German unification has been more costly than expected: output and employment have fallen and there has been a real wage explosion. In Discussion Paper No. 730, Research Fellow David Begg and CEPR Director Richard Portes argue that this did not result from the Ostmark's conversion at par, since Eastern real wages would have risen to uncompetitive levels regardless of the chosen exchange rate, reflecting political obligation, trade union pressure and the need to limit migration. Transfers to the East totalled over DM 150 billion in 1991, of which two-thirds went to consumption, while investment subsidies were ad hoc, complex and highly differentiated, stimulating capital intensity and rent-seeking. Further transfers through the Treuhandanstalt have guaranteed state-owned firms' loans from commercial banks. The high-wage policy is an inefficient means of redistributing consumption or stemming migration, and it has impeded the Treuhand from selling off state enterprises and deterred the emergence of new private-sector activity.

Begg and Portes propose a simple, uniform, universal subsidy to Eastern wages: 75% of the wage bill in the first year, 50% in the second, 25% in the third, and then zero. This requires no detailed evaluation, monitoring or negotiation and also avoids the moral hazard problems created by any conditional formula. Investment subsidies, export guarantees and other credit guarantees should also be scrapped, leaving budgetary funds to clean up enterprise and bank balance sheets as the only other subsidy.

Begg and Portes maintain that this package will stimulate current employment without distorting longer-term decisions on investment or labour mobility. If it increases output and employment and raises wages no higher than is required to prevent migration, it will cost no more than the alternatives. Wage subsidies can be recouped from reductions to unemployment payments and the elimination of investment subsidies, as well as increased profits and income taxes, VAT and privatization revenues. Wage subsidies need not raise wages and unemployment, while under the current ad hoc, open-ended system unions perceive a less elastic demand for labour. Begg and Portes conclude that wage subsidies should have been introduced a year or more ago, but the case for them remains compelling today.

Eastern Germany Since Unification: Wage Subsidies Remain a Better Way
David Begg and Richard Portes

Discussion Paper No. 730, September 1992 (IM)