East Germany, Poland and Czechoslovakia have pursued their economic transformations through various types of `shock therapy' designed to achieve rapid transition to fully-fledged market economies; assessments of their relative performance may be useful to the members of the Commonwealth of Independent States that are now deciding whether to adopt similar policies or a more gradualist approach. In Discussion Paper No. 686, Research Fellow Peter Bofinger and Ivan Cernohorsky first survey the three countries' initial economic and political conditions, the specific transformation strategies they adopted and the development of main economic indicators since the beginning of their transformations. They find an L-shaped pattern of output and employment performance in all three countries.

Bofinger and Cernohorsky then focus more closely on the policy strategies adopted in Germany's five `new Länder'. The huge transfers from Western Germany currently three times Czechoslovak GNP will clearly be advantageous in the medium and long term, but their impact on demand for East German goods may not have been positive to date. Their relatively high incomes enabled East Germans to switch rapidly to more expensive Western goods, while major wage shocks rendered most of the existing capital stock obsolete. This major policy failure resulted from the premature introduction of the West German wage-bargaining system to an economy entirely without private property rights, which contrasts sharply with the incomes policies adopted in Czechoslovakia and Poland: East German wages rose from rough parity with Czechoslovak wages under the old regimes to more than ten times higher today.

Bofinger and Cernohorsky note that the rapid and comprehensive restructuring of the banking system also played a key role in the former GDR's transition. The cleaning-up of commercial banks' balance sheets with government guarantees for all outstanding credits accrued before July 1990 allowed their fast privatization, while banks became more independent of their customers and thus better able to ration credit effectively. The East German strategy also assigned a major role to the Treuhandanstalt, which monitors, liquidates and restructures privatizing firms. This enabled East Germany to establish a principal-agent relation between the government as the owner of state-owned firms and their managements. The enormous organizational vacuum that remains in all other formerly socialist countries produced incentive structures incompatible with the expected supply-side responses. This prevented the achievement of the comprehensive economic improvement expected in the other countries of Central and Eastern Europe, despite their immense wage-cost advantages over Eastern Germany.

Some Lessons from Economic Transformation in East Germany
Peter Bofinger and Ivan Cernohorsky