East Germany, Central Europe, and the Risk of Real Convergence Overshooting

In East Germany, political considerations and ample funding precipitated a fast income convergence with the West in the early 1990s. However, the ensuing deterioration of competitiveness has led to a standstill in real convergence since the middle of the past decade. By contrast, Central Europe suffered a deep recession during the initial years of system transformation and real convergence has progressed gradually from low levels ever since.EU accession raises the risks that Central Europe could, on a smaller scale, repeat some of the East German experience. Accession will provide the region with more ample funding, as it facilitates access to global financial markets and unlocks sizeable public transfers. Acceleration of convergence in real spending becomes increasingly feasible and attractive. Using an intertemporal equilibrium model, we show that this undue acceleration would occur partly through an overshooting of the real external value of Central European currencies and may entail a prolonged period of poor economic performance. Averting this pitfall requires fiscal discipline, price and wage flexibility and a continuous focus of macroeconomic policy on competitiveness.