The currency union effect on trade: early evidence from EMU[‘A theoretical foundation for the gravity equation’]

Trade effectThe euro’s trade impact is clearly important for the nations that have already joined euroland. But the size and nature of the trade effects are even more important for the EU members who have not joined the euro: the UK, Denmark, Sweden and the ten new nations scheduled to join next year. What are they missing? Will they face trade diversion if they do not join? For example, the debate on whether or not to join the euro is raging in the UK where it has been polarized to an extraordinary degree. This debate is in desperate need of economic analysis, in order to help clarify the potential impact of the euro on a number of dimensions, one of which is trade. This paper, we hope, will contribute to the debate, by providing estimates of the currency union effect on trade, for the specific case of the countries in the European Union. For this purpose, we use a panel data set that includes the most recent information on bilateral trade for 22 developed countries from 1992 to 2002. During this period 12 European nations formally entered into a currency union. This unique event allows us to study the effect of currency union on trade among a relatively homogeneous group of industrial countries. Controlling for a host of other factors, we find that the effect of EMU on bilateral trade between member countries ranges between 4 and 10%, when compared to trade between all other pairs of countries, and between 8 and 16%, when compared to trade among non-EMU countries. In addition, we find no evidence of trade diversion. If anything, our results suggest that the monetary union increases trade not just with EMU countries, but also with the rest of the world.– Alejandro Micco, Ernesto Stein and Guillermo Ordoñez