European Integration
German Unification

A workshop on `German Unification and European Integration' held in Bonn on 23 November focused on the impact of German unification on other EC member countries in particular on the EMS. It aimed to promote the interaction of German research on these topics with that conducted in other EC countries. The workshop was organized by Martin Klein, a Research Fellow in CEPR's International Macroeconomics programme, and Manfred J M Neumann, Professor of Economics and Director of Bonn University's Institute for International Economic Policy. It formed part of CEPR's research programme on Financial and Monetary Integration in Europe, supported by a grant from the Commission of the European Communities under its SPES programme and also by the Ford Foundation. Further financial support was provided by the Fritz Thyssen Stiftung, Köln.
East-West migration within Europe threatens to deplete the East of much-needed human resources while also leading to congestion in the West. Such migration has had the greatest effects in Germany, whose experience may provide important lessons for the rest of Europe. In their paper, `Labor Mobility and German Integration: Some Vignettes', Michael Burda (INSEAD and CEPR) and Charles Wyplosz (INSEAD, DELTA and CEPR) challenged the general case for wage subsidies. Working through several examples to contrast the socially optimal regional allocation of labour with that achieved by the market mechanism, they showed that some form of government intervention would raise welfare relative to the market outcome, but this should not generally take the form of wage subsidies in the East. If the average skill level in the East is significantly below that in the West, a capital subsidy in the East may be the best solution.
David Begg (Birkbeck College, London, and CEPR) argued that modelling the social optimum as the solution chosen by a `benevolent dictator' had little relevance for policy: in practice, Western German politicians will make policy with Western German interests in mind. Richard Portes (CEPR and Birkbeck College, London) questioned the relevance of policy recommendations derived from German experience to other East-West population flows. Germany's two economic regions have similar education systems and a common cultural background; assessing the education and skills of internal migrants is much more straightforward than screening those from elsewhere in Eastern Europe.
In his paper on `German Labour Markets After Unification', Wolfgang Franz (Universität Konstanz) described recent trends in Eastern German employment and unemployment and noted significant catch-up of Eastern wages towards Western levels, which he attributed to the peculiar structure of the Eastern German wage bargaining process. This involves employers, trade unions, politicians and the `Treuhandanstalt', the public institution in charge of privatizing the former GDR's state enterprises: unions and politicians favour rapid wage increases in the East to limit migration to the West, while managers often retained from the previous regime know that their positions are temporary and have little motivation to resist wage demands. Remaining uncertainties about property rights and deficiencies in the Eastern region's infrastructure also contribute to the lack of Western German investment there. Franz concluded that there is little hope of a significant reduction of German unemployment in the near future.
Michael Burda agreed with the general thrust of Franz's arguments and added that employers face `soft budget constraints': they know that the Treuhandanstalt will ultimately bear the losses that result from their agreement to excessive wage demands. Michael Funke (Freie Universität Berlin) pointed out that even if Eastern real wages ultimately converge to Western levels, firms should still have an incentive to invest in the East because they will remain lower during the transition.
In their paper, `East Germany, West Germany, and their Mezzogiorno Problem: An Empirical Investigation', Andrew Hughes Hallett (University of Strathclyde and CEPR) and Yue Ma (University of Strathclyde) considered Eastern and Western Germany's convergence in a broader macroeconomic setting. Using the IMF's MULTIMOD simulation model to investigate the impact of unification on the G7 countries and to explore the effects of various policy measures, they found that its repercussions outside Europe would be small. But higher German real interest rates would generate significant negative spillovers on other EC countries, which may bear up to one-third of unification's macroeconomic costs. Moreover, convergence would probably remain incomplete for a long time, implying a need for continued fiscal support to the East and the development of a `Mezzogiorno' problem. The authors also noted the key role of relative wage-price flexibility in determining the pace of convergence and advocated policy measures to enhance such flexibility: for example, self-eliminating wage subsidies, as proposed by Akerlof and others, may be more effective than investment subsidies.
Michael Funke pointed out that MULTIMOD is demand-driven and was not designed for such long-run policy analysis. He maintained that the authors' projection that convergence would take 30-40 years was overly pessimistic, while several participants noted that Germany should now have a greater interest in a rapid transition to EMU, which would further spread the burden of its adjustment costs across the Community. Heinz Herrmann (Deutsche Bundesbank) argued that not all spillovers from German unification had adverse effects on other EMS members. In particular, higher German real interest rates gave countries wishing to pursue contractionary monetary policies more room for manoeuvre. David Currie (London Business School and CEPR) doubted that the growth effects of a wage subsidy would be as high as the authors' simulation results suggested.
A second set of papers focused on monetary issues and on problems arising during the transition from the EMS to EMU. In their paper, `Einigkeit Macht Stark The Deutsche Mark Also?', Daniel Gros (Centre for European Policy Studies, Brussels) and Alfred Steinherr (European Investment Bank) disputed the view that German unification would require an appreciation of the Deutschmark. Although inflationary pressures arise from price liberalization in the East, increased taxation in the West will moderate both household demand and inflation. They maintained that protracted current account deficits will lead to a net loss of foreign assets and a depreciation in the long run; while an adjustment in the relative prices of the two regions' non-tradable goods will prevent an appreciation in the short run.
Jacques Mélitz (Institut National de la Statistique et des Etudes Economiques, Paris, and CEPR) argued that the increase in German aggregate demand as a result of unification would put upward pressure on interest rates, so the Deutschmark should tend to appreciate. David Begg added that this result concerned real exchange rates and left the prospective evolution of the nominal exchange rate unclear. Richard Portes noted that the well-established positive correlation between national savings and investment levels indicates that the integration of national financial markets is still imperfect, so a rise in German interest rates is required to accommodate the widening savings-investment gap.
Axel Weber (Universität Gesamthochschule Siegen and CEPR) presented his paper, `On Two-Speed EMU and Whom to Leave Behind: Some Answers from Cluster and Discriminant Analysis', which provided a quantitative evaluation of the Dutch proposal for a two-speed transition. He first used multivariate statistical methods to divide EC member countries into homogeneous groups or `clusters' and then sought to identify the major economic variables that best explain the membership of these groups. He found that fiscal variables can play a significant role, but that this was insufficient to establish the case for binding fiscal rules or no-entry clauses. The relationship between fiscal policies and inflation performance is more likely to be grounded in the constitutional design of national central banks.
David Begg argued that discriminant analysis was an inefficient analytical tool for investigating the possible merits of no-entry clauses and that convergence of actual fiscal policies is neither desirable nor necessary in the transition to EMU. Manfred Neumann (Universität Bonn) added that no-entry clauses should be based on the convergence of fiscal structures rather than outcomes. Wolfgang Franz and Johnny Akerholm (Bank of Finland) supported Weber's general approach, however, arguing that structures could only be assessed in terms of observable outcomes.
In their paper, `Converting EMS to EMU: Why not at Par with Sterling?', Martin Klein (Universität Bonn and CEPR) and Manfred Neumann (Universität Bonn) focused on the optimal choice of numeraire for the currency conversion that will form the final step of the transition to EMU. Drawing some parallels from the German monetary union of 1990, they noted that the current basket-structured ecu is not the cost-minimizing choice and that any EMS member country's national currency would do better. On the basis of consumers' bounded rationality they proposed sterling as a first choice, but if the UK does not participate in EMU from the start this will be politically infeasible, leaving the Deutschmark as the only reasonable choice. Germany has both Europe's largest economy and most widely used currency, so a Deutschmark numeraire would yield the greatest savings of price adjustment costs.
David Currie agreed that any EMS member currency would be a more efficient numeraire than the current ecu in terms of cost savings, but he suggested that any such choice would involve too much national pride to permit this solution.