What is the optimal monetary policy for Norway?

What is the optimal monetary policy for Norway? Would another currency be a better alternative than the Norwegian Krone? Author: JØRGEN BJØRKE Supervisor: ERIK STRØJER MADSEN Msc in Finance 2013

Abstract: The Norwegian export economy faces some challenges because Norway has an independent floating currency. These challenges are exchange rate volatility and/or overvaluation of the currency. This hurts the Norwegian export economy and poses the question if adopting or pegging to another currency could be a better alternative to Norway keeping its own currency. Because of recent bad experiences with pegging to currencies in the 90s adopting another currency would be the best option of the two, and this paper thus only focuses on whether Norway should adopt another currency or not. As the Eurozone is the largest trade partner of Norway the Euro would be the most suited currency to consider, and this paper thus analyses using Optimal Currency Area theory if adopting the Euro would be more beneficial than keeping the Norwegian Krone. The conclusion to this is that while the Euro seem to be beneficial to trade, it might also be costly for Norway as it can be hit by asymmetric oil shocks that would be better adjusted for with monetary independence and an independent currency. Labour mobility might help as an adjustment mechanism in the Eurozone, but it seems too low in the Eurozone to be effective as am adjustment mechanism. There is also some doubts as to how large the trade gains may be as both exchange rate volatility might not be reduced and trade gains might not be as high for Norway as it has a low level of Intra-Industry trade with the Eurozone. Keywords: Monetary Policy, Currencies, Exchange rate, Oil Shock, Euro

Table of Contents Introduction:... 1 Problem Statement:... 3 Structure:... 3 History of Norwegian monetary policy:... 3 Trade between Norway and its trade partners:... 6 Optimal Currency Area Theory:... 11 Optimal Currency Area Analysis:... 14 Trade gains from adopting the Euro:... 14 Summary:... 25 What if Norway hypothetically adopted the Euro in 2000?... 26 Symmetry of Shocks between Norway and the Eurozone:... 29 Having the Euro as an oil exporting country:... 30 Summary:... 37 Labour mobility in the Eurozone:... 37 Experiences from the Crisis in the Eurozone:... 46 Conclusion:... 54 Bibliography:... 56 Appendices:... 59

Introduction: The economy of Norway can be divided into two sectors, the competitive and the uncompetitive sector. The difference between those two are that the competitive sector competes with the world market on prices and the uncompetitive sector can set its own prices in Norway. The reason for this is that the competitive sector produces goods that can be either imported or exported, and thus have to compete with other companies worldwide with comparable goods. The part of the economy that does not produce such products on the other hand is free to set its own price as there is no competition. (NOU 2003: 13) chapter 4.6) The competitive sector of the Norwegian economy faces challenges to remain profitable and competitive, the reason for this is both that the wage level is higher in Norway than other countries but the strong exchange rate also affects this. As wages are outside the scope of my thesis, I will here only focus on the exchange rate level. If this uncooperativeness persists it will lead to balance of trade deficit. As Norway has an oil income, it can afford to pay for this in the short term but the balance would have to be restored in the long term to avoid economic problems (NOU 2003: 13) chapter 4.6) Thus having an optimal exchange rate level would be important to avoid the competitive parts of the Norwegian economy loosing market shares or facing bankruptcy. But how do an appreciation of the exchange rate affect the companies in the competitive sector? (NOU 2003: 13) chapter 4.7.3) did an analysis of this where they specify that the exchange rate appreciates 2% and stays that way long term. This reduces price of imports, and leads the goods in the competitive sector of Norway to become relative more expensive. This leads to the competitive sector of Norway losing market share at home and in foreign markets. (NOU 2003: 13) If the competitive sector is reduced because of this loss of market share and ends up at a level lower than what is optimal for the Norwegian economy, then this would lead to costs for the Economy and the need to rebuild the sector later. In some cases this might not even be possible. Some of the cost that because of a reception of the competitive sector is the loss use for valuable fixed capital, as the companies that need that type of fixed capital is gone the fixed capital is just standing there and becomes a cost for the owner. Another cost is the employees who both lose their work and, if they had specific skills for a certain sector that no longer exists in the economy, may need re-education to enter the labour market again. This may also lead to the Economy loosing valuable knowledge, which may be hard to get back if sector being rebuilt in the future. This means that the companies or sectors 1

that are planned to be re-established may not be as efficient as before, and may not be able to be competitive because of it. Another effect of a reduction in the competitive sector is the loss of clusters. A cluster in the economy is a collection of companies at a location that complements each other and produce a type of good. For this to work there need to be a sufficient amount of companies in the location for the companies to gain from the effects of having the other companies there, if some of the companies becomes bankrupt because of lower competitiveness this may lead to the whole cluster ending up becoming uncompetitive because of the lost gain from complementation. (NOU 2003: 13) chapter 8.3) Because of this having a stable and correct level on the exchange rate is important for any country, but also especially important for a small open country such as Norway that depends on Imports and Exports. This is as mentioned before important for the competitive sector of the industry, but an unstable exchange rate will also affect the inflation negatively. But if on the other hand inflation is too high and the economy is experiencing a shock having a stable exchange rate might be contra productive. (NOU 2003: 13) chapter 5.6) These effects are illustrated in a NHO workshop done in 2003 with some important companies in the export sector. They say that for companies with a high degree of exports the strong exchange rate greatly affects their income and profit, and also that it has led them to move from Norwegian to foreign suppliers. (NOU 2003: 13) chapter 4.8) We can also see this in the annual business cycle report published by «Norsk Industri», an employer association for the Norwegian industry. They divide the exporting companies into 3 categories, Small companies with a output no more than 50 million NOK, large companies with a output of more than 1000 million NOK and medium companies that is located between 50 million and 1000 million NOK. For the small companies NOK is the largest currency used for exports but Euro also makes up 40% of the trade, Dollar dominates for the largest companies and for the medium consists largely of a mix of Euro and Dollar. Weighted by output the Dollar is the largest currency used with 43%, but this is mostly because the largest companies primarily use the Dollar. Counted by number of companies using a currency the Euro is the largest, but only has a trade weighted percentage of 37%. (Norsk Industri (2013) chapter 3.4). 2

Most companies also use some form of currency heading. This is done in different ways, firstly they can increase the size of inputs valued in the currency needed to be hedged by either buying from foreign suppliers or producing abroad. This has led to increasing outsourcing of production for Norwegian Companies. Some companies who owns foreign capital also take up loans in the currency they need. Some companies with significantly large market shares also have the ability to have contracts where the buyer agrees to compensate the seller in the case of exchange rate movements. Currency heading instruments are also used, for example to hedge a contract due in the future, or to use futures to secure a flow of currency at a desired exchange rate in the future. (Norsk Industri (2013) chapter 3.5). Problem Statement: It seems that the floating exchange rate provides significant challenges for the export industry, with both increased costs because of a strong Norwegian Krone, but also because of exchange rate uncertainty. This also has the negative effect of some Norwegian companies outsourcing the production to reduce the cost and exchange rate variability. But as the Norwegian wage costs are high, the question is if this would happen regardless of a strong or volatile exchange rate. This is hard to tell, but reducing this factor would not hurt the situation for the exporting companies in Norway. The problem can then be state as Would it be more beneficial for Norway to adopt or peg to another currency instead of keeping its own currency with a flexible exchange rate? Structure: To be able to solve this problem I will first review the monetary history of Norway to see if there are any lessons to be learned from it regarding the future monetary policy. After this I will look at what countries Norway trades with to see what currency would be the most suited to adopt or peg to. Then finally I will conduct an Optimal Currency Area analysis to see if the currency found most suited as an alternative would be optimal for Norway. History of Norwegian monetary policy: The monetary policy of Norway has historically been focused on maintaining a fixed exchange rate. This was done after the Second World War by using the Bretton Woods 3

system, where the Norwegian Krone (afterwards referred to as the NOK) was anchored to the US Dollar. By relying on extensive capital controls the Bretton Woods was kept stable for a while but ultimately collapsed in 1970s, Norway then decided to move to the EEC s (European Economic Community) exchange rate system, with the Deutche Mark as the nominal anchor. But in 1978 Norway was decided to abandon this exchange rate system because of asymmetric economic cycles because of the 1973 oil crisis and moved to keeping the NOK stable against an index consisting of the currencies of Norway s main trade partners. The reason for this was that the Oil crisis had led to an increase in inflation in Norway leading to a loss of competitiveness, which forced Norway to make 4 devaluations of the currency to try to become competitive again. Then after the 4th devaluation Norway decided to exit the exchange rate system. But as Norway was not able to keep its inflation at the same level as its main trade partners, it was forced to devaluate a lot and after an oil crisis in 1986 with a subsequent devaluation, Norway introduced a more strict peg where the exchange rate could not be adjusted frequently and where it had to be within a certain band. This was done to reduce inflation and in turn the interest rate. The exchange rate system where Norway pegged to an index lasted until 1990, when Norway decided to again join the EEC's exchange rate system, but now through the European Monetary System's Exchange rate Mechanism (afterwards referred to as ERM). A lot of countries had also joined the ERM at that time. Norway joined because it was hoping that the reduction in the risk premium of the NOK would reduce Norway's interest rate. But because of the German Unification Germany increased its interest rate. Combined with the recent deregulation of capital markets and technological improvements this led to an increase in pressure on currencies prone to devaluation in the exchange rate markets because of an increase in short term capital flows. Because of this market pressure which led to interest hikes and an increase in market interventions a lot of countries had to abandon the ERM and float their currency in 1992, with Norway floating its currency on the 10 December 1992. After this crisis in 1992 a lot of countries abandoned the exchange rate target for monetary policy, and introduced Inflation targeting for example UK in 1992 and Sweden in 1993. This regime had already been introduced in a few countries outside Europe, New Zealand being the first in 1989 and Canada in 1991. In this new regime the interest rate would be set to keep inflation stable. But in Norway on the other hand wanted to return to a fixed 4

exchange rate as soon as possible, with the European Monetary System as the desired peg. But in 1993 the as the ERM widened its band to 15+-% up from the previous 2,25+-% because of turbulence in the exchange rate market, Norway realised that possibility of reintroducing a fixed exchange rate with the ERM was small in the short to medium term. Thus Norway had to reorient its monetary policy towards a floating exchange rate. (Kleivset, Christoffer (2012) ) Then in 1993 a new regime was introduced for the NOK where the exchange rate was to be set according to the market, thus a floating exchange rate. This stabilised the situation and led to a decrease in the interest rate. But the aim was still to someday return to a fixed exchange rate. This meant that the interest rate had to be set with this as an aim, and could not be lower than the European level because of a fear of a rise in prices because of a depreciation of the NOK. But the question still remained what to do with the monetary policy now that the country had a floating exchange rate. So in May 1994 the Government decided that the exchange rate was to be kept stabilised against the European currencies. The Central bank was to try to steer the exchange rate back in case of destabilisations if possible, but was also not obligated to intervene in the market if needed. But since this policy was vaguely defined it in practice left the Central Bank with the control over the monetary policy. Because the central bank remembered the market interventions in the 1990s and how they did not help, they did not use this much. Thus the interest rate was the only tool left for the central bank to influence monetary policy. The interest rate was thus set with an aim to stabilise the exchange rate. The introduction of the euro also did not change this policy, and the Central Bank focused the price and cost change on the level of the European Central Bank, while being aware of possible deflations. In 1998 because of a deprecating exchange rate the interest rate was changed by 4,5% through 7 interest rate changes. The introduction of the euro also did not change this policy, and the Central Bank focused the price and cost inflation of Norway on the inflation level of the European Central Bank, while being aware of possible deflations. ( Mestad, Viking (2002) ) When Svein Gjedrem became the Governor of the Central Bank turn of the year 98/99, he announced the 4 January that the goal of the Central Bank was still to keep a stable 5

exchange rate, but that a focus on inflation was more important than fine tuning the exchange rate. (Kleivset, Christoffer (2012)) Then 2years later the inflation targeting was implemented by the Government formally with the Monetary Regulation of 2001. It specified that Norway was to continue a floating exchange rate, where the focus was on the stability of the international and national value of the Norwegian Krone. This was to be done in contrast to before by focusing on an inflation target instead of an exchange rate target. This inflation target was set as 2,5% increase in the Consumer price index. But the monetary policy was also to focus on keeping output and employment stabilised. The Norwegian Central Bank also now got a formal mandate to control the monetary policy with the specified inflation target. This was a change from before when the Central Bank had to interpret the mandate and authorisation that they had. (Mestad, Viking (2002) ) As Norway has had bad experiences with pegging to another currency in the past it seems that the best option would be to either adopt another currency or to keep the floating currency. So the question is then what currency would be optimal as a possible replacement for the Norwegian Krone. As the reason for maybe changing to another currency than the Norwegian Krone is to help the export industry it would make sense to look at adopting the currency that has the largest number of user among Norway s trade partners. Trade between Norway and its trade partners: To find out what currency this is I will look at the average of imports and exports to and from Norway in the period 2010-2012 per country and then group the countries into different eight different regions. These regions are 1: The Eurozone + Denmark (As Denmark has a peg to the Euro). 2: The European Union countries outside the Eurozone. 3: The countries in Europe not part of either the EU or the Eurozone. 4: North America. 5: South America. 6: Africa. 7: Oceania. The reason I use the average between 2010 and 2012 is to avoid any year specific events that affected the level of trade between a country and Norway in a specific year, but I also did not want to go too far back and for example use the average of the last 10 years as this might be outdated numbers that do not represent the current situation of trade to and from Norway and thus only choose to use the average of the last three years. 6

Figure 1: Average exports from Norway in the period 2010-2012 Exports from Norway Average per region in the period 2010-2012 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Euro Eu Asia North america Europe Africa South America Oceania Source: Statistics Norway As we can see from the table with the percentage of average exports from Norway in the period 2010-2012, the largest part of Norway s exports go to Europe compared to the rest of the world, and inside Europe it goes mainly to Eurozone or EU countries. This would point towards the Euro being a good alternative for a currency, as slightly over 40% of exports already go to countries that have the Euro and over 35% of exports goes to the countries in the European Union not part of the Eurozone. Having such a high percentage of trade initially with the Eurozone would be an obvious benefit when adopting the Euro, but having a high percentage of trade with the rest of the European Union could also mean that having the Euro would be a benefit. The reason for the latter is that the Eurozone currently consists of 17 of the 28 European Union countries, meaning the Eurozone covers 60% of the countries in the European Union and also around 67.5% of the total population in the European Union. 7

Figure 2: Population of the European Union Population European Union % Rest of EU 33 % % Eurozone 67 % % Eurozone % Rest of EU Source: Eurostat Because of this, and the fact that the European Union is a common market I assume that the Non-Eurozone countries also trade significantly with the Eurozone countries, especially because the Eurozone countries constitutes the majority of the countries in the European Union. Because of this they would probably try to hedge against volatility in the exchange rate between their currency and the Euro. This can be beneficial for Norway if it adopts the Euro. The reason for this this is that when a country want s to trade with Norway now they may have to pay or receive payment in Norwegian Kroners, and because of volatility in the exchange rate between the Norwegian Kroners and their currency they try to hedge this to reduce the risk that the payment or the price changes because of exchange rate volatility. As hedging is costly some countries may choose to avoid trading with Norway because they do not consider the trade important enough to pay the cost needed to reduce the risk of a volatile exchange rate. This is also a larger problem for a country such as Norway which have a currency that no one else uses, because this means that if a person from another country that wants to trade with Norway hedges against Norwegian Krone exchange rate volatility, this hedge can only be used for trade with Norway. If on the other hand Norway had the Euro, this person could hedge against Euro volatility and then use this hedge for trade with a large number of countries. So if Norway adopts the Euro this means that potential trade partners in non-euro countries may already have hedged against Euro volatility and would then be more willing to trade with Norway after they adopted the Euro than before when Norway had its own currency. But 8

how large the benefit from this would be is hard to tell, and it might not have any significant effect, but if Norway is to choose another currency to adopt the fact that Norway currently has 40% of exports to the Eurozone and Denmark, and over 35 % of exports to the rest of the European Union do point to the fact that the best currency to adopt would be the Euro as it is the currency union that receives the highest level of initial exports from Norway, with the exports to countries that use the Dollar, which is another alternative for a common currency, only being somewhat less than 5% of total exports from Norway. Having a high level of trade with the Non-Eurozone countries can also bring future benefits as all European Union countries are obliged adopt the Euro eventually, with the exception of Denmark and the United Kingdom that have opt outs from adopting the Euro. ( Who Can Join and When? ) However the current Euro crisis going on could potentially make this less likely to happen or at least postpone it until the crisis is resolved. Still however if the Euro survives the crisis the countries are obligated to join it eventually thereby increasing the number of trade partners for Norway that have the Euro. Another benefit for Norway from having the Euro is that it makes payment of exports more stable and less costly. The reason for this is that as Norway is a small country it may have to receive payment in Euros when it trade with the Eurozone instead of in Norwegian Kroners as the larger country has more bargaining power in choosing what currency to pay in. Because of this some companies in Norway today may have to hedge this future payment they will receive in Euros or risk receiving less money if the exchange rate changes. If Norway on the other hand has the Euro this is avoided, and also increases Norway s bargaining power towards other trade partners. 9

Figure 3: Average Imports to Norway per region in the period 2010-2012 40% 35% 30% 25% 20% 15% 10% 5% Imports to Norway Average per region in the period 2010-2012 0% Euro EU Asia North am. Europe South am. Africa Oceania Source: Statistics Norway As we can see Norway imports less from the Eurozone and the EU than it exports to it and thus at the same time imports more from the rest of the world, notably Asia. But the Eurozone and Denmark is still the region that Norway imports the most from with over 35% of imports coming from the Eurozone. This would mean that having the Euro would be beneficial for importers as the price of a large part of their imports would be stable after the adoption of the Euro. How much having the Euro would benefit Norway regarding imports from the non-euro EU on the other hand depends as the hedging benefits that Norway can get for its exports from having the Euro may not be as large for imports. The reason for this is that an importer probably has to pay for the imports in the price of the exporter and thus does not benefit from that country trading a lot with the Eurozone in the same way as for exports. However there may be some benefits if the importer manages to price the contract in Euros instead of the currency of the exporter. Having the Euro would also mean that Norway would get the exchange rate of the Euro towards its trade partners that does not have the Euro, and as import from the Eurozone only makes over 35% of total imports there is a possibility, if the Euro is more volatile towards Norway s trade partners than the Norwegian Krone, that import prices could become more volatile when measured in the exchange rate adjusted price for Norway. This could also happen for the exports, but is also less likely as the percentage of exports going 10

to the Eurozone and the European Union is higher. So considering this it seems that if Norway should adopt any other currency than the Norwegian Krone the Euro is the best option when you consider the number of trade partners, both initially and potentially that also use it. But this does necessarily mean that the Euro is the right currency for Norway as adopting a common currency does not only bring potential benefits but also potential costs, and if such costs are higher than the benefits adopting the Euro would not be optimal for Norway. A much used theory to analyse the cost and benefits of adopting a common currency with other countries is the Optimal Currency Area theory, and I will use it to analyse if adopting the Euro would be optimal for Norway or not. Optimal Currency Area Theory: A much used theory to analyse if a country should have a common currency with another country or group of countries is the Optimal Currency Area theory. It was first introduced by Robert A. Mundell in his 1961 paper «A Theory of Optimum Currency Areas». In it he argues that for flexible exchange rates to be optimal they should cover an area than he calls an «optimal currency area», if not they would not help in avoiding unemployment and inflation. He argues that such an area would be one that has a similar type of economy in the whole area, so that for example one part of the area does not face asymmetric shocks (even though he does not use that word) such as experiencing unemployment while other parts do not. If this happened in an area with a flexible exchange rate, by for example one sector having a rise in unemployment, then the area is forced to either reduce unemployment by increasing inflation, or decrease inflation by increasing unemployment. He uses an example to illustrate this where he creates a hypothetical 2 country world with Canada and USA where they have separate currencies and a flexible exchange rate between them. Both countries also have similar economies, in that the Eastern parts of both countries produce cars and similar items, and a Western part that produces lumber and similar items. He then argues that if the productivity of cars increased leading to an increase in the demand for lumber and an increase in supply of cars, then this would increase the inflation the west while at the same time increase the unemployment in the east. As both countries is divided into these two regions, they both face the problem of choosing to either decrease the unemployment by loosening the money supply or lower inflation by tightening the money supply. So while the flexible exchange rate can adjust to reduce balance of payment problems between the USA and Canada, it does not prevent the 11

internal balance of payment problems after an asymmetric shock. Thus he argues that if the hypothetical world was divided up into two currency areas that covered the East and the West respectively with a flexible exchange rate between them, this problem would be avoided. A shift in the demand because of an asymmetric shock leading to unemployment in one of the regions and thus a balance of payment problem could then be countered by the flexible exchange rate shifting to restore equilibrium in the balance of payments. Then such currency areas as the East and the West would be optimal currency areas. He however also argues that for this to work the currency areas need a high degree of factor mobility internally and a low degree of factor mobility externally. The reason for this he argues is that with a low internal factor mobility there could be for example internal imbalances in unemployment because the factor mobility is not sufficient to stabilise the economy, and if the factor mobility is high externally there may be no need for a flexible exchange rate to stabilise the economy. (Mundell, Robert A. (1961)) The theory on the need of factor mobility as a substitute for a flexible exchange rate when a country has a common currency was further developed and Tamim Bayoumi and Barry Eichengreen argues in their 1994 article ONE MONEY OR MANY?, Analysing the prospects of monetary unification in various parts of the world that as Mundell said that if labour mobility was high enough between two regions, then the region affected by an asymmetric shock that raises unemployment would avoid the costs form this because workers would move from the affected region to the other region and thus bring down the unemployment in the affected region. But they also argue that the rise in unemployment because of an asymmetric shock can also be reduced by other ways than labour mobility, such as a reduction in wages, labour participation or capital mobility. (Bayoumi, Tamim and Eichengreen,Barry (1994)) This theory was then further developed by others, and a more recent paper from 2003 called Optimal currency areas by Alberto Alesina, RobertJ. Barro, presents the Optimal Currency Area theory as weighting Cost and Benefits of joining a currency union against each other to find out if a country should join or not. The benefits of joining a currency union they argue comes from two things, benefits to trade and benefits to inflation stabilisation. And the cost associated with joining a currency union are the loss of stabilisation policies. Firstly for the effects on trade, they argue that the more countries trade with each other, the more they would gain from adopting a common currency. As for 12

the benefits to inflation they argue that if a country has had persistent problems with high inflation because of a lack of monetary discipline in the country, then the adoption of a anchor currency of a country with disciplined monetary policy and low and stable inflation can help in lowering inflation as the country adopting the anchor currency is forced to also adopt the monetary policy of country that has the anchor currency. However they also point out that because a country that adopts an anchor currency get an inflation rate that is the difference in price level between the country adopting the anchor currency and the country that has the anchor currency plus the inflation rate of the country with the anchor currency. Thus if the country adopting the anchor currency has a high price level compared to the anchor they will still have a high level of inflation. Because of this they argue that countries that have a common currency should have price levels that to not differ too much. But as said before the adoption of a common currency does not only have benefits as the country adopting a common currency lose the ability to have an independent monetary policy. They argue that as the loss of an independent monetary policy means that the country loses the ability to counter shocks that affect only that country and not the rest of the countries sharing the common currency, so called asymmetric shocks. Thus they argue that the shocks experienced by the members in a currency union having a common currency should be as symmetric as possible, but also be of similar size. The reason for this is that if a country is hit with a shock that is symmetric, but which is much larger than the shocks affecting the other members of the currency union then the monetary policy adopted by the other members to counter the shock will still not be sufficient to help the country affected by the larger shock. Thus they argue that a country would have less benefits from joining a currency union if they have asymmetric shocks or shocks that are large compared to the other members even if they are symmetric. However they also point out that the cost of having loosing monetary policy independence can be reduced if the country adopting a common currency forms an agreement with the country of the common currency, so that the adopting country is compensated if they incur a cost by having the common currency. This can be done for example if the country issuing the common currency see a benefit in having the more countries joining it's common currency area, and see the benefit of this as larger than the possible compensation needed. They also argue that countries with more trade could benefit more from a currency union as a higher level of trade could lead to more comovements of output and prices after the adoption of the common currency, however they point out that the type of trade also matters as intra-industry trade promotes comovements of output and prices while intra- 13

industry trade on the other hand promotes more specialisation instead of more comovement for the country after the adoption of the common currency. (Alesina, Alberto, Barro, Robert J. and Tenreyro, Silvana (2003)) And as countries who adopt a common currency lose their policy autonomy, they should experience the same disturbances as the other countries in the common currency. If this is the case they would not face any negative effects of using the same policies as the other country, but if on the other hand they face asymmetric disturbances using the same policy would be costly. The size of the disturbances also matters, as even with asymmetric disturbances between countries the same policy can still work if the size of the disturbances is low enough to not cause any effects on the economy. This correlation of disturbances is affected by the similarity of the economies in a common currency area, as an economy specialised in something is likely to face asymmetric economic disturbances than a diversified economy. (Bayoumi, Tamim and Eichengreen,Barry (1994)) Optimal Currency Area Analysis: Using the OCA theory to analyse if the Eurozone would constitute an Optimal Currency Area for Norway I focus on three main areas in my analysis, Potential Trade gains, Asymmetric Oil shocks that affect Norway and Labour mobility. The first is the potential benefits from joining the Eurozone, the second is the potential costs and the last is whether the Eurozone has enough alternative adjustment mechanism trough labour mobility to be a suitable replacement for the loss of an independent monetary policy and a flexible exchange rate. I will here start with the analysis of the Potential Trade gains and then cover the other areas respectively after. Trade gains from adopting the Euro: As having the Euro clearly has some disadvantages because of the loss of policy autonomy, the question is how large the gains from having the Euro are. One such gain could be an increase in trade. The gains in trade from having a common currency happens because of the removal of currency volatility. While hedging can remove some of this volatility in the case where a country does not have a common currency, it can never remove long term exchange rate changes or the uncertainty that an importer or exporter face. This removal of volatility would then lead to greater competition between companies in different countries sharing 14

the common currency because of an increase in transparency. The common currency also makes trade easier because of the reduction in transaction costs associated with changing one currency to another. Joining a common currency area also leads to the country having a more liquid currency, this would then make it easier for the country to hedge against the exchange rate changes of its trade partners that do not share this common currency. The combination of these factors would then increase trade both with the common currency members and the trade partners outside the common currency area. (Micco, Alejandro, Stein, Ernesto and Ordoñez, Guillermo (2003) chapter 2.1) The earliest look at effects of a common currency on trade was Rose's paper in 2000. He used a gravity model to analyse the effects a common currency had on trade with a sample of 300 country pairs with common currencies out of 186 countries analysed. He found that trade was 3 times as high between countries with a common currency compared to trade between the countries without a common currency. This however does not fit the Euro exactly as the sample included a lot of colonies and small countries, and also only found out that trade was larger between countries with a common currency, not how adopting a common currency affected trade. (Micco, Alejandro, Stein, Ernesto and Ordoñez, Guillermo (2003) chapter 2.3) A more recent empirical analysis of trade effects in the Eurozone is a study by Alejandro Micco, Ernesto Stein and Guillermo Ordoñez called Inter-American Development Bank The currency union effect on trade: early evidence from EMU where they use a panel data set of bilateral trade between 22 developed countries between 1992-2002. They find, controlling for other factors, that the introduction of the Euro has boosted bilateral trade by 4-10% compared to other country pairs in the sample, and that it has increased by 8-16% compared with the non-eurozone country pairs. They also find no evidence of trade diversion which is switching of trade from non-eurozone members to Eurozone members after the introduction of the Euro but rather that trade has increased both with non-euro members and Euro members. (Micco, Alejandro, Stein, Ernesto and Ordoñez, Guillermo (2003) ) Another study of the trade effects of the adoption of the Euro in the Eurozone is the study by David Barr, Francis Breedon and David Miles called Life on the outside: economic conditions and prospects outside euroland By estimating a standard gravity model with 17 countries, that is EU and EFTA members, with the time period 1978Q1-2002Q1 they find a 15

29% increase in trade from joining the Euro, and a 12% reduction of trade per 1% increase in standard deviation of exchange rate volatility. They also simulate what the trade gains would have been for the non-euro countries Denmark, Sweden and the UK if they joined the Euro in 2001. All countries would have a 29% increase in trade with the Eurozone members if they adopted the Euro, but they differ markedly when looking at exchange rate volatility effect. The UK would increase its trade with the Eurozone by 43%, Sweden by 20% and Denmark by 4%. (Barr, David, Breedon, Francis and Miles, David (2003) ) As Denmark has its currency pegged to the Euro, having only 4% trade increase from having the Euro is not that strange. But Sweden and especially the UK is losing out on a great deal of trade gains by not having the Euro. Helge Berger and Volker Nitsch however argue in their paper Zooming out: The trade effect of the euro in historical perspective that the trade effects of the Euro are just a continuation of the trade gains from European integration of trade such as the common market and other agreements. When they control for a trade integration trend in a sample from 1948-2003, they find that the trade effect of joining the Euro is not significant. They do however argue that a reason for the increasing trade gains from European integration is because of a lowering of exchange rate volatility, and they also argue that exchange rate stability may promote trade as they find that periods with lower exchange rate volatility in the sample correlates with a more rapid increase in trade integration. As most countries in the Eurozone had lower exchange rate volatility before joining the Euro because of the European Monetary System, the gains from the elimination of exchange rate volatility may be higher by adopting the Euro for Norway than it was for the countries that joined the Euro when they already was EMS members. They also say that even though the trade effect of joining the Euro seems to be a continuation of the trade effects from trade integration in the Euro and not an effect of the just the Euro in itself, it may be that this increase after joining the Euro would not have happened if the countries did not join the Euro. (Berger, Helger and Nitsch, Volker (2008) ) Even though the introduction of the Euro may have increased trade, it may not have increased the same for all trade partners and may have led to trade imbalances because one country in a trade pair has had an increase in trade surplus while the other country in the pair has an increased trade deficit leading to a higher trade imbalance. Hamid Faruqee analyses the trade effects of the introduction of the Euro in his paper called Measuring the trade effects of EMU, and also how and why this effect differs between countries joining 16

the Euro. He finds similarly to the other studies on EMU trade that the introduction of the Euro has led to an increase in intra-euro trade on average, and also that there has been no trade diversion as extra-euro trade has also increased. He estimates this gains in intra- Euro trade on average for Euro countries after the introduction of the Euro to be an increase of 7-8% compared to similar trade between industrial countries. But by looking at the trade effect of the Euro on each country he finds that while the effect has had an average of 6-9,5% for the different countries, there are countries that has experienced much lower gains or much higher gains than others. He finds that Finland, Portugal and somewhat Ireland has experienced trade gains to intra-euro trade largely below average gains from the introduction of the Euro, and that Netherlands and Spain have experienced gains to trade largely above average. For example he estimates that these trade gains to intra-euro trade; for Spain 13,1%, for Netherlands 12,9%, for Ireland 5,6%, for Finland - 0,5% and for Portugal 1,8%. This shows that the difference in trade gains from the Euro are vast for some countries, with some even having a trade loss. He also finds that this difference in trade gains looks to be persistent and does not seem to be converging at later points in time. He also analyses how the gain from trade for the different countries is when he includes gains to extra-euro trade, and finds that similar to before that Finland and Portugal are below average on intra-euro gains, but also on extra-euro trade. Spain and Netherlands have similar to before above average intra-euro trade gains, but only Netherlands have above average extra-euro trade gains as Spain have only average trade gains. The rest of the EMU countries have mostly the EMU average in trade gains from extra-euro trade. He analyses why there are such big differences between countries in trade gains from the Euro, and what caused this. He finds that the difference in intra-industry trade at the introduction of the Euro explains 1/3 of the difference in trade gains. Most countries that had low intra-industry trade with other Euro countries had low trade gains form the introduction of the Euro, and most countries with high trade gains from the Euro, with the exception of Spain, had a high level of intra-industry trade with other countries with the Euro. He argues that the reason for this is that intra-industry trade is more exposed to exchange rate changes as it's easier to substitute a good from a foreign country for a home good as they are both from the same industry. He also finds that countries that have implemented more of the policies related to the Internal Market, with Finland as an exception, also has higher trade gains from the Euro. (Faruqee, Hamid (2004)) 17

This poses interesting questions about the trade benefits of the euro that would help reduce the costs of having the same monetary policy. As the research above shows the Euro seems to have helped increase trade around 10% or lower, but some countries seem to benefit more from this than others. Thus the countries that end up with both being stuck with a having the same monetary policy and then seeing no or little gains from trade would be in a worse spot than before when they had a floating independent currency. So for a country such as Norway that is currently on the outside of the EMU and that have to weigh the costs and benefits from joining that common currency area this is an important point. If joining the Euro would lead Norway to having the same trade gains as the average or the Netherlands or Spain, then that would be beneficial to Norway. It would maybe not outweigh the disadvantages that being restrained to a common monetary policy would lead to, but it would at least reduce it, and if the trade gain was below the average it is doubtful that Norway would face any benefits from joining the Euro as there would be very little to outweigh the costs of the common monetary policy. How the trade effect for Norway after joining the EMU is hard to tell ex ante, but Hamid Faruqee at least points to some factors that could help illustrate this. For example he shows that there is a correlation between a lower deficit on the Internal Market Score board and the trade gains (Faruqee, Hamid (2004)) As Norway is a member of the Internal Market it already has implemented a lot of the policies relating to this and it is thus easy to look at how Norway compares to other EMU members in implementing the internal market policies. Keeping track of the implementation of the internal market policies is done by the European Commission in the Internal Market Scoreboard that measures each member in the EU and other countries that are admitted to the Internal Market such as the European Economic Area and EFTA members Norway, Iceland and Liechtenstein. Looking at a recent report on this by the European Commission from 2013 shows that Norway has a good record of implementing the Internal Market polices. For example looking at the transposition deficit, which is «the percentage of Single Market directives not yet communicated to the EFTA Surveil-lance Authority as having been transposed, in relation to the total number of Single Market directives which should have been notified by the deadline.» (European Commission (2013) page 33) shows that Norway has had a transposition deficit between 0,2-1.3% in the period of annual observations between November 2008- November 2012, an average of 0,69% over the whole period and a transposition deficit of 0,7% in November 2012. The average EU transposition deficit for the same period was between 0,6-1,1% with an average of the whole period of 0,93%. (European Commission (2013) 18

So it would seem that Norway is close to the EU average in implementing the Internal Market regulations, and have been on average better than the other EU average over the period Nov 2008- Nov 2012. But when comparing the results of the EFTA and EEA members with the other EU members it is important to remember that the report by the European Commission points out that the scoreboard for the two are not completely the same as the results for the EFTA and EEA members have a lag because it takes some time for the policies of the EU to be implemented in the EEA agreement. (European Commission (2013) But I assume it would be close enough for some comparison. Compared to the EMU countries Norway is also in a good position, even though some countries in the EMU are far better with some having a very low transportation deficit in Nov 2012 with Ireland having 0%, Malta 0,1%. But large countries like France and Germany have 0,3% and 0,6% respectively in Nov 2012 and the average of all the EMU members is 0,7% in Nov 2012. (European Commission (2013)) So Norway with a transportation deficit of 0,7% in Nov 2012 is at least at the EMU average and also close to the score of Germany. Another way the European commission measures the implementation of Internal Market policies is the number of infringement cases that are pending at a point in time. The reason for such infringement cases is incorrect applications or transpositions of Internal Market policies. The rapport by the European Commission show that Norway has 21 pending infringement cases as of 1 November 2012. Compared to the EU and EMU members this is not a bad score, as the EU average in Nov 2012 was 31 pending infringement cases, and an EMU average of 35 in Nov 2012. (European Commission (2013)) So it would seem that Norway has less infringements than most countries in the both the EU and the EMU. Considering this it seems that Norway does not have a deficit in the implementation of Internal Market policies larger than the EU average and also perform well in implementing internal market policies compared to the other countries in the Internal Market. Norway also have few infringements after the policies has been implemented. Thus it seems Norway could have at least the average trade gains that are correlated with having a low Internal Market policy implementation deficit. But as mentioned in the article by Hamid Faruqee a large factor in explaining the differences in trade gains from the Euro is the level of Intra-Industry trade, with the rapport showing that 1/3 of the variance in trade gains is explained by the initial differences in intra- 19

industry trade between countries in the EMU. (Faruqee, Hamid (2004)) So what is the level of Intra-Industry trade between Norway and the EMU? An index used to measure this is the Grubel-Lloyd index which has a value of 1 if there is 100% Intra Industry trade and 0 if there is 0% intra industry trade. The first equation (6.1) shows the Grubel-Lloyd index for a certain sector in the economy, the third (6.3) equation calculates the percentage of trade in certain sector compared to total trade, and the second (6.2) shows the Grubel- Lloyd index for the whole country by multiplying the Grubel-Lloyd index of each sector by their weight of total trade. (Hoen, Alex R. (2002) Page 163-164) The Grubel-Lloyd index Equations: GL-index for a sector: gl j = 1 e j m j (e j m j ) (6. 1) Trade in a sector as a percentage of total trade: w j = e j + m j e j + m j (6. 3) Total GL-index for a nation: n gl w = w j gl j j=1 (6. 2) Where j is a commodity, e j is the ratio of exports and m j is the ratio of imports (Hoen, Alex R. (2002) Page 164) To find the intra-industry trade for Norway with the Eurozone I calculated the Grubel- Lloyd index for all 1 digit SITC index trade groups using data on Norway s trade from Statistics Norway, and then multiply them by the percentage of trade (import + export) that the SITC group has of total trade (import + export) to find the total GL index for Norway's trade. I do this for the combined trade between Norway and the Eurozone, which is I calculate the GL index of the aggregated trade between Norway and all the countries in the Eurozone. A sample used for the trade is the value of trade so far that year from June 2013. For June 2013 I interestingly find that while most trade groups have a high percentage of Intra-industry trade measured by the GL index, with 4/10 having over 80% 20