Peter Hampe

English

Research Papers in Economics

TEN YEARS AFTER:G ERMAN
UNIFICATION REVISITED
CESifo Forum 35
Conference Report
Wage policy and 
welfare system
caused major 
problems
Conference organised by Rüdiger Dornbusch,
MIT, and Hans-Werner Sinn, CESifo, in co-opera-
tion with the German Economic Review.
Exactly ten years after German unification,
Rüdiger Dornbusch and Hans-Werner Sinn held
their jointly organised conference not far from the
Berlin Reichstag. The panel of experts, which also
included Georg Milbradt, the Saxon state minister
of finance, and Karel Dyba, the former Czech min-
ister of economics, discussed the following ques-
tions:Would we do it the same way again? Was the
transformation of the east German economy a suc-
cess? What went wrong? 
Hans-Werner Sinn opened the discussion by look-
ing at the enormous improvement in the standard
of living in east Germany.According to recent esti-
mates,it has risen,in real terms,by a factor of three.
Real average income is now 90% of west
Germany’s, the level of nominal wages is 74%, and
pensions are even higher than in the west. Sinn
characterised this development as phenomenal,
beset only by the problem that this success was and
is financed by west Germany to a degree which is
simply not sustainable. Every third D-Mark which
is spent in east Germany still comes from the west:
Whereas annual absorption in east Germany is
DM 655 billion, its GDP is only DM436 billion.The
difference is financed, on the one hand, by a net
transfer of private capital of DM 78 billion,which is
appropriate; on the other hand, DM141 billion, or
4.5% of west German GDP, is provided by west
German government budgets. Accumulated over
the entire period, the public net transfer adds up to
DM1,200 billion. Because most of it was financed
by borrowing,the public debt rose from DM900 bil-
lion to DM2,300 billion.That implies a large burden
on future generations, especially in view of the
severe demographic problems facing Germany in
the longer run.
Hans-Werner Sinn emphasised the need to move
to a situation where the east Germans will finance
themselves. Such a move is expected to provoke
resistance, however. Thus Sinn expects a severe
crisis when the current transfer system expires in
2004 and the west German side refuses to contin-
ue the large payments of the past.This is the major
remaining problem of German transformation
policy.
Would it have been possible to avoid this dramatic
development? Of course, considering all political
constraints at the time, Hans-Werner Sinn argued,
only the things that happened could have hap-
pened. But as economists we should critically
examine these constraints. Sinn mentioned two
main problems which could have been avoided:
• The first is the wage policy pursued in east
Germany as a result of which nominal wages
rose from 7% of the west German level in 1989
to almost 75% today. For Sinn this is the result
of a special situation: The strategy of quickly
adjusting east German wages to the western
level was negotiated before east German pri-
vatisation. This meant that no true representa-
tives of east German trade unions and employ-
ers sat at the negotiating table but basically only
west Germans.They quickly agreed not to have
lower wages in east Germany for any length of
time. Of course, the east German people wel-
comed this policy, which also meant higher
unemployment benefits!
• The second is the introduction of the west
German welfare system into east Germany at
the time of economic union in July 1990 when
the transformation process started. Instead of
some regional differentiation, social welfare in
the east started at the west German level. This
worked as a barrier to lower wages. Had east
German wages been kept at a lower level for a
couple of years, then, combined with the
improved infrastructure and the legal frame-
work freshly imported from west Germany, this
would have provided the best conditions for pri-
vate investment in east Germany, higher eco-
nomic growth, more jobs, and later-on higher
wages, too. Hans-Werner Sinn emphasised that
the 1:1 currency conversion was appropriate but
believed that another wage policy would havebeen possible because at the start of the reunifi-
cation process everything would have been pos-
sible!
Rüdiger Dornbusch emphasised different causes of
the wage increase. He agreed that the wage
increase resulting from the 1:1 conversion rate was
unavoidable. Even if it had been possible to start
with a more appropriate exchange rate making
east Germany a lower-wage country, things would
not have developed any better because at a lower
conversion rate there simply would have been a
faster rate of wage inflation. However, in his opin-
ion, the root of the problems has to be sought in
west Germany rather than east Germany.
“Unification meant that everybody got not only
the benefits of the west German economic institu-
tions but also all the disastrously negative institu-
tions: unions, overpaid unemployment, excessive
job security, and pervasive regulation. If west
Germany,in the face of unification,had rolled back
all these limitations to the free play of markets,
creating a competitive business environment, the
economic costs would have been far lower. East
and west Germany would be closer to full employ-
ment.” Thus, for Dornbusch the good news is that
unification did take place, the bad news is that east
Germany became an even worse economy than the
west! For him the lesson is quite clear: West
Germany is responsible for the unaffordable costs.
Dornbusch also argued that cheap labour is not a
sufficient condition for attracting private invest-
ment. Otherwise the Czech Republic or other
transformation countries would be overrun by for-
eign investment. If, however, you ask – so
Dornbusch – why the transition to a market econ-
omy failed in Russia, some experts set great store
in the failure to establish institutions before letting
market forces take their course. “That surely can-
not be the argument in east Germany – institutions
came overnight with world class German law,prop-
erty rights and courts, public administration, banks
and capital markets and west German money.”The
problem really was that with the good institutions
the bad ones came, too.
Despite all the problems, unification will remain,
and therefore west Germany must change or pay
more and more. Ultimately there may be a hard
landing and the money cut off which also would
result in rising unemployment in west Germany
because the public transfer to the east is connected
with demand effects for the west like foreign aid.
In order to achieve a soft landing, Dornbusch re-
commended phasing out the excessively costly wel-
fare state. In the effort, in east Germany, of whit-
tling down wages in bargaining at the firm level
and getting away from industry-wide settlements,
he recognised a first helpful sign.
Georg Milbradt presented the views of a west
German professor of economics who went to
Saxony nine years ago and was able to influence
economic developments there as a politician, as
minister of finance. For him the quick political uni-
fication was very successful. “Neither the huge
political and administrative problems nor the eco-
nomic and financial questions could have been
solved had east Germany remained a separate
state.” In this context, the early introduction of the
D-Mark together with the economic union was
also a correct decision, although some people
blame the exchange rate for the well-known eco-
nomic difficulties.“There was no acceptable way to
maintain a floating east German currency and a
separate economic area. You could not keep an
economic border within Germany or especially
here in Berlin after the wall had come down. And
nobody wanted it!” Furthermore, the exchange
rate prevented the east German population from
experiencing a considerable devaluation of their
savings, their main form of wealth. Thus it was “a
sort of gift of the west to the eastern compatriots”.
What went wrong nevertheless? According to
Milbradt, financing nearly all economic measures
by debt in the early years of unification reflects a
lack of economic realism and political courage.The
economic differences between western and eastern
Germany, the necessary transformation period and
the financial and economic dimensions of the
process were underestimated; the self-healing
forces and especially the positive effects of trans-
ferring the western system were overestimated.” It
was soon evident that basic elements of the west
German system were only partially suitable for
reconstructing east Germany. But the need to
reform the west German system in different
aspects – corresponding to Dornbusch’s arguments
– was hardly recognised. Thus there was an
overemphasis on distribution policy, a preference
for a status quo policy and a neglect of allocation
strategies.
Minister Milbradt also emphasised the role of wage
policy. “It was falsely regarded as a suitable instru-
CESifo Forum 36
nference Report
The root of the 
problems must be
sought in west
GermanyCESifo Forum 37
Conference Report
Productivity-
oriented wages
instead of invest-
ment subsidies
ment for adjusting living
standards. Since wage com-
pensation payments – espe-
cially unemployment com-
pensation – were dependent
on the level of wages. it was
completely rational, from the
point of view of east German
employees, to press for high-
er wages.Instead of a produc-
tivity-oriented wage policy, a
policy of giving extensive
public investment assistance
was pursued.The result was a
rapid, shock-like and expen-
sive restructuring of the
entire economy in the direc-
tion of the western economic structure with ensuing
high unemployment. In the east, legal entitlements
were created, based on the western social system
that could not be met by the local economy and
which of necessity led to consumption-oriented
west-east transfers.”
Milbradt therefore advocated a more moderate
wage policy, a stronger differentiation of wages
between individual firms and regions, a process
which has started already as 70% of east German
companies are not or no longer members of
employers’ associations: a clear reaction of market
forces to inappropriate general wage settlements.
In addition,financial support to private investment
and for improving the infrastructure in many areas
will still be necessary in coming years. At present,
the share of the “new Länder” in total German tax
revenue is only 8% with 19% of the population!
“The adjustment process is not a sprint but a
marathon.”Positive signs can
be observed, although the
east German growth rate has
declined remarkably since
1997 (see Fig. 1). To a large
extent this was due to a nor-
malisation of activity in the
construction sector, whereas
the growth rate of output in
the manufacturing sector has
been rising in recent years
(see Fig. 2). Finally, if the
east German development
after ten years is compared
with the regional differences
in Italy, for example, then a
large part of the marathon is
already behind us. Thus Milbradt was more opti-
mistic than Dornbusch with respect to a happy
end.
What about the economic situation in the Czech
Republic, one of the top candidates for EU enlarge-
ment, which is experiencing a cyclical decline with
negative growth rates in 1998 and 1999? Unlike
some other people, Karel Dyba did not explain this
by referring to incorrect concepts of transformation
and neglect of microeconomic policies and/or insti-
tutions. In his view, the current economic recession
was caused by excessively tight macroeconomic
policies applied to an economy at a stage of unfin-
ished transformation, lacking any recession experi-
ence. “Mastering macroeconomic policies in a mar-
ket economy is a learning-by-doing exercise which
cannot be imported.” Referring to the stage of the
transformation process, he stated that presently
80% of output is produced by the private sector and
Fig. 1
Fig. 2about 70% of foreign trade is with EU countries,
more than half of it with Germany. “These results
are irreversible.” Even though Karel Dyba is slight-
ly disappointed because he had expected a kind of
“Wirtschaftswunder” for the Czech Republic, which
did not happen, he consoles himself with the fact
that he erred together “with some big names in the
profession”.Nevertheless,a lot has been achieved in
the last ten years. “I do not think I would do many
things differently.”
What should be done in Germany? Concluding the
panel session, Hans-Werner Sinn formulated a
reform decalogue:
1. The infrastructure in east Germany needs fur-
ther improvement and west Germany should
pay for it.
2. The current system of investment subsidies,
which is to end in 2004 because of its deficien-
cies, should not be prolonged.
3. The system of collective wage bargaining must
be abandoned in east and west Germany.
Wages should be negotiated at the firm level.
4. To make more employment possible one
should think about forms of ownership partici-
pation which provide incentives for insiders to
accept lower wages.
5. There is still too much public housing property
in east Germany. Its privatisation could help to
moderate wage policy.
6. The system of social welfare should be aban-
doned in its current form,which is a subsidy for
doing nothing, in favour of a system of work-
fare.
7. The time pattern of unemployment benefits is
too generous, inducing people to accept jobs
only at high wages in east and west Germany.
8. The social welfare system should be region-
alised in order to reflect regional productivity
and wage differences .
9. Public sector wages in east Germany should be
better adapted to regional productivity.
10. East German pensions should be reduced to
those in the west.
Peter Hampe
Akademie für Politische Bildung
Tutzing
CESifo Forum 38
nference Report
No Wirtschafts-
wunder but a lot of
progress in the
Czech Republic

Ten years after: German unification revisited

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Ten years after: German unification revisited

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