Should the Eurozone enlarge?

Kari Alho 05 June 2011

a

A

The title question may look odd in the midst of a severe crisis. It is much more common to ask whether some Eurozone members should leave.

Over time, however, the Eurozone has gradually enlarged from 11 to 17 members – and there is room for more. The euro is the spearhead of the Economic and Monetary Union (EMU) to which all EU members belong. It is thus vital to analyse whether new countries should take the step from EMU to monetary union (ECB 2011).

In this column, I consider the case of a possible Swedish membership in the Eurozone. Rather than focusing on the macroeconomic instability that defines the anatomy of the crisis, I focus on the way that the euro continuously creates economic efficiency gains in terms of lower trade barriers and cost savings.

Even though Sweden has no-opt-out clause in its accession treaty with the EU, the country has decided to stay outside the Eurozone, mainly because of political reasons. However, at times it has quite seriously considered joining the Eurozone. There was a referendum in 2003 with a clear negative outcome, even though the then-government endorsed adoption of the euro. More recently, during the current global and European financial crisis, Sweden has performed quite well outside of the Eurozone. At first, the krona weakened markedly and this softened the recessionary blow. Since February 2009, the krona has tended to appreciated vis-à-vis the euro.

A suggested methodology

One core microeconomic aspect of the effects of Eurozone is trade, which has been the subject of intensive research. Recently, for the Swedish debate and Eurozone preparation, Flam (2009) produced a summary evaluation of this field of research. However, no systematic general equilibrium effects were derived in this study. My recent research, Alho (2011), contributes to this research in two ways:

  • First, it presents an estimation result of a properly micro-based trade model.
  • Second, more importantly, it presents a general-equilibrium framework based on this model to derive effects of a changes in trade barriers.

As a result, we can infer about the effects, both under certainty and uncertainty, relating to the changes felt in trade flows and the wider economy as a result of Eurozone membership.

In recent years, the analysis of trade has made frequent use of the classical gravity model. It has been used to analyse, for example, the trade effects of currency unions. Baldwin et al. (2008) and Flam (2009) present recent summaries of the literature.

Simulating changes in trade barriers so that their general equilibrium effects through the price variables and income levels are taken into account is an important issue raised by Anderson and van Wincoop (2003). We suggest a computationally straightforward way to carry this out. Like Anderson and van Wincoop, we first need to make an assumption about the elasticity of substitution between imports from various countries. But a neat feature of our trade model is that its estimation simultaneously produces an estimate of this parameter. The estimate of the elasticity of substitution in imports between various source countries is 6.5 on the basis of the estimated gravity model. The hypothesis that trade barriers representing the various stages of intensity of regional economic integration in Europe towards the EU are symmetric is clearly rejected.

The change in the trade barrier, say, between countries 1 and 2, has both a direct impact on their mutual trade and an indirect one through a change in the price levels. The latter is a result of the equilibrium export price changing as a reaction to a change in exports. We also take into account that the aggregate price level in the importing country changes and further affects trade flows. In general, lower import barriers lead to a lower domestic price level boosting competitiveness of exports.

Application to the case of Sweden

Let us now use this framework and the estimated gravity model to analyse the general-equilibrium effects of a possible accession of Sweden to the Eurozone. We consider three groups of countries: Sweden, the Eurozone, and the rest of Europe. We allow for a similar trade barrier to be dismantled from Swedish exports to the Eurozone and respectively in exports from the Eurozone to Sweden as a result of a Swedish membership in the Eurozone.

Baldwin et al. (2008) report that the consensus estimate of the effect of the euro on trade is of 5% to 15%, while Flam (2009) states that his preferred estimate is higher, around 30%. Due to the markedly diverging estimates of barriers reached in the literature, we allow the estimate of the existing barrier to vary in size. We depict in Figure 1 the outcome on real GDP.

Figure 1. The impact of a Swedish entrance into Eurozone on real GDP

Both Sweden and the Eurozone gain from a liberalisation of trade but Sweden much more. The gains are bigger the larger the initial trade barrier. There is also a slight positive effect, in spite of trade diversion, on those countries remaining outside. The basic reason for our fairly high estimate for Sweden is that we also take into account the gain through a lower price level induced by a lower trade barrier, and the indirect effect of this on trade. This effect is much higher for Sweden than for the Eurozone, which again boosts Swedish exports. If the Swedish gain would be at most 1% of GDP, the trade barrier effect on Eurozone-related trade should be at most 5%.

As there is quite a big uncertainty about the size of the trade barrier removed by Eurozone membership, we want to complete the above calculations with a stochastic simulation. We specify uncertainty with respect to two elements.

  • First, with respect to the impact related to the Eurozone trade barrier so that the standard deviation of the effect of the barrier on trade is the higher the higher barrier effect,1 and
  • Second, related to our estimation above of the elasticity of substitution as based on the trade model.

Table 1. The impact on real GDP of an accession of Sweden into the Eurozone (%)

Barrier effect on trade eliminated in Eurozone, %

Sweden,

mean

Sweden,

st. dev.

Euro Area, mean

Euro Area,

st. dev.

3

0.61

3.78

0.02

0.06

10

2.25

4.11

0.07

0.08

21

4.04

4.51

0.13

0.09

33

6.22

4.78

0.20

0.10

 

The results in Table 1 imply that the output effect for Sweden is quite uncertain and only slightly higher than the standard deviation of the estimate at the upper end of the interval considered here. These gains are related to enhanced long-run efficiency in trade.

References

Alho, KEO (2011), “Should Sweden Join the EMU? An Analysis of General Equilibrium Effects through Trade”, ETLA Discussion Paper 1245.

Alho, KEO, M Kotilainen, and N Nikula (2010), “Prospects of the Northern EU Integration (in Finnish)”, Central Chamber of Commerce, Finland.

Anderson, JE and E van Wincoop (2003), “Gravity with Gravitas: A Solution to the Border Puzzle”, The American Economic Review, 93(1):170-192.

Baldwin, R, V DiNino, L Fontagné, RA De Santis, and D Taglioni (2008), “The Rose Effect: The Euro’s Impact on Aggregate Trade Flows“, in Study on the Impact of the Euro on Trade and Foreign Direct Investment, European Economy, Economic Papers No. 321.

European Central Bank (2011), “Economic and Monetary Union (EMU)”, ecb.int

Flam, H (2009), “The Impact of the Euro on International Trade and Investment: A Survey of Theoretical and Empirical Evidence”, Swedish Institute for European Policy Studies, Publication No. 2009:8.


1 In the numerical evaluation the trade barrier effect t was generated so that at the upper end, t being 33%, the standard deviation of the estimate of the impact of the barrier on trade is a half, 16%, allowing for a substantial uncertainty pertaining to the impulse.

a

A

Topics:  EU policies Europe's nations and regions

Tags:  Sweden, Eurozone crisis, Eurozone englargement

Kari EO Alho

Economist, ETLA (Research Institute of the Finnish Economy)

Events