Making the case for the euro: no economy is an island, entirely of itself or why Britain should join the EMU.

• Author: Kenen, Peter B.

There has been a change in economists' thinking about monetary unions. When we wrote about them in the 1960s, we took as given the extent of trade and financial integration, then focused on their implications for the functioning of a monetary union. We paid little attention to the effects of a monetary union on the intensity of integration or to the ways in which a single monetary policy would its affect its members.

We were wrong to neglect these effects. The introduction of the euro is stimulating trade, foreign investment, and financial integration in the euro area. We must therefore ask what it can do for Britain--its trade and standard of living, its ability to attract foreign investment, the outlook for economic stability, and London's preeminent role as a financial center.

TRADE, PRODUCTIVITY, AND GROWTH

Adam Smith was right. Productivity depends upon specialization, and the scope for specialization depends upon the size of the market. That was the economic rationale for creating the European common market in the 1950s and for the ongoing effort to transform it into a true single market. But economists are becoming aware of obstacles to trade that cannot be addressed merely by removing tariffs and harmonizing national regimes and standards. We know, for example, that trade between Canada and the United States is much smaller than interregional trade within each of those countries, and that the difference is not due to tariffs, transport costs, or differences in country size.

There may be several explanations for this missing trade, but recent research suggests that the mere existence of separate currencies has strong trade-reducing effects. The costs of currency conversion are a small part of the story. Separate national currencies also complicate cost calculations and pricing decisions. The main trade-reducing effect, however, derives from exchange-rate risk, especially the risk of large, long-lasting changes in exchange rates. There is no way to hedge against it.

If a British firm could know precisely how many euros it would earn next year from its exports to France, it could hedge against exchange-rate risk by selling the euros forward for pounds. A change in the exchange rate, however, will also affect the firm's exports to France, so it cannot know how many euros it will earn and cannot sell them forward.

If the firm had a factory in France, it could shift production from Britain to France whenever the pound appreciated against...