VoxEU Column Europe's nations and regions

Muffled jumpstart

Twenty years after the fall of the Berlin wall, Germany’s political unification has succeeded. This column argues that its economic unification has not – East German growth has been very disappointing and pulled down the economy as a whole. It blames policies that raised East German wages above market levels.

Germany’s political unification has succeeded; its economic unification has not. Twenty years after the fall of the Berlin wall, GDP per capita in the formerly communist area is 69% of that of the former Federal Republic of Germany including West Berlin. This value sounds better than it is, as it is artificially inflated by civil servants’ wages and salaries, which have reached West German levels. East Germany’s privately produced GDP per capita is only about 66% of the West German level. Moreover, a substantial part of the convergence is explained by West Germany’s slow growth and the outmigration from East Germany.

If the new citizens had to feed themselves, the still lower cost of living in the East would let them achieve a standard of living of slightly more than 70% of the West German level or 86% of the EU average in 2008. Regarding its own contribution to the standard of living, East Germany comes in behind Slovenia (90% of the EU average) and the Czech Republic (80%). In terms of performance, both of these countries will far outrun East Germany once the world economic crisis is over. Hungary, the Slovak Republic, and Poland are also already in the passing lane. 

Given East Germany’s 13-year insider advantage over the other former communist states aspiring to EU membership, this is a disappointing outcome. As a result of unification, East Germany did lose its East European markets, but it gained almost 400 million West Europeans as potential customers. It missed the chance of being the first to supply them and capture customers.  

The result is especially sobering considering the gigantic reconstruction subsidies East Germany received. According to cautious estimates, a net amount of about €1.3 trillion (in current prices) flowed in from the public budget. In per annum terms, this is more than twice the amount for which Oskar Lafontaine, Helmut Kohl’s competitor for chancellorship in 1991, was criticised at the time.

A lot of money went to social transfers, an inflated public sector, and a consumptive infrastructure. Many East German cities became beautiful again. But there has never been a self-sustained upswing. During the past fifteen years, East Germany did not grow faster than West Germany; hence, there is no sign of convergence (see Figure 1). In view of these results, however, one must still not agree with Oskar Lafontaine who wanted to do the unification in instalments. The stability of Central Europe, the solidarity with relatives, and the unification of the nation were surely worth the price paid by West Germany. Nonetheless, the question arises as to whether there was not a better way.           

Figure 1. Productivity and income in the former GDR compared to West Germany

West Germany including West Berlin, East Germany including East Berlin; division into West and East Berlin: estimates of the Ifo Institute (except for pensions). Sources: Working Group National Income Accounting, Results for the States, Series 1, Volume 2 (April 2009), Series 1, Volume 5 (May 2009); German Pension Insurance, time series, 2009; Purchasing power: calculation of the Ifo Institute; GDP 2009: estimates of the Ifo Institute.

Getting East German wages wrong

The major problem was that a basic economic rule was stood on its head. If a new market economy is constructed from scratch, the endowments may be distributed arbitrarily, but one must not interfere with the free determination of prices and wages, because it fulfils a central steering function. Politicians simply ignored the constitutionally binding mandate of the Unification Treaty (Art. 10.6) “to provide possibilities” for the citizens of East Germany for “giving them a securitised share in the nationally owned assets”. Instead, West German firms imposed non-market wage increases designed to raise Easter German wages to the West German level in just five years.

This was the true error. As early as the spring of 1991, wage negotiations took place according to the West German collective bargaining law, although there were no private entrepreneurs at the time that could have fought the devaluation of their capital by wage increases. Before privatisation, there were proxy wage negotiations between West German competitors of East German firms sitting on both sides of the table. Their objective was to raise wages to the West German level as fast as possible in order to protect their own jobs. If foreign investors, who were in the starting blocks, were to come in to buy and restructure the East German state firms with their know-how and their products, they were to do so at West German wages.

The investors preferred to stay away, the East German firms foundered, and in the end there were indeed no longer any assets left that could have been distributed. Sony, one of the most important investors of the first hour, meanwhile sold its imposing centre at the Potsdamer Platz, disappointed over the way things turned out.

In 1991, we proposed an alternative – upon the one-to-one conversion of the currency, which had increased wages to one-third of the west German level, wages were to be frozen until the conclusion of privatisation, and the state firms were to establish joint ventures with domestic and foreign investors in order to transfer the existing workforce as fast as possible into a modern working environment and to equip it with new machines and competitive products. Many of the East German firms would have had value, and the East German people could have received company shares to compensate them for slower wage increases. However, when the government took notice of our proposal, it only stepped up its pace. Instead, joint ventures were established in the Czech and Slovak Republics and Hungary. At the time, the German privatisation agency was proud of “trying the impossible” when it gave away the East German firms handicapped by the wage increases under the condition of preserving the jobs, but as always when someone tries the impossible, it failed miserably. Three quarters of the jobs entrusted to it were lost nonetheless.

As a result of the proxy wage negotiations, East German wages rose much faster than East German productivity in those early years (see Figure 1). Due to the income transfers from the West, welfare incomes also rose much faster than productivity. They have largely arrived at West German levels and legal retirement pensions are even higher. Via the wage competition of the welfare state in the labour market, the welfare incomes cemented the wages above the level corresponding to productivity. It therefore did not help much when newly established East German firms gradually unshackled themselves from the collective wage agreements. Stagnation and mass unemployment were pre-programmed.

East Germany’s disappointing growth

There is an ironclad rule in a market economy; first the economy must flourish, then the wages can rise. Low wages attract investment, the economy grows, there are more unfilled jobs, and in the end competition for workers among employers will push up wages. The economy can pull wages along, but wages can never pull the economy along. It is like the revolving door at the airport that stops when people shove.

Slovenia and the Czech Republic experienced more growth without the help of a big brother. Ireland, too, once the poorhouse of Europe, has chosen a better way (Figure 2). When hourly labour costs in East German industry overtook those in Ireland as early as 1995, without comparable investment conditions being in place, all investors knew that they could not become rich in East Germany. Internationally mobile capital went to Ireland instead. Ireland has since grown by 110%, while East Germany stagnated with just 17% growth during the same period of time. In the meantime, Ireland has even overtaken West Germany in terms of per capita income, and Irish wages are above those in East Germany, because they allowed to be pulled along instead of running ahead.

Figure 2. Economic growth in selected EU countries and regions

Source: Eurostat; calculation of the Ifo Institute; 2009: Joint Economic Forecast Autumn 2009.

Of course, everyone knows the argument in favour of rapid wage convergence, i.e. the danger of migration, time and again castigated by politics. If wages lagged, there might be west-migration of many people and that had to be prevented. But why? What is so terrible about people moving within a country to where the jobs are? Did it make sense to send these people into unemployment and to let them wait there for new jobs? Even under favourable conditions, it would take at least one decade for the necessary investments to restore an industrial base. It was a mistake to prevent capable young people from moving west for a while in order to earn good incomes there and acquire some know-how. In the end, East Germany would have grown faster without the push for higher wages, and most people would meantime have returned home again when a flourishing economy would have developed. 

Mass unemployment, caused by aggressive wage politics, probably resulted in much more emigration (and much less immigration) than would have been the case with lagging wage convergence. The population of the former GDR declined by 1.5 million people or 10% from 1991 to 2008, while the population of the former Federal Republic including West Berlin increased by 3.7 million. The wage push became a program for “deconstruction of the east” and, if at all, “reconstruction of the west“, i.e. the opposite of what had been intended.

The failed unification of the East and West German economies has also dragged down West Germany in an international comparison. Until German unification, West Germany had grown properly and in terms of per capita national income had held a top position in Europe, at about the same level as Denmark. Under favourable conditions, it could have maintained this growth thereafter and Germany as a whole could have grown much faster than the rest of Europe due to the convergence of East Germany to the Western European level. But this is not what happened. Since 1995, both parts of the country have crept along in step and have taken turns with Italy for the lowest rung on the European ladder. Things turned out worse than we had expected.

The economic crisis has enforced a new realism in Germany. Net transfers to East Germany have been declining for a few years, wage increases have become more modest, and the constitution prohibits East German states to continue their policy of rising indebtedness from 2020. The times of easy money are past, and that is why a phase of growth may start now. Unfortunately, it is twenty years late.

Note: This column is an edited translation of an article published in FAZ am Sonntag on 8 November 2009. 

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