|
Financial markets and policy-makers alike expected German economic and monetary union to have little effect on German or EC economic performance, although many anticipated that strains on the ERM might force a realignment. Fiscal expenditures in the East are now much higher than anticipated; markets are finding it hard to absorb the increased debt; high interest rates and low productivity in the East imply low expectations of future productivity growth and a continuing need for fiscal transfers, which will be exacerbated by persistent inflation and depressed foreign demand. These factors brought Germany into recession in early 1992, and convergence of the two regions' productivity levels within ten years now seems quite unrealistic. In Discussion Paper No. 623, Research Fellow Andrew Hughes Hallett and Yue Ma examine the German case as an object lesson for policy-making for a monetary union of asymmetric and incompletely converged economies such as the European Community. They consider a variety of adjustment mechanisms to bring about (or accelerate) the two regions' convergence on to an equilibrium path. They examine supply-side changes, financing of the savings- investment gap, and fiscal and exchange rate responses to show that convergence will take longer than expected and that this slow catch-up entails the risk of a `Mezzogiorno' effect. They then use the IMF's MULTIMOD model to compare unification with current policies with `no unification', and they find that output and incomes are consistently higher under unification, although these gains are unevenly distributed between East and West. The costs of servicing the deficit imply a near-permanent rise in fiscal expenditures and hence a `Mezzogiorno' effect and recessionary pressure on Germany's EC partner countries, which may bear up to one-third of reunification's costs. Productivity catch-up will not offset these effects within 15-20 years, so investment will lag behind conventional expectations. Hughes Hallett and Ma find that policies to reduce Eastern wage growth and loosen monetary control may hasten convergence, but the current policy of subsidizing investment is more effective, while the best policy is a subsidy to Eastern wages that is abolished once convergence is achieved. By front-loading the budget deficit, and allowing increases in real income to spur growth and raise fiscal revenues, this allows interest rates to fall, so that recessionary pressures, servicing costs and the burden on the rest of the Community all reduce, and full catch-up takes place in about 30 years. East Germany, West Germany, and their Mezzogiorno Problem: An Empirical Investigation Andrew J Hughes Hallett and Yue Ma Discussion Paper No. 623, February 1992 (IM) |
|