At a joint Bonn lunchtime meeting with the Anglo-German Foundation for the Study of Industrial Society on 21 February, Michael Burda argued that recent forecasts suggesting that Eastern Germany may take 80 years to converge to Western living standards take no account of Eastern Germany's special circumstances and are much too pessimistic. Burda is Professor of Economics at the Humboldt Universität zu Berlin and the Institut Européen d'Administration des Affaires (INSEAD), Fontainebleau, and a Research Fellow in CEPR's International Macroeconomics and Human Resources programmes. His remarks were based on his CEPR Discussion Paper No. 863, `Eastern Germany: Can't We Be More Optimistic?', written with Michael Funke. The opinions expressed by Professor Burda were his own, however, not those of the Anglo-German Foundation nor of CEPR, which takes no institutional policy positions.

Burda noted that central planning had left the ex-GDR much poorer than many expected, with an aggregate per capita GDP nearly 60% below that of Western Germany in 1992. Recent empirical studies comparing the growth of US and Japanese regions and European countries have found that economies converge to their steady states at about 2% per annum. Simple extrapolation of this `law of convergence' suggests that convergence of the ex-GDR's per capita productivity to Western levels should take more than 80 years. Burda noted, however, that the approach used to estimate the `2% rule' elsewhere assumes that the initial conditions in poorer regions reflect the outcome of a market economy. In the ex-GDR, however, the transition may itself induce `jump increases' in efficiency as the economy moves rapidly to its production possibility frontier, and preliminary evidence confirms the Eastern Länder's spectacular gains in labour productivity since early 1991. Labour productivity also varies greatly across sectors from 8% of Western levels in oil refining to 80% in printing and publishing. Shifts of resources across sectors may therefore also raise aggregate productivity sharply in the short run, and Burda reported estimates that the `sectoral exit' effect would raise aggregate productivity to 60-70% of Western levels before the convergence process really begins. These structural change would also entail costs to employment, but this will also rise with the output of productive sectors and productive firms in less productive sectors, and labour will also move into sectors whose productivity gaps relative to the West are less pronounced such as services. The available pessimistic forecasts are also based on models of a closed economy, in which growth arises only from internal capital formation, while migration of labour and human and physical capital from regions with low factor incomes will play a major role in hastening convergence in Germany. For plausible values of the mobility of physical and human capital, the rate of convergence could rise to more than 5% per annum and the time-period required could fall to 13-15 years.

Burda then noted that the Federal government's emphasis on the role of investment in improving medium-term prospects for productivity and growth in the East also provides grounds for optimism, since cross-country comparisons reveal a robust empirical link between investment spending and growth. Rough calculations from cross-country data suggest that Current rates of investment of 50% of GDP (total) and 25% (business equipment), if sustained, could raise growth to 3.5% per annum above Western levels over the medium-to-long term (in contrast to the 1% differential assumed under the `2% rule'). DeLong and Summers have found that the high observed correlation between investment and growth is primarily due to investment in business equipment, which is now 10 percentage points higher than in the West and greater even than in Japan, Singapore or Hong Kong. This suggests that the Eastern German growth rate could be 3 percentage points above the Western German level. Investment in infrastructure may also have spillover effects on the productivity of private economic activity, and such spending is already high: at DM 30 billion in 1991 and DM 36 billion for 1992, this is 50% higher in per capita terms than in the West, and if sustained it could raise growth relative to the West by up to 5 percentage points.

Burda concluded by cautioning against attaching too much weight to the precise values of these numerical forecasts; nevertheless, the bulk of empirical evidence on Eastern Germany's current performance indicates that the prospects for its continued growth are much more promising than many studies based on current growth theories suggest. The Treuhandanstalt's policy of favouring an immediate, radical restructuring rather than a more gradual and protracted adjustment has proved painful, but it has also created favourable initial conditions for convergence to Western living standards. There was a clear trade-off between the pain of unemployment today and faster catch-up with the West, and the rapid productivity increases experienced to date appear to have vindicated the Treuhand's `shock therapy' policy.