Comment: Scorecard for the euro

COMMENT BY CENTRALBANKNEWS

In one of the most detailed studies* of the trade effects to date, Richard Baldwin of the Graduate Institute of International Studies in Geneva, finds that while there is evidence of a boost to trade due to the euro, it may not be of the magnitude previously expected. Baldwin's empirical tests reveal that the countries outside the single currency - Britain, Sweden and Denmark - have shared nearly all the increase in trade, and would therefore not receive much additional benefit from joining the euro now.

Baldwin estimates that intra-eurozone trade has increased by between 5% and 15% as a result of the introduction of the euro, controlling for other factors, with the best estimate at 9%. Interestingly, he dismisses the argument that gains to trade have occurred due to a reduction in transaction costs. Instead, the boost to trade came from the fall in the fixed cost to firms of expanding their activities into different eurozone countries, given that they now only need to invest once in the infrastructure for handling transactions in euros. For example, once a French firm has set up their systems for selling to Germany, the cost of expanding their operations to Spain will be much reduced by the presence of the single currency.

A separate and broader research programme** led by Alberto Alesina, an economist at Harvard, under the auspices of the National Bureau of Economic Research, finds as one of its main conclusions that "the first six years of the Euro have confirmed the pros and cons that economists had identified." The benefits include ruling out competitive devaluations and improving the prospects of highly indebted countries such as Italy and Belgium. The big downside is that cyclical harmonisation has not occurred at anywhere near the pace anticipated. At some stages of interest rate cycle monetary policy is optimal in only a small number of eurozone countries. Both Baldwin and Alesina suggest that the difficulties of managing the whole eurozone with just one interest rate are likely to persist.

What are the implications of this research? The first thing to stress is that the single currency has produced significant trade benefits, even if they were not of the magnitude some predicted or hoped for. But these benefits accrue to all countries, in or out of the eurozone, and member countries only get small additional gains. There are, therefore, elements of a public good to the single currency, and by extension a potential free-rider problem.

Given the costs of joining the single currency in terms of a loss in monetary policy autonomy, the case for any of the three big "outs" now joining seems weaker. However, the benefits of independent monetary policy are probably less substantial for aspiring euro entrants with smaller economies in a phase of (potentially) rapid catch-up growth.

Finally, one can read between the lines that, if Baldwin's analysis is correct, there will be a substantial contribution from more efficient payments systems across the eurozone. More efficient payments processing could enhance trade benefits further by reducing the transaction costs of eurozone member trading between each other, relative those outside the system. To the extent that the flagship of these efforts, SEPA, will be a "euro-only" process, the free rider problem could be solved as these benefits will not accrue to the likes of Britain, Sweden and Denmark.

*Richard E. Baldwin, In or Out: Does it Make a Difference? An evidence based analysis of the trade effects of the euro. Centre for Economic Policy Research, 2006. [Or see his ECB paper: http://www.ecb.int/pub/pdf/scpwps/ecbwp594.pdf]

** http://www.nber.org/reporter/summer06/alesina.html