With the creation of the euro, will the regional business cycles of EMU members become more synchronized? Antonio Fatás surveys the latest research.

The introduction of the euro will mean that the exchange rate is no longer available as a tool for adjustment to ‘asymmetric shocks’ – changes in economic conditions that are specific to regions or countries within the currency area. As prices and wages are not flexible enough to compensate for this loss and labour mobility in Europe is very limited, there are fears that without an effective adjustment mechanism, such shocks may lead to deep regional recessions.

But in eliminating exchange rate risk between EMU members, the euro will change the pattern of trade and investment flows within Europe, with inevitable consequences for the business cycle dynamics of Europe’s regions. While economic research on ‘optimum currency areas’ tends to question the ‘optimality’ of the euro bloc, such studies naturally rely on historical business cycle data. It is not clear that the optimum currency area criteria will apply in the same way once EMU begins since the euro will change the regional pattern of business cycles.

Theoretical analysis – for example, by Paul Krugman in the CEPR volume Adjustment and Growth in the Monetary Union (Cambridge University Press, 1993) and Luca Ricci in his IMF Working Paper ‘Exchange Rate Regimes and Location’ (1997) – suggests that EMU could have a variety of effects on regional business cycles:

First, increasing trade might lead to an increase in the level of regional specialization. As the volume of trade increases, there are greater incentives for countries to specialize in those products in which they have a comparative advantage. If this is the case, and different industries experience different shocks, national business cycles will become more pronounced under EMU.

Second, increasing trade might result in a higher degree of interdependence among countries. Increased trade does not necessarily mean increased specialization because of the great importance of intra-industry trade. If this is the case, integration might result in increased demand linkages across European regions that will tend to synchronize their business cycles.

Third, there will be a natural tendency to more symmetric or synchronized business cycles as national fiscal policies and supra-national monetary policy become more coordinated.

So the outcome from theoretical papers is ambiguous. In contrast, recent empirical papers point decisively to the conclusion that increased integration leads to greater synchronization of regional business cycles.

For example, a recent CEPR Discussion Paper by Antonio Fatás uses European regional data on employment to assess the similarities of business cycles within and across countries. Breaking the sample into two sub-periods (1960–79 and 1979–93), allows us to gauge the impact of European integration and the creation of the European Monetary System. The results show that business cycles correlations across countries tend to be smaller than within countries but the difference is small and, more importantly, decreasing over time. There is a clear pattern of decreasing correlations within countries while cross-country correlations have increased.

These results are more pronounced for some countries. Within Italy, for example, the correlations between regions are as low as the correlations between Italian regions and German regions. If countries weredefined by correlations among all the regions of Italy and Germany, it is unlikely the resulting areas would correspond to actual national borders.

Similar conclusions are reached by Jeffrey Frankel and Andrew Rose in their recent CEPR Discussion Paper, to be published in the July 1998 issue of the Economic Journal. Studying a sample of OECD economies, they ask whether increased trade leads to higher correlations in the business cycle. The answer is a clear yes: countries with higher trade shares have more synchronized business cycles.

Finally, Tam Bayoumi and Barry Eichengreen, in their European Economic Review article ‘Ever Closer to Heaven?’ (1997), attempt to construct an ‘optimum-currency-area index’ for European countries. Beyond the cross-country differences they find, there is a clear positive relationship with the level of economic integration of different countries. The more integrated countries are, the better they perform as candidates for a European currency area.

Overall, these three empirical papers suggest that the euro will transform Europe into something closer to an optimum currency area as country asymmetries vanish through coordinated economic policies and the effects of increased trade on regional linkages. In other words, the process of integration and trade specialization will produce a Europe of regions where national borders lose much of their economic significance. Mario Forni and Lucrezia Reichlin reach similar conclusions in their CEPR Discussion Paper, which compares regional dynamics in Europe and the United States.