Wage Subsidies Could Aid Unification of Germany

As the nations of East Europe asserted their independence from the Soviet Union, most coupled political reform with movement toward market-oriented economic systems. Nowhere did the prospects for success appear brighter than in East Germany, where unification with West Germany promised a relatively easy infusion of capital, technology and management know-how with an educated and skilled work force.

Yet when it came in mid-1990, union brought on economic depression rather than a new German miracle. Within a couple of months, industrial output in eastern Germany had fallen to half its 1989 average and employment in all major industrial sectors had declined. By this past winter, 30% of the eastern work force was unemployed or working only part time.

The reasons for this debacle, together with a plan for setting it straight, are presented in a new study by George Akerlof, Andrew Rose, Janet Yellen and Helga Hessenius soon to be published in the Brookings Papers on Economic Activity. The authors find that both demand and supply changed in ways that could account for the decline in output and employment. On the demand side, once goods from the west became widely available and Germans in the east had marks with which to buy them, their demand for alternative eastern goods dried up. Yet this depressing effect should be short-lived in a new, profit-driven economy. Given a little time, the quality and style of eastern goods should start to compete with those from the west.

By contrast, problems Akerlof and his colleagues identify on the supply-side threaten to be more lasting and pervasive. The heart of these problems are wages that are far higher than the productivity of eastern firms can support. In the aftermath of the July currency union, producer prices fell by close to 50%. Wages, by contrast, started rising early in 1990 and continued to rise after unification. As a result, the ratio of wages to producer prices nearly tripled late last year. With no corresponding improvement in labor productivity, most firms were caught in severe cost-price squeeze and could only continue production with government help.

Wages in the east are now about half the level of wages in western Germany and, in some industries, are scheduled to reach parity with the west in a few years. They are several times as high as wages most East European nations. Analyzing cost data from a large cross-section of East European firms, the authors found that only 8% of workers are employed in firms that can cover their variable costs at present wage levels.

How did wages get so high? Nearly all wages in eastern Germany are determined through bargains struck with the help of western unions. On the other side of the bargaining table sit socialist managers who may have neither the expertise nor the incentive to bargain for lower wage levels that would make eastern firms viable. Meanwhile, the government and labor unions claim high eastern wages are necessary to prevent a more massive migration of workers from east to west.

On this last point, Akerlof and his colleagues report on opinion surveys that show pay differentials are unlikely to influence migration to an important degree. They conclude that, on balance, high eastern wages encourage migration by destroying jobs and raising unemployment in eastern Germany.

As the way to maintain and create employment in the east and to facilitate the sale of state-owned firms, the authors recommend a wage subsidy that would be phased out as productivity in the east improves. The needed subsidy is large. Using their estimates of costs and productivity in eastern firms, they calculate that a subsidy of 75% of hourly compensation would be needed to make viable the employment of 75% to 80% of workers in existing firms.

They also believe that the subsidy would encourage investment to start new companies in the east by providing the lure of low wage costs. And despite its size, they calculate that the budgetary cost of a wage subsidy would be small, and possibly even negative, because instead of paying generous unemployment benefits, the German government would collect payroll and income taxes from the newly created jobs.

The subsidy plan is an audacious response to problems that are all too real and important. But it carries political and economic risks, and might replace existing problems with new ones. It could prove politically difficult to phase out the subsidies as eastern productivity improves.

The subsidies could steal jobs from unsubsidized workers in western firms, particularly those near the border. And if mishandled, subsidies might perpetuate old bureaucratic managements.

The plan for transitional wage subsidies deserves a serious hearing in the course of which these risks can be considered alongside alternatives. By focusing attention on the very special problems that high wages and economic unification have created in eastern Germany, Akerlof and his colleagues may contribute to their solution even if their subsidy plan does not carry the day.