The Euro at ten: Why do effects on trade between members appear smaller than historical estimates among smaller countries?

Jeffrey Frankel, 24 December 2008



With the tenth anniversary of the launching of the euro, everyone is taking stock. The record of the euro shows both pluses and minuses. Looking back, the euro has in many ways been more successful than predicted by the sceptics – many of them American economists. The historic transition to a monetary union among 11 countries in 1999 went smoothly, the euro instantly became the world’s number two international currency, and the officials of the European Central Bank (ECB) have from the beginning worked as citizens of Europe rather than as representatives of home constituencies. After a rocky start, the ECB has achieved a strong reputation, the euro has achieved a strong value, and new members to the east have achieved membership in the club.

At the same time, however, some of the sceptics’ warnings have turned out to have merit: shocks have hit members asymmetrically, cushions such as US-type labour mobility have remained thin, and the Stability and Growth Pact has proven unenforceable. Furthermore, the popularity of the project with the elites does not extend to the public, many of whom are convinced that when the euro came to their country, higher prices came with it.

One of the most interesting questions at the inception of the euro was whether the elimination of currency risk and of foreign exchange transactions costs would promote trade among members. Facilitating trade had been one of the most important of the original motivations of founders such as Jacques Delors. Prior to 1999, however, most economists believed that the effects of currency barriers between countries, if even greater than zero, were small – small, for example, relative to trade barriers.

In 2000, Andrew Rose published in Economic Policy what turned out to be one of the most influential empirical papers of the decade: “One Money, One Market…” Applying the gravity model to a data set that was sufficiently large to encompass a number of currency unions led to an eye-opening finding: members of currency unions traded with each an estimated three times as much as with otherwise-similar trading partners. Many found the tripling estimate implausibly large. No sooner had Rose written his paper than the brigade to “shrink the Rose effect”1 – or to make it disappear altogether – descended en masse. But however plausible their methodological critiques, most replication-with-twists came away, at most, only denting the finding. Few studies, if any, managed to shrink the estimated effect of currency barriers below the estimated effect of trade barriers.

This research was of course motivated by the coming of the euro in 1999, even though estimates were necessarily based on historical data from (much smaller) countries that had adopted (or left) currency unions in the past.

By roughly the five-year mark, enough data had accumulated to allow an analysis of the early effects of the euro on European trade patterns. Studies include Micco, Ordoñez and Stein (2003), Bun and Klaassen (2002), Flam and Nordström (2006), Berger and Nitsch (2005), De Nardis and Vicarelli (2003), and Chintrakarn (2008). The general finding was that that bilateral trade among euro members had indeed increased significantly, but that the effect was far less than the one that had earlier been estimated by Rose and others on the larger data set of smaller countries. Overall, the central tendency of these estimates seems to be a trade effect in the first few years on the order of 10-15%. None came anywhere near the tripling estimates of Rose, or the doubling estimates (in a time series context) of Glick and Rose (2002).

Why such small trade effects?

There are three leading explanations for the discrepancy between the estimates of the euro’s effects (10-15% increase in trade among members) and those from historical estimates (doubling or tripling).

  1. It takes time for the effects on trade to rise to their full magnitudes;
  2. Monetary unions have much smaller effects on large countries, and
  3. The Rose estimates on smaller countries were spuriously high as a result of the endogeneity of the decision to form a currency union; in other words, bilateral currency links have historically been the result of bilateral trade links rather than the cause.

In a new paper (Frankel, 2008) I try to assess the importance of each of these factors in explaining the discrepancy. Surprisingly, the evidence does not support an important role for any of the three explanations.

Pursuant to the question of time lags (Explanation 1), I have updated the estimates. The effect of the euro on trade between members remains highly significant statistically, but no higher in magnitude than it was four years ago; it is steady at 10-15%. It is entirely possible that the future will reveal substantially larger effects as substantially more time goes by. But at the moment there is little evidence to support the lags explanation.

Pursuant to the question of country size (Explanation 2), I tested for an effect of the interaction of size and currency union membership. There is no tendency, overall, for currency unions to have larger effects on the trade of small countries than large.

The question of endogeneity (Explanation 3), is trickier. I tried a “natural experiment,” designed to be as immune as possible from the argument that the choice of currency is endogenous with respect to trade. The experiment is the effect on African CFA members’ bilateral trade of the French franc’s 1999 conversion to the euro. The long-time link of CFA currencies to the French franc has clearly always had a political motivation. So CFA trade with France could not in the past reliably be attributed to the currency link, perhaps even after controlling for common language, former colonial status, etc. But in January 1999, 14 CFA countries woke up in the morning and suddenly found themselves with the same currency link to Germany, Austria, Finland, Portugal, etc., as they had with France. There was no economic/political motivation on the part of the African countries that led them to an arrangement whereby they were tied to these other European currencies. Thus if CFA trade with these other European countries has risen, that suggests a euro effect that we can declare causal. The dummy variable representing whether one partner is a CFA country and the other a euro country has a highly significant coefficient of .57. Taking the exponent, the point estimate is that the euro boosted bilateral trade between the relevant African and European countries by 76%. It is not doubling, and the timing is not perfect. But it does suggest that the effect on trade among small countries is very substantial even after correcting for endogeneity.

Thus none of the three explanations appears to explain the gap between the recent euro estimates and the historical estimates. Perhaps time will offer more evidence for one or more of the explanations in the future. For the moment, the gap remains something of a mystery. But promotion of trade must nevertheless be counted one of the successes of the euro. If Rose had come up with a 15% effect on trade from the beginning, that would have been considered important. Furthermore, there has been virtually no evidence of diversion of trade away from non-members, which is important for judging economic welfare.


Baldwin, Richard, 2006, “In or Out: Does it Matter? An Evidence-based Analysis of the Trade Effects of the Euro”, Centre for Economic Policy Research.
Berger, Helge & Volker Nitsch, (2005) "Zooming Out: The Trade Effect of the Euro in Historical Perspective," CESifo Working Paper No.1435
Bun, Maurice and Franc Klaassen, 2002, “Has the euro increased trade?
De Nardis, Sergio and Claudio Vicarelli (2003) “Currency Unions and Trade: The Special Case of EMU”, World Review of Economics, 139 (4): 625-649.Chintrakarn (2008)
Flam, Harry, and Hakan Nordstrom (2003) “Trade Volume Effects of the Euro: Aggregate and Sector Estimates”, Institute for International Economic Studies unpublished.
Frankel, Jeffrey (2008) “The Estimated Effects of the Euro on Trade: Why are They Below Historical Evidence on Effects of Monetary Unions Among Smaller Countries?” NBER WP 14542
Glick, Reuven and Andrew Rose (2002) “Does a Currency Union Affect Trade? The Time Series Evidence”, European Economic Review 46-6, 1125-1151.
Micco, Alejandro, Ernesto Stein, Guillermo Ordonez (2003) “The Currency Union Effect on Trade: Early Evidence Form EMU”, Economic Policy, 316-356.
Rose, Andrew K., 2000, “One money, one market: The effect of currency unions on trade,Economic Policy 30, 7-46.

1 The phrase is from Richard Baldwin (2006). Baldwin’s survey of the critiques concludes in the end that there is a Rose effect, but that it is probably substantially smaller than a tripling.


Topics: EU policies, International finance
Tags: CFA franc, ECB, EU trade, euro, monetary unions

Jeffrey Frankel

Professor of Economics, Harvard Kennedy School