...(The Economic Journal 108(449):pp. 1009-1025, 1998). However, we analyse this relationship in sub-periods--1967-1975, 1976-1985, 1986-1992, and 1993-2003--we conclude that endogeneity hypothesis just hold in the first two, although the correlations are increasing. This could mean that, after the Single European Act in 1986, other forces beyond trade are contributing to business cycle synchronization. The Portuguese business cycle correlation with the European Union and the Euro zone had also increased in these four decades, despite the fact that endogeneity hypothesis is at a 90 percent confidence level. We also analyse the bilateral relationships between the Portuguese economy and the other European Union countries and find that the endogeneity is confirmed in just four cases: Spain, Ireland, Netherlands, and UK.

Keywords economic and monetary union (EMU) * business cycles correlation * optimum currency areas * international trade

JEL Classification E32 * E42

Introduction

Six years have passed since the beginning of the third phase of Economic and Monetary Union (EMU) in Europe with the official introduction of a common currency. For that reason it is still very early to completely evaluate all its implications. Moreover, the new currency was only physical introduced in 2002 and some of its consequences may present some delay. So, all the conclusions eventually obtained now face serious risks of incompleteness and precocity but are always interesting to observe. All these precautions should be retained for this analysis which results must be considered just a small contribute to the wide evaluation of the EMU effects in European economy.

This develops the previous works presented in Silvestre (2004) and Silvestre and Mendonca (2005) and the main objective of this work is to perceive if the countries that share the European common currency are moving to an Optimum Currency Area (1) or, instead, even with all the efforts, are walking in the opposite direction. This question is intimately related to the endogeneity of the optimum currency area criteria hypothesis proposed by Frankel and Rose (1996) in a paper published by the National Bureau of Economic Research (NBER). (2) The authors argue that a rise in trade intensity between countries should lead to a wider correlation of their business cycles. If this holds true, the countries will have, therefore, lower needs of autonomous monetary and exchange rate policies and opens the possibility that optimum currency area criteria could be verified ex-post even if they were not gathered ex-ante. Our intention is, precisely, to estimate this relationship in European Union, euro zone and evaluate, also, the particular case of Portuguese economy to understand if these countries follow a Krugman-type specialization (inter-industry) or an intra-industry specialization.

The text is organized as follows. The first section introduces the endogeneity hypothesis proposed by Frankel and Rose. The next section reviews some empirical results about European business cycles and the endogeneity hypothesis. Then the paper presents the econometric model and the results for European Union and euro zone. The final section analyzes the Portuguese case.

The Endogeneity of Optimum Currency Area Criteria Hypothesis

Many authors argued that the creation of a monetary union could lead the involved countries to an optimum currency area. This argument was first introduced by Frankel and Rose (1998) and has been broadly discussed since then. These authors argue that an increase in trade integration can lead to tighter business cycles correlation and, consequently, to a smaller need of monetary independence. This conclusion is the opposite of inter-industry specialization process defended by Paul Krugman (1993). With this paper Frankel and Rose opened a wide debate about optimum currency areas, arguing that the introduction of a common currency in a region can help to meet criteria ex-post even if they are not verified ex-ante. They analyze the business cycles and trade intensities of 20 industrialized countries, between 1959 and 1993, and find a positive statistical relationship between these two criteria. At the end, they say it is just an application of the famous "Lucas Critique" (Lucas, 1976) to the analysis of optimum currency areas, arguing that business cycles correlation is endogenous regarding trade between States because both are affected by policies. Intuitively, this means that business cycles of the countries belonging to a monetary union are affected, after the integration, by a centralized monetary policy but also by an increase their trade flows.

This relationship between trade intensity and business cycles correlation, in a theoretical point of view, is able to assume positive or negative signs. If there is an inter-industry specialization based on comparative advantages, as defended by authors like Paul Krugman (1993) or Kenen (1969), then cycles tend to be less symmetrical and the coefficient should be negative. In the opposite way, if the specialization process is mainly intra-industry, i.e., the bulk of the trade flows are within the same sector, cycles will be more correlated and the coefficient is positive. This is the vision of the European Commission (1992) that gave theoretical support to the Economic and Monetary Union project in the Europe.

Despite the obvious influence of specialization pattern in business cycles correlation there are, in fact, many other factors playing an important role in idiosyncratic shocks transmission across monetary union members. An increase in public expenditure or private investment in a specific country has consequences not only in the domestic economy but also in the economies with higher rankings of economic integration. The eventual benefit taken from business cycle correlation as...

NOTE: All illustrations and photos have been removed from this article.



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