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Economic consequences of German unification.

After describing the steps toward unification of West and East Germany, the author compares and contrasts the economic status of the two countries. The problems involved in the transition to one economy are considered, and the fiscal costs and inflation risks of unification are described. The author concludes that the differences between the two countries are surmountable and that, with financial support from West Germany, the medium-term outlook for East Germany is bright, especially as a bridge to other countries in Eastern Europe.

STEPS TOWARD UNIFICATION

The peaceful revolution of the East German people during September and October 1989 was made possible by the Gorbachev era of perestroika. When Hungary opened its border with Austria, permitting an exodus of East Germans to West Germany, it hastened the events that led to the demise of state and party chief Honecker, to the breaching of the wall in mid-November and to the first free elections in March 1990.

On February 7, 1990, Chancellor Kohl offered a monetary union with the introduction of the DMark in East Germany, conditional upon simultaneous economic reforms. This proposal came as a surprise to most, including Bundesbank President Pohl, who had favored a slower pace with two currencies during a transitional period. Existing large productivity differentials should be smoothed by the exchange rate. According to this view, a common currency would presuppose a common price level, but not a common productivity level; therefore, currency union would imply closing the income gap by massive transfer payments from West to East Germany. The Council of Economic Advisers had also recommended a fixed exchange rate between the GDR-Mark and the D-Mark, with external convertibility of the GDR-Mark a near-term goal. These proposals for a slower pace and a retention of the exchange rate as an instrument of adjustment between the two Germanies, with the implementation of an intra-German currency union only as a final "crowning act," were reasonable from a purely economic point of view. But they did not consider that the tide of emigration could only be slowed by a faster move towards unification.

Mass demands in East Germany for a termination of communist rule, for German unification and the immediate introduction of the D-Mark as a symbol of economic liberty and prosperity, the continuing exodus of the people to West Germany, the imminent collapse of economic order and the growing circulation of the D-Mark as a parallel currency in East Germany more or less forced the Federal Government to offer the currency union as a vehicle of fundamental economic reform and political unification.

On May 18, 1990, the governments of the Federal Republic and the GDR signed the state treaty on establishing an economic, monetary and social union to become effective on july 1, 1990. Given the partly conflicting targets of minimizing the risk of inflation, strengthening the competitive position of the East German business sector, containing budgetary cost and satisfying the high expectation of East German population, the rates for converting East German marks into D-Marks were seen as a compromise (general conversion rate for financial assets and liabilities of one D-Mark for two East Marks, preferential rate of 1:1 for limited amounts of private savings and for contractual payments such as salaries, wages and rents).

Together with the currency union, an economic union was established that introduces in East Germany the legal framework for the market-based economy as it exists in West Germany.

In addition, on May 16 the West German federal and state governments agreed on establishing the German Unity Fund in support of East Germany, totaling DM 115 billion to be transfered to East Germany during the coming four and one-half years.

The last step towards unification is political unification, which was originally envisaged for December 1990 after a common election but has been advanced.

THE UNEQUAL BROTHERS

East Germany, with a population of 16.4 million people at the end of 1989, occupies an area of 100 square kilometers. This corresponds to 27 percent of the population and 44 percent of the area of West Germany. In the north, East Germany borders on the Baltic Sea, in the west on West Germany, in the south on Czechoslovakia, and in the east on Poland, where the border runs along the Oder and Neisse rivers.

In spite of the many problems caused by central planning and its obligations within the Comecon, East Germany has achieved a remarkable standard of living, especially when compared to the other East-bloc countries. But like these, it did so at tremendous environmental costs. Although exact comparisons are difficult because of the scarcity, distortion or falsification of East German data, differences in the composition and the quality of the market basket, the poor quality of the infrastructure, and the unrealistic previous exchange rate visa-vis the dollar, East Germany ranks about seventeenth in the world in terms of per capita income, thus in the neighborhood of Portugal.

When compared to West Germany, the standard of living in East Germany is drastically lower. This may be illustrated by households' ownership of durable consumer goods: About half of all East German households own a car and a color television set, compared to 68 percent and 87 percent, respectively, in West Germany. Only 16 percent possess a telephone, whereas a telephone is in almost every West German household. In East Germany there are 27 square meters of living space per person, a rather high figure by international standards and not that much lower than in West Germany, where the figure is 38 square meters. The quality of East German housing is inferior, however, as 42 percent was built before 1919, and 29 percent still lacked private toilets at the end of 1988.

The economic potential of the GDR permits a much higher standard of living and a much higher growth path. Labor has an above-average level of skill, but industry lacks a modern capital stock.

The traditional industrial sectors still contribute most to national income. They also employ most of the labor (see Table 1). A total of 4 million people work in the mining, energy, manufacturing, and construction sectors, almost half of the labor force. The number of people still employed in agriculture and forestry is relatively high, although low productivity makes for a markedly lower share of value added here. East Germany has deficiencies in all services, especially in modern services, which excludes it most clearly from the group of highly developed countries.

The structure of the industrial sector is very similar to that of West Germany (see Figure 1). It is dominated by mechanical engineering, chemicals, electrical engineering, precision tools and optics. One of the largest branches of industry in East Germany - like in West Germany - is mechanical engineering; most of its output is exported to the Soviet Union. Of great importance is the chemical industry, which has achieved inglorious fame by what it has done to the environment. This also applies to the energy sector, because four-fifths of East German energy demand is met by lignite-based power plants.

In 1988 East Germany's exports totalled $32.2 billion, while its imports amounted to $31.1 billion. Accordingly, the value of East German trade corresponds to one-tenth of West German trade and a little more than I percent of world trade.

State trading countries accounted for about three-quarters of East German trade (exports plus imports) in 1988, with the Soviet Union ranking in first place with about 40 percent of total East German trade. According to OECD statistics, trade with West Germany, as the major western trading partner of the GDR, has a share of almost 15 percent.

With the unification, Germany's population will be almost 80 million or about a quarter more than the present population of West Germany. But with its low living standard East Germany will add only one-tenth to West Germany's gross national product. Germany, already the largest economy in terms of GNP in Western Europe, will be somewhat larger - about the size of France, the Netherlands and Belgium together. This does not suggest, however, that a combined Germany will dominate Europe. In fact, with the EC integration more and more areas of economic policy will be shifted to the EC level.

Unification is saddling the German economy with a serious regional development problem, and, with the lower living standard of East German citizens, unification will push the average German living standard back into line with that in other large European countries. The average income per head in the united Germany (as measured at purchasing power parity) will at the start be somewhat lower than in France, United Kingdom and Italy.

SHORT-TERM RISKS

Recent economic developments in West Germany and in Western Europe as a whole are supportive to overcome the transitional problems of the East German economy. Demand conditions are favorable and capacity utilization is high, providing a good chance that more and more western-based firms will extend their operations by new investment in East Germany. There land and skilled labor are available at a still relatively cheap price. Nevertheless, in the first stage of the restructuring process, high unemployment is unavoidable in East Germany. The decline of the East German economy started months before the beginning of the currency union. During the first half of 1990, industrial production declined by about 7 percent, caused by political and economic uncertainties, emigration of labor, strikes and the disintegration of the central planning system.

After the start of the currency union and the official ending of socialistic planning on july 1, the decline of the economy continued. Unemployment increased in july to 270,000 (3.4 percent of the labor force) and the number of short-term workers increased to 660,000 (8.3 percent of the labor force).

In economic terms, the latter to a large extent have to be added to the official number of unemployment, because they are still on the payroll of the firm without continuing work. Obviously unemployment, which was hidden in the old system, now becomes open. In addition new unemployment arises as firms have problems adjusting to the new situation. The process of demolition of old jobs and creation of new jobs does not develop in a synchronous way.

Consumer prices in East Germany have in the past been highly distorted by state intervention; food prices have been subsidized and consumer durables have been burdened by excises. Before the currency union, prices for some consumer goods (textiles, consumer durables) were reduced.

After the introduction of the D-Mark, prices for consumer durables and for foodstuffs of western origin declined further while prices for basic food increased with the ending of subsidies. Taken as a whole, the purchasing power of the average East German citizen increased with the currency union.

Compared to the precurrency union situation, average cost of living declined and nominal income increased, leading to substantial positive effect on real income. Contractual income (rents, wages and salaries) was converted 1:1. As for rents, a more favorable calculation system was adopted, and wages and salaries for key industrial sectors were increased substantially with the first wage round. The higher demand for goods and services for East German citizens is directed to a large extent towards West German or other western suppliers.

The net demand impact for the West German economy stemming from East German purchases is estimated to be about DM 20 billion during the second half of 1990 and about DM 40 billion during the year 1991. About one-third of this demand is due to tourism of East German citizens.

West Germany's real GNP is expected to be increased by higher demand from East Germany by 1/2 percentage point and 1 percentage point to 4 percent and 3 1/4 percent in 1990 and 1991, respectively. The present difference between overall demand and domestic production of East Germany is financed by high public transfers from West Germany.

This raises three questions:

1 .What are the consequences of the high cost of unification on West Germany?

2 .Is there an inflationary risk when demand is growing and production is declining in East Germany?

3. How long will the transitional period with high unemployment in East Germany continue and what are the medium-term prospects?

FISCAL COST OF UNIFICATION

With the German Unity Fund (total amount of DM 115 billion during 1990 to 1994) the West Germany federal and states' governments are granting budgetary aid to East Germany. About 80 percent of this Fund is financed by increasing public debt of West German federal and state authorities. In order to cover fully public spending and low tax revenues in East Germany, additional borrowing is needed by the East German government. Taken as a whole, the overall deficit of all budgetary levels (including the social security systems) of both parts of Germany could reach DM 70 billion in 1990 and DM 80 billion in 1991 or 21/2 to 3 percent of total gross national product or 40 percent of private domestic savings. Given the high risks about short-term development in East Germany, this cost may still be a conservative estimate. In comparison with the recent past, the size of the budget deficit is large (West Germany reached a small budgetary surplus in 1989 in the definition of the National Accounts). The already high level of long-term interest rates will continue for some time, and some crowding out effects will occur with adverse effects on private housing investment.

Nevertheless, given high private savings and the still-high current balance surplus and a high capital import potential, these financial problems of unification appear to be surmountable.

INFLATIONARY RISKS

In contrast to some fears by international economists as expressed early in the year, most forecasters now discard the risk of high inflation in Germany resulting from unification. But some acceleration of the actual inflation rate of 2.5 percent to 3.5 percent can be expected for the near future, of which 0.5 percent could be due to higher demand pressure caused by unificiation. Optimism about a continuation of internationally low price inflation is based on the fact, that since july 1, 1990, the West German National Bank (Bundesbank) has all central banking functions for the whole D-Mark currency. Operating through its own branch offices in fifteen East German cities, the Bundesbank exercises full monetary control over the East German economy. The Bundesbank is prepared to continue its cautions monetary policy, which has helped in the past to keep inflation under control.

MEDIUM-TERM OUTLOOK

There is much uncertainty how fast the East German economy will adjust to the new situation. Much will depend on direct investment from West Germany and from other industrial countries and on new foundations of small and medium-sized business. Much activity is already underway. Three-quarters of the 12,000 firms nationalized in 1972 want to be privatized again, about 100,000 small firms have been founded up to the end of july, and much direct investment, mainly from West Germany, is already starting in many sectors. The bulk of new investment goes at present to the service sector (banking and insurance services, retail sales, tourism, and restaurants).

There are prominent examples for new production lines of West German investors. Given the low levels of productivity and of the living standard on the one hand and the availability of skilled labor and the substantial financial support by West Germany on the other, the medium-term outlook for the East German economy is bright. Assuming a high rate of capital formation for the private sector and for public infrastructure, the process of "catchup" with the West German economy could be fast. The speed of this adjustment process will also depend on the future economic development of Eastern Europe, including the Soviet Union. Given the depressed starting level, it may take at least a decade until the level of productivity and the average living standard in East Germany come close to West German levels.

CONCLUSION

The pace of German unification has been astounding. Concerning the economic impacts this unification creates hopes and uncertainties: hopes about an enlarged dynamic European market with a better bridge to the East, uncertainties about inflationary risks, new social problems in East Germany and fears that a larger Germany could dominate European economies.

Proposals for a slower pace of unification, which have been made by most economists and also by the Bundesbank, were reasonable from the purely economic point of view. But they did not consider that the tide of emigration forced a faster pace. Due to the big differences between both parts of Germany, there are short-term risks especially for the labor market in East Germany. However, they appear to be surmountable. Given the low levels of productivity and of the living standard, combined with a high availability of skilled labor in East Germany on the one hand and the substantial financial support by West Germany on the other hand, the medium-term outlook for the East German economy is bright, especially as it could serve as a bridge to other countries in Eastern Europe.

* Willi Leibfritz is Head of the Department for Macroeconomics and Public Finance, IFO Institute for Economic Research, Munich, West Germany.
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Author:Leibfritz, Willi
Publication:Business Economics
Date:Oct 1, 1990
Words:2852
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