WHY EUROPEAN MONETARY UNION WILL WORK - EVEN IF IT LOOKS LIKE A BAD IDEA IN ADVANCE

European economic and monetary union (EMU) is about to happen. Should it? Many economists argue ‘No.’ But writing in the latest issue of the Economic Journal, Professors Jeffrey Frankel and Andrew Rose show that they’re mis-interpreting the data. Succinctly, EMU may look like a bad idea before it happens. But by integrating markets, it will result in more synchronized business cycles across the participating countries. EMU will work after it takes place and because it takes place even if it looks like a bad idea in advance.

On the basis of the evidence, many economists conclude that EMU is a bad idea. Business cycles are poorly synchronized in Europe, so that countries give up an important policy when they merge their currencies. If a country like Finland is hit by a bad shock (say, because of events in Russia after EMU), it won’t be able to devalue its currency and lower its interest rates. Losing the markka means that Finland loses a national tool of stabilization by acquiring European monetary policy.

This argument is a reasonable reading of the historical evidence. But history may not be relevant. By eliminating different currencies, EMU will lead to a large expansion of trade. The growth in trade will in turn lead to more synchronized business cycles. As Finland experiences fewer Finnish shocks, European monetary policy will be more appropriate. Countries joining EMU will have given up an irrelevant tool; but they will still reap the benefits of increased trade.

EMU is usually discussed by asking whether Europe is an ‘optimum currency area’ (OCA)? The main criterion for an OCA is that the countries involved should share a single currency if they trade intensely with each other and have synchronized business cycles. But both trade intensity and business cycles will change because of EMU.

From a theoretical viewpoint, the effect of increased trade integration on the cross-country correlation of business cycle activity is ambiguous. Reduced trade barriers can result in increased industrial specialization by country and therefore more asynchronous business cycles. On the other hand, increased integration may result in more highly correlated business cycles because of demand shocks or intra-industry trade. Happily, this ambiguity is theoretical rather than empirical.

Frankel and Rose present econometric evidence suggesting strongly that as trade links between countries strengthen, their national incomes become more highly correlated (not less correlated, as some have claimed). Using a panel of 30 years of data from 20 industrialized countries, they find a strong positive relationship between the degree of bilateral trade intensity and the cross-country bilateral correlation of business cycle activity. In other words, greater integration has historically resulted in more highly synchronized cycles.

This has important implications for the OCA criterion. It means that a naïve examination of historical data gives a biased picture of the effects of EMU entry on a country. Some countries may appear, on the basis of historical data, to be poor candidates for EMU entry. But EMU entry per se, for whatever reason, may provide a substantial impetus for trade expansion; this in turn may result in more highly correlated business cycles. That is, a country is more likely to satisfy the criteria for entry into a currency union ex post (after the fact) than ex ante (before).

Note: ‘The Endogeneity of the Optimum Currency Area Criteria’ by Jeffrey A. Frankel and Andrew K. Rose is published in the July 1998 issue of the Economic Journal. The authors are Professors of Economics at the Haas School of Business, University of California, Berkeley, CA 94720-1900. The paper was produced as part of a research programme of the Centre for Economic Policy Research (CEPR).

For Further information: contact RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or mobile 0468-661095 (email: romesh@compuserve.com ); or Andrew Rose on 001-510-642-6609 (fax: 001-510-642-4700; email: arose@haas.berkeley.edu ).