Three years after monetary union, political debate in Germany centres on how long the Eastern Länder will take to converge to Western productivity and living standards. In Discussion Paper No. 863, Research Fellow Michael Burda and Michael Funke calculate that simple extrapolation of the `robust rates of convergence of about 2% per annum, derived by Barro and Sala-i-Martin, Mankiw and others for US and Japanese regions and European countries, implies this will take more than 80 years. This is inappropriate to the ex-GDR, however, since neoclassical growth models assume that initial conditions reflect the outcome of an efficient market economy. Eastern labour productivity has risen spectacularly since early 1991; it also varies substantially across sectors and should therefore rise further with structural change. Human and physical capital migration, which models derived for a closed economy framework typically neglect, will further accelerate convergence of per capita incomes.

Burda and Funke then consider the implications of the robust empirical link between investment spending and growth in cross-sections of economies. This is difficult to rationalize in the Solow framework, but the massive investment rates in Eastern Germany recently as high as 45% of GDP for total and 25% for business equipment investment should have substantial effects. This higher investment, if sustained, should be associated with additional growth of some 3.5% relative to the West in the medium-to-long term. Per capita public spending on infrastructure is also currently 50% above Western levels, which could translate into as much as 5% higher growth. Burda and Funke conclude that the trade-off between short-term losses from increased unemployment today and convergence to Western productivity levels in the longer term, derived from their `corrected' measures of expected convergence, appears to vindicate the Treuhand's shock therapy approach.

Eastern Germany: Can't We Be More Optimistic?
Michael Burda and Michael Funke

Discussion Paper No. 863, December 1993 (IM)