Much attention has recently focused on economic reforms in Eastern Europe, but comparatively little on their implications for the rest of the world. In Discussion Paper No. 527, Research Fellow Charles Wyplosz assesses the effects of German economic and monetary union on the short- and long-run evolution of the Deutschmark. There is broad agreement that capital accumulation in Eastern Germany will lead to steady productivity growth once the initial `cleansing' period is completed. Assuming that free mobility of labour between the two parts of the new Germany will eventually reduce the now substantial difference in their living standards to zero, Wyplosz finds that unification will lead to a permanent decline in the per capita wealth of the `average German' and hence in average spending. In the long run, if per capita output returns to its pre-reunification trend, unchanged output and reduced spending together imply that the Deutschmark must depreciate if foreign demand for German output is to increase.

In the short run, unification will have ambiguous effects on the Deutschmark. Many argue that increased Eastern German consumption, subsidies to smooth the transition and possibly a tight monetary policy to contain inflationary pressures will combine to raise both interest rates and the exchange rate. Wyplosz maintains, however, that the diversion of substantial resources to the build-up of the Eastern German capital stock will keep average German income net of investment below the level it would have reached in the old DM-zone. The prospect of rising net income implies, however, that consumption which anticipates future revenues will exceed output from an early stage. This will lead in turn to a trade deficit, a build-up of foreign debt and a tendency for the exchange rate to depreciate, even in the short term. Further, if foreigners' propensity to purchase German goods remains unchanged so German `per foreign capita' exports remain the same, `per German capita' exports must fall, which will require a further depreciation to sell Germany's increased output.

Assuming that the build-up of capital in Eastern Germany is complete within ten years, Wyplosz estimates that it will absorb about 10% of Western German GNP and that per capita output will initially fall by 15%. In discounted terms, the shortfall after ten years amounts to 86% of 1990 Eastern German GNP, which implies a permanent, non-trivial reduction of spending of some 5% of GNP.

In Discussion Paper No. 528, Wyplosz again considers the implications of increased labour mobility in this case for Europe as a whole. Eastern Europe's endowment of physical capital is very low in comparison with the West, but it has abundant qualified labour, so investment in the East is potentially highly profitable while labour productivity is very low. Real wages must remain low to sustain a reasonable level of employment, which will act as a powerful incentive for migration.
Wyplosz assumes that the total capital stock installed and the long-run level of unemployment in the East are determined by the level of real wages throughout the transition. The West shares the benefits of wealth creation in the East through lending, which raises Western consumption; but pressure on Eastern wages from migration will reduce such lending and raise Eastern unemployment. In the short run, the high return on investment in the East raises world-wide real interest rates, which depresses Western stock prices and triggers a slow-down in investment. Labour productivity falls, and real wages fall and/or unemployment rises.

Wyplosz illustrates the role of labour markets during the post- reform transition with two extreme cases. First, with full wage flexibility in East and West, the initial slow-down in investment in the West while real wages decline is compensated by increasing wealth in the East from capital accumulation and in the West from lending. Second, if Eastern real wages are immediately raised to Western levels, there is a permanent rise in Eastern unemployment, no capital accumulation in the East or borrowing from the West and no wealth creation.

Further, if real wages are rigid in the West, this temporary decline in investment may become permanent. The rise in world interest rates will be met by higher Western unemployment, which will moderate pressure of migration on Eastern wages. If capital accumulation in the East outweighs capital decumulation in the West, world wealth will increase. Migration would reduce both capital accumulation and wealth creation in the East, while forcing down wages in the West; so East and West have a common interest in averting migration. This calls for high wages in the East, and Wyplosz proposes that wage subsidies, financed by the West, may provide a second-best solution during the transition.

A Note on the Real Exchange Rate Effect of German Unification
Post-Reform East and West: Capital Accumulation and the Labor Mobility Constraint
Charles Wyplosz

Discussion Papers Nos. 527-8, March 1991 (IM)