Tuesday, May 08, 2007

New Study On EMU & Trade

Last year I reported on a study by Swedish economists Harry Flam and Håkan Nordström on the effects of the European Monetary Union. They estimated that Sweden's foreign trade would have been 13% higher if Sweden had abolished the krona and introduced the euro as currency.

Now, a economist by the name of Claes Wihlborg hired by anti-EU party Junilistan have estimated a much smaller effect (like the first study, it is written in Swedish). They argue that trade would have increased a lot less. Only about 10% versus euro zone countries and zero versus non-euro zone countries, meaning a total effect of about 4%.

So, who is right? Well, actually both have faults in their logic. First, let us make clear that the effect on monetary unification on internal trade is unambiguously positive. There are no theoretical reasons to expect it to be negative while there are good theoretical reasons to expect it to be positive. The effect on trade outside the currency zone is by contrast theoretically ambiguous. On the one hand, increased specialization could have a spill-over effect on countries outside the monetary union. On the other hand, the reduced internal trade barrier that monetary unification constitutes could have a trade diverting effect away from trade with third countries.

However, while we know from theory alone that monetary unification will increase internal trade we don't know by how much. And as far as external trade goes, we don't know from theory which of these effects will be bigger. This is why empirical studies are needed.

Given the fact that the effect on external trade is theoretically ambiguous, the estimate of Flam & Nordström that the positive net effect was as much as 12% seems implausible. Not impossible, but certainly implausible.

On the other hand, Wihlborg's arguments against Flam& Nordström's estimates of internal trade are not persuasive either. He argues that improved macroeconomic stability in some of the countries are one explanation. Just what he means by "macroeconomic stability" is not clear, but there is no reason at all to think that any macroeconomic variable other than the exchange rate would impact relative trade intensiveness. And the effect of the elimination of exchange rates is of course what this discussion is all about. He also argues that cyclical fluctuations rather than absolute levels of GDP growth should be used as a statistical control variable. But there is no reason to expect that cyclical fluctuations in growth should result in anything else than fluctuations in trade. The theoretically correct control variable is in fact as Flam & Nordström argued absolute levels of GDP growth.

Moreover, his argument that it is strange that so much of the positive effect happened already in 1999 is not a good one. Supposedly he would argue that it takes time for companies to initiate the investments and trade stimulated by the euro. But it's not like the imposition of the euro was something that took people by surprise on New Year's Day 1999. The final decision was made already in 1997, giving companies plenty of time to invest.

These errors, particularly his use of cyclical fluctuations rather than absolute levels of growth is the main reason why he landed at a estimate of increased internal trade that was a third less than Flam & Nordström. But as Flam & Nordström's control variable was more theoretically correct, their estimates must be considered more credible.

On the other hand, their estimate of the boost external trade certainly seems implausibly high. But, and this needs to be emphasized, this would make little difference as with regard to the total boost to trade. The reason for this is that the boost to internal trade was calculated by dividing it to the boost to external trade. Internal trade in euro-zone countries increased 26% relative to internal trade in the control group. So, the 13% estimate was derived by dividing the 26% boost to internal trade with the 12% increase to external trade. But if the 12% estimate of external trade boost is revised down, while the 26% relative increase in internal trade is left unchanged, this means that the estimated boost to internal trade from a Swedish EMU-entry must be revised up by an equal amount. And while non-EMU trade is 1.5 bigger than Swedish trade with EMU, the net effect of revising down the estimated boost to external trade is very little. Indeed, even assuming zero effect would leave the estimated boost to total Swedish trade at 10.4%. While that is lower than the 12-13% that Flam & Nordström estimated, it is far above Wihlborg's 4%.


Blogger Flavian said...

One aspect that perhaps has been overseen is the fact that the dollar gained sharply against the euro during the beginning of 1999.

I agree that the absence of nominal exchange rate movements is a great pro of the EMU.

On the other hand the EMU is poor substitute for free banking under gold. I also think that the complete absence of inflation is a more important feature of a good monetary system than the absence of nominal exchange rate movements.

9:10 PM  
Blogger stefankarlsson said...

Actually, it hasn’t been overseen. Both Flam & Nordström and Wihlborg took exhange rate movements against the dollar and other currencies into account in their studies.

9:30 PM  

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