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“The estimated effects of the euro on trade: Why are they below historical evidence on effects of monetary unions

among smaller countries?”

Prof. Jeffrey Frankel, Harvard University

for Dubrovnik Economic Conference XIV,organized by

Croatian National Bank

June 26-27, 2008.

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Introduction: The status of the Rose finding and of

the first trade effects of the euro

To be discussed:1. Rose’s (2000) famous gravity-model estimate:

monetary unions triple trade among members.2. Critiques of Rose 3. First post-1999 results on effects of the € on European

trade patterns.4. The key question: what explains the smaller effects of

the € to date relative to historical estimates 1. Country size?2. Gradual adjustment over time?3. Spuriously high previous estimates?

5. Approach of this paper

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Rose, “One Money, One Market”

• Probably the most influential empirical paper in the field in the last decade

• The research was motivated by the coming EMU, • but estimates were based on historical data from

much smaller countries.• Findings

– MU => tripling of trade among members– Fixed exchange rate in itself also =>

statistically significant increase in trade

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Link to “Growth theme” of first part of Dubrovnik conference

• Total trade/GDP is estimated to rise when a country joins a monetary union.

• Combined with theories and empirical findings regarding the effect of trade on growth, the implication is a positive effect on growth.

• Frankel & Rose, QJE, 2002• Sample estimate: If Poland joins the euro

openness eventually doubles, and income then rises 40% over the subsequent 20 years.

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Four critiques of Rose, e.g., survey by Baldwin (2006) 1/

and Critique of the critiques, e.g., response by Frankel (2006)

1) Small-country results may not apply to large countries.

Response: There has been no evidence of MU effect varying with size. 2/

Admittedly no big countries were in MUs, pre-1999.

1/ Richard Baldwin, “The Euro’s Trade Effects,” in What effects is EMU having on the euro area and its member countries?,” ECB, Frankfurt, 2006.

2/ J. Frankel & A. Rose, QJE, 2002.

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Critiques, continued

2. Gross magnitudes • Tripling “seems too large to be believable.”• Van Wincoop critique:

Re-parameterizing the gravity-based estimate to fit a theoretical model cuts the magnitude of the MU estimate below “x3.” 1/

Response -- But the effect remains:• Statistically significant• On the same order of magnitude

• as the estimated effects of FTA, and

• as the estimated effects of borders (home bias), e.g., Canada-US 2/

• Greater than thought 10 years ago.

1/ Rose & van Wincoop (2001): trade barriers are halved when joining MU. € => ∆ trade >50%. 2/ McCallum (1995), Helliwell (1998), Wei (1996), and Nitsch (1990, 1991)

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Critiques, continued

3. Endogeneity of the MU decision

Response: – Rose controlled for many third-variable determinants of

trade & MU (colonial past, etc.), which should reduce endogeneity.

– Some alleged cures worse than the disease -- They either use poor instruments, or throw out the data-baby with the bathwater.

But endogeneity remains a likely problem: What if the observed correlation arises because pairs that trade for each other (for reasons not captured by controls) decide to link currencies on Optimum Currency Area grounds?

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Critiques, concluded

4. Cross-section comparative statics ≠ time series experiments

Response: Glick & Rose (2002), with a 1948–97 sample that includes countries that exited MUs, found trade among members twice as high in the currency union period as in the subsequent 30 years..[1]

[1] Lags in adjustement of trade in gravity models may be longer than 30 years. Eichengreen and Irwin (1998), Frankel (1997) .

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First post-1999 results on effects of the € on European trade patterns

Micco, Ordonez & Stein (2003): for pairs of the 1st 12 EMU joiners, trade rose significantly.

• ≈ 15 % beyond what could be explained by growth, etc.

• a range of 6 - 26 % (depending on dummies), with a larger set of 22 industrialized countries.

• “Preferred estimates” (with pair dummies): 4 -16%.

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Other studies of € effect on trade

• Bun & Klaassen (2002, p.1): “the euro has significantly increased trade, with an effect of 4% in the first year” => a long-run effect ≈ 40 %

• Berger & Nitsch (2005) and De Nardis & Vicarelli (2003) report similar positive results.

• Flam & Nordström (2006): 26% (1995-98 to 2002-05)

• Chintrakarn (2008): 9 to 14%.

• Consensus to date: – results in 1st four years significant – but “small”: ≈ 10-20% .

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Results on effects of the € on European trade patterns, continued

• No trade-diversion from non-members– among MUs in general 1/

– from euro in particular (e.g., effects on UK, Sweden) 2/

• Difficulties disentangling MU from: – customs unions (EU) – UK, Sweden.,Denmark, & the 2005 Ten.

– political (dis-) unions, e.g. Czech-Slovak, Yugoslavia, FSU

– transition from socialism to capitalism, e.g., Slovenia

– Re-orientation away from trade with USSR, e.g., Finland

1/ e.g., Frankel-Rose, 2002

2/ Begg, et al (2003), Micco, Stein & Ordoñez (2003), and Flam & Nordström (2006).

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The key questions:

Are the effects of the € to date still smaller than the historical estimates based on larger sets of smaller countries?

If so, is that because:• Time is needed for gradual adjustment?• Small countries ≠ large countries?• Earlier results are biased up by

endogeneity?

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Approach of this paper

• Update gravity estimates of € effect

• while also imbedding recent European years in panel data set of other MUs, e.g., from Glick & Rose

• Address each of the three thorny problems:– Allow for lagged adjustment

– Test explicitly if MU effect declines with country size.

– Address endogeneity with a natural experiment.

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Special cases to shed light on causality

• Ireland’s switch – off of £ in 1979, and onto euro in 1999– was a valuable example, the largest pre-1999. – But separate trade effect not statistically significant

• Because covariance with joining EU was too close (Thom & Walsh, 2002)

• and dominated by long-term trend in intra-EU trade (Lane, et al, 2008)

• Estimation for Slovenia in 2007, when data permit– will be a valuable example, as the 1st transition country to join €.– But, again, we are unlikely to get enough data

to separate out the effects of € from effects of • transition out of Socialist Yugoslavia • joining EU

• Also Cyprus and Malta in 2008

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Moreover, possible endogeneity is still with us

• The decision to join the €, by Slovenias or Irelands, could be misleadingly correlated with shift in trade pattern toward continental Europe, either because:– such a shift is a political goal, encouraged by

other means as well, or

– trade is shifting direction for natural economic reasons, and policy-makers want to reduce fx costs for importers & exporters.

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Reproducing the results in Micco, Ordoñez & Stein (2002)

• They estimated the effect of € on trade patterns during 1992-2002, for relatively narrow samples: – Europe or, alternatively, – all industrialized countries.

• Table 1 does successfully replicate the results: – pairs of euro countries enjoy greater bilateral trade; – coefficient gradually rises in level & significance,– reaching about 15% in 2002, – after first appearing suddenly significant in 1998.

• Why does the effect show up the year before EMU formally goes into effect?

– Same with FTAs. – Explanation: businesses seek “first-mover advantage.”

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Effect becomes significant in 1998

Reaches 16% in 2001-02.

Table 1 --

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Finding: € effect reached 14-18% by 2001Micco, Stein and Ordonez (2003): EMU Impact on Trade

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Time

EM

U I

mpact

on T

rade (

in %

)

Developed Sample EU Sample

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Update of results, as 4 more years of data have become available.

• The effect of the euro on bilateral trade remains highly significant statistically during the years 2003-2006,

• but the point estimate is no longer rising. • Rather, it appears to have leveled off,

≈ 0.15 in the EU-only sample, still very far below the Rose doubling or tripling estimates. – In the sample that includes all developed countries, the

euro effect is only ≈ 0.10.

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Effect becomessignificant in 1999

Reaches 16% in 2001

Steady through 2006

Table 2 --

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Now imbed in the complete data set

• 1948-2006

• 200 countries, including – enough data to get sharp estimates

of parameters, and– a fair number of monetary unions

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Do the effects of monetary union diminish with the size of the countries involved?

• Add an interactive size term -- the product of the respective country sizes and the CU dummy variable --

• to see whether CU effects on trade are bigger for small countries than for large countries, so that this might explain the smaller effect in Europe.

• Larger countries do not experience smaller boosts to intra-MU trade to a statistically significant extent.

• The effect of EMU on bilateral trade remains, even after controlling for size.

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Mystery: If neither time lags nor size explain

the gap between 15% and doubling, then what does?

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The Effect of EMU on Trade: Different Estimators and Samples, 1948-2006

-20%

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

Full Sample FixedEffects

Full Sample OLS Developed SampleFixed Effects

Developed SampleOLS

EU Sample FixedEffects

EU Sample OLS

In cross-section, EMU is estimated to increase intra-member trade by 2-3 times, but only when entire data sample is used

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We proceed step-by-step from our reproduction of M-O-S, to see at which stage

the coefficients change

• Table 6 expands the dataset to 1948-2006, a panel with almost 60 years of data, while retaining a separate coefficient to distinguish EMU from others.

• The graph reveals that sample size is the crucial difference between MSO & broader estimates.

• While estimates of the euro’s effect on trade continue to linger around 10-25% for the developed & EU samples that MSO used, they climb dramatically to .9-1.0 for the full sample

• exponentially = 2.5-2.7, almost tripling. • Estimates are highly significant, because there are more

data to work with now.

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The Effect of Non-EMU Currency Unions and of EMU on Bilateral Trade over Time:

Fixed Effects Estimators

-100%

0%

100%

200%

300%

400%

500%

600%

700%

1 YrPrior

toNon-EMUCU

1 YrPrior

toEMU

1-5YrsPostNon-EMUCU

1-5YrsPostEMU

6-10YrsPostNon-EMUCU

6-10YrsPostEMU

11-15YrsPostNon-EMUCU

16-20YrsPostNon-EMUCU

21-25YrsPostNon-EMUCU

26-30YrsPostNon-EMUCU

Full Sample Fixed Effects Estimator Developed Sample Fixed Effects Estimator EU Sample Fixed Effects Estimator

6-10 years after monetary union, estimated effects on tradefrom other MUs are virtually the same as from EMU,

provided estimation is on full sample of countries/years (1948-2006)

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Mystery solved?

• We have uncovered the possibility that the large gap is an artifact of the largely non-overlapping historical periods analyzed in the Rose & M-O-S studies (pre- & post-1999, respectively).

• Perhaps some parameters such as common border and common language dummies are not estimated well enough on smaller samples, affecting estimates of €-area coefficient.

• Estimated trade effects of € as great as trade effects of non-EMU CUs.

• Moreover, the estimated coefficient of EMU > coefficient for EU or other FTAs !

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But could all estimates of CU effects be biased upwards due to endogeneity

of the currency decision?

• As our last task, we address endogeneity.

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A natural experiment:The effects of the French franc’s conversion to

€ on bilateral trade of African CFA members.

• The long-time link of CFA currencies to the F franc has clearly always had a political motivation.

– So CFA trade with France could not reliably be attributed to currency link,

• perhaps even after controlling for common language, former colonial status, etc.

• But in Jan. 1999, 14 CFA countries suddenly found themselves with the same currency link to Germany, Austria, Finland, Portugal, etc.

– No economic/political motivation. A natural experiment.– If CFA trade with these other countries has risen,

that suggests a € effect that we can declare causal.

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Results of CFA experiment

• Table 7. • The dummy variable

representing when one partner is a CFA country and the other a € country has a highly significant coefficient of .57.

• Taking the exponent, the point estimate is that the euro boosts bilateral trade between the relevant African and € countries by 76%.

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Conclusions

1. Update of first estimates of effect of € on intra-EMU trade shows the coefficient in 2003-2006 remained significant and steady at the level attained in 2001-02.

2. But it didn’t continue to rise. No evidence that lags explain the big gap between effect of € (15%) and earlier estimates of effects of other Monetary Unions (x2 or x3)

3. There is also no evidence that the gap is explained by a MU effect that diminishes with country size.

4. The natural experiment of the CFA suggests that the high estimates of effects among small or poor countries have not resulted from endogeneity of currency decisions.

5. Solution to the mystery? Apparently the additional data from the full data set is necessary for accurate estimates of the parameters. Perhaps the € effect is as large as effects of other MUs after all.

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Rev., June.

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Paper also to be presented at NBER conference on Europe and the Euro,

October 17-18, 2008

Alberto Alesina & Francesco Giavazzi, Organizers

The author wishes to thank Clara Zverina, who provided exceptionally good research

assistance, and Ernesto Stein, who was originally a co-author.