Germany ; Foreign exchange rates ; Mark, German

Hang-Sheng Cheng

English

Research Papers in Economics

FRBSF WEEKLY LETTER
June 29, 1990
German Economic Unification
The world is about to witness an unprecedented
economic experiment to determine whether the
two disparate economic systems of East Ger-
many and West Germany can be rapidly merged
into one without incurring unacceptably large
social and economic costs. The merger will com-
pletely dismantle the East German centrally-
planned economy and replace itwith the West
German market economy. The first step in this
historic experiment will be monetary unification.
That economic unification of the two Germanys
should begin with monetary unification is star-
tling. Historically, nations that seek closer
economic ties have started by removing trade
barriers, and then proceeded to integrate or
harmonize domestic economic policies. With
national currency generally regarded as the
epitome of national economic sovereignty, mone-
tary unification has been viewed as appropriate
only at the final stage of economic integration.
The difference in this case lies in the over-
whelming desire of the people on both sides
of the border between the two Germanys for
immediate political and economic unification.
Precisely because money symbolizes national
economic sovereignty and permeates all national
economic activities, both sides decided to start
with monetary unification, thereby setting up
irresistible market forces that would in one stroke
propel the two economies toward rapid and
complete economic integration.
This Letter discusses the provisions of monetary
unification, and examines the implications of
German economic integration for Germany and
the rest ofthe world.
The two Germanys
The Second World War left Germany politically
divided and economically devastated. Aided by
massive economic assistance from the United
States under the .t\./\arshall Plan, \AJest Germany
recovered rapidly after 1948. Its remarkably
successful economic growth since then shows
how well a free market economy can perform
under sound monetary and fiscal management.
With a population of 61 million, West Germany
now ranks among the foremost industrially ad-
vanced nations in the world, and has one of the
highest per capita incomes ($14,200), lowest an-
nual inflation rates (3 percent), and largest trade
surpluses ($55 billion, current account balance)
in the world.
Its 16 million brothers and sisters on the other
side of the border, in contrast, have not fared
so well with their Soviet-type, centrally-planned
econpmy. Since 1945, virtually all means of
production have been owned and operated by
the state, prices and wages have been rigidly
controlled by the planning authorities, and
capital markets have been nonexistent. Produc-
tive incentives have been lacking, and resources
have been allocated through a bargaining pro-
cess between enterprises and the planning
authorities. As a result, investment in infrastruc-
ture and plant and equipment has been woefully
inadequate. Environmental pollution is rampant,
and shortages of consumer goods are common.
Though significantly higher than those ofthe
other East European countries (Bulgaria, Czecho-
slovakia, Hungary, Poland, and Romania), its per
capita income is estimated to be only one- to
two-thirds that of West Germany.
Monetary unification
It is against this background that monetary
unification between the two Germanys will
occur on July 2. From then on, the West German
Deutsche mark (DM) will be legal tender on
both sides of the border. All debts (including
bank deposits) and payments (including pensions
and wages) will be converted from the East
German Ost mark (OM) to the DM at rates
stipulated in an agreement signed by both
governments on May 2.
The agreement provides for conversion at a
one-to-one rate for all East German wages and
salaries, pensions, rents, and personal savings upFRBSF
to 4,000 Ost marks, and at a two-to-one rate (that
is, two OM per OM) for all other monetary
exchanges.
Many observers are concerned about these
conversion rates. Both are considerably lower
than the current official rate of 3-to-l and the
black market rate of between 5- and 6-to-l in
East Germany. These rates reflect West Ger-
many's accession to the East Germans' strong
desire to "preserve" the value oftheir savings;
a low conversion rate gives East German con-
sumers greater purchasing power over goods
manufactured in West Germany and other
countries. At the same time, however, a low
conversion rate raises the OM price of East
German products, and makes those products
less competitive against West German goods
and those of other countries.
Costs to West Germany
To the extent that the conversion rates overvalue
the OM relative to its "true" purchasing power
in OM, the agreement represents an immediate
transfer of wealth from West German residents
to East German residents. The magnitude ofthe
transfer depends on the total amount ofthe OM-
denominated assets converted and on the "true"
value of the OM. For illustration, consider the
conversion of East German personal savings. The
total amount of East German currency and bank
deposits held by individuals has been estimated
to be about OM 170 billion. Assuming that the
official one-to-one conversion rate applies to this
entire amount, but that the true value of the OM
is, say, 4-to-l, then the transfer of wealth arising
from personal-savings conversion would be
OM 127.5 billion (OM 170 billion less the true
value of East Germans' personal savings of
OM 42.5 billion). This is a relatively modest
amount compared to the OM 2.2 trillion West
German economy.
However, the cost of economic integration to
West Germany is not limited to this one-time
wealth transfer. The May 2 agreement also
provides for raising the average East German
pension from OM 420 per month to the average
West German pension of OM 1,100 per month.
Given the approximately 3 million retirees in
East Germany, the increased pension payment
will be about OM 25 billion per year. In addi-
tion, there are currently an estimated 1.4 million
unemployed workers in East Germany. Raising
their unemployment benefit to the West German
level will cost an estimated OM 10 billion a year.
Officials on both sides of the border have
estimated that unrestricted trade between the
two Germanys at the stated currency conversion
rates will make many East German businesses
uncompetitive, causing at least a third of them
to go bankrupt and adding another one million
workers to the unemployed. In order to reduce
the severity of the social dislocation, it has been
proposed that the West German government help
to reduce East German firms' costs by extending
a OM 300 monthly wage subsidy per worker to
them. Given the 9 million workers in East
Germany, the proposal would add another
OM 32 billion a year to the cost of unification.
All this does not include an estimated OM 150
billion to rebuild East Germany's road and rail-
way systems and an estimated OM 100 billion
for cleaning up East Germany's badly polluted
environment in the next two years.
Estimating the total cost of German unification
to West Germany is a hazardous undertaking.
Estimates range from DM 250 billion ($147 bil-
lion) to DM 1 triiiion ($586 biiiion) over several
years. However, most of these estimates are no
more than lists of what East Germany needs to
improve its infrastructure, reduce pollution, and
renovate outmoded and worn out plant and
equipment. Whether such an extraordinary
volume of capital actually would flow into East
Germany depends both on the West German
taxpayers' willingness to pay for East German
reconstruction and on the expected returns to
private investment in EastGerman projects. In
both cases, a large capital infusion into East
Germany cannot be taken for granted. Rather
than focusing on needs, then, it is more useful
to examine how much capital is likely to be
forthcoming for the rebuilding of East Germany.
Supply of funds
Taxpayers' willingness to bear the cost of East
Germany's rehabilitation will determine the
supply of public capital available to East
Germany. Already, Chancellor Helmut Kohl's
Christian Democratic Party lost in two recent
state elections, allegedly because of voters'
unwillingness to support the high cost of
unification.
Moreover, on May 16, when a OM 115 billion
($70 billion) "German unity fund" was an-
nounced to finance the expected East German
budget deficit over the five years from 1990 to
1994, the West German finance minister madea point of declaring that the funding would be
partly from government budgetary savings and
partly from borrowing in the capital market-not
from tax increases nor from central bank mone-
tary expansion. This public funding averages
only DM 23 billion ($13 billion) a year, consider-
ably less than the total value ofthe desired
subsidies from the West German government.
It is much more difficult to gauge private busi-
nesses' responses to investment opportunities
in East Germany. Not surprisingly, as soon as the
barriers were lifted, the perceived needs of a
market of 16 million people starved for new
capital and new technology brought forth a
stampede of West German firms in various indus-
tries, including autos, electric equipment, metals,
machinery, banking, insurance, and hotels-all
eager to set up joint ventures in East Germany. A
casual tally of these announced investment plans
gives the impression that tens of billions of
dollars will be poured into East Germany for
rebuilding its economy.
In fact, however, the initial announcement is
no more than a declaration of intention. On-site
exploration must follow before concrete plans for
investment are made, if such plans are made at
all. Given the obstacles to business investment in
East Germany, which include inadequate infra-
structure, a legal and political framework that
is in flux, and expectations of widespread eco-
nomic dislocation arising from an overvalued
cost structure, it would not be surprising to see
some of the ambitious investment plans reduced
in size, stretched out in time, or eventually
abandoned.
In short, the "stampede" may be nothing more
than an onrush of enthusiasm that will be fol-
lowed by much reduced actual business invest-
ment on the basis of more realistic appraisals. To
interpret this as a torrential inflow of capital and
technology may be a bit farfetched.
Inflation and interest rates
Although the euphoria over growth prospects in
East Germany is likely to fade as businesses and
the West German public begin to make more
realistic assessments of investment prospects in
East Germany, in the meantime, two concerns
have arisen concerning the strains that rebuilding
the East German economy will place on West
Germany and the rest ofthe world. The first is
that increased demand for West German goods
and capital due to the opening of East Germany
will fuel inflation in West Germany. Indeed,
inflation has been rising in West Germany in
recent years, largely because the West German
economy has been operating at a level that
strains capacity.
In and of itself, however, increased spending
in East Germany need not fuel inflation in West
Germany. The one-time wealth transfer to East
Germans when OM-denominated assets are con-
verted to DM can be offset through open-market
operations by the West German central bank (the
Bundesbank). Likewise, increased borrowing by
West German firms to fund investments in East
Germany should not put upward pressure on
goods prices, but, instead, on interest rates. Also,
an increase in the West German budget deficit
arising from aiding East Germany should not be
inflationary as long as it is not financed by money
creation by the central bank.
Given the Bundesbank's staunch anti-inflationary
policy stance and past track record, it is doubtful
that the German central bank would allow rapid
monetary expansion tofinance East German re-
construction. The more likely course would be
for the increase in demand to drive up German
interest rates and the exchange value of the
Deutsche mark, reducing business investment
in West Germany and the nation's trade surplus,
thereby freeing up resources for East German
reconstruction.
The second concern is that West Germany's
increased demand for capital will raise world
interest rates and make credit less available to
borrowers in the rest of the world. Although the
direction ofthe effects is perhaps correct, a sense
of proportion is essential for proper assessment.
The analysis in this Letter suggests that the
amount of German borrowing is not likely to
be as large as often alleged. Thus, there appears
to be little basis for expecting a "world credit
crunch" or a significant rise in world interest
rates to result from German economic
unification.
Hang-Sheng Cheng
Vice President
Opinions expressed in this newsletter do not necessarily refiect the views ofthe management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.OUt6 v:) 'O:lSPUI?J:I UI?S
lOLL xog 'O'd
O)SI)UOJ~ UOS
JO· ~uo8
aAJaSa~ IOJapa~
~uaw~Jodaa lpJOaSa~

German economic unification

http://www.frbsf.org/publications/economics/letter/1990/el90-26.pdf

German economic unification

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics