PROCEEDINGS OF JUNE 2005 WORKSHOP ON WORKING PAPER SERIES WHAT EFFECTS IS EMU HAVING ON THE EURO AREA AND ITS MEMBER COUNTRIES? NO 594 / MARCH 2006 THE EURO’S TRADE EFFECTS ISSN 1561081-0 by Richard Baldwin comments by Jeffrey A. Frankel 9 771561 081005 and Jacques Melitz WORKING PAPER SERIES NO 594 / MARCH 2006 PROCEEDINGS OF JUNE 2005 WORKSHOP ON WHAT EFFECTS IS EMU HAVING ON THE EURO AREA AND ITS MEMBER COUNTRIES? THE EURO’S TRADE EFFECTS1 by Richard Baldwin 2 comments by Jeffrey A. Frankel and Jacques Melitz In 2006 all ECB publications will feature This paper can be downloaded without charge from a motif taken http://www.ecb.int or from the Social Science Research Network from the €5 banknote. electronic library at http://ssrn.com/abstract_id=886260 1 First draft 8 May 2005; Second draft 29 May 2005; Third draft June 2005. Prepared for the ECB Workshop “What effects is EMU having on the euro area and its member countries?” Frankfurt, 16 June 2005. I would like to thank Nadia Rocha for assistance with data-wrestling. Andy Rose, Volker Nitsch, Howard Wall, Alejandro Micco and Hakan Nordstrom provided excellent comments and answered my many questions about their data and regressions. They also saw early drafts of this paper and eliminated several mistakes but there may be still some left in this version. Special thanks to Francesco Mongelli who carefully read the first complete draft and caught many typos, thinkos and omissions. 2 Graduate Institute of International Studies, 11a, avenue de la Paix, CH-1202 Geneva, Switzerland; e-mail: [email protected] PREFACE On 16 and 17 June 2005, the ECB has hosted a Conference on “What Effects is EMU Having on the Euro Area and its Member Countries?” One and a half decade after the start of the European Economic and Monetary Union (EMU) and more than six years after the launch of the euro, the aim of the conference was to assess what can be learned about the impact of economic and monetary integration and how it has benefited the euro area and its member countries. The conference brought together academics, central bankers and policy makers to discuss the existing empirical evidence on changes brought about, either directly or indirectly, by EMU and, in particular, the introduction of the euro in five main areas: Area 1. Trade integration; Area 2. Structural reforms in product and labour markets; Area 3. Financial integration; Area 4. Business cycles synchronisation and economic specialisation; and Area 5. Inflation persistence and inflation differentials. Lead presenters for each of the aforementioned areas had been asked to put together - and interpret - all the available information, flag any open questions, and also discuss the implications in their respective field of expertise. With the benefit of hindsight, lead presenters and discussants have also addressed some initial presumptions with the evidence that has accumulated thus far. In order to exchange information and ideas on the above effects, and increase mutual awareness of ongoing work in the diverse areas, we deemed it useful to issue the five leading presentations, together with the accompanying discussions, in the ECB Working Paper Series. Otmar Issing Francesco Paolo Mongelli Juan Luis Vega Member of the Executive Board Conference Organiser Conference Organiser © European Central Bank, 2006 Address Kaiserstrasse 29 60311 Frankfurt am Main, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main, Germany Telephone +49 69 1344 0 Internet http://www.ecb.int Fax +49 69 1344 6000 Telex 411 144 ecb d All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the author(s). The views expressed in this paper do not necessarily reflect those of the European Central Bank. The statement of purpose for the ECB Working Paper Series is available from the ECB website, http://www.ecb.int. ISSN 1561-0810 (print) ISSN 1725-2806 (online) CONTENTS Abstract 4 Non-technical summary 5 1. Introduction 6 2. The Rose vine: review of the pre-euro literature 7 2.1. Roots: the world through Rose coloured glasses 7 2.2. Garden pests: biases in gravity model estimations 11 2.3. Rose branch #1: Rose and van Wincoop (2001) 20 2.4. Rose branch #2: omitted variables 21 2.5. Rose branch #3: complicated mis-specification 28 2.6. Rose branch #4: roster-makes-the-sun-rise reasoning 32 2.7. Meta-Analysis: a rose is a rose is a rose 35 2.8. Lessons for the eurozone from non-European experience 36 3. Empirical findings on the eurozone 36 3.1 MSO (2003) 37 3.2 Berger and Nitsch (2005) 41 3.3 Flam and Nordstrom (2003) 42 3.4 Other studies 47 4 Collection of clues 48 4.1. Spatial variation of the Eurozone Rose effect 48 4.2. Timing of the Eurozone Rose effect 52 4.3. Sectoral variation in the Eurozone Rose effect 54 5. What could it be? 56 5.1. Spurious results 56 5.2. Microeconomic changes that might produce a Rose effect 61 6. Battery of diagnostics 66 6.1. Checking for spurious results 66 6.2. Real changes 67 7. Concluding Remarks 67 References 68 8. Appendix on methods 71 Comments by Jeffrey A. Frankel 76 References 87 Comments by Jacques Melitz 91 References cited 98 European Central Bank Working Paper Series 99 ECB Working Paper Series No. 594 March 2006 3 Abstract This paper reviews reassesses the methodology and principal findings of the “Rose effect”, i.e. the trade effects of currency union, looking at both EMU and non- EMU currency unions. The consensus estimate suggests that the euro has already boosted intra-euro area trade by five to ten percent. The paper discusses a gamut of models that might explain the Rose effect in Europe and suggests a series of empirical test that could help identify the economic mechanisms involved. Key words: Rose effect, exchange rate volatility, monetary union, gravity model. JEL codes: F12, C33, E0 ECB Working Paper Series No. 594 4 March 2006 Non-Technical Summary The paper is articulated in three main parts. The first part reviews the origins, methodology and principal findings of the empirical literature that has looked at currency unions preceding EMU. The specification of the gravity model and estimation strategies are newly reassessed. As a result the trade effects of currency unions for non-European cases are completely recalibrated (i.e., the trade effects are still important but less sizeable than in early estimates by Rose and others). One needs to keep in mind that cases of pre-euro currency unions usually pertain to small (and often poor) countries adopting the currency of a larger partner country. I.e., such studies do not carry direct policy implications for the euro area. The second part of the paper reviews the trade effects of currency unions – i.e., the euro -- for the European Economic and Monetary Union thus far. The bottom line of this literature is that the euro probably did boost intra-Eurozone trade by something like five to ten percent on average, although the estimated size of this effect is likely to change as new years of data emerge. The third part of the paper investigates the economic mechanisms that might be driving the euro’s trade effects. A theoretical model is presented. Diverse competing hypotheses are examined and a battery of diagnostic tests -- that could help reject some or all of the theoretical explanations – are lined up. The way forward needs to be guided by detailed theoretical hypothesis as to HOW the euro affects trade. As there is not enough data yet to answer the question “How much did the euro boost trade?” one needs to tackle the question “If the euro boosted trade by sharpening competition, then in which dataset should we find the footprints?” and some footprints will have nothing to do with trade. In a nutshell, studies of trade effects need to come out of their infancy and move beyond the question of ‘how big is the magic.’ ECB Working Paper Series No. 594 March 2006 5 1. INTRODUCTION The euro must be the world’s largest economic policy experiment. Six years ago, European nations accounting for 20% of world output, 30% of world trade and 300 million people found themselves using the same currency. Given the importance that monetary regimes have on economies, switching to the euro should have had effects all across the board – changing everything from union’s wage bargaining to educational exchanges and corporate investment strategies. Every problem looks like a nail when you have a hammer in your hand, so being a trade economist I am naturally drawn to the euro’s trade effects. In this paper, I review the empirical literature on the trade effects of currency unions for non-European and European cases. This is done in sections 2 and 3. My bottom line summary of this literature is that the euro probably did boost intra-Eurozone trade by something like five to ten percent on average, although the estimated size of this effect is likely to change as new years of data emerge. Then I collect together the clues in section 4 and use them in section 5 to speculate on the sorts of economic mechanisms that might be driving the euro’s trade effects. I come up with a set of competing hypotheses and, in Section 6, propose a battery of diagnostic tests that could help reject some or all of the theoretical explanations.