German Merger to Affect Economies Around World

Officials of many countries spent the winter and spring working on aspects of the economic and political union of the two Germanys, an unprecedented merger of two large economies. Finally, on July 2, the economic union took place. East Germany agreed to adopt West German economic rules and laws, scrapped its currency, adopted the West German mark and joined the market system.

Although long described as the economic power of the Socialist Bloc, the East German economy was more a shambles than a powerhouse. Modernizing the East German economy and putting the union together will be costly for the West Germans but ultimately productive for both. The transaction will have effects on Germany and on the world economy powerful enough to be thought of as a second Reaganomics, a Reaganomics on the Rhine.

Once the wall dividing the two Germanys was breached in November, 1989, economic union was unavoidable. By law, East Germans were entitled to claim West German citizenship. They could move to West Germany, receive social benefits and housing and look for jobs. Thousands did just that, including many with skills that were more highly valued and better paid in West Germany. Butchers, bakers, skilled craftsmen of all kinds and many others needed no urging to leave the socialist East for the capitalist West.

The decision to merge the two economies was made by the citizens with their feet. Political and administrative leaders were left to decide the terms. The issues that attracted most attention in public discussion were how to value East German marks and whether the valuation would produce inflation.

But this was not the main problem. The East German economy is about 10% of the West German economy, and the increase in money is 10% to 12% of the current West German money stock (M3). As long as the West German central bank--the Bundesbank--remains committed to an anti-inflationary policy, inflation will be contained.

The more difficult problem is assuring an orderly transition of East Germany from a heavily subsidized, inefficient, polluted, socialist economy to a more efficient competitive market economy.

Comparisons are difficult, but officials in West Germany estimate that, under socialism, East German workers received about 35% to 40% of the West German wage but produced about half the output of a West German worker. (If true, this looks like the kind of exploitation that is not tolerated in a market economy; on average, workers received much less than the value of their contribution to output.)

East German workers are now paid their previous wage in West German marks. The productivity and wage estimates suggest that East Germany should be able to supply many goods and services at competitive prices.

But this is likely to be true of only a small portion of East German output. As in all communist countries, much of the output is shoddy, badly styled and unlikely to be salable in Western markets--or in Eastern countries, now that those countries have more choice. In the past, sales to the West were heavily subsidized by the government.

Further, those with skill and ambition can migrate to West Germany and raise their wages. To keep them in place will require large subsidies from the West Germans and rapid increases in productivity to support higher real wages. The West Germans have agreed to subsidize wages for the present. But subsidies will not maintain employment or prevent migration for long.

Raising productivity by modernizing plants and improving products are the keys to success. This requires investment, but the heavily polluted water and land discourage investment. West German investors are put off by the large, uncertain costs and future liability for cleaning up the environment. Rather than invest in existing plants and incur these costs, many prefer to start over with new plant and new equipment in unpolluted locations. This takes time and is costly. For a West German businessman, the alternatives in Spain, Poland, Hungary or Czechoslovakia may be more attractive.

Without substantial new investment, East German productivity will not rise rapidly. To encourage that rise and overcome the disadvantages, West Germany will heavily subsidize investment in East Germany. Even so, unemployment will rise during the transition, and West Germany will pay unemployment compensation at a rate tied to the East German wage.

Add together the payments for unemployment, the subsidies to employees and investment, and the social benefits. The sum will be a heavy burden for West German taxpayers. Add in some costs for rebuilding infrastructure, such as roads and bridges. And that’s not the end. West Germany has agreed to increase the pensions of about 3 million retired East Germans (including former spies who operated in West Germany).

Estimates of the cost of economic union range from an official projection of 115 billion marks ($70 billion) for a German “unity fund” to private estimates of as much as $300 billion over the next four to five years. A reasonable guess is that budget deficits will run to 4% or 5% of West German output for several years and cost as much as $5,000 per West German citizen overall. In addition, there will be large expenditures by private investors.

Following the transition, the productivity of East German workers will jump. New and better machines will make that possible, and the wide range of consumer goods will provide the incentive to work harder, longer and smarter.

To judge what will happen, put the pieces together. Big increases in spending for investment, for subsidies and for social welfare during the transition will add to demand. If the monetary authorities act responsibly, they will not finance the increased spending.

The German government has said it does not plan to raise taxes. The result, as in the Reagan program, will be a large budget deficit and a big increase in debt. After a time, if the program works as expected, Germany will have a supply-side increase in output and productivity.

Capital markets have responded to the German program in much the same way that they responded to the first years of Reaganomics. Interest rates have increased, not just from fears of inflation, as many market commentators suggest, but from an anticipation of the jump in productivity, output and real, after-tax returns to investment.

These same anticipations are manifested in an increased flow of foreign capital into Germany and a sharply reduced outflow of capital from Germany. The mark has appreciated, reflecting the high real returns and the capital flow to Germany.

Will the markets be right? Will the unified Germany experience the spurt in output, productivity and real returns that capital markets anticipate? I believe that East German workers will respond to incentives, show more initiative and produce more under capitalism than under communism.

But, there will be a painful transition. The length of the transition will depend on how fast investment increases in East Germany and how many skilled workers, uncertain about the future in the East and encouraged by the higher incomes available in the West, can be persuaded to stay put.

Reaganomics raised the expected return to investment in the United States and thus raised real interest rates around the world. German unification will do the same; in fact, it has already done so.

Market interest rates in the United States and elsewhere can decline if inflation is reduced, but real interest rates--after adjusting for inflation--are likely to remain in the neighborhood of their present high levels as long as anticipation of successful German unification dominates market sentiment.

The transition in Germany should have a further, desirable effect. The prophets of America’s non-competitiveness are about to be squashed by events. The appreciation of the mark and the other European currencies has already produced robust export growth for the United States. That growth should continue, if German investment and expansion remain strong. Germany will gain from the end of communism on its eastern border. So will we.