Risk Sharing, Financial integration, and "Mundell II" in the Enlarged European Union

While empirical research in the tradition of the classical optimum currency area theory, inspired by Mundell (1961), has stressed the costs of a common currency ("Mundell I"), the later and less well-known contribution of Mundell (1973) high- lights the benefits that arise from the risk-sharing opportunities in a financially- integrated currency union. This paper assesses the degrees of risk sharing and financial integration in the enlarged EU in the context of Mundell II. We find limited but increasing comovement of consumption, output and real interest rates between the new member states (NMS) and the euro area. In comparison, we find substantially higher figures for the "old" EU countries which give rise to the hope that the NMS will develop in a similar fashion. Also, we observe that output comovement increases faster than consumption comovement which may lend support to Imbs (2006) who argues that the consumption correlation puzzle may not be rooted in a lack of risk sharing but rather in the even stronger effect that financial integration experts on output comovement in comparison to consumption comovement. In essence, the benefits for the NMS to join the euro area rather earlier than later may have been underestimated.