Real Convergence and Euro Adoption in Central and Eastern Europe: Trade and Business Cycle Correlations as Endogenous Criteria for Joining EMU

Abstract

Optimum currency area theory says that trade patterns and cyclical correlations are important criteria for whether a country should join a monetary area such as EMU. But these criteria are endogenous. Recent econometric estimates suggest that currency unions have far greater effects on trade patterns than previously believed. Since currency unions are good for trade, and trade is good for growth, that is one major argument in favor of adopting the euro. There are the usual countervailing arguments for retaining monetary independence, particularly the famous asymmetric shocks. But the pattern of shocks is also endogenous. For the countries of Central and Eastern Europe joining the EU in 2004, one risk-averse argument for joining later, but not necessarily yet, is that trade with euroland can be expected to continue increasing. Econometric estimates suggest that the growing trade links will in turn lead to growing cyclical correlation, that is, to cyclical convergence. The implication is that the new EU members may better qualify for the optimum currency area criteria in the future, even in just five years, than they do as of today. Another kind of convergence, income convergence, is also relevant, but will take too long to wait for.