Internal *revaluation* in the Baltics

For quite some time Latvia was an austerity and internal devaluation poster child. Lately, however, the voices lauding ultra-unemployment and the crushing of already very low wages have silenced – as wages are rising rapidly. For a time I suspected, cynically, that this wage shock might be a cunning plan of these sly Baltics – once they joined the Euro they increased their wage level (Latvia business economy wages increased at a healthy 7% rate, 2014 Q1 (Eurostat), directly after Latvia joined the Euro), to obtain a free Bratwurst.

But this was probably not the case. According to a new NBER working paper by Cavallo, Neiman and Rigobon, market forces might be at work. Joining the Euro seems to lead to a fast convergence of price levels:

Does membership in a currency union matter for prices and for a country’s real exchange rate? The answer to this question is critical for thinking about the implications of joining (or exiting) a common currency area. This paper is the first to use high-frequency good-level data to demonstrate that the answer is yes, at least for an important subset of consumption goods. We consider the case of Latvia, which recently dropped its pegged exchange rate and joined the euro zone. We analyze the prices of thousands of differentiated goods sold by Zara, the world’s largest clothing retailer. Price dispersion between Latvia and euro zone countries collapsed swiftly following entry to the euro. The percentage of goods with nearly identical prices in Latvia and Germany increased from 6 percent to 89 percent. The median size of price differentials declined from 7 percent to zero.