German Unification
Privatization and public works

The rapid pace of German unification in 1990 was driven by considerations of foreign rather than economic policy, and Eastern Germany has faced an adjustment crisis on an unprecedented scale. In Discussion Paper No. 584, Manfred Neumann attributes the severity of its current crisis to the early completion of monetary union at an average exchange rate of 1.8:1, which exacerbated the shock of economic transformation with a real appreciation shock of over 50%.
Neumann finds that privatization has revealed more than 70% of the region's present capital stock as obsolete. Taking Western German per capita net capital stock as a target for the unified Germany, he calculates a maximum capital gap of some DM 1.8 trillion. Although only part of the (lower) actual demand will be met by net imports, Eastern Germany's development will clearly have a major impact on the world savings/ investment balance.
Neumann also examines the modernization of Eastern Germany's public infrastructure and finds that it is hampered by severe shortages of real and human capital. Building or extending industrial plants requires administrative and regulatory support from local authorities, which are unaccustomed to making their own decisions and have insufficient technical and legal expertise to do so efficiently. Because of the region's shrinking tax base, public transfers from the West are now the dominant source of public expenditure, probably amounting to 6% (73%) of Western (Eastern) German GNP in 1991, of which some two-thirds will finance consumption. The total public sector deficit will rise to 5.7% of total German GNP in 1991 and will remain above 4% if there is no corrective action.
Neumann also notes that monetary union raised the M3 money stock of the DM-zone by 15%, while East Germany's GNP proved to be less than 10% of West Germany's, yielding a potential price level rise of between 3.7% and 6.6% for 1991. The underlying inflation rate depends, however, on the permanent rates of monetary and real growth currently 5% and 3% respectively. Although fiscal and monetary rectitude are important, Neumann maintains that Germany's most pressing policy issue is completing the economic transformation of its Eastern Länder. The rapid privatization of the remaining 10,000 state enterprises is both the key to stimulating economic activity from the supply side and a precondition for reducing transfer payments and consolidating the budget.

German Unification: Economic Problems and Consequences
Manfred J M Neumann

Discussion Paper No. 584, September 1991 (IM)