Key new findings on price convergence from the euro

After spluttering results in the original eurozone, later adopters of the euro in Central and Eastern Europe saw strong price convergence with other EU nations, says new study from Cambridge Judge Business School.

When 12 European countries adopted a single European currency around the turn of the Millennium, it was widely expected that increased transparency and reduced market frictions would quickly create price convergence – by steering those nations closer to the law of one price (LOOP).

“The addition of a single currency to a single market will perfect the resource allocation function of the price mechanism at the level of the Community as a whole,” the European Commission had said a decade earlier in its seminal report One Market, One Money (1990).

Studies of original eurozone found disappointing price convergence

There was just one big problem: it didn’t quite happen like that in the initial years of the euro, according to multiple early studies on euro-area price convergence. Some early studies instead reported diverging prices, including on a basket of goods and expensive items like cars, while other studies found that any price convergence could not be attributed directly to the new euro but instead to patterns of economic integration that spanned the 1990s in parallel with establishment of the European Single Market.

(The 11 original members of the eurozone were Germany, France, Belgium, Italy, Luxembourg, Spain, Portugal, Finland, Austria, Ireland and the Netherlands – followed by Greece in 2001.)

Yet a new study from Cambridge Judge Business School – focusing on subsequent Central and Eastern Europe entrants to the eurozone between 2007 and 2015 – finds that those initial predictions of euro-area price convergence were, in fact, close to the mark for most of these new euro entrants.

Robust price convergence in most Central and Eastern European euro adopters

“We find a robust and significant convergence effect due to euro adoption for 4 out of 5 new adopters” from Central and Eastern Europe, says the study published in the International Journal of Central Banking – referring to Slovakia (which adopted the euro in 2009), Estonia (2011), Latvia (2014) and Lithuania (2015), with prices rising toward levels in Germany and elsewhere in the eurozone.

Slovenia was the region’s exception, which prices diverging slightly from the eurozone, which reflects the fact that Slovenia has always been closest to Germany in price levels and perhaps that Slovenia’s euro entry in 2007 broadly coincided with the Great Recession (though Slovakia joined only 2 years later). The study uses Germany, the EU’s largest and most stable economy, as the benchmark for measuring price convergence with the late euro adopters.

(The study focuses on Central and Eastern Europe, and thus deliberately excludes Malta and Cyprus, which adopted the euro in 2008.)

Important findings at a time of debate over eurozone reform

“Our study provides useful information on price convergence at a time there is rising euroscepticism among some in Central and Eastern Europe,” says Paul Kattuman, Professor of Economics at Cambridge Judge Business School, who co-authored the study with Filip Lurka, Scholar at Corpus Christi College, Cambridge.

“There is also now an ongoing debate about reform of the euro zone, so the study helps provide a broader understanding of the costs of euro-zone membership in terms of price convergence. This will hopefully provide some guidance to existing EU member states as well as prospective member states given that euro adoption is now required of all new members of the EU.”

The early studies that questioned whether the euro would bring price convergence may have lacked sufficient time since the launch of the euro for arbitrage mechanisms to take effect, and the countries that initially adopted the euro in 1999 “were characterised by a higher initial degree of integration amongst them”, says the new study.

Study is based on Eurostat data on hundreds of product categories

The study (“The Euro and Price Convergence in Central and Eastern Europe”) is based largely on a large data set of price level indices in the late euro adopters, covering 238 non-government product categories across 37 countries in the period 1995 to 2017 as compiled by Eurostat. Using the comprehensive Eurostat data helped the researchers avoid the bias that some national statistical institutes place on capital cities in measuring prices relating to household consumption.

The research uses a “difference-in-differences” approach taking into account the staggered nature of adoption to compare price findings in the Central and Eastern European (CEE) euro adopters to a control group of countries (Bulgaria, the Czech Republic, Hungary, Poland, Romania and Croatia) comprised of Central and Eastern European countries that, while they were EU countries in similar levels of development to Slovakia, Estonia, Lithuania and Latvia, had not adopted the euro during the study period. (Croatia joined the euro zone on 1 January 2023.)

Price convergence strongest in earlier euro-adopter Slovakia

Excepting Slovenia, the study finds that the later the euro was adopted by a CEE country the weaker the price convergence effect – so Slovakia had the strongest convergence, followed by Estonia, Latvia and Lithuania. The authors attribute this to the euro and the earlier initiative of the European Single Market being convergence-inducing substitutes to a certain degree. “Countries closest in price levels to Germany at the point of euro entry saw their prices converge by more due to the euro,” says the study. “It is plausible that high initial convergence permitted countries to reap the benefits of the common currency more fully.”