Half-empty or half-full? East Germany two decades later

Michael Burda

East Germany has done better than other ex-communist states, but it has not caught up to West Germany. There were two key mistakes – using politically expedient but highly distortionary payroll taxes to fund social buy-outs and trying to resist agglomeration effects by spreading money thinly across every town and village. This column argues that closing the gap will be tough, since convergence will come only when East Germany has the same level of social, institutional, business, and marketing infrastructure.

Twenty years after the fall of the Berlin Wall, the East German economy remains the proverbial glass of water – half-full and half-empty at the same time. Households there have fared far better than those in any other ex-communist European economy over the past two decades. Despite the ubiquitous rust-belt wastelands in the East, consumption per capita has reached 80% of West German levels – and is probably closer to 85% if one accounts for the lower prices of nontradable goods (rents, transport and personal services). These differences are similar to those between the poorest northern and richest southern states in western Germany. Household ownership of durables goods such as automobiles, telephones, refrigerators, microwave ovens, is virtually equal to Western levels and even higher for televisions, camcorders and washing machines. Life expectancy – perhaps the most easily agreed-upon indicator of well-being – has converged for East and West German women and nearly so for men, with West German males expecting only one more year of life than Eastern men.

Yet this all seems to have followed a script written by the great British economist Frank Ramsey. Consumption gains were front-loaded, the most significant in the early 1990s and very modest over the past ten years; they were also bankrolled by Western taxpayers. Even though labour productivity now is more than 80% of Western levels, GDP per capita continues to lag behind at about 72%, reflecting an unemployment rate still double that of the West and a rapidly ageing population. Furthermore, Eastern German continues to lose 40-50,000 of its inhabitants each year – and most of these are young people who are essential for a sustainable growth path in the future. This slow depopulation continues even as investment in the East – both government and private – has been enormous. Was unification a blessing, a disaster, or simply a big mess?

It is important to begin with the observation that comparisons with other ex-communist transition economies are difficult, if not meaningless. Monetary union left Eastern Germany with unusually unfavourable initial conditions. Despite the claims of US intelligence services, the GDR economy was an old-timer that had seen better days, and the introduction of the Deutsche Mark in July 1990 rendered it a junk heap. At the time, George Akerlof, Andrew Rose, Janet Yellen and Helga Hessenius inferred from once top-secret Richtkoeffizienten (the planning ministries’ assessments of the foreign exchange value of East German goods in international trade) that less than a fifth of industry was competitive at a 1-1 Ostmark-Mark conversion rate, and they were subsequently proved more than right. The backdrop of an overvalued real exchange rate was compounded by high labour mobility, instantaneous trade integration, Western trade unions, plus the introduction of onerous regulation of product and labour markets. With businesses initially in public hands, it was no wonder that real wages skyrocketed by 200-300% after the wall came down, and GDP dropped by about a third.

Despite this, progress has been remarkable in reintegrating the ex-GDR into the world economy after a half a century of deep economic distortions. Robert Barro boldly predicted in 1991 that it would take 35 years to close half of East Germany’s productivity gap with the West, which was 70% at the time. This prediction, based on econometric evidence from the United States, West European regions, and Japanese prefectures, was wildly wrong. Layoffs, reorganisation of production, and specialisation yielded significant one-off productivity gains in the early 1990s. After a collapse to about a third of its 1989 value, Eastern industrial production has risen relative to the West steadily ever since – through the recession of 2001-2 and even in the current downturn. In the past fifteen years, more than half of the per-capita GDP gap between East and West has been closed. For the first time since 1991, an Eastern German state has a lower unemployment rate than a Western one. If the persistence of the time series is any guide, some eastern states such as Saxony and Thuringia may soon overtake weaker western states such as Schleswig-Holstein.

While losing more than a million inhabitants, East Germany benefited from 1.5 trillion euros of investment since 1991, and much if not most of this has been financed by “foreigners” (non-East Germans). Intensive factor mobility in both directions has been a harbinger of significant structural change. Indeed, the recovery of economic activity since the early 1990s in the new states has by no means been uniform, as can be seen in Figure 1, which shows the relative overall evolution of gross sales in industrial sectors in the period 1995-2008. Noteworthy are the strikingly uneven recovery of East German industry, both absolutely and relative to the West, as well the reallocation of production towards the East in the vast majority of sectors. This shift is consistent with at least a partial restoration of the preeminent position held by central in Germany’s industrial economy until World War II.

Figure 1. East-West Structural Change in Germany, 1995-2008



Note: Each point corresponds to one of the following industrial sectors: mining and quarrying (MQ); coal mining, peat, oil and gas production (CG); food processing and tobacco (FP); textiles and clothing (TC); leather production and processing (LP); wood products excluding furniture (WP); paper and printing (PP); coke and oil refining (CO); chemical manufactures (CM); rubber and plastic products (RP); glass, ceramics and stone processing (GC); metal production and processing (MP); machinery and machine tools (MM); office equipment, data processing and electronics (OE); automotive and automobile production (AP); furniture, jewelry and musical instruments (FJ). In addition, the following aggregated sectors are marked red: mining, quarrying, coal, oil, peat and gas production (MI); durable manufactures (DG); nondurable manufactures (NG); intermediate goods (II); all manufacturing (M); investment goods (IG); and total industry (IN). Source: Statistisches Bundesamt

Aggregate indicators conceal these enormous structural shifts under the surface of the East German economy. Labour costs have now fallen significantly below western levels, while unionisation is scattered and disorganised, implying modest wage growth and cooperative labour relations. Given the dramatic transformation of the Eastern German economy, it was inevitable that this structural change would spill over to the West. My research with Ronald Bachmann based on micro labour data provides evidence for this claim. Since 1990, the West German economy has lost roughly a fifth of its socially insured employment in industry, while significantly increasing the number of jobs in services, especially business-related services. At the same time, instability in the West German labour markets has increased markedly.

The expectation that East Germany will someday merely be a replication of the West meant, paradoxically, that initial conditions and the path of adjustment could ultimately determine the long-run future of the economy. In 1991, I augured that one could just as easily imagine an East German economy in 2020 that looked like the Dresden-Leipzig-Halle region in the late 19th century as one in which the new states were nothing but a giant national park, dedicated to biodiversity of flora and fauna, including that of the legendary Ossi. This potential multiplicity of outcomes must have prompted the Kohl government to act as it did, arguably with more decisiveness than the economists who surrounded it. Indeed, the German Council of Economic Advisors as well as the Bundesbank militated against economic and monetary union. Yet instead of “blossoming landscapes” promised by Chancellor Kohl, the future of East Germany now more like a patchwork – a lattice of relatively prosperous medium and large cities and towns like Berlin, Dresden, Leipzig, Halle, Jena, and Rostock and a few others dotting a map dominated by depopulated and economically depressed areas.

Could anything have been done differently with the benefit of hindsight? Probably not. Looking back, I recall a multitude of proposals in the early 1990s for currency boards, wage subsidies, capital subsidies, value-added tax subsidies, stay-put subsidies for workers – even rebuilding the wall to give the GDR a breather from Western competition. Most of these proposals proved impractical, politically dangerous, or simply wrong. A separate currency would have ended in disaster, with continuing out-migration and eventual collapse. Wage subsidies would have become permanent, just as the “temporary” Solidaritätsbeitrag – the tax surcharge used to help finance unification – has yet to be rescinded.

There are however two important lessons. First, it is a mistake to fund social buy-outs using politically expedient but highly distortionary payroll taxes. Ironically the left-wing Oscar Lafontaine pointed out early on that unification would be an expensive undertaking. Using payroll taxes to pay for long-term unemployment and early retirement actually helped make West German labour more expensive in the 1990s. Second, if there are agglomeration effects as we seem to observe, it is senseless to apply the “watering can” principle, spending money in every town and village; a tough system of triage may yield more long-term economic gain.

The last bit of convergence is going to be tough. It’s my guess that East Germany in the 21st century will reproduce the existing north-south divide in the West. This is because convergence is not only about equating East and West Germans’ levels of physical and human capital but also endowing them with the same level of social, institutional, business and marketing infrastructure. On this metric, the Eastern German economy looks like a mixed bag, like much in life, a glass half-empty and half-full at the same time.