raes? by M. Frazscher, Ocober Esimaing and forecasing he euro area monhly naional accouns from a dynamic facor model by E. Angelin M. Bańbura and G. Rünsler, Ocober Fiscal policy responsiveness, persisence and discreion by A. Afonso, L. Agnello and D. Furcer Ocober Moneary policy and sock marke boom-bus cycles by L. Chrisiano, C. Ilu, R. Moo and M. Rosagno, Ocober The poliical economy under moneary union: has he euro made a difference? by M. Frazscher and L. Sracca,. 46

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