Readdressing the Trade Effect of the Euro: Allowing for Currency Misalignment

The run-up to the Economic and Monetary Union (EMU) of the EU has been dominated by tension between a big aspiration and a big concern. The aspiration was that a common currency would reinvigorate the single market program by establishing more cross-country transparency, wiping out all exchange rate uncertainty, and lowering administrative cost of intra-European trade. Euro members were hoping for a significant rise in bilateral trade generating sizable welfare gains across the currency union. The concern was that some member countries might face problems in absorbing shocks in ways that are consistent with a common anchor. Absent nominal exchange rate adjustment within the union, this would result in misalignments of real exchange rates and, thus, diverging competitiveness. Such misalignments have a trade effect that is of a different nature compared to the one triggered by a reduction in trade costs, as usually expected from a common currency. Lower trade costs affect countries in symmetric fashion, raising all countries exports and imports. In contrast, misalignment-induced trade effects are asymmetric, whereby bilateral exports and imports deviate in opposite direction from the benchmark case where bilateral purchasing power is maintained. In short, misalignments introduce a drifting apart of intra-euro area trade balances. The welfare implications are different, too. Higher exports from lower trade costs clearly indicate higher gains from trade. The same is not true, however, if higher exports reflect a deterioration of the terms of trade, as with a currency misalignment. In this paper, we use gravity methods to test whether this type of implicit currency misalignment has had a statistically significant impact on bilateral intra-euro area exports. We first extend the traditional gravity model to incorporate nominal exchange rates. A currency union may then raise the hypothetical "gravity-norm-level" of trade between member states, but may also cause misalignment-induced deviations from this norm. Guided by our extended gravity model, we then conduct a thorough empirical assessment of these two effects, using state-of-the art econometric methods. We find that the introduction of the euro has had a significant currency misalignment effect. The numbers tell us that an increase in relative nominal unit labour costs by 10% leads to a 7% reduction in exports, if membership in the euro area rules out nominal exchange rate adjustment, but leaves exports unaffected for country pairs with different currencies with flexible exchange rates. Given that euro members show diverging patterns of cost competitiveness, being part of the euro area - judged from the trade effects - means different things for different countries. For instance, we find Germany and Austria to benefit from the common nominal anchor in terms of higher export volumes. In contrast, for countries like Portugal, Ireland and Greece, using the euro has had the opposite effect. We calculate summary measures highlighting these asymmetries that have so far escaped all attention in the literature. Our results have important implications for overall euro area macroeconomic developments. If there is a trend of competitiveness divergence in euro area trade balances, we might also expect countries to have different outlooks regarding the stability of current account deficits and the amount of external debt. In summary, the hopes might only come true for some, while others will remember the concerns.

Hogrefe, Jan, Benjamin Jung and Wilhelm Kohler (2010), Readdressing the Trade Effect of the Euro: Allowing for Currency Misalignment, ZEW Discussion Paper No. 10-023, Mannheim.