East Germany
Factor price distortions

In Discussion Paper No. 1155, Research Fellow Hans-Werner Sinn reconsiders East Germany's development since unification, focusing on the factor price distortions brought about by wage negotiations and government subsidies for the use of capital. While wages have risen by about 1000 per cent since 1989, public subsidies have reduced the cost of capital to negative values for typical industrial assets as well as for modernization investment in housing. Both aspects of this development are extraordinary, and have important implications for the economic development of East Germany.

The author finds that economic development in East Germany is not uniform. The building and construction industry is booming whilst manufacturing is stagnating. Severe distortions in relative factor prices are argued to be the root cause of this dichotomous development. These distortions arise from excessive wage increases and investment support large enough to make the cost of capital negative for East German industry. The negative cost of capital implies that this factor in fact mutates into an economic good the `production' of which the firm tries to increase by using more of other factors. It is suggested that the support for investment be abandoned and that a political compromise be sought, the aim of which is to reduce planned wage rises. The compromise could include an investment wage agreement for insider workers and a distribution of the stock of public housing to prevent workers from suffering wealth losses. It would be a Pareto improvement, avoiding the large welfare losses incurred by current policies.

Factor Price Distortions and Public Subsidies in East Germany
Hans-Werner Sinn

Discussion Paper No. 1155, May 1995 (IM)