The Saga of Currency Unions and Trade

One of the first full papers I wrote was on currency unions and trade. I was taking Alan Taylor's field course at UC Davis, which was essentially and Open-Economy Macro History course, and the famous Glick/Rose findings that currency unions double trade was on the syllabus. Not to be outdone, Robert Barro and coauthors then found that currency unions increase trade on a 7-fold and 14-fold basis! This raised the prospect that Frenchman may suddenly go out and buy a dozen or more Volkswagens instead of settling for just one after the adoption of the Euro. Another paper, published in the QJE, found that currency unions even raise growth, via trade. In that case, one can only imagine what the Greek economy would look like if they hadn't joined the Euro. No result, it seems, can be too fanciful.

Always a doubting Thomas, I was instantly skeptical. For one, a doubling of trade implies an impact more than 10 times larger than what has been measured for the Smoot-Hawley tariff, while we already knew the effect didn't operate via the impact of exchange rate volatility on trade, thanks to an excellent paper by Klein and Shambaugh. For two, countries don't enter into (or exit) currency unions randomly. Obvious omitted variables alert! It was only a question what.

To his credit, Andrew Rose always provides his data online. This also helps citations, as the cost of extending or critiquing his papers are small. So, I fired up Stata, and after a solid 30 minutes, I discovered part of what was driving the seemingly magical effect. Roughly one-quarter of the CU changes were of countries that had former colonial relationships, many of them between the UK and its former colonies. It turns out that the impact of the "former colony" dummy in the gravity equation has been decaying slowly over time. This led to a more interesting insight -- that history matters for trade. In any case, many colonies had currency unions with the UK until the late-1960s/early 1970s. Thus, given the decay of trade for all former colonies, if you average trade before and after 1970, of course you get that there was relatively less trade after. However, if you add in a simple trend for trade between the UK and all its former colonies -- a rather mild control -- the magical "currency union" effect on trade disappears completely. Indeed, if you have two variables that exhibit trends, and you regress one on the other, you're almost guaranteed to find a significant correlation even if no relationship exists. I've since discovered that this is by far the most ubiquitous problem in empirical international trade, to the extent that I've been to conference sessions in which every paper regressed trending variables in levels on other trending variables. It doesn't mean that they were all wrong, necessarily, but showing robustness to trends is a best practice. Plotting pre-and post-treatment trends can also help. But the more relevant research question in this case is "How much does a currency union increase trade relative to trend?" Particularly when there are already strong upward or downward pre-trends. 

In any case -- back to currency unions. For other country pairs aside from colonies, there were other problems. India and Pakistan dissolved their currency union in 1964, after which trade declined. However, there's an obvious problem here: this occurred because of a brutal border war, and these two countries hate each to this day. A number of other examples were similar. You probably know less about what happened between Madagascar and Comoros in 1975. They dissolved a currency, and trade indeed collapsed. But two minutes of googling told me that, in the same year, there was an ethnic cleansing episode in Mahajanga, targeted at "island" peoples. (Yes, Madagascar is also an island, but this was apparently targeted at people from smaller islands, including the Comorians...) Same thing with the "Liberation War" that resulted in the overthrow of Ugandan dictator Idi Amin -- and also resulted in the tragic end of a currency union, depending on your view. And on and on the examples went. Wars, ethnic cleansing episodes, financial crises, currency crises, banking crises, communist takeovers. These are what cause currency unions to end. And if you take out the most obvious examples of cases where geopolitical events overshadow the change in CU status, there's not much left, and what is doesn't suggest that CUs have any effect on trade. And this is before one even blows up the error terms by adopting realistic assumptions about spatial correlation. 

In any case, in 2015, I deleted this paper and my regression and code from my webpage, and assigned the paper to my brilliant undergraduate students. They alerted me to the fact that Glick and Rose had recently written a mea culpa, where the authors declared that they could no longer have confidence in the results. I wasn't cited. Indeed, they probably hadn't seen my paper. Despite this, I was worried about having pissed them off in the first place, and I also wanted to get some love in the final version, so I wrote them an email and thanked them for sharing their data online, congratulating them for having the intellectual integrity to admit that they were wrong (even if their new paper still suffered from many of the same issues, such as not controlling for trends). 

This sounds like it should be the end of the story, correct? Particularly since the early evidence on the Euro and trade was not supportive. However, Glick and Rose changed their minds, and decided instead to double-down on a positive, measurable impact of currency unions on trade. This time, they concluded that the Euro has increased trade by a smaller, but still magical, 50%. And I did get some love, although not in the form of a citation -- instead they thanked me in the acknowledgments! I'm still quite happy to have been acknowledged, even though, admittedly, I hadn't commented on the substance of their new paper. 

In any case, Jeff Frankel at Harvard apparently used to assign his Ph.D.'s students a "search-and-destroy" mission on the original CU effect. Thus, thanks to the fact that Andrew Rose still provides his data online -- for which I'm grateful -- I've just assigned my students a similar mission on the new EMU result. Thus, we get to see if they can overturn anything that the good referees at the European Economic Review may have overlooked. If I were a gambling man, and I am, I would put my money on my sharp undergraduates at the New Economic School over the academic publication process. If I were Croatia, or Greece, contemplating the relative merits of joining/staying in the Euro, I would write off the academic literature on this topic completely.