2  BIS central bankers’ speeches  But in several countries, the process of real convergence proved itself difficultly sustainable. During the period before the global crisis, expectations were overly optimistic, and investors and consumers engaged in economic behaviour that generated excess domestic demand, strong credit growth and inflationary pressures. As in many other markets, risk premia were squeezed, leading to asset price misalignments (particularly in the housing market) and over-indebtedness in a context of abundant global liquidity and a strong appetite for risk. Foreign direct investment flows often focused on the non-tradable sector, for example, construction and financial sector intermediation. Furthermore, foreign currency lending grew rapidly, leading to increasing balance-sheet mismatches. As a result a number of countries experienced notable departures from price stability and wide external imbalances that eroded competitiveness – developments that went over and above what could be justified by “equilibrium” catching-up. Macroeconomic policies added to the risks. In countries with a fixed exchange rate, independent monetary policy was not available, resulting in monetary policy conditions that became too expansionary. In principle, this could have been compensated by very tight fiscal policy. But with the benefit of hindsight, fiscal policies were often insufficiently restrictive or even loose. The global crisis revealed these weaknesses with particular virulence. When capital flows dried up in late 2008 and trade collapsed, real output declined sharply, in some cases leading to severe recessions. With the main and remarkable exception of Poland, the region was severely hit by the crisis.

This means that growth in prices has generally been higher than growth in productivity. Potential rigidities in labour and product markets and, in some cases, an excessively loose macroeconomic stance may have complicated the delivery of low inflation rates. Indeed, while all countries have reduced inflation to moderate levels, the entrenchment of a low inflation environment still constitutes a challenge in many economies. 2. Importance of ensuring polices that support fast and sustainable output growth  The second aspect of convergence that I would like to highlight relates to the growth model followed by some new EU Member States. Given its lower starting point in terms of real income, it could be expected that, in a world with full financial integration, large capital inflows would flow into the region. Moreover, as people expect to be richer tomorrow than today, they may choose to smooth consumption over time by borrowing today, the more so the higher the expected gains in disposable income. A process of gradual real exchange rate appreciation, supported by strong, domestically driven output growth and temporarily accompanied by relatively large current account deficits, would seem fully in line with what the theory of convergence suggests. 1  According to Mihaljek, D. and M. Klau (2008), over the period from the mid-1990s to the first quarter of 2008, the Balassa-Samuelson effect would explain around 24% of the CEE inflation differentials vis-à-vis the euro area. For more details, see, “Catching-up an inflation in transition economies: the Balassa-Samuelson effect revisited”, BIS Working Paper.