The eight newest European Union (EU) members (Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, and Romania) are committed to eventually adopting the euro.
But, all already suffer from the problems that dragged the GIIPS—Greece, Ireland, Italy, Portugal, and Spain—into crisis: lost competitiveness, widening external deficits, and deteriorating public finances.
However, the “peggers”—Estonia, Latvia, Lithuania, and Bulgaria, who have fixed exchange rates—are in much worse shape than the “floaters”—the Czech Republic, Hungary, Poland, and Romania.
The structural distortions, including external imbalances, in all of the newcomers suggest that none of them will be ready to join the euro soon, as joining would likely only accentuate the distortions.
When, or if, they adopt the euro, they should apply valuable lessons from the GIIPS’s experience so as to avoid painful adjustments later on.
The Initial Boom among the Newcomers
The process through which the EU newcomers lost competitiveness was largely similar to the one in the GIIPS: lower interest rates and their expectations of rapid convergence to Euro area members’ economic fundamentals led to a boom in domestic demand. Deepening financial integration and low barriers to incoming capital, as well as reduced perceptions of exchange rate risk, particularly among the peggers, helped attract capital inflows.
This furthered the demand surge, which saw domestic demand grow by more than 10 percent annually in the three Baltics (Estonia, Latvia, and Lithuania) and by nearly 9 percent annually in Bulgaria from 2002 to 2007. The price of non-tradables rose compared to tradables and labor markets tightened—inducing wage increases well in excess of productivity.
The deterioration of competitiveness soon resulted in large macroeconomic imbalances. Economic activity was pushed above potential, and the output gap (the difference between actual GDP growth and potential GDP growth as a percentage of potential GDP) in the three Baltics grew to be very large. The phenomenon was less pronounced among the floaters, but Romania and the Czech Republic also observed rapid output gap growth.