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.

The Euro at Ten: Time to Assess

The Euro At Ten

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.

The Tenth-Ranked Quotation of 2008?

The good news is that the title line in my blog post of July 17 was chosen as one of the top ten quotes of 2008 (tied for tenth place, it is true). The bad news is that the quote was attributed to Paul Krugman, who had used it subsequently on the Bill Mayer Show. The sentence is: “If there are no atheists in foxholes, there are no libertarians in financial crises.” I had originally used it in 2007 as the first line of an article in a Cato Journal issue devoted to financial crises. Among the others who subsequently picked up on the line were Ben Bernanke, Mark Shields, Bloomberg,, Brad deLong, and Tom Keene – generally with attribution, when the format permitted.

The list of Top Ten Quotations of 2008 went out over AP on Monday, and has appeared in lots of newspapers over the last couple days. Those are the breaks. Krugman immediately set the record straight on his blog, as I knew he would.

But there are some other, more interesting, aspects.

One is an illustration of how tough is the world in which highly visible columnists like Krugman live. There are lots of Krugman-haters out there. Of course the phenomenon originates in the fact that he consistently has been liberal and anti-Bush (not precisely the same thing). But the antipathy goes very deep. The Yale/AP list was called to my attention yesterday by one Joel West. I told him I was indebted to him for pointing out the misattribution. But I also told him that I was sure that there had been no desire on Paul’s part to steal my line: TV shows like Bill Maher don’t customarily allow their guests to display footnotes. But Mr. West must be one of the Krugman-haters, because his subsequent blog post blithely accused Krugman of dishonesty. As had another Krugman-hating blog post before that. These people are eager for ammunition against someone of a different ideological persuasion and are not sufficiently discriminating about what they use.

Ironically, of the other two soundbites that share tenth place on the Yale/AP list with the atheists-libertarians quote, one is something else attributed to Krugman (“Cash for trash”), and the third is from the all-time champion Krugman-hater, Donald Luskin. Luskin earned the Top Ten honor when quoted as saying “Anyone who says we’re in a recession, or heading into one — especially the worst one since the Great Depression — is making up his own private definition of ‘recession'” in the Washington Post, September 14. This was of course after a huge fraction of economic commentators had already decided that the country was probably in recession, as turns out to have been the case. (I myself took a bit of grief on various blogs both for saying it too early and also for saying it too late.)

The atheists-and-libertarians line itself has also drawn some grief from two minority communities — atheists and libertarians — on various blog sites. I don’t mean to put these two philosophies together (although that would be an interesting essay question on some exam). Nor is it the case that either group is objecting to being associated with the other. But both have pointed out that the statement is not literally true. They are entirely correct: There are plenty of atheists in the military; and there are plenty of libertarians in a financial crisis. But of course the statement did not literally mean there are no atheists in foxholes or lilbertarians in financial crises. The claims are, rather, that on average: (i) soldiers under fire tend suddenly to grow more religious in outlook, and (ii) policy-makers facing a financial crisis tend suddenly to grow more interventionist in outlook. If anything, I admire the intellectual consistency of those that do not change their views under such pressure. 1) Yes there really are atheists in foxholes. They are a minority, but a substantial one. (2) And yes there really are libertarians in financial crises. Again a minority, but not to be dismissed.

Origins of the Economic Crisis? In One Chart!

Every two years, Harvard Kennedy School hosts the newly elected Members of Congress for a three-day “briefing” on a wide variety of topics. We had an excellent turnout of forty this week, new congresspeople from both parties. I participated in a panel titled “Understanding the Economic Crisis,” along with Greg Mankiw, Elizabeth Warren and Robert Lawrence (on video).

Trying to explain the financial crisis and recession in ten minutes, even to the extent any of us understands it, was a tall order. But I tried to cram it all into a single slide. Here it is.

Flowchart of Origins of Economic Crisis

NBER Eggheads Finally Proclaim Recession

The National Bureau of Economic Research today announced that its Business Cycle Dating Committee had officially determined a peak in economic activity at December 2007, which signals the start of the recession. I am a member of the committee. Though I speak only for myself, not the committee, I offer my views on two questions of possible interest:

(1) Who needs the NBER Business Cycle Dating Committee (BCDC) anyway?

(2) Why did we pick December 2007 as the starting month of the recession?

(1) We sometimes hear the question “Who needs the NBER Committee anyway?” This question most often comes in one of two forms:

(1a) Everyone in the real world has known that the economy has been in a serious recession for some time. In past cycles, media reports have sometimes taken the line “Ivy Tower Eggheads Finally Figure Out What Everybody Else Has Known All Along.” The implicit critique is that the committee takes too long after the event — typically almost a year — to make its declaration. One short answer is that our job is to be definitive, not fast. GDP and other government statistics are often revised after the fact, for example. We don’t want to have to revise our dating of the peaks and troughs later, in part because it would sow confusion among those who rely on them (from econometric researchers to political speechwriters). We leave it to others — pundits, forecasters, consulting companies, financial newsletters, and so on — to try to get there first. We deliberately get there last.

(1b) The other form taken by the question “Who needs the NBER committee?” runs as follows: “The rule of thumb is simple: two consecutive negative quarters of GDP growth. Why complicate things?” The Frequently Asked Questions segment of the BCDC announcement answers this in detail. For now, observe simply that questions (1a) and (1b) are inconsistent with each other. As of December 1, 2008, the US economy has not yet experienced two consecutive negative quarters. So an argument that we should wait for two consecutive quarters (critique 1b) is the opposite of the critique that we should have acknowledged a recession before now (critique 1a).

(2) The more important question is: Why did we pick December 2007 as the start of the recession? As is the case surprisingly often, different economic indicators give very different answers to the date of the peak.

Of the monthly indicators to which the BCDC gives primary attention, the most important is jobs, more specifically Payroll Employment (from the Labor Department’s Bureau of Labor Statistics). It peaked in December 2007, and has been declining ever since. My personal favorite indicator is Total Hours Worked (which is closely related, because it is number of people employed times the average number of hours per worker). Hours Worked also peaked in December, as shown in the graph below.

Of the quarterly indicators, the most important is aggregate economic activity, more specifically, Output. The Commerce Department’s Bureau of Economic Analysis computes two measures of output: Gross Domestic Product (GDP) and Gross National Income (GNI). The two should be the same in theory, but differ in practice due to measurement errors. GDP receives far more public attention, but in fact has no claim to be a more accurate measure of output than does National Income. The statistics currently available show that GNI peaked in Quarter 3 of 2007, whereas GDP peaked in Quarter 2 of 2008. A simple-minded average of the two peak dates would seem to point to midnight of New Year’s Eve, December 2007, as the peak. Another (comparably unsatisfactory) way of forcing the output data to cough up a precise month is to look at Personal Income, which is available monthly. The BCDC’s computed measure of real personal income less transfers peaked in December 2007.

It would be wrong to claim that all roads arrive at the same destination, December 2007. Other indicators point to other dates, some earlier, some later. If we are very lucky, revisions that the BEA makes in July 2009 will help resolve the discrepancy between the GDP and GDI measures somewhere in the middle. But perhaps the best characterization of the output measures is that they show a rough plateau from the fall of 2007 to the summer of 2008. That the employment statistics speak more clearly allows them to have the predominant say.