Dealing with unobservable common trends in small samples: a panel cointegration approach

Non stationary panel models allowing for unobservable common trends have recently become very popular. However, standard methods, which are based on factor extraction or models augmented with cross-section averages, require large sample sizes, not always available in practice. In these cases we propose the simple and robust alternative of augmenting the panel regression with common time dummies. The underlying assumption of additive e§ects can be tested by means of a panel cointegration test, with no need of estimating a general interactive e§ects model. An application to modelling labour productivity growth in the four major European economies (France, Germany, Italy and UK) illustrates the method.