Joao Santos Silva and Silvana Tenreyro investigate whether the new currency has delivered the promised growth in trade between member countries

Joao Santos Silva

Silvana Tenreyro

English

Research Papers in Economics

CentrePiece Autumn 2010
6
W
hat are the
costs and
benefits of
establishing a
currency union
between
countries? In his seminal theory of
‘optimum currency areas’, Nobel laureate
Robert Mundell (1961) envisaged that the
main economic benefit would be the
increase in international trade stemming
from the elimination of currency
conversion costs and the possibly greater
predictability of prices.
The main argument against currency
unions is the loss of member countries’
independence to tailor monetary policy to
their local needs. But Mundell suggested
that three conditions reduce the cost of
relinquishing monetary independence –
similarity of the economic shocks that
members experience; wage and price
flexibility; and mobility of capital and
labour. These conditions tilt the policy
choice in favour of a currency union.
Until very recently, there has been little
progress in the empirical assessment of
the costs and benefits of joining a
currency union. Indeed, 40 years after
Mundell’s seminal paper, Andrew Rose
(2000) would present the first systematic
attempt to quantify the effect of currency
unions on trade. Rose estimated that
sharing a common currency increased
bilateral trade between countries by 
over 200%. This result was received 
with some scepticism, and a large 
number of papers, including some by 
Rose himself, investigated the robustness
of the initial finding.
Empirically assessing the effects of
currency unions on trade is a difficult task
that raises a number of methodological
issues (discussed in Baldwin, 2006), which
have not always been dealt with
satisfactorily. Despite concerns about the
reliability of the empirical results, most
work in this area found a substantial effect
on trade from pre-euro currency unions,
and a consensus grew that such unions do
indeed enhance trade, even if by less than
initially estimated. But projections for the
eurozone were hard to make because the
union involved relatively richer countries
that were already fairly well integrated.
Time was needed to gauge the trade
effect of the euro.
The creation of the euro has reinvigorated a
long-running debate about the wisdom of
currency unions. João Santos Silva and Silvana
Tenreyro investigate whether the new currency
has delivered the promised increase in trade
between member countries.
Has the euro 
increased trade? 
Short answer: noCentrePiece Autumn 2010
7
The first evaluation of the euro’s effect
was undertaken by Alejandro Micco and
colleagues (2003), who concluded that the
currency increased trade among eurozone
members by between 4% and 16%.
Subsequent work has addressed various
shortcomings of that study, including the
short sample period (from 1992 to 2002),
the 1993 break in the trade series
resulting from changes in the way
statistics are collected, as well as other
methodological issues discussed in
Baldwin’s 2006 paper.
These studies generally confirmed the
positive effects of the euro on trade. 
But the range of estimates for the euro’s
effect is very wide: from 2% to more 
than 70%. Unfortunately, most of these
studies are marred by methodological
weaknesses and their results should be
viewed with caution.
In an attempt to provide more reliable
evidence, our research estimates the effect
of the euro on trade using what is known
as a ‘differences-in-differences’ approach.
Loosely speaking, this technique is based
on the comparison between trade flows
for the periods before and after the euro
was introduced for two groups of
countries: those that joined the euro
during the observation period (the
‘treatment’ group) and a comparable
group of trading partners that did not join
the euro (the ‘control’ group). The effect
of the euro can then be obtained as the
difference in the changes from the pre- to
the post-euro period for the two groups. 
The use of the differences-in-
differences approach is now standard in
labour economics and health economics,
but has not been used in this context. It is
particularly appealing for this purpose
because it allows estimation of the 
euro’s effect while taking account of
systematic differences between the
countries that joined the euro and
comparable countries that did not join,
such as the UK and Denmark.
In particular, the method takes
account of the fact that the economies of
the eurozone countries were already
deeply integrated before the currency was
introduced. Micco and colleagues also
accounted for this in some of their
estimates but, as indicated, their work
suffered from other limitations.
Our study is also novel in that it
implements the differences-in-differences
estimation using methodological advances
in our earlier work on the estimation of
models for trade flows (Santos Silva and
Tenreyro, 2006).
We implement the approach using the
‘euro-12’ (Austria, Belgium, Finland,
France, Germany, Greece, Ireland, Italy,
Luxembourg, the Netherlands, Portugal
and Spain) as the treatment group and
analysing three control groups of different
sizes and various degrees of similarity to
the euro-12. 
Our new results confirm that long
before the euro was created, trade
between the euro-12 was already
considerably stronger than between
comparable countries, even those that
were part of the European Union. More
interestingly, the results strongly suggest
that after controlling for the fact that the
euro-12 countries already traded much
more intensively, there is little evidence
that the euro had any effect on trade
between them.
So what Mundell considered the main
benefit of a currency union does not
appear to have been realised for the euro,
at least not for the euro-12. It is, however,
possible that the euro has had and will
continue to have a significant trade effect
for newer eurozone members, the
economies of which were not so deeply
integrated before joining the euro. More
time will be needed to evaluate this
possible effect. 
This article summarises ‘Currency Unions in
Prospect and Retrospect’ by João Santos Silva
and Silvana Tenreyro, Annual Review of
Economics 2: 51-74 (September 2010).
An earlier version is available as CEP
Discussion Paper No. 986 (http://cep.lse.ac.uk/
pubs/download/dp0986.pdf).
João Santos Silva is a professor of economics
at the University of Essex. Silvana Tenreyro
is a reader in LSE’s economics department
and an associate in CEP’s macroeconomics
programme.
Further reading
Richard Baldwin (2006) In or Out: Does it
Make a Difference? An Evidence-based
Analysis of the Trade Effects of the Euro,
Centre for Economic Policy Research.
Alejandro Micco, Ernesto Stein and Guillermo
Ordoñez (2003) ‘The Currency Union Effect
on Trade: Early Evidence from EMU’,
Economic Policy 18: 315-56.
Robert Mundell (1961) ‘A Theory of Optimum
Currency Areas’, American Economic Review
51: 657-65.
Andrew Rose (2000) ‘One Money One Market:
Estimating the Effects of Common Currencies
on Trade’, Economic Policy 15: 9-48.
João Santos Silva and Silvana Tenreyro (2006)
‘The Log of Gravity’, Review of Economics
and Statistics 88: 641-58.
The economies of the
eurozone countries 
were already deeply
integrated before the
currency was introduced
There is little
evidence that the
creation of the
euro has had 
an effect on
trade between
the original
members

Has the euro increased trade?

http://cep.lse.ac.uk/pubs/download/cp320.pdf

Has the euro increased trade?

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