an important contribution to reviving europe and making it flourish again. one challenge along the way is that of gaining a more comprehensive understanding of the financial cycle – which is the topic of our conference. the global financial crisis and subsequently the sovereign debt crisis have ( once again ) strongly highlighted the key role financial developments play for economic activity and, at the same time, the necessity to review our understanding of the finance - growth nexus. let me briefly spell out what i mean by that. prior to the crisis, most economists believed that financial deepening strengthens long - term growth as it improves the allocation of resources by facilitating the collection of information, the monitoring of projects, the trading, diversifying and managing of risks, the mobilization and pooling of capital and, finally, the exchange of goods and services within the economy. 1 consequently, most observers did not consider the strong growth of private sector credit and house prices in several euro area economies ( like e. g. spain or ireland ) prior to the global financial crisis to be overly problematic but were of the opinion that it was – at least largely – sustainable. in a similar vein, the credit boom in cesee ( which started around 2003 ) and the substantial increase in house prices in many cesee economies before the global financial crisis were conceived as part and parcel of the catching - up process these economies went through – at least during the first years of the boom. given the low starting levels of credit - to - gdp ratios and of house prices in the early phases of the transition process ( as compared with fundamentals ), there was general agreement that there was a need – and indeed room – for further financial deepening in cesee. aptly reflecting these considerations, the ceei 2005, for example, dealt with the topic of “ financial development, integration and stability. ” while most of the contributions at the time emphasized the considerable potential for further financial deepening in cesee, which would increase growth and foster economic convergence in the region, several discussants aired concerns that rapid credit growth and soaring house prices, if they continued unchecked, could breed instability further down the road. oenb research at the time suggested that credit - to - gdp levels had surpassed equilibrium values ( as given by fundamentals ) in some, but not in all, cesee countries by 2005 / 06 – while the credit boom went on until late 2007 in the baltic countries and until the fall of 2008 in most other cesee economies. however, the tendency

to think that “ this time is different ” 2 – a well - known phenomenon in late - boom episodes – caused these concerns to be widely ignored, and even those who acknowledged them hoped for a soft landing ( rather than a deep and painful correction ). now – five years later – it is undeniable that several cesee economies ( as well as some peripheral euro area countries ) experienced a severe levine, r. 2005. finance and growth : theory and evidence, in p. aghion and s. durlauf ( eds. ). handbook of economic growth. elseview. chapter 12. 865 – 934. reinhart, c. m. and k. s. rogoff. 2011. this time is different : eight centuries of financial folly. princeton university press. bis central bankers ’ speeches and rather protracted financial bust that is weighing on their recovery and also slowing down the convergence process – a topic we also discussed at the ceei 2012 in helsinki. thus, the crisis has recalled a key point : the finance - growth nexus is not just a long - term phenomenon but has an important cyclical component that was widely underestimated prior to the crisis. in other words, sustainable output was systematically overestimated during the boom years, as too much of the upturn was attributed to improvements in the underlying trend component and ( much ) too little to cyclical factors. this happened because the financial cycle at work was not appropriately taken into account. this, in turn, led to ( or at least contributed to ) overly optimistic expectations and the build - up of excessive leverage – as expressed in strong credit and house price growth. the magnitude of the risks involved was widely underestimated and, consequently, inappropriate policies and policy responses resulted in a high degree of vulnerability in quite a few countries as soon as the financial cycle went into reverse. clearly, pre - crisis failures in regulation and supervision further aggravated the situation that has developed since 2008, making it more difficult to deal with banking sector problems without either risking a financial sector meltdown or tainting public sector solvency. in the euro area, these developments led to substantial euro area - wide frictions, which we are currently addressing and need to continue to tackle until the crisis is fully solved and a sustainable new growth model as well as a complete and robust institutional set - up for economic and monetary union are in place. on the global level, the regulatory agenda that emerged from the crisis is still unfinished business