Economic focus: The euro, trade and growth

Date: 12/07/03

Do not expect a miracle

EUROPE'S single-currency area is in the mire. The German economy, which accounts for almost one-third of the region's output, is shrinking. Growth forecasts across the euro area are tumbling, in part because the euro has risen against the dollar. Meanwhile, the European Central Bank has been slow to cut interest rates, and the stability-and-growth pact, which restricts fiscal policy, is at best a joke, at worst an ordeal. You might suppose all this to be more than enough to test the faith of believers in the wisdom of the single currency.

Oddly, that faith is burning as brightly as ever. Despite the euro area's weak performance, enthusiasts are still expecting higher growth in the long run, because they think trade within the single-currency area will explode. The source of their confidence is an empirical finding from research into earlier currency unions. In this research, published in 2000, Andrew Rose, an economist at the University of California, Berkeley, extended the “gravity” model of trade. The idea, by analogy with Newton's theory of the gravitational pull of planets, is that trade between two countries increases with their economic size, but decreases with the distance between them (and therefore transport costs). Mr Rose's innovation was to add membership of a currency union as a possible influence on trade. Remarkably, he found that members of such unions trade three times as much with one another as do countries outside unions.

To many economists, this effect looked implausibly large. Currency unions should boost internal trade because companies and individuals no longer incur costs for changing money and because uncertainty about exchange rates within the union is eliminated. That said, the costs of currency transactions are small, and previous research has established that exchange-rate volatility reduces trade only marginally.

The critics questioned whether the research had allowed sufficiently for other factors likely to be associated with currency unions that would also generate higher trade volumes. These might simply reflect historical ties between countries. Leaving them out would exaggerate the estimates of the effect on trade of currency-union membership. In any case, because currency unions before the euro mainly linked small, poor countries, research into them was of little relevance to the euro area.

Subsequent research by Mr Rose and others has sought to overcome these objections. The general conclusion has confirmed that currency unions boost trade, but tempered the order of magnitude. A recent review of the evidence by the British Treasury concluded that joining the single currency would eventually boost Britain's trade with the euro area by between 5% and 50%, without diverting trade from non-euro countries.

As the range in this forecast suggests, doubts remain. The ending in 1979 of the currency union between Britain and Ireland seems not to have reduced trade across the Irish Sea. At first sight, the results from the euro area do not look encouraging, moreover. Trade within the euro area as a proportion of total trade fell in the three years to 2001. However, special factors are largely to blame: first America's boom and then rising oil prices lifted the proportion of trade with countries outside the zone. More detailed research suggests that the single currency is increasing trade among its 12 member states. The Treasury's best guess is that the long-run effect on trade of British membership would be towards the top of its 5-50% range.

Even if euro enthusiasts are right to expect a substantial increase in trade, they may be overstating its impact on growth. Gordon Brown, the chancellor of the exchequer, has told Parliament that a 50% increase in trade could raise living standards by almost 10% over the next 30 years. That is equivalent to an increase in Britain's potential growth rate over the same period of 0.3 percentage points a year, an impressive effect.

Meanwhile, on the back of another envelope

However, the Treasury's economists also calculated that the gain in living standards might be only half that. The reason is that the greatest gains in living standards are reaped when economies first open up to trade. But after more than four decades of economic integration, culminating (one day) in a single market, European economies already trade intensively with each other. They are therefore likely to experience diminishing returns, in terms of economic growth, from further increases in trade.

Increased trade may also mitigate the biggest drawback of a currency union: the imposition of a single interest rate on diverse economies. As members trade more among themselves, their economic structures may become more alike: a large proportion of trade is between firms in the same industry. This may enable them to cope better with a common interest rate. Although a single interest rate makes national output more volatile, increased trade could dampen the impact. Alas, a contrary effect is also at work. One of the chief gains from a currency union may involve greater specialisation: Detroit as the centre of American carmaking, for example. But that would mean that economies got richer by becoming less, not more, alike. The recent collapse in the information-technology industry hit Finland and Ireland, which both have big IT sectors, hard.

It is plausible to argue that a single currency will boost trade and growth in the long run, offsetting the strains implied by a single interest rate. But the net benefits depend on much else besides. For a start, European countries have to be readier to pursue economic reforms. Bad policies, such as job-destroying regulations, could vitiate the potential gains from a single currency, just as they have limited the benefits from the single market. So could the stability-and-growth pact, by curbing governments' room for manoeuvre, which is already cramped by their decision to give up monetary policy to the ECB.

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