The Euro at Ten: Why Do Effects on Trade Among Members Fall Short of Historical Estimates in Smaller Monetary Unions?

By roughly the five-year mark after the launch of the euro in 1999, enough data had accumulated to allow an analysis of the early effects of the euro on European trade patterns. Studies include Micco, Ordoñez and Stein (2003), Bun and Klaassen (2002), Flam and Nordström (2006), Berger and Nitsch (2005), De Nardis and Vicarelli (2003, 2008), and Chintrakarn (2008). The general finding was that bilateral trade among euro members had indeed increased significantly, but that the effect was far less than the one that had earlier been estimated by Rose and others on the larger data set of smaller countries. Overall, the central tendency of these estimates seems to be a trade effect in the first few years on the order of 10-15%. None came anywhere near the tripling estimates of Rose (2000), or the doubling estimates (in a time series context) of Glick and Rose (2002).

There are three leading explanations for the discrepancy between the estimates of the euro’s effects (10-15% increase in trade among members) and those from historical estimates (doubling or tripling).

• Explanation (1): It takes time for the effects on trade to rise to their full magnitudes;
• Explanation (2): Monetary unions have much smaller effects on large countries than small countries, and
• Explanation (3): The Rose estimates on smaller countries were spuriously high as a result of the endogeneity of the decision to form a currency union; in other words, bilateral currency links have historically been the result of bilateral trade links rather than the cause.

In a new paper (Frankel, 2008), I try to assess the importance of each of these factors in explaining the discrepancy. Surprisingly, the evidence does not support an important role for any of the three explanations.

Pursuant to the question of time lags, Explanation (1), I have updated the estimates. The effect of the euro on trade between members remains high significant statistically, but no higher in magnitude than it was four years ago; it is steady at 10-15%. It is entirely possible that the future will reveal substantially larger effects as substantially more time goes by. But at the moment there is little evidence to support the lags explanation.

Pursuant to the question of country size, Explanation (2), I tested for an effect of the interaction of size and currency union membership. There is no tendency, overall, for currency unions to have larger effects on the trade of small countries than large.

The question of endogeneity, Explanation (3), is trickier. I tried a “natural experiment,” designed to be as immune as possible from the argument that the choice of currency is endogenous with respect to trade. The experiment is the effect on African CFA members’ bilateral trade of the French franc’s 1999 conversion to the euro. The long-time link of CFA currencies to the French franc has clearly always had a political motivation. So CFA trade with France could not in the past reliably be attributed to the currency link, perhaps even after controlling for common language, former colonial status, etc. But in January 1999, 14 CFA countries woke up in the morning and suddenly found themselves with the same currency link to Germany, Austria, Finland, Portugal, etc., as they had with France. There was no economic/political motivation on the part of the African countries that led them to an arrangement whereby they were tied to these other European currencies. Thus if CFA trade with these other European countries has risen, that suggests a euro effect that we can declare causal. The dummy variable representing when one partner is a CFA country and the other a euro country has a highly significant coefficient of .57. Taking the exponent, the point estimate is that the euro boosted bilateral trade between the relevant African and European countries by 76%. It is not doubling, and the timing is imperfect. But it does suggest that the effect on trade among small countries is very substantial even after correcting for endogeneity.

Thus none of the three explanations appears to explain the gap between the recent euro estimates and the historical estimates. Perhaps time will offer more evidence for one or more of the explanations in the future. For the moment, the gap remains something of a mystery. But promotion of trade must nevertheless be counted one of the successes of the euro. If Rose had come up with a 15% effect on trade from the beginning, that would have been considered important. Furthermore, the evidence is that the euro, like other currency unions, has not diverted trade away from non-members, which is important for judging economic welfare.

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