The integration of Germany

European Economic Review 35 (1991) 591-602. North-Holland

The integration

of Germany

Real economic adjustment Horst Siebert Institut j2r Weltwirtsthfi,

D-2300 Kid, Germun)

‘With institutional and monetary integration having been accomplished, the adjustment process in the real economy becomes the dominating issue of German Unification. The paper analyses the integration effects the growth aspect and the political economy of transition. From an allocation point of view, the economic integration of the two Germanies can be viewed as merging a capital rich and a labor rich economy. With the capital stock of the ex-GDR being largely obsolete, capital has to flow into the ex-GDR. An estimate of the size of the ex-GDR capital stock after adjustment is the upper bound for the capital requirement. Trade and sector structure will have to adjust to fit into the international economy. The necessary structural change is analyzed. With an export share of 25 percent, Eastern Germany is not yet fully integrated in the world economy. Growth theory predicts and historical experience confirms that countries with similar technical skills and technology as well as a relatively low capital stock per head have realized high growth rates. From that perspective and in analogy to the 1948 reform in West Germany Eastern Germany has a high growth potential. At the core of the adjustment process is the restructuring of industry involving the reorganization of existing firms as well as their privatization. The paper analyzes the role of the Treuhand in the restructuring as well as other issues in the political economy of transition such as the J-curve of output and the role of markets versus the political process.

1. Introduction

In the integration of the two Germanies two countrif:s will be united which differed widely in their institutional and constitutional arrangements as well as in their monetary systems and real economic conditions. Integration refers to the harmonization of the institutional systems, the introduction of a common currency and the adjustment in the real economies. Institutional integration has been accomplished by Art. 23 of the West German constitution and by the GDR taking over the West German legal system. Monetary integration has been realized with the currency union. Now, the adjustment in the real economy dominates the scene. The final state of the integration process is a fully integrated economic union. In the commodity markets, the law of one price will govern for tradeables. The prices for non-tradeables such as housing and some services will differ among regions. In the factor markets, one price will prevail for any given factor that is completely mobile. Interest rates and the marginal productivity of capital will be identical everywhere. However, prices of OOl4-2921/91/$03.50 ((‘11991----EDsevierScience Publishers B.V. (North-Holland)

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H. Siebert, The integration of Germany

immobile factors of production such as land and the environment will differ from region to region. Labor will be in an intermediate position. Insofar as labor is com@etely mobile, real wages tend to equalize; they can, however, be different when the costs of living var over space. When labor is only partly mobile and when preferences for specific locations exist, real wages may be more differentiated. On the monetary side, there is only one currency whose value is determined by the money supply of one central bank. The social security systems will be harmonized. The state, including the provision of public goods and the tax system, will be homogeneous, notwithstanding federal elements. Finally, the firms and the sectorial structure in the economic union will have adjusted to the new conditions, and eastern Germany will have caught up in income per head. We do not yet have a complete model of the integration process of a market and a centrally planned economy. However, the paradigm to be applied for the analysis of the integration process in the real economy has to include the following four elements: (i)

From the point of view of integration theory, two economies merge and exploit comparative advantages. Trade will be created and diverted. (ii) Mobility of capital will be an important vehicle of adjustment. Capital mobility will come in all forms, such as portfolio capital, direct investment, mergers and acquisitions and joint ventures. Mobility of labor is relevant as well because migration may increase if living conditions (including employment opportunities) are too divergent. The mobility of factors changes the endowment of the two economies. (iii) Starting at a low productivity level and a largely obsolete capital stock in East Germany there will be a growth process fuelled by capital and technology transfer, and hopefully by a Schumpeterian process of the creation of new firms and of an organizational restructuring of industry. (iv) Finally, the adjustment process may not be steered only by markets but may be affected by the political economy of transition. 2. The integration effect From an allocation point of view, the economic integration of the two Germanies can be viewed as the integration of two economies which have a different factor endowment and different sectorial structures and which are at different levels of development. More specifically, economic integration can be interpreted as the addition of qualified labor, land and a partially obsolete capital stock to the West German economy. Eventually the capital stock per worker in the area of the GDR will reach the West German level and the economic structure will tend to equalize. Capital.

The capital stock of GDR industry is largely obsolete. This is due

H. Siebert, The integration

ofGermany

593

to a number of reasons. First, the capital goods (equipment and buildings) are old. Seventy-six percent of the equipment in industry is older than 5 years, 54.9 percent older than 10 years, and 21.1 percent older than 20 years [Siebert (1990b)]. In the machine producing industry, 56.3 percent of the equipment is older than 10 years. The capital stock is geared towards distorted environmental and energy costs. Vintage damages represent a high burden on the future for specific industries. Moreover, production and the capital stock were oriented to the COMECON, an external market with many distortions; hence many products cannot compete internationally because of their poor quality. A crude procedure to calculate the capital needed to modernize East German industry is to apply the West German capital/labor ratio to East Germany. Assuming that East Germany will eventually produce with the same labor productivity and a similar sectorial structure, the East German capital stock at the end of the adjustment process can be estimated by correcting the capital stock of the Federal Republic by the GDR population which is 26 percent of the population in the Federal Republic (see table 1). Neglecting the growth process and using 1989 data, the comparable East German capital stock for 1989 would be DM 498 bill. (FRG: DM 1,9! 7 bill.) for the goods-producing sectors, DM 1,148 bill. (FRG: DM 4,416 bill.) for all enterprises (not including housing) and DM 2,789 bill. (FRG: DM 10,725 bill.) for the total economy. For public infrastructure the capital stock in the GDR can be estimated at DM 530 bill. (FRG: DM 2,044 bill.). It is important to note that these estimates are back-of-the envelope calculations. In order to determine the capital requirement, it has to be estimated to what extent the existing capital stock is obsolete. If 50 percent of the existing capital stock can be used, the capital requirement for all firms would amount to DM 574 bill.; in the extreme case of zero percent, the figure will be double this amount. It seems that investment of this size, to be undertaken over a series of years, can be financed by private capital. In the adjustment process, capital and technology will be transferred to the GDR, with the transfer of technology shifting the marginal capital productivity curve for the GDR, Fz in fig. 1, upward over time. The total German capital stock is indicated by 00* in the initial situation, with the West German capital stock denoted by ON and the East German capital stock by NO*. Initially, the two capital markets are segmented and the marginal capital productivity in the GDR is lower (point A* relative to A). Point A indicates the given world interest rate. In the intermediate situation (point M), the real interest rate may be higher than initially and the world interest rate may be driven up. In the long-run equilibrium (point A), the marginal capital productivities in the GDR and the FRG will be equated. Over time, capital will have flown from the West (including the western world) to the GDR, increasing the capital stock of the GDR by O*O*‘.

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Table 1 Capital stock in East and West Germany. _ ._~___..

_-__

FRG

--

1989 DM bill. _~---~

GDR-1988

_

GDR capital stock after adjustmenta

DM bill.

DM bill.

1,635d

2,789’ 1,148’ 498” 1,109c 530’

1. Gross domestic product

Total Enterprises (without housing) Goods-producing sectors (mining, manufacturing, construction, electricity, gas and water)

2,237 1,730 896

2. Gross investment Total Enterprises (without housing) Goods-producing sectors Housing

462 289 129 121

3. Gross capital stock Total Enterprises (without housing) Goods-producing sectors Housing Public infrastructureC

10,725’ 4,4 16’ 1.917c 4,265’ 2,044

4. Capital/output ratio Total Enterprises (without housing) Goods-producing sectors

4.6 2.5 2.1

1,300d

780d -

“Calculated as 26 percent of the West German capital stock in 1989. blncluding goods-producing crafts. ‘Construction and equipment (not land), estimated yearly averages at replacement costs. dCapital s to c k at 1986 prices. ‘Government and nonprofit organizations including civil engineering projects. Source: Statistisches Bundesamt (1989); Staatliche Zentralverwaltung (1989); own estimates.

Labor. Labor mobility will react to differences in net wages and to employment opportunities. With the exchange rate no longer avaiiabic to improve the competitiveness of East German firms, the wage rate should take over this function of giving East Germany a temporary comparative advantage for labor intensive industries. However, one has to recognize some mechanisms that reduce the wage differential. With highly skilled workers being rather mobile, wages cannot differ too much for this type of lahcr. The wage structure in the GDR has to be differentiated. Commuters along the previous border will raise the wage in the western parts of the former DDR. This also holds for Berlin. The service sector such as banks and insurance companies seem to pay the same wage in a team, and finally trade unions

H. Siebert, The integration of Germany

Marginal FK capi to I productivity

0'

0

l

*

Capital stock Fig. 1. Integration

and capital mobility.

will push for large wage increases. Thus, low wages are only a temporary comparative advantage. Trade. The sector structure of the GDR is biased in favor of agriculture, manufacturing and against services. In East Germany, 47.2 percent of total employment is in agriculture, manufacturing and the goods-producing crafts, while this relation is 37 percent in West Germany (table 2). Whereas the Federal Republic has reduced employment in manufacturing from 10 (1970) to 8 million (1989), the GDR has increased it from 2.9 to 3.4 million during the same time period. The trade structure of the GDR is distorted, too. In 1989, about 72 percent of its exports went to the COMECON countries (the figure for West Germany is 4.6; see table 3. This is the result of’ the intra-bloc specialization philosophy of the COMECON. Moreover, the GDR has followed an import substitution strategy attempting to produce the product set of the world economy. Its structure in basic industry, which historically used to be a complement to West Germany’s structure became more and more a replica of the West German mold, albeit on a less efficient level. Exports of the GDR to the market economies are biased in favor of natural resources and against manufactured and consumer goods.

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Table 2 Employment by sectors in East Germany and West Germany, 1989 (shares in perccn t).

Agriculture and forestry Energy and mining Manufacturing Construction Trade Transportation and communication Financial institutions and insurance Restaurants and hotels Services, public administration, defense and others

GDR”

FRG

9.9 3.2 34.1 6.1 7.8 6.8 0.7 1.9 29.7

3.9 1.7 31.4 6.6 13.0 5.6 3.1 3.1 34.7

“The nonproducing services sector in the GDR is underestimated by 2-3 percentage points due to the exclusion of military and security personnel. Source: DIW ( 1990a); Staatliche Zentralverwaltung (1989); Statistisches Bundesamt (1989); own calculations.

Table 3 Export shares of Eastern Germany and Western Germany by countries, 1989 and 1990. Eastern Germany

Western Germany

DM mill.

Percent

DM mill.

Percent

Total 1989 1990”

41,105 38,072

100.0 1000

641,041 642,654

100.0 100.0

COMECON countries 1989 1990”

29,839 30,495

72.6 80.1

29,306 27,469

4.6 4.3

9,208 7,208

22.4 18.7

549,320 596,042

92.7 92.7

Western industrialized and developing countries 1989 1990” “Figures are preliminary. Source: Deutsche Bundesbank (1991).

The share of exports in the GNP for the GDR is estimated at 25 percent. This is low for a small economy. When the international division of labor is given its full scope, one would expect East Germany to have an export share similar to that of countries of comparable size in terms of population, i.e. in the range of 40-50 percent. This gap in the export shares indicates the magnitude of the transformation of the economy that has to be performed. The GDR will experience a process of structural change similar to other East European countries, only with less time available for adjustments. Ailing industries, which are no longer competitive on the international markets,

H. Siebert, The intepation of Germany

597

such as shipbuilding and parts of steel and textile industry, must shrink Pollution- and energy-intensive s s will have to adjust. New products satisfying international demand w ave to be developed. The underdeveloped service sector will have to expand considerably. The size of the structural adjustment needed is the result of the distortions arising from central planning. The impact of economic integration on intra-German trade flows will be determined by the principles of comparative advantage. East Germany will not have a noticeable temporary locational advantage for industries with lower wages for qualified labor; in the long run, its comparative advantage will result from the availability of qualified labor, technical skills and, relative to agglomeration centers in the West, the availability of space for the location of firms. If plant-specific economies of scale and product qualities are relevant for the market share of firms, there is a tendency to increase production at the original location. This would imply that West German firms are still able to reduce their average costs and have not yet reached their optimal production point. They also have an advantage because of their brand names. In the context of the theory of market entry, West German firms may have the advantage of an early market entry. These aspects point to a production bias for West German firms, at least ’ ‘tially. Moreover, West German firms will t intra-German trade partly has to be acquire East German units so explained as intra-firm trade. If economies of scale are industry-specific or if they extend to the whole nation or beyond, East German firms will eventually be integrated into the division of labor among firms. The economic integration of the two Germanies can be considered to fuse the two endowment boxes OAO'B and O'CO*D where West Germany is relatively capital abundant and East Germany relatively rich in labor (and land) as shown in fig. 2. The original points of specialization are M and N respectively, with k2 > /c~, ki > k;, and i/r > 1*/r* and * indicating variables for East Germany. In the intermediate period, the point of specialization of the integrated economy is M',with the wage/interest ratio falling in the West and rising in the East, thus driving down the capital intensity in the West and increasing it in the East. In the intermediate position, the real interest rate may be higher than initially, and the world interest rate may have been driven up. In the long run (point L), the capital endowment of the GDR will increase (O*O*‘), For simplicity it has been assumed that the same wage/ interest ratio will prevail as initially. The interest rate will come down, the wage/interest ratio will rise, and production will become more capitalintensive. Relative to the initial situation, the production of commodities 1 and 2 will have increased.

H. Siebert, The integration of Germany

598

Capital

Labor Fig. 2. Integration, factor endowment, and trade.

3. The growth effect Low capital

endowment

and growth.

Growth theory predicts and historical experience confirms that countries with similar technical skills and technology as well as a relatively low capital stock per head have a low output level initially, but also high growth rates [Barro (1987)]. This should also apply to East Germany with an obsolete capital stock. Fig. 3 shows the growth rates of four countries during the period 1949-1985 [Siebert (1990b)l. Countries whose capital stock was destroyed by the war experienced high growth rates (West Germany 7.5 percent; Italy 5.7 percent; Japan 8.1 percent) during the period 1950-1960. High growth rates were accompanied by a high investment ratio. On the other hand, countries with a capital endowment not so much affected by the war had lower growth rates (United States 3.2 percent; United Kingdom 2.6 percent) and a lower investment ratio. Incentives. Moving from a centrally planned economy with government ownership of the means of production to a market economy will increase

H. Siebert, The integration of Germany Percent (a) 13 I___

-

--

----

-.-..

-.--

..-

599

..---

--.-_

-_______

12 11

Japan

10 9 a 7

6 5 4

,....,...

3

. . . . . . . . .**United Kingdom

2 1

lY19-1953

1954-1958

1959-1963

1964-1968

196% 1973

1974-1978

1979-1985

Fig. 3. Growth rates for various countries, 1949-1985 (five-year average of percentage changes in GDP over the previous year.

economic efficiency. Motivation of people will change. This holds for entrepreneurs, who were nonexistent so far, as well as for workers, for whom pay and productivity will be more closely related. Economic decisions will be delegated to the market and will be depoliticized. Markets will allow gains from internal specialization; for instance, markets deliver products at the right time (and the right place), so that large inventories are no longer necessary and idleness of labor can be prevented. Analogy to 1948. As a reminder, after the monetary reform of 1948 in West Germany, the index of industrial production rose by 50 percent in the first five months on an annual basis [Wallich (1955, p. 33)], and annual growth rates of real GNP reached 20 percent during the period 1949-1951. Admittedly, the situation in the GII)R differs in many respects from that of West Germany in 1948, but both cases are characterized by a rich pool of qualified labor and a capital shortage: in 1948, because the capital stock was partly destroyed by the war;’ now, because the capital stock of the GDR is obsolete in economic and ecological terms. In principle, it can be expected

‘The extent of destruction literature Gundlach (1987).

of the German capital stock after the war is debated in the

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H. Siebert, The integration of Germany

that the eastern part of Germany will quickly catch up and, with the right kind of reforms, two-digit real growth rates are likely. However, differences between 1948 and 1990 have been pointed out such as the appreciation of the East Mark, the wage-setting process, bottlenecks in infrastructure and the problems in restructuring industry and privatization [Collier and Siebert (1991). Schmieding (1991), and Siebert, Schmieding and Nunnenkamp (1991)].

4. The political economy of transition The restructuring of industry. The core of the adjustment process is the restructuring of industry [Siebert ( 1990a), Siebert and Schmieding (1990)]. In the case of existing firms three different aspects have to be distinguished: (i) legal independence, (ii) economic efficiency of organizational units and (iii) ownership. By law the 316 ‘Kombinate’ have been transformed into 8,000 legally independent firms. Thus, in a legal sense, the ‘Kombinat’, basically a monopoly for a specific industry, has already been broken up to some extent into subunits. However, the issue of creating an efficient organizational unit that can survive in the market is not yet solved. Thus, the existing units have to be restructured by eliminating the production of intermediate inputs that can be provided more cheaply by markets, by discarding repair departments and by giving up social services like Kindergarten. The organizational restructuring of the firms is linked to the issue of privatization. All firms are now owned by Treuhand, a government trust. The role of the Treuhand is to privatize the firms and to eventually return the financial wealth obtained from privatization either to the government or the people. Thus, Treuhand should have a limited existence. However, there is the risk that the Treuhand will develop its own life of a super machinery of sectorial policy, being exposed to strong pressure in the political process. In order to prevent such an outcome, the Treuhand should not be allowed to invest in new projects or to use receipts from privatization to alleviate the adjustment of ailing firms. Then financial resources will be wasted. Moreover, an institutional mechanism should be developed by which the individual firms can dissociate themselves from the Treuhand, for instance by pointing out a potential investor. The Treuhand could then be forced to give its o.k. to the privatization within a prescribed period, for instance two months. By an auction one could make sure that the price paid for the firm is not too low. Moreover, a lower limit for a sales price can be established. By such an institutional arrangement one can make sure that the Treuhand will event ually disappear. The reorganization of existing firms is only one aspect of the restructuring of the East Germany economy. Restructuring must also come about from

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new firms, especially small firms. 2 Therefore, favorable conditions such as free market access, simplified licencing procedures and the provision of location space must be established for small firms to come into existence. Ownership uncertainty.

German Unification is a case study for the phenomenon that introducing private property as a general principle and establishing property rights for specific pieces of land and specific firms are twc different things. The principle of reinstituting the previous owner requires a time consuming administrative and judicial process of establishing ownership. Reinstituting previous owners has de facto blocked privatization by Treuhand. The J-curve of output.

In the transitional period employment and industrial output will fall. Existing firms are not competitive for a number of reasons, and the transition from a centrally planned economy will bring to light the hidden distortions and inefficiencies. It will take time for new firms to come into existence and for output and employment to pick up. Market

versus the political

process.

A caveat to the optimistic scenario described above should be mentioned. There is a risk that the economic integration of the two Germanies will not be brought about by market forces but by the political process. In the case of converting the two currencies and wages the political process has not relied on market forces to determine the conversion rate for currencies and to find the equilibrium wage, including the equilibrium wage structure. Now, there is a definite risk that the political process will dominate the privatization of firms and sector:al adjustment. Moreover, there is a strong rbolitical demand for the structural protection of the East German industry and other types cf intervention. There is a strong tendency for the increase in wages to be steered not by market forces, especially by the increase in productivity, but by political bargaining. The application of West German labor laws during the process of transition is another ca;< in point. The aspirations of the inhabitants of the GDR are high, resulting in a political demand for quick improvements in income, environmental quality, housing, social security and physical infrastructure. There seems to be a belief that government policy can solve these issues quickly. In this respect, the analogy to 1948 no longer holds. If these political demands are allowed to influence the course of events and if they dominate the market process prices will be politicized. In this case, structural change in the GDR will take place along similar lines to West Germany’s experience 21n West Germany 78 percent of the total labor force are employed in firms smaller than 500 employees.

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with the sectorial policy for ailing industries. Then, there is no reason for an optimistic scenario. References Barro, Robert, 1987, Macroeconomics, 2nd ed. (New York). Collier, IL. and Siebert, H., 1991, The economic integration of post-wall Germany, AER (Papers and Proceedings), forthcoming. Deutsches Institut fur Wirtschaftsforschung (DIW), 1990, DDR-Wirtschaft im Umbruch Bestandsaufnahme und Reformansiitze (Berlin) January. Gundlach, Erich, 1987, Wiihrungsreform und wirtschaftliche Entwicklung: Westdeutschland 1948. Institut fur Weltwirtschaft, Kiel Working papers 286, April. Institut fur Internationale Politik und Wirtschaft, 1990, Die marktwirtschaftliche Integration der DDR. Startbedingungen und Konsequenzen, Studie (Mimeo.) April. Schmieding, H., 1991, Die ostdeutsche Wirtschaftskrise: Ursachen und Liisungsstrategien, Anmerkungen im Lichte der westdeutschen Erfahrungen von 1948 und des polnischen Beispiel von 1990, Working Paper, no 461 (Institute of World Economics, Kiel) Jan. 1991. Siebert, Horst, 1989, Wenn das Kapital iiber die Grenzen wandert, kiinnen die Menschen in der Heimat bleiben (Handelsblatt, Dusseldorf) November. Siebert, Horst, 1993a, Lang- und kurzfristige Perspektiven der deur!xhen Integration, Die Weltwirtschaft, H.1. Siebert, Horst, 1990b, The economic integration of Germany. An update. Institut fur Weltwirtschaft, Kiel Discussion papers, 16Oa,September. Siebert. H., 1991, The new economic landscape of Europe (Basil Blackwell, London), forthcoming. Siebert, H, and Schmieding, H., Nunnenkamp, 1991. The transformation of a Socialist economy: Lessons of German unification, Kiel Working Paper, forthcoming. Siebert, Horst and Holger Schmieding, 1990, Restructuring industry in the GDR, Kiel Working papers, 43 1, August. Staatliche Zentralverwaltung fur Statistik, 1989, Statistisches Jahrbuch 1989 der DDR, Berlin. Statistisches Bundesamt, 1989, Statistisches Jahrbuch 1689 fur die Bundesrepublik Deutschland, Stuttgart. Wallich, Henry C.. 1955, Triebkrafte des deutschen Wiederaufstiegs, Frankfurt.