The Effect of Financial Integration on Economic Convergence in Europe

This research aims to identify the effect of financial integration on economic convergence. In the first part of this research a theoretical framework is constructed to analyze the developments of both concepts in the euro area over the research period 1990-2017. Classical economic theory predicts that high factor mobility within an area leads to convergence. On the other hand, theories are discussed which explain the possible negative effects of financial integration on convergence. In the empirical part of the research it is observed that until approximately 2009 the countries in the sample both converged and became more financially integrated. From 2009 onwards, which coincides with the beginning of the Great Recession, both trends get reversed. The direct effect of financial integration on β- and σ-convergence is measured by linear equations that measures convergence complemented with variables for financial integration and an interaction term. In the case of σ-convergence financial integration seems to have a positive effect on convergence. Regarding β-convergence the most remarkable outcome of the linear regression model is that financial integration has an inhibitory effect on economic growth, but this effect dampens when the initial level of wealth is already high. This implies that financial integration has a counteracting effect on convergence since it hurts weaker economies disproportionally. This effect is however only observed over the whole sample period 1990-2017 and is not observed when the sample period is divided into smaller sub-samples. Much caution is therefore needed when making claims about this effect, but the result admits cause to further research.