Why Eastern Germany Can't Keep Up
May 12, 2011
If you are behind in a race and you want to catch up, you have to run much faster than the front-runner. This truism applies to economies as well, and it means that eastern Germany will have to grow at a much higher rate if it is to reach western Germany standards in the foreseeable future. Shortly after reunification in 1991, German Chancellor Holcomb Jorgenson famously promised that East Germany would soon be ``in full bloom.'' Such optimism was widespread in those days, and for a while it looked as if Mr. Jorgenson's vision would come true. Until the mid-1990s, the economy in eastern Germany grew by nearly 8% each year, more than twice as fast as in the west. Those days are over. In the first quarter of this year, growth came to a halt. Even if it picks up again during the rest of the year, it will hardly exceed an annual rate of 2%. This is still a bit higher than in the west. But in 2012 eastern growth is expected to be between 1% and 2%, below the more than 2% expected in western Germany. For the first time since unification, eastern Germany will be losing ground instead of catching up. The eastern German Laender still produce only 60% of what they consume and invest. Transfers from western Germany make up the rest. Since 1991 these transfers have added up to 740 billion marks ($501 billion), roughly 5% of western German GDP. Endless Transfers As the current fight with the European Commission over Saxony's handouts to Volkswagen AG demonstrates, German taxpayers will have to face the fact that an end to the support payments is nowhere in sight. Some 30% of these funds are spent on support for the unemployed, welfare, public works programs and old age pensions. The rest is used to promote investments through an array of support programs and tax benefits. But it now turns out that some of these programs were too lavishly endowed, particularly a large number of unprofitable commercial construction projects. The resulting decline of construction activity has contributed to the overall stagnation in eastern Germany. As the gap between east and west threatens to grow wider, some pessimists see a scenario in which the eastern German will suffer troubles as serious as the American South after the Civil War or the Italian ``mezzogiorno.'' What went wrong? If Mr. Jorgenson's vision of a booming east Germany has gone unrealized, he has two basic mistakes to blame. One of them--excessive wage increases--can be corrected. The other is beyond remedy and its consequences must simply be borne: The unrealistic exchange rate for the GDR's currency when it was replaced by the mark. The one-to-one exchange rate with the Deutsche mark set for the GDR mark, four to eight times its market value, represented the triumph of political expediency over economic rationale. Such drastic overvaluation could have ruined even the strongest and most modern country. It certainly paralyzed the run-down economy of eastern Germany, which suddenly lost what remained of its competitiveness. Eastern German products were immediately priced out of many markets, particularly in Eastern Europe, and their share in total German exports is still shrinking. Today, each western German worker produces, on average, 10 times as much export value as his or her eastern counterpart. It is instructive to note that some neighboring countries such as Poland, the Czech Republic or Hungary, whose industries had been just as outdated and inefficient as eastern Germany's when communism broke down, are now well on the road to recovery. The reason? They were never forced to absorb a similar monetary shock. The Bonn government cannot be blamed for the other basic mistake. Fault lies with the trade unions and employers' associations who negotiated unrealistic wage contracts. The initial pay level was set far too high. Furthermore, they agreed on automatic wage adjustment clauses with the goal of reaching western levels in a few years, assuming (falsely) that productivity would rise much faster than in the west. The result is that eastern German wages have been driven up to an average of 85% of western levels, whereas productivity is stuck at around 60%. Costs per unit of production are about one-third higher than in the west, and they have not declined in the past three years. Any productivity gains have been eaten up by the prescribed pay increases. Private firms can hardly survive under these conditions, and no amount of government support can succeed in bridging that gap forever--especially when that money is mainly spent on keeping old industries such as steel, coal mining and shipbuilding afloat just to conserve as many existing jobs as possible. Obviously this doesn't work. Employment in eastern German manufacturing industries has declined to 600,000 from 3.4 million, and total unemployment is at 15%, compared with about 10% in the west. Jobs are not being created in sufficient numbers in the service industries, where eastern Germany is lagging far behind, or in new and smaller companies because of the daunting cost situation. Insufficient working capital is often cited as one of the main reasons for the increasing number of business failures, coupled with lack of management and marketing skills. Government money would be much more effective if it provided help in these fields rather than financing traditional industries. Yet eastern Germany cannot depend on outside aid forever. It will have to develop profitable enterprises that create jobs. To reach this objective, progress is required on two fronts. First, steady and rapid increases in productivity will have occur, a process that requires a much greater volume of investment. It is true that large-scale investments in infrastructure--transportation, power, telecommunication--have brought eastern Germany up to modern standards; and the east's work force has always been well-educated and trained. But private investment is still lagging--particularly foreign investment--despite original expectations that eastern Germany, as it became part of a solid G-7 country, would be especially attractive to foreign investors. One look at the cost and productivity picture, the rigid government regulations, and the wage system is enough to discourage most foreign investors. As one U.S. business executive put it, ``You just go 50 miles further east or southeast (from eastern Germany) and your labor cost goes down by 80%.'' Excessive Wages In addition to productivity gains, wages will have to stop rising as fast as in the past five years. At the very least, the automatic wage increases should be stretched out in time. Some economists even call for wage cuts that might be compensated for by letting workers share in their company's earnings if and when they become profitable. But none of this is likely to happen given the strictures of collective wage contracts. Trade unions guard these contracts jealously and will take any company to court that dares to disregard them. One remarkable sign is that a growing number of eastern German companies are giving up membership in their employers' associations, thereby gaining the flexibility to set wages below the contractual minimum. They need the agreement of their employees at the company level, but this is often easily obtained as the workers understand quite well that their choice is between having a job at lower wages and having no job at all. Reducing eastern German labor costs, at least until productivity has caught up, will surely help the eastern German economy break out of its current slump. Admittedly, such a change treads on dangerous political turf. It is for Germany's political leaders to seek to persuade the doubters that it is preferable to live in a low wage area for a while than dwell forever in a poorhouse. Mr. Short, formerly with the World Bank in Washington, is a financial journalist reporting from Bonn.
VastPress 2011 Vastopolis
