Specialization and business cycle co-movement in the euro area

According to the Optimum Currency Areas literature, the main costs of a currency union are the loss of exchange rate flexibility and country-specific monetary policies. Without them, members of a currency area are ill-equipped to offset country-specific shocks. Therefore, countries with synchronized business cycles are more likely to benefit from a common currency. A number of papers have debated the effects that economic integration resulting from joining a monetary union should have on business cycle synchronization. One view is that currency unions foster intra-industry trade and increase the correlation of business cycles. Therefore, a currency union that is inadequate ex-ante may become optimal ex-post. An opposing view claims that further integration causes countries to specialize in different types of products, which increase inter-industry trade but reduces business cycle co-movement. As industries concentrate in particular member countries, shocks to those industries create divergence in business cycles within the currency union. Therefore, a currency union may become more inadequate ex-post than it was ex-ante. While these two views disagree on the effects of integration on business cycle co-movement, they both assume that industry-specific shocks are a significant cause of business cycle divergence in a currency union.

This paper studies whether differences in productive structures (specialization) across countries have been an important source of business cycle divergence in the European Monetary Union. First, a measure of similarity in productive structures between two countries is constructed using value added data from 62 sectors obtained from Eurostat. Then, the paper tests whether this index can explain different measures of business cycle co-movement, using ordinary least squares regression. If, after controlling for other factors, the results of the tests find no negative relationship between differences in productive structures and business cycle correlation (or a relatively weak one), then similarity in production structures is not a good predictor of the adequacy of a currency union. Furthermore, the emphasis of the Optimum Currency Areas literature on whether integration promotes intra-industry or inter-industry trade is misguided. Instead, other factors must be responsible for business cycle divergence within the currency area, and those factors are the ones that should be evaluated when considering adopting a single currency. On the other hand, if the tests find a strong negative relationship between differences in productive structures and business cycle co-movement, they would confirm the longstanding assumption that currency unions work better for countries producing similar products.