The Euro at Ten: Time to Assess

January 1, 2009, is the tenth birthday of the euro. On this occasion, everyone has been taking stock. The record of the euro shows both pluses and minuses. Looking back, the euro has in many ways been more successful than predicted by the skeptics — many of them American economists. The historic transition to a monetary union among 11 countries in 1999 went smoothly; the euro instantly became the world's number two international currency; and the officials of the European Central Bank (ECB) have from the beginning worked as citizens of Europe rather than as representatives of home constituencies. After a rocky start, the euro has achieved a strong value; the ECB has achieved a strong reputation (the tradition of the Bundesbank has not been diluted as feared); and new members to the East have achieved membership in the club.

At the same time, however, some of the skeptics' warnings have come to pass: shocks have hit members asymmetrically; cushions such as US-type labor mobility have remained thin; and the Stability and Growth Pact has proven unenforceable. Furthermore, the popularity of the project with the elites does not extend to the public, many of whom are convinced that when the euro came to their country, higher prices came with it.

One of the most interesting questions at the inception of the euro was whether the elimination of currency risk and of foreign exchange transactions costs would promote trade among members. Facilitating trade had been one of the most important of the original motivations of founders. Prior to 1999, however, most economists believed that the effects of currency barriers between countries, if even greater than zero, were small — small, for example, relative to trade barriers.

In 2000, Andrew Rose published in Economic Policy what turned out to be one of the most influential empirical papers of the decade: "One Money, One Market..." Applying the gravity model to a data set that was sufficiently large to encompass a number of currency unions led to an eye-opening finding: members of currency unions traded with each an estimated three times as much as with otherwise-similar trading partners. Many found the tripling estimate implausibly large. No sooner had Rose written his paper than the brigade to "shrink the Rose effect" (the phrase is from Richard Baldwin) -- or to make it disappear altogether — descended en masse. But their plausible methodological critiques can be answered. Authors tended to replicate the finding with a twist. Although they came away denting the magnitude of the estimate, few studies, if any, managed to shrink the estimated effect of currency barriers below the estimated effect of trade barriers.

This research was of course motivated by the coming of the euro in 1999, even though estimates were necessarily based on historical data from (much smaller) countries who had adopted (or left) currency unions in the past. But now, 10 years later, we have enough data to see the extent to which the trade-promoting effect that currency unions have showed among smaller countries also carries over to European countries. This will be the subject of my next post to follow.

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