The transformation in Eastern Europe has provided economists with an experimental crucible for testing economic propositions with real data in real time. In Discussion Paper No. 548, Research Fellow Michael Burda evaluates the merits and the costs of two very different approaches to market liberalization adopted by the ex-German Democratic Republic (GDR) and the Czech and Slovak Federal Republic (CSFR), which were very similar in size, industrial structure, labour force composition and worker productivity at the outset of the reform process.

Burda contrasts the ex-GDR's `shock therapy' approach, which has priced its industry out of the market, with the CSFR's slower path of restricted convertibility, limited privatization and foreign ownership, deep devaluations, and most recently price liberalization. To reach West European levels of development, both regions must shift their production and employment structures radically from agriculture and manufacturing to services.

Burda finds that the precipitous collapse of East German industrial output arising from the Ostmark's revaluation has been avoided in the CSFR by a judicious combination of devaluations with wage policies. The monetary overhang will be important for the CSFR in 1991, as it has been in the ex-GDR. Monetary union reduced average per capita East German monetary wealth by roughly 30%, and without countervailing measures inflation is likely to do the same in the CSFR. Institutional factors especially collective bargaining will also play a key role. West German unions took over from their discredited communist counterparts and concluded new wage agreements with average increases of 25-50% for virtually all major sectors in the ex-GDR. Unions enjoy little popularity in the CSFR, however, which has adopted a tripartite approach to collective bargaining as found in Austria or Sweden. The government's current strength vis-à-vis both unions and employers should enable it to effect a significant reduction of real wages to maintain industrial competitiveness.

Burda also finds that the `soft budget constraint' that has long been characteristic of the centrally planned economies seems to have operated throughout Germany in 1990, where management has had insufficient incentives to resist excessive wage increases. Until state enterprises are privatized or placed under corporate control, the government will continue to subsidize their deficits. Since there is no comparable financier in the CSFR, however, the government can only subsidize one industry at the expense of others. Finally, in Eastern Germany a modified form of short-time work functioning like an enhanced unemployment insurance benefit scheme will discourage migration and also delay the necessary structural adjustment, so the development of a `Mezzogiorno syndrome' seems increasingly likely. Such problems are unlikely to arise in the CSFR, however, since migration is feasible for very few of its citizens.

Labor and Product Markets in Czechoslovakia and the ex-GDR: A Twin Study
Michael C Burda

Discussion Paper No. 548, April 1991 (IM)