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A short history of price level convergence in Europe.

Article Excerpt
DURING THE LAST five decades, European countries made a huge effort to integrate their national markets. The signing of the Treaty of Rome on the establishment of the European Economic Community 50 years ago (1957), the completion of the Single Market (1993), and the recent introduction of the euro (1999) have been milestones in the process toward economic, monetary, and political unification of Europe. The demolition of "border effects" (Engel and Rogers 1996) makes Europe a particularly interesting case for studying price level convergence. The two main objectives of this paper are (i) detecting general trends in price level dispersion starting from the earlier days of economic cooperation in Europe and (ii) the identification of the main determinants behind this process. In other words: how successful has European integration policy been?

Due to limited availability of data on absolute price levels, little is known about the long-term development of European price level dispersion. Regular price data collected by national statistical agencies are mainly published in terms of indices and are for that reason not suitable for international comparisons. Since 1995, Eurostat publishes price level differences between countries (see Allington, Kattuman, and Waldmann 2005), but this period is too short to answer our questions. Also, from the Organisation for Economic Co-operation and Development's (OECD) International Comparison Project some comparable national price levels are known, but again country and time coverage are limited. To avoid these problems, several studies use microdata.

First of all, there are studies that focus on one specific product, like automobiles (Goldberg and Verboven 2005) or hamburgers (Parsley and Wei 2007). Although these studies produce interesting insights, such ah approach does not help much in detecting general price level trends. The second type of research uses data sets that cover a broad set of products. Engel and Rogers (2004) and Rogers (2007) use a city data set provided by the Economist Intelligence Unit (EIU), which is available from 1990 onward. Crucini, Telmer, and Zachariadis (2005) (henceforth CTZ) use an extensive Eurostat microdata set that covers 4 individual years (1975, 1980, 1985, and 1990). Both studies provide interesting insights but cover just parts of the European integration process.

For our historical investigation into the trends and determinants of price level dispersion in Europe, long time spans are needed. To that end, we scale harmonized indices of consumer prices (HICP) back to 1960 on the basis of occasional measurements of price level differences between countries. So we convert harmonized indices of consumer prices into proxies of absolute price levels. Chen and Devereux (2003) use a similar method to construct price level data for U.S. cities. (1)

The calculation of these long price level series allows us to construct time series on price level dispersion for almost the complete period of European integration and to uncover the determinants of price level dispersion over time. Moreover, we can compare developments in the European Union (EU) and the Economic and Monetary Union (EMU) with long-term developments in other regions, like the United States. The United States is a natural benchmark, as it has been a political, cultural, and monetary union for a long period of time. We also compare European-wide developments with those in the former DM zone (Germany, Austria, Belgium, Luxembourg, and the Netherlands). Such a comparison might help to understand the significance of monetary unions relative to customs unions since the DM zone was already an area of monetary and exchange rate stability long before the EMU started. Our main result is that European price levels converged over much of the last 40 to 50 years, while in the United States price level dispersion remained more or less stable. Moreover, price levels converged faster in the DM zone than in the EMU.

To identify the determinants of price level dispersion and to get an indication of their contributions to the dispersion level and its decline, we use the model that CTZ apply to European cross-sectional micro price data. In that model, retail price dispersion is a function of dispersion of nontraded input costs (e.g., wages) and dispersion of traded input costs. Our data set allows us to introduce a time dimension to the CTZ framework for price level dispersion. A back-of-the-envelope calculation suggests that indirect tax rate harmonization, convergence of nontraded input costs, and convergence of traded input costs (in the form of exchange rate stability and increased openness) all contributed to European price level convergence.

The macroapproach may be subject to a number of shortcomings. Consumption baskets are not completely identical across EU countries. Furthermore, the composition of consumption baskets changes throughout time, as products disappear or are replaced by new ones. Moreover, aggregate HICP might be subject to a summation bias, that is, different price level movements in HICP subcategories, which may average out or dominate. In this paper, we take a closer look at these and other issues. We conclude that, as far as we can judge, our approximation of price levels is reliable.

As mentioned before, there are studies that investigated similar questions either in the context of specific markets using product-level data, or for sets of products for only subperiods of our sample. However, to our knowledge, this is the first study that provides reliable documentation of the evolution of price level dispersion in Europe and its determinants over a long period based on a representative basket of products.

The remainder of the paper is organized as follows. Section 1 introduces our dispersion measure and briefly discusses the (marginally) adapted CTZ model. Section 2 describes the data. In Section 3 new evidence of European price level convergence at the aggregate and one-digit HICP product level is presented. Section 4 studies the main factors driving price level convergence. The reliability of our methodology and comparisons with other studies...

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