Managing Economic Reunification
In the 1960s, the world marveled at the German “economic miracle” as the West German economy came back from the rubble of World War II to become the economic superpower of Europe. Now, with the end of the Cold War and the promise of German reunification, the world looks for an encore as East Germany is pulled up to parity with its brother to the west.
East German workers are virtually as skilled, trained and educated as their West German brethren, yet they earn lower rel wages as corresponding to their lower productivity working in the centrally planned and state-run East German economy. West German firms have everything needed to improve that productivity: capital, technical skills and business experience. For them, East Germany represents the opportunity for highly profitable new investments, both in new plants and equipment in the private sector and in the national infrastructure.
Given these conditions, interest rates in Germany will need to rise to attract investment funds. Similarly, the West German mark will need to appreciate against other currencies so as to reduce the German current account surplus and shift the export of West German capital from Western Europe, where it now goes, to East Germany.
Because new investment promises to be so profitable, the stock prices of German firms that figure to be involved in the modernization of East Germany shuld rise. The effect on the overall stock market will be tempered by the fact that some of Germany’s traditional export industries, such as chemicals, will suffer from the expected appreciation of the West German mark. But because the return to investment in East Germany promises to be so great, the German stock market ought to rise, on balance, even as its bond market falls and the West German mark appreciates. As investment and the efficiencies induced by market incentives act on the East German economy, productivity will rise and, with it, real wages and living standards of East German workers.
Is it inevitable that all this will work out neatly? If not, what are the likely complications? For starters, there is the range of micro-management problems associated with converting to a market economy. This conversion will lead to largely uncharted territory for all the formerly state-run economies. They will surely have problems with both the economic transitions and the political and social issues that are part of the change. One would expect East Germany to manage these problems comparatively well, thanks to the guidance and material aid that will be available from West Germany.
Ironically, the ethnic ties between the Germanys also create a problem that is distinctly their own--the massive migration of workers from East to West. Rather than wait for new capital to come to him and raise his living standard tomorrow, the East German worker with freedom to relocate has been coming to the West where the existing capital and market system raises his living standard today.
Motivated largely by the desire to stem this tide of migration, the West Germans have proposed imminent full economic union. The idea seems to be that if Germany were all one big economy, there would be little incentive to leave the East. In this spirit, what exchange rate to use in forging the monetary union has been a central issue. Although some of what is being discussed publicly may be motivated by today’s East German elections, the desire to set an exchange rate generous to the East Germans is clear. The black market rate has been near one West German mark to 10 East German marks. Estimates based on comparative manufacturing productivity have been near one to three. But proposals for conversion with unification have gravitated to one to one, which is the rate that West German Chancellor Helmut Kohl supported last week.
Such a generous exchange rate would provide a substantial transfer from West to East. It is estimated that 180 billion East German marks are waiting to be converted, roughly 150 billion in savings and 30 billion in circulation. At an even conversion, 180 billion West German marks (about $105 billion) would amount to nearly 15% of annual consumption in West Germany.
Because much of this liquid wealth represents retirement savings of East Germans, it would not all be suddenly spent. Nonetheless, if a generous exchange rate is provided, it would have to be accompanied by some combination of a plan for partially freezing the converted East German assets so that they would be spent only gradually over a period of years, and higher taxes to suppress West German purchasing power.
Whatever else it does, a generous exchange rate will not stop emigration, because the movement of labor mainly depends on the opportunity to increase real earnings--to buy more with a week’s pay. Providing parity in exchange rates, so that one East German mark trades for one West German mark, cannot produce parity in earnings.
Whatever the exchange rate--or when eventually there is a common currency--in a market economy, wages in East Germany will have to adjust to reflect the lower productivity of its workers. Thus, the migration incentive will be as great as ever, diminishing only gradually as productivity and living standards improve in the East.
The dilemma is that encouraging employment and investment in the East requires a realistic low wage, while suppressing migration from the East requires an unrealistic high wage. To achieve both goals, the West would have to subsidize employment in East Germany. Only then could firms in the East have net costs low enough to maintain employment at the same time their employees received net wages high enough to keep them from leaving.
Although, in principle, they can resolve the dilemma, introducing subsidies is risky. Finding the right level of subsidy would not be simple, and the right level would not be the same for all industries. Furthermore, subsidies should be phased out as new investment and the incentives of a free market raise the productivity of East German workers. But even if they could be well designed and temporary, introducing a system of subsidies could undermine the broad aim of moving East Germany to a market economy.
Excessive migration could be stopped more directly, perhaps by requiring that workers have a place to stay and a job to which to go before they relocate. Such a direct approach would minimize the economic hazards that would go with trying to dampen migration by manipulating wages. But that might not do politically.
The fall of the Wall was such a powerful symbol of freedom that to impose even sensible restraints on relocation may now be difficult. If so, and if policy-makers do not face up to the need to temporarily subsidize employment in the East, Germany could face difficult transitional problems, however promising the medium run prospects for its economy may be.
