German unification has to date brought about a rapid rise in wages relative to productivity and enormous unemployment in the East together with a high tax burden to finance massive transfers from the West. In Discussion Paper No. 956, Research Fellows Andrew Hughes Hallett and Jacques Mélitz, with Yue Ma, modify the IMF's MULTIMOD model to consider Eastern Germany as a separate region, assuming that Western support will be phased out by the year 2000. Their simulations predict rapid growth and capital accumulation in the East and substantial migration of labour to the West. Allowing Eastern wages to rise to 90% of Western levels by the year 2000 produces an unemployment rate of 16% double the Western level in 2003, while the alternative of imposing sufficient wage restraint to reduce unemployment to the Western level within ten years expands the wage gap by 5 percentage points.

Elementary principles dictate that labour market flexibility is necessary to achieve high employment and high wages simultaneously, and allowing Eastern wages to converge rapidly towards Western levels and subsidize those driven out of work as a result has only aggravated the policy dilemma. This also has implications for other cases of the sudden integration of disparate economies into financially integrated trading blocs, where the trade-off between efficiency and convergence eases (rather slowly) over time. Achieving efficiency early allows fuller convergence in the long run, while early convergence delays the attainment of efficiency gains and imposes greater costs on the budget deficit. Germany provides a striking example of the `wrong' ordering of the two goals. Subsidies to Eastern employment amount to about one-third of aggregate output and come not only from the West but also from implicit transfers from capital to labour in the East, which reflect the continued survival of labour-intensive production and imperfect privatization. The authors call in conclusion for further analysis of optimal forms of transitional support to the East and policies to improve labour market flexibility.

Unification and the Policy Predicament in Germany
Andrew Hughes Hallett, Yue Ma and Jacques Mélitz

Discussion Paper No. 956, May 1994 (IM)