V East Germany The New Wirtschaftswunder?
Author:
International Monetary Fund
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Language:
English
Print Publication Date:
04 Dec 1990
Keywords:
OP; government; deutsche mark; Germany; enterprise; productivity gap; investment ratio; saving-investment perspective; government investment expenditure; Unemployment; Wages; Income; Extra-budgetary funds
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Abstract

The regional imbalances that characterize many advanced industrial economies have long frustrated economic policymakers. The large gaps in our understanding of these imbalances prompt the question: Will the evolution of the east German economy over the next decade reveal a new economic miracle—Wirtschaftswunder—or the emergence of another regional problem within the European Community? On the one hand, the saving surplus in west Germany provides a large pool of resources from which the investment needs of east Germany can be financed. Moreover, the tradition of enterprise in the eastern part of the country was strong before World War II and it may be possible to revive this tradition quickly, despite its long suppression by the system of central planning. On the other hand, given the present dearth of capital in east Germany, it will be some time before west German wage levels can be supported in the east without large-scale subsidies or substantial unemployment. This creates obvious tensions. While a slow closing of the earnings gap might result in a migration of the most skilled to the west, a premature narrowing of the gap could well discourage investment; either might endanger the process of economic recovery in the east.

Donogh McDonald and Günther Thumann

Introduction

The regional imbalances that characterize many advanced industrial economies have long frustrated economic policymakers. The large gaps in our understanding of these imbalances prompt the question: Will the evolution of the east German economy over the next decade reveal a new economic miracle—Wirtschaftswunder—or the emergence of another regional problem within the European Community? On the one hand, the saving surplus in west Germany provides a large pool of resources from which the investment needs of east Germany can be financed. Moreover, the tradition of enterprise in the eastern part of the country was strong before World War II and it may be possible to revive this tradition quickly, despite its long suppression by the system of central planning. On the other hand, given the present dearth of capital in east Germany, it will be some time before west German wage levels can be supported in the east without large-scale subsidies or substantial unemployment. This creates obvious tensions. While a slow closing of the earnings gap might result in a migration of the most skilled to the west, a premature narrowing of the gap could well discourage investment; either might endanger the process of economic recovery in the east.

To highlight some of these issues, this chapter presents scenarios for east Germany during the first 11 years of unification (1991–2001) under alternative assumptions as to how quickly the productivity gap between east and west Germany is narrowed.1 The scenarios take as their starting point a profile of the economic situation in east Germany in the second half of 1990, incorporating official fiscal projections and the assumption that, immediately prior to German economic, monetary, and social union (GEMSU), underlying labor productivity in the east was about 30 percent of the level in west Germany. The growth rates required in the east to narrow the productivity gap over the next decade depend not only on the size of the initial gap but also on the increase in labor productivity in west Germany; it is assumed that labor productivity in west Germany will increase at about 2½ percent a year or cumulatively by close to one third between 1990 and 2001.2

To provide some perspective on the present size of the productivity gap, Table 1 contains information on productivity differences between regions of the Federal Republic of Germany (FRG) in 1987.3 The Länder in the FRG are arranged into three groups, ranked according to output per capita and productivity levels. The third ranked group (comprising Rhineland-Palatinate, Lower Saxony, and Schleswig-Holstein), which had a population of some 13 million in 1987, had an average productivity level about 13 percent below that of the FRG as a whole and 18 percent below that in the other eight Länder.

Table 1.

Federal Republic of Germany: Regional Profile of Output and Employment, 1987

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Source: Statistisches Bundesamt, Statistisches Jahrbuch, 1989.

Population and labor market data as of May 25, 1987.

Against this background, two scenarios for east Germany are illustrated (see Chart I).4 In scenario A rapid growth boosts productivity levels in east Germany to 80 percent of the west German level by the year 2001. Unemployment is initially high—one fourth of the labor force in 1991—but falls rapidly and by the end of the scenario is at about the same level (6 percent) as in the baseline scenario for west Germany. The investment needs in this scenario are large: In 1991–92 gross investment averages DM 110 billion a year (43 percent of GDP).5 This investment is financed entirely by external resources (i.e., resources from outside east Germany, including fiscal transfers from west Germany); indeed, external resources amount to about 150 percent of net investment. Over the period 1991–2001 as a whole, total net investment is of the order of DM 1¼ trillion, equivalent to two thirds of west Germany’s net national product in 1990, with three fourths of this net investment financed from outside east Germany.6 The declining recourse to external saving over time reflects, in part, falling investment requirements in relation to output, but, more important, a rising saving rate. Private saving increases, but the principal source of the stronger external position is the improvement in the government accounts. The general government deficit in the east is initially very large (50 percent of GDP in 1991), principally on account of substantial government dissaving. Over time, the deficit drops steadily, with a small overall deficit and a primary budget surplus by the end of the scenario.7

Scenario B is less optimistic, with productivity in 2001 only 60 percent of that in west Germany and migration from east to west occurring on a much larger scale. The weaker economic performance results from lower investment and a slower reduction of inefficiencies in the use of labor and capital. Net investment in 1991–92 is only 60 percent of that in scenario A, and this relative weakness of investment persists throughout the scenario as the initial hesitancy of investors is reinforced by aggressive wage demands and by ingrained structural weaknesses in the economy. The fiscal imbalance declines more slowly than in scenario A as low growth restrains revenue and boosts social expenditure relative to GDP; by the end of the scenario the primary fiscal deficit in east Germany is of the order of 9 percent of GDP. Larger accumulated deficits also increase interest payments.8 Given these fiscal developments, the imbalance in the external accounts throughout the scenario is also much larger than in scenario A.

Scenarios A and B are discussed in greater detail in the following sections. In interpreting these scenarios, one should bear in mind the uncertainties surrounding the initial conditions in east Germany, the likely response of foreign investors, prospective migration patterns, the ability of east Germany to absorb large-scale investment (particularly in the initial years of GEMSU), the policy and institutional framework, and the behavior of economic agents. Moreover, as noted above, there are large gaps in our knowledge of the factors that promote rapid growth in some less developed regions but allow others to languish alongside rich neighbors. Thus, it is important to look at scenarios A and B not as projections but as providing a consistent framework within which issues related to GEMSU can be explicitly examined. Some of these issues are brought up as details of the scenarios are presented, with a more wide-ranging discussion following in the final section of the chapter.

While the two illustrative scenarios produce what are in many respects quite different outlooks, a common feature is that they both imply rapid growth rates; in scenario A, output grows at a rate of 10½ percent a year and labor productivity at a rate of 11½ percent, while in scenario B the output and productivity growth rates are 6½ percent and 9 percent, respectively.9 The challenge over the next ten years is clearly formidable; in Box 1, it is put in a historical context.

Chart 1.
Chart 1.

Scenarios for East Germany, 1991–2001

1 Percent change in real net domestic product. For 1991, growth is measured using output in the second half of 1990 as a measure of the underlying value of output for all of 1990. See footnote 23 in the text.2 In percent of the labor force; including the effective period of unemployment for those on short-time work.3 Net imports of goods and nonfactor services, in percent of GDP, at 1990 prices.4 Overall deficit, excluding interest payments, in percent of GDP, at 1990 prices.

The Model

The supply side of the model has already been outlined in Chapter IV (see section on “A Supply-Side Framework for East Germany”). As discussed there, the key elements are capital accumulation, improvements in the general and labor-specific efficiency parameters (g and h), and changes in employment. In scenarios A and B, all but one of these variables are used as inputs into the model, the exception being employment, which is determined interactively with wages. The model is structured so as to allow wage levels to reflect profit maximization in an environment of well-functioning factor markets; that is, for a given level of employment, there is a warranted real wage. However, in the early years, wage income is allowed to exceed this notional equilibrium. This might be the result of employers being off their profit maximizing labor demand schedules;10 alternatively, institutional factors might provide those employed in certain sectors with substantial protection from the operation of competitive forces. There is no explicit link in the model between labor markets in the eastern and western parts of Germany. However, the two scenarios presented differ in the scale of migration, with larger westward migration in the less optimistic scenario.11

The assumptions on labor income outlined above are a key element in the development of household disposable income. The extent to which income from capital is distributed is also of importance. In broad terms, the distribution rate is set low initially, reflecting the high degree of public ownership and the need to retain earnings to finance investment and restructuring expenditures. Over time, the distribution rate increases but still remains below the west German level at the end of the scenario. Taxation and social transfers are determined within the legal framework adopted under the State Treaty on GEMSU. Given the relatively low initial level of income in east Germany, the average tax rate on wage income is significantly less than that in west Germany; it rises quickly with income growth but remains lower than in the west as long as wage levels are lower. Transfer payments to households are related to caseload (e.g., number of unemployed) and, for unemployment and pension benefits, wage levels in east Germany.

In addition to fiscal operations that take place within the usual framework of the general government accounts, it is important also to consider the operations of the public Trust Fund (Treuhandanstalt). The calculations of the Trust Fund’s financial balance are on a national accounts basis incorporating dividend receipts, interest payments, and capital transfers to enterprises. Asset transactions related to privatization, the amortization of debt, and compensation of the former owners of property expropriated by the Government of the GDR, are included “below the line”; they, thus, do not influence the financial balance but do affect the gross financial debt of the Trust Fund. The Trust Fund is assumed to have an initial net worth of DM 100 billion.12

The Scenarios in Historical Context

To help place the challenges facing east Germany in some historical context, the table below presents data for key macroeconomic aggregates in the FRG in the 1950s. Between 1950 and 1960, real net domestic product in the FRG grew at an annual rate of 8¼ percent, and with employment growing at about 2¼ percent, the annual growth of labor productivity was just under 6 percent. While these figures are impressive, it is noteworthy that the growth of output and labor productivity in scenario A is much larger. However, one should be careful when making such comparisons. First, labor hoarding and general inefficiency in factor use in the FRG in 1950 may not have been as large as those believed to prevail in east Germany at the time of GEMSU. For example, unemployment in the FRG was 11 percent of the dependent labor force in 1950 and declining, whereas in east Germany, prior to GEMSU, there was hardly any open unemployment but the underlying unemployment rate was some 25–35 percent of the labor force according to scenarios A and B. Improving the efficiency of factor use in the east German economy is expected to be an important source of productivity gain in the coming years.

Second, the investment ratio in the FRG in the 1950s was not unusually large. On average, gross fixed investment was 22 percent of GNP, sustaining a rate of growth of the net capital stock of 7¾ percent a year. These investment ratios do not suggest that the FRG’s economy was reaching the limits of its ability to physically absorb capital; investment ratios were higher in the FRG in the 1960s as they were in many other industrial countries. Nor was the FRG straining its investable resources in the 1950s: the FRG ran an external surplus which averaged 4 percent of GNP (on a national accounts basis) over the period.

It is worth noting that with higher investment, the Japanese economy grew at an average rate of 9 percent over the period 1955–73. In the 1960s, growth in Japan was even faster at 10½ percent on average with labor productivity rising at a rate of 8¾ percent. Moreover, these latter growth rates were, presumably, achieved from a base (1960) that was not characterized by the scale of inefficiency in factor use that presently prevails in east Germany.

Historical experience, however, is unable to give clear guidance on the scale of investment that can be absorbed in relation to output. While the proximity of suppliers of capital goods as well as the general slack in east Germany’s economy might be expected to enhance its ability to absorb investment, the investment ratios envisaged in scenario A in the initial years of GEMSU are quite large—in Japan, gross fixed investment was close to one third of GNP, on average, over the period 1960–80, with a peak investment ratio of 36 percent in 1973. More generally, one needs to be cautious in using historical comparisons given that the political and economic circumstances of east Germany are so different. Indeed, the situation in east Germany is unique in many respects. First, the political imperative to close the productivity gap between west and east Germany would seem to favor the prospects for large investments in the east. Second, expectations of rapid income gains may influence wage demands and investment incentives; more modest expectations undoubtedly prevailed in the FRG in the 1950s and in Japan in the 1960s. Furthermore, the system of social protection in east Germany over the next decade is likely to be more comprehensive than that in the FRG in the 1950s.

Federal Republic of Germany: Selected Data from the 1950s

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Sources: Deutsche Bundesbank, 40 Jahre Deutsche Mark: Monetare Statistiken, 1948–1987 (1988); and Statistisches Bundesamt, Volkswirtschaftliche Gesamtrechnungen.

Nominal wages deflated by the consumer price index.

National accounts basis; excludes transfers.

Bundesbank definition.

In percent of the dependent labor force.

In current prices.

On the demand side, private consumption is related to developments in disposable income and the behavior of the household saving rate. Government consumption is assumed to decline relative to GDP over time, in light of its very high initial level. Investment is determined by the path for the capital stock, which in turn is related to the productivity target. The difference between supply and domestic demand represents the net foreign balance on goods and nonfactor services.

An important question is how the demand and supply sides of the model are made consistent. Over the medium to long term, with east German producers likely to be price takers in the larger German and European markets, output will be determined by supply-side conditions. For the initial years of the scenarios, however, this is not a reasonable assumption. A feature of the demand pattern that has just been discussed is that relative prices play no explicit role in the model in allocating domestic and foreign demand between domestic output and foreign output. This is not because relative prices are believed to be irrelevant but rather that the large market disequilibria that are likely to exist in the initial stages of GEMSU and the marked shifts in the composition of supply and demand make it extremely difficult to judge what the degree of substitutability might be. Implicitly, it is assumed that, in the initial stages, output and demand elements of the scenarios have been made consistent by a combination of relative price adjustment and disequilibrium quantity adjustment. This issue is discussed further below; taking note of it at this stage serves to underline the illustrative nature of the scenarios.

Starting Conditions

The base for the scenarios is the second half of 1990. Key elements of the starting position are presented in Tables 2–4, with all data for 1990 referring to the second half of the year on an annualized basis. On the supply side of the economy, it is assumed that, on the effective date of GEMSU, productivity in east Germany was 30 percent of the west German level, in terms of output that could be profitably sold in open markets. The factor inputs and factor efficiency underlying this output level are taken from Table 3 in Chapter IV, using the central case (B.II) from that table. According to those calculations, capital per worker in east Germany was 28 percent of the level in west Germany but, owing to a general 20 percent inefficiency in the use of factor services, effective capital services per worker were lower. Labor was also inefficiently used; apart from the below potential use of labor services due to the general economy-wide inefficiency, labor services were also effectively reduced by large labor-specific inefficiencies.

Table 2.

East Germany: Key Supply-Side Elements of Scenario A

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Source: Authors’ calculations.

In percent a year, rounded to the nearest ½ of 1 percent; except for the unemployment rate, which is the annual average for the period specified, in percent of the labor force, and migration, which is the annual average in thousands.

Second half of the year at an annual rate.

Relative to the second half of 1990, with data for the second half of 1990 on an annualized basis. See footnote 23 in the text.

In constant 1990 prices.

Including those on short-time work.

In percent of the labor force; includes only full-time unemployed.

Adjusted to incorporate the degree to which part-time workers are unemployed.

Table 3.

East Germany: Demand Pattern Under Scenario A

(Period averages)

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Source: Authors’ calculations.

Second half of 1990 on an annualized basis.

Percent changes are relative to the second half of 1990, with the second half of 1990 expressed on an annualized basis. See footnote 23 in the text.

Differences between GDP growth and the growth of net domestic product in Table 2 reflect principally the influence of the changing share of net indirect taxes in GDP.

Including balances on transfers and investment income. The balance on investment income includes all property income (net of tax) attributable to nonresidents, including retained earnings of enterprises owned by nonresidents.

Excludes fiscal transfers from west Germany.

End of year, or average of end-of-year data for groups of years; represents the initial debt level plus the cumulation of the external current account deficit.

All investment income attributable to nonresidents is treated as an outlay, including retained earnings of enterprises owned by nonresidents.

Table 4.

East Germany: Government Finances Under Scenario A

(In percent of GDP in east Germany, period averages)

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Source: Authors’ calculations.

Second half of the year on an annualized basis.

National accounts basis; excluding fiscal transfers from west Germany.

At year-end, or average of end-of-year data for groups of years.

Interest in the west German accounts related to financing fiscal transfers to east Germany.

Debt incurred in the west German fiscal accounts related to financing fiscal transfers to east Germany and the associated interest costs. The dept level at the end of 1990 reflects the initial debt level assumed for July 1, 1990 and the borrowing requirement in the second half of 1990 (i.e., at half of the annual rate implicit in the column for 1990).

The above characterizes the supply-side position on the eve of GEMSU. For the second half of 1990, it is assumed that there is no increase in the underlying value of output13 but labor productivity rises as some dishoarding of labor occurs. Wages are considerably higher than warranted by supply conditions, owing in part to recent large wage awards,14 and absorb 90 percent of net domestic product.

The base for the demand projections is derived from the assumptions made about labor income and investment and from official projections for the government finances. Private disposable income is initially high relative to GDP, reflecting the size of the labor share, large social transfers, and the low rate of direct taxation. Assuming a household saving rate of 5 percent, private consumption absorbs about 83 percent of GDP, compared with 54 percent in west Germany. Government consumption is also assumed to be higher than in the west (36 percent of GDP compared with 18 percent).15 Thus, in total, consumption expenditure represents 120 percent of GDP and an even larger percentage of national income. The assumed value of investment is about the same (on an annual basis) as in 1989 (converted at an exchange rate of DM 1 = M 1), though this involves a significant increase in quality. Moreover, given that the underlying value of output is much lower than implied by official estimates of production under the former economic system, this level of investment represents a substantial share of GDP (34 percent). The high levels of consumption and investment relative to output result in a large external deficit in the second half of 1990 financed in part by fiscal transfers from west Germany. The decomposition of this imbalance shows that it is mostly accounted for by the general government deficit.

In the construction of the scenarios, it has been assumed for analytical purposes that east Germany retains a full range of government institutions, including those absorbed by the Federal Government at the time of political unification. This separation of fiscal accounts can be seen as a device that facilitates the examination of the effects of the integration process on the combined fiscal position of east and west Germany. The starting fiscal situation in the east is constructed so as to be consistent with official projections for the fiscal effects of GEMSU in the second half of 1990.16 A central feature of the unification process is that the legal and institutional structures governing social expenditures and taxes in west Germany have been adopted in the east. However, given the differences in the level of income, in the composition of demand, in infrastructural needs, and in the previous budgetary systems, the structure of the government budget in the east is quite different from that in the west. On the revenue side, total receipts relative to GDP are about 4 percentage points lower than in the west. The yield from income and profit taxes in the east is limited as a result of the interaction of lower wage levels with a progressive tax structure and exemption levels attuned to west German income levels. Offsetting this, however, collections of indirect taxes relative to GDP are greater in the east, given the high initial consumption level.17 Potential social security tax receipts are also above those in west Germany, owing to the large share of labor income in output in east Germany; collections are, however, well below this potential as many companies with liquidity problems do not remit either their own contributions or workers’ contributions withheld from wages.18

Thus, differences between east and west Germany on the spending side are at the center of the government fiscal imbalance in the east; the ratio of expenditure to GDP is double that in the west in the second half of 1990.19 In part, this reflects higher expenditure on infrastructure and capital transfers to enterprises. However, the principal difference lies in current expenditure: public consumption reflects the high employment levels that characterized the government sector of the GDR and the high cost, relative to GDP, of health services in east Germany under the influence of the higher drug prices and medical fees that prevail in the west; and social transfers are boosted by heavy expenditure on unemployment insurance and pension payments.20

The outcome of these assumptions is a general government deficit (on a national accounts basis) equivalent to one half of GDP in east Germany in the second half of 1990. In addition, the Trust Fund runs a deficit of 9 percent of GDP, as a result of transfers made to enterprises to promote structural adjustment. It is assumed that the general government authorities in the east borrow to finance capital expenditures, with current deficits financed by transfers from west Germany.21 The Trust Fund finances its activities by borrowing.

Scenario A

Supply Developments

Table 2 illustrates how key supply-side variables might look in the year 2001 with east German productivity having reached 80 percent of the west German level. A basic premise is that inefficiencies in factor use will have been eliminated.22 Over the 11-year period, output grows at 10½ percent a year and productivity at about 11½ percent a year. Improved efficiency in factor use accounts for a large part of the growth rate differential vis-à-vis west Germany, with the narrowing of the gap in the capital-labor ratio being the other important factor.

In this scenario, output growth quickly rises to a peak and then falls back gradually.23 The important factors determining this pattern are as follows. First, over the initial four years, the general efficiency of factor use rises markedly, particularly in 1991–92. Labor dishoarding occurs even more rapidly owing to the competitive pressures generated by GEMSU. The growth of the capital stock in 1991, which reflects investment in 1990, is only 4½ percent, but then jumps to a 11½ percent rate of increase in 1992–94. The front-loaded growth of the capital stock seen in Table 2 is due to the assumption that major public expenditures on infrastructure occur at an early stage as a prerequisite for profitable private investment and that considerations related to profitability and strategic positioning induce large up-front private investment. Among the factors that would be expected to encourage private foreign investment are lower land prices and an abundant trained labor force, which for a number of years is expected to be less expensive than that in the west.24

As regards employment, the dishoarding of labor is initially only partially offset by increased demand for labor services induced by economic growth, with the result that the unemployment rate is about one quarter of the labor force in 1991—about two thirds of this is assumed to be open unemployment with the remainder being in the form of short-time employment. Despite the high unemployment rate, real wages rise, though at a much lower pace than productivity. Over the next few years, wages continue to grow less rapidly than productivity under the influence of high unemployment and the initial excessive share of labor income in output. Net wages increase more slowly than gross wages, as the progressive tax structure boosts average tax rates. With the high investment rate feeding into the capital stock, profitability rising and domestic output becoming more substitutable with foreign output, labor market conditions improve and the unemployment rate begins a steady decline.

Demand Developments

Following a strong growth of consumption in the second half of 1990, investment expenditure surges in 1991 (Table 3). The increase in private consumption in 1991, on the other hand, is more restrained than that of output, owing to the relatively moderate growth of household income. While gross wage rates rise by 8 percent, this is offset by a decline in the number of people employed, and a fall in disposable income is prevented by increases in pension payments and unemployment compensation. Government consumption expenditure drops notably in 1991, as a result of economies in the demand for goods and a reduction in employment. On balance, total domestic demand grows at about the same pace as GDP in 1991; the external deficit on goods and services, although higher in terms of deutsche mark, is unchanged in relation to GDP. The stability of the external imbalance conceals shifts in sectoral financial balances; in particular, the government balance improves relative to the period July-December 1990, while the sharp increase in private investment is only partially financed by improved company profits.

Over the first half of the 1990s, household income expands at a much slower pace than output, reflecting a smaller rise in wages than in productivity, increasing average tax rates, and reduced growth of social transfers (principally due to lower unemployment payments). As a result, the share of private consumption in GDP falls markedly. In the second half of the decade, with wages moving more in line with productivity, a rising household saving rate restrains the growth of private consumption relative to GDP. Public consumption also increases more slowly than GDP, as economies are made in employment and other current expenditure. Investment growth gradually declines through the scenario (reflecting the assumed time pattern for the growth of the capital stock), but remains the leading factor in the growth of domestic demand.

The external imbalance on goods and nonfactor services in east Germany, which is 5 percent of west German GDP in 1990—91, declines steadily throughout the scenario, as demand grows more slowly than output. The foreign imbalance that remains in 2001 essentially reflects net income payments to foreign investors. From a saving-investment perspective, the fall in the external deficit is due in part to the declining investment demand in relation to GDP, but the principal source is an increase in the national saving rate. In 2001, the net national saving rate (19 percent of NDP, excluding fiscal transfers from west Germany) is above the level in the west (17 percent) and is still rising; although the productivity gap has been narrowed significantly, a large difference remains in the wealth-income ratios of the two regions.25 It should be noted, however, that this estimate of the saving rate in east Germany is sensitive to the assumption on fiscal transfers from the west.26

Fiscal Developments

The basic premise of the scenario is that the major differences in the fiscal structures of east and west Germany will be eliminated over the next decade. In east Germany, the fiscal imbalance (DM 110 billion in 1991)27 declines rapidly relative to GDP, almost entirely because of a falling expenditure ratio. Government consumption expands less quickly than output as manning levels are reduced and the growth of wages is slower than that of production; by the end of the scenario the government consumption ratio is assumed to be 3 percentage points lower relative to GDP than that in west Germany, due to economies of scale in public administration (for example, in defense and in foreign relations), which are assumed to be reflected entirely in the east German accounts. After 1991, social transfers also drop sharply as the unemployment rate falls. Government investment expenditures are assumed to rise markedly in 1991–92; after 1993 they stay constant in real terms and thus decline steadily relative to GDP. Over the entire scenario, net fixed investment of the Government accounts for one fifth of the economy-wide total, broadly in line with the share of the west German capital stock located in the general government sector. Interest payments, on the other hand, rise in relation to GDP. Indeed, the rise is much larger if one includes interest payments made by the fiscal sector in west Germany related to the financing of transfers to east Germany (see the memorandum item in Table 4).

On the revenue side, collections of indirect taxes fall notably relative to GDP over the scenario as consumption grows more slowly than output. The underlying trend in the ratio of social security contributions to GDP is also downward as the share of labor income in national income declines; initially, this is not apparent in actual receipts as collection efficiency rises with the improved liquidity situation of enterprises. Falling shares of indirect taxes and social security contributions are only partially offset by rising direct tax collections relative to GDP. At the end of the scenario, the tax ratio is about 3 percentage points lower than in west Germany, reflecting lower income levels and a higher saving ratio.28

By 2001, the imbalance in the general government accounts has been almost entirely eliminated. Thus, net saving by the Government covers most of its net investment. However, incorporating also interest payments recorded in west Germany’s fiscal accounts, fiscal operations in east Germany still represent a drain on government saving.

Table 4 also contains an illustrative scenario for the finances of the public Trust Fund. Over time, the Trust Fund finances its operation through privatization and dividends from the subsidiary holding companies. These receipts are used to service the Trust Fund’s debt, make capital transfers to enterprises, and pay into a compensation fund.29 In 1991, it is assumed that the Trust Fund makes DM 15 billion in capital transfers to enterprises for restructuring purposes, with a further DM 15 billion in transfers to banks as guarantees on liquidity loans made in the second half of 1990 are called. In subsequent years, outlays above the line are solely in the form of interest payments; these are largely covered by dividends received, with the result that the deficit drops rapidly.30 Below the line, as the privatization process gets under way, receipts are directed to reducing the debt of the Trust Fund and making compensation payments. By the late 1990s, all assets have been privatized, the debt of the Trust Fund has been redeemed, and substantial payments have been made to the compensation fund, but no funds have been applied to reducing the debt of the general government.31

Scenario B

Supply Developments

This scenario takes the same starting point as scenario A. However, the development of key supply-side variables soon sets the path of the economy on a lower trajectory. Investors are more reluctant to commit themselves than under scenario A,32 and this reluctance is exacerbated by aggressive wage demand—real wages grow by 21 percent in 1991 (Table 5), compared with 8 percent in scenario A. These developments are compounded by a slower rate of improvement in the efficiency parameters in the economy.

Table 5.

East Germany: Key Supply-Side Elements of Scenario B

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Source: Authors’ calculations.

In percent a year; rounded to the nearest ½ of 1 percent except for the unemployment rate, which is the annual average rate for the period specified, in percent of the labor force, and migration, which is the annual average in thousands.

Second half of the year at an annual rate.

Relative to the second half of 1990, with data for the second half of 1990 on an annualized basis. See footnote 23 in the text.

In constant 1990 prices.

Including those on short-time work.

In percent of the labor force; includes only full-time unemployed.

Adjusted to incorporate the degree to which part-time workers are unemployed.

In contrast to scenario A, output at factor cost declines in 1991, and the relatively large increase in labor productivity is the mirror image of the sharp fall in employment. In the following few years, wage developments respond to market forces and real wages stay broadly unchanged, encouraging some recovery in investment and stimulating employment but output growth is slower than in scenario A. In the second half of the scenario, the economy settles into a pattern of steady expansion at 6–7 percent a year. With the labor force declining more rapidly than in scenario A, owing principally to increased westward migration, the unemployment rate falls for a number of years but then levels out at a rate of about 9 percent toward the end of the scenario. The high unemployment is a reflection of structural rigidities that are assumed to become ingrained in the economy. These rigidities are also apparent in the path of the efficiency factors, which by 2001 are still considerably below levels in west Germany.

Demand Developments

Demand rises more slowly in 1991 than under scenario A, but, with output growth also weaker, the external deficit on goods and services is not much lower (Table 6). Investment expenditure falls, but this decline is to a large extent offset by a faster rate of expansion of private consumption. Despite the higher unemployment, labor income grows more quickly than in scenario A, owing to rapid wage growth, and disposable income is further raised by unemployment benefits. Over the remainder of the scenario, investment rises at quite a respectable rate, but both its level and growth rate are much lower than under scenario A. After its initial surge, private consumption is restrained by slow growth of disposable income. Government consumption also rises more slowly than in scenario A after 1991, reflecting, inter alia, lower wage growth and the declining population.

Table 6.

East Germany: Demand Pattern Under Scenario B

(Period averages)

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Source: Authors’ calculations.

Second half of 1990 on an annualized basis.

Percent changes are relative to the second half of 1990, with the second half of 1990 expressed on an annualized basis. See footnote 23 in the text.

Differences between GDP growth and the growth of net domestic product in Table 5 reflect principally the influence of the changing share of net indirect taxes in GDP.

Including balances on transfers and investment income. The balance on investment income includes all property income (net of tax) attributable to nonresidents, including retained earnings of enterprises owned by nonresidents.

Excludes fiscal transfers from west Germany

End of year, or average of end-of-year data for groups of years; represents the initial debt level plus the cumulation of the external current account deficit.

All investment income attributable to nonresidents is treated as an outlay, including retained earnings of enterprises owned by nonresidents.

Over the entire scenario, the reduction in output relative to scenario A is only partially compensated by lower demand, with the result that the external imbalance on goods and nonfactor services declines more slowly and still represents 10 percent of GDP by the end of the simulation period. From a saving-investment perspective, the weaker external position reflects a smaller national saving rate under scenario B; this is partially offset by a decline in the investment ratio. The drop in saving is mirrored in the higher government deficit.

Fiscal Developments

Because of less buoyant economic conditions, the fiscal situation in scenario B is considerably weaker than that under scenario A (Table 7). The rise in the deficit in 1991 reflects a higher expenditure ratio as government consumption and investment absorb larger shares of national output and social transfers are boosted by the increased unemployment rate. Surprisingly, the ratio of revenue to GDP is also greater in scenario B as collections, relative to GDP, of indirect taxes and social security are raised, respectively, by the surge in consumption expenditure already noted and the higher share of labor income in national income. In subsequent years, the deficit declines, albeit at a more gradual rate than in scenario A. As in scenario A, most movement occurs in the expenditure ratio. While government consumption grows more slowly in this scenario, it is not sufficient to compensate for weaker output growth, and thus by the end of the simulation period, the ratio of government consumption to GDP is considerably above that in scenario A. The burden of social transfers also remains greater under scenario B, owing to the larger unemployment and the higher dependency ratio in the economy.33 Capital expenditure, on the other hand, is only slightly higher relative to GDP than in scenario A as real outlays are lower. Over the entire scenario, however, government net fixed investment represents one fourth of total net fixed investment, a higher share than under scenario A (one fifth). Interest payments rise relative to GDP throughout the scenario; the increase is particularly fast if one takes into account interest payments reflected in the west German fiscal accounts.

Table 7.

East Germany: Government Finances Under Scenario B

(In percent of GDP in east Germany, period averages)

article image
Source: Authors’ calculations.

Second half of the year on an annualized basis.

National accounts basis; excluding fiscal transfers from west Germany.

End of year, or average of end-of-year data for groups of years.

Interest in the west German accounts related to financing fiscal transfers to east Germany.

Debt incurred in the west German accounts related to financing fiscal transfers to east Germany and the associated interest payments. The debt level at the end of 1990 refects the initial debt level assumed for July 1, 1990 and the borrowing requirement in the second half of 1990 (i.e., at half of the annual rate implicit in the column for 1990).

The financial position of the Trust Fund is also weaker under this scenario. The principal difference is below the line, however. The less buoyant economy results in lower receipts from privatization for the Trust Fund.34 Thus, when privatization has been completed, and assuming the same payments to the compensation fund as under scenario A, a significant debt remains on the books of the Trust Fund.

Issues Arising from the Scenarios

The illustrative scenarios presented in the previous two sections demonstrate, at the very least, the degree of uncertainty that surrounds developments in east Germany over the next decade. The two scenarios, thus, provide a useful background for discussing a range of issues related to GEMSU.

Supply Issues

Investment plays a key role in the supply side not only by providing additional capital services but also as an important vehicle for technical change. The capital needs to bring productivity levels in east Germany close to those in west Germany over the next decade are clearly enormous. The belief that capital will be quickly forthcoming is based on a presumption that the potential rate of return in the east is much higher than in the west. However, there are a number of factors that might create uncertainties about the prospective rate of return and generate a weaker response from investors such as illustrated in scenario B. It is important, for example, that the legal and institutional structure be supportive. Three key questions arise here: Will the issue of property rights, related, for example, to past nationalizations, be resolved quickly enough to give investors confidence that legal complications will not arise? How will the costs of the environmental cleanup be allocated? And how promptly will the new administrative structure in the east be able to make the change from a planning system to one more oriented to market requirements?35 Then there is the question about the adequacy of the economic infrastructure; this issue arises not only because provision of complementary public services is important for enterprise efficiency but also because it affects the absorptive capacity of the east. Absorptive capacity is of course a wider concern; one can imagine machinery and equipment being largely imported and construction activities being able to draw on a large pool of unemployed workers. But bottlenecks could emerge in areas such as the transportation of investment goods or the availability of specialized construction skills. Investors are also likely to be sensitive to the stance that unions take in wage bargaining; large wage demands may scare off investors. More generally, there are important gaps in our knowledge of the reasons why some underdeveloped regions attract capital and grow quickly while others get relegated to the economic periphery. In this context, tradition may favor east Germany: before World War II, industry in the southern part of east Germany, in particular, was strong. This suggests that, if the other factors mentioned above are, on balance, favorable, there are good prospects for the east’s economy.

Scenarios A and B, as well as the calculations in Chapter IV, illustrate the importance of assumptions on the degree of inefficiency in the economy and the speed with which this can be removed. These inefficiencies affect the rate of return and hence the level of investment. Moreover, eliminating inefficiencies is likely to be the most important source of supply response in the first year or two of the economic integration process. It is difficult, however, to get a sense of the scale of these inefficiencies or the speed with which they could be eliminated. For example, if substantial migration of highly skilled workers to west Germany continues, what would be the implications for the potential productivity of workers remaining in the east? The nature of inefficiencies is also quite important. The existence of general factor inefficiency is more favorable to the size of the initial supply response. In the case of labor dishoarding, on the other hand, the released labor finds a shortage of capital with which it can be combined.

Next we turn to the link between wages and employment. A notable feature of scenario A is that wages grow rapidly (as does productivity) for a number of years despite high unemployment.36 Why would there not be higher employment and lower wage growth? Clearly, this trade-off exists in principle, but in the short run, the coexistence of rapid wage growth with high unemployment would not be particularly surprising. First, rapid wage growth is a means of breaking free of the compression of the wage range that has characterized the former GDR and seems particularly likely for highly skilled workers for whom the option of migration to the west is greatest. Meanwhile, the social safety net will limit downward pressure on the wages of those who have been relatively overpaid.37 Second, unemployment rates tell little about the match of skills of the unemployed to the emerging work opportunities; this may well be an important issue in the initial years of the transition, when some skills are likely to be in particularly short supply and others in large surplus. Moreover, offering labor services at reduced wages in an area in which effective demand is not perceived as being readily forthcoming may not be a strong encouragement to employers to boost employment or for unions to be more moderate in their wage demands.38 Finally, linkages between labor markets in east and west Germany can be expected to develop quickly, especially in areas close to the former border between the GDR and the FRG and in the market for skilled labor.39 This said, the response of wage growth to market conditions does play an important role in the scenarios. In both scenarios, the initial large labor share is unwound as wages grow more slowly than productivity for a number of years. Moreover, in scenario B, in response to the particularly large jump in unemployment in 1991, wages stagnate for a few years.

Demand Issues

Developments on the demand side are likely to play an important role in influencing initial supply conditions. While a large increase in demand in east Germany is to be expected, it is not clear to what extent this will fall on domestic products. Investment in machinery and equipment and consumption spending, for example, are both likely to have a large import content. This pattern of demand may pose a problem for realizing the potential response of supply to improved efficiency in the initial stages of GEMSU, when the options of boosting exports or displacing imports may well be perceived as limited. Of the various components of demand, output is likely to be most responsive to increases in construction demand, underlining the importance of a favorable investment climate for short-term output developments as well as for the long-term supply response. Over the medium to long term, however, marketing goods should be less of a problem as new investment comes on line producing goods oriented to a market environment, and a prominent role of foreign investors could further ease placement of goods in external markets.

A second uncertainty on the demand side revolves around consumption behavior. Initially, a key question is the degree of financial dissaving that can be expected and the extent to which such behavior has already occurred, given the greater availability of consumer goods since the opening of the border between east and west Germany. Moreover, the general uncertainty and high unemployment may initially engender more cautious consumption behavior on the part of those who remain in their jobs. Nevertheless, household saving is likely to be low for a number of years, reflecting pent-up demand for consumer goods and the large share of income support payments in disposable income. In scenario A, with rapid growth in household incomes, the household saving rate subsequently rises quickly toward the level in west Germany. In scenario B, lower income levels and higher unemployment restrain the rise in the saving rate.40

Fiscal Issues41

The government finances are likely to be used as a barometer for developments in the overall economy. Already in the early months of GEMSU, there has been concern about reports that the fiscal situation in the second half of 1990 is worse than was, perhaps optimistically, projected. That the budget has deviated from projections is not, however, particularly surprising; the scenarios illustrated the uncertainties about the fiscal situation and how vulnerable it is to weakening in economic conditions.

On the revenue side, apart from concerns about the vulnerability of revenue collections to less favorable economic developments, questions arise as to the extent of administrative difficulties in levying taxes in the early stages of GEMSU. There are also issues related to uncertainties about the prospective size of receipts from privatization and the financial position of the Trust Fund.

On the expenditure side, the finances of social expenditure programs are vulnerable to adverse developments in the economy. Moreover, the fiscal burden that might arise from providing west German standards of health care in the east is not yet fully apparent. Uncertainty also surrounds the needed scale and the timing of public infrastructural expenditure.42 Perhaps even more important, however, than the total investment needs of the Government is the scale of government investment in the initial years of GEMSU; this will be important, both for encouraging private investment and limiting social (and migration) problems associated with high unemployment. A further unknown is the initial level and growth path of government consumption; important considerations here are the level of government employment that existed in the former GDR, the scope for its reduction and for improving efficiency in other areas of government consumption, and the economies of scale in public expenditure that might come from the process of economic integration. Finally, the scenarios and scenario B in particular, highlight tensions that are likely to give rise to pressures for subsidies to support employment and wages.

One of the more controversial issues facing fiscal policy is how deficits resulting from fiscal operations in east Germany should be financed. As mentioned above, these deficits are already looming much larger than had been projected earlier by the authorities. The considerations bearing on the question of financing were outlined in Chapter I (section on “The Stance of Policies”). There, the degree to which higher deficits would be a temporary phenomenon was judged a key element. A comparison of Tables 4 and 7 underlines the extent to which this will depend on the success in revitalizing the economy of east Germany.43

1

The duration of the simulation was chosen to allow ten years of investment to influence the terminal productivity level. Investment in 2001 is assumed to have no influence on productivity in 2001.

2

Further details of the underlying assumptions are given in Chapter IV, section on “Supply Conditions in West Germany.”

3

Of course, to the extent that these productivity differences were due to structural weaknesses in the poorer Länder, they reflected problems one might hope to avoid in restructuring the east German economy.

4

The model used is described in the following section.

5

All deutsche mark figures are in terms of 1990 prices. Unless otherwise indicated, all ratios to GDP relate to GDP in east Germany.

6

The calculation of the investment needs to reach a relative productivity level of 80 percent by 2001 reported in Chapter IV was lower as it did not include investment in the year 2001. The share financed by external resources is sensitive to the assumption on fiscal transfers from west Germany. In this chapter, it is assumed that fiscal transfers cover government dissaving in the east. See footnote 26 for further discussion.

7

For analytical purposes, fiscal operations in east Germany have been separated from those in west Germany. It is also assumed that there are no changes in tax rates or in the rules governing the operations of the social insurance funds.

8

Given the assumption on fiscal transfers from west Germany, larger interest payments resulting from greater government dissaving in east Germany are recorded in the fiscal accounts of west Germany.

9

The larger gap between output and productivity growth rates in scenario B reflects the assumed scale of westward labor migration, lower labor force participation, and higher unemployment in this scenario.

10

One can imagine a number of reasons for this. For example, much of the economy will remain in public or cooperative ownership and this may moderate the extent to which profit maximizing criteria are used. Employers in new enterprises may also be willing to pay above the “going wage” to engender good labor relations or, in the case of investors from outside of east Germany, because of pressure from unions at the home base of the investor.

11

The underlying trend of the labor force in east Germany is based on demographic projections (see Deutsches Institut für Wirtschaftsforschung, Wochenbericht, 23–24/90, June 14, 1990, pp. 315–21), and the assumption that the female labor force participation rate, presently significantly above the rate in west Germany, will decline.

12

The initial endowment of the Trust Fund is based on the estimate of the capital stock in the economy, using sectoral shares for west Germany to distribute the east German capital across sectors—only the industrial sector is attributed to the Trust Fund. It is assumed that most of the initial debt of the enterprises is offset by the value of land holdings. Initially the value of the endowment is below potential owing to the general inefficiencies in the economy. Over time, the efficiency of the enterprises in the Trust Fund does not increase as fast as that of the economy as a whole, as the firms experiencing the largest efficiency gains are privatized.

13

Output as measured by official statistics is likely to fall substantially. See Chapter III, section on “Recent Economic Situation,” for a discussion of output developments after GEMSU took effect.

14

See Chapter III, section on “Recent Economic Situation,” for a discussion of wage developments in the early months of GEMSU.

15

The assumptions on government finances are discussed in greater detail below.

16

See Chapter II, section on “Fiscal Implications of GEMSU.”

17

Actual collections in east Germany have, however, been adversely affected by the extent to which east German residents have made their purchases in west Germany. This has been ignored here as it has had no effect on the fiscal situation in Germany as a whole.

18

In principle, slow payment should not affect revenue as recorded in the national accounts, as the latter are on an accrual basis. But to the extent that the firms experiencing liquidity difficulties are not likely to survive, and, thus, unlikely to make payment, this revenue should be excluded. Accordingly, social security receipts are set at about 80 percent of potential in the second half of 1990.

19

The figures that follow on the composition of government expenditure are illustrative; information on the structure of government spending in east Germany is, as yet, relatively limited.

20

The large size of unemployment expenditures results from the high level of unemployment (including part-time unemployment) and the assumption that almost all the unemployed are eligible for either benefits or retraining programs. Pension benefits are larger in relation to average incomes than in the west as female pensioners receive pensions closer to those received by male pensioners, reflecting the high female participation rate that has prevailed in the east.

21

This assumption is in line with the general principle governing finances in the FRG that government borrowing should not be greater than capital expenditure. Of course, given that central government operations in east Germany are within the budget of the Federal Government, many of these transfers will take the form of internal accounting transfers as the Federal Government collects much less in revenue from east Germany than it spends there. This assumption on the financing of government expenditure in the east has little implication for the measurement of the economic situation in Germany as a whole. It does over time affect the distribution of the government deficit between east and west Germany, as a substantial part of the interest expenditure related to accumulated deficits in east Germany appears in the fiscal accounts in west Germany. The size of these interest payments recorded in the west German fiscal accounts is indicated in Tables 4 and 7. See also footnote 26.

22

There is no allowance for a positive vintage effect on production; see Chapter IV, section on “The Capital Stock in 2001” for further discussion.

23

In interpreting output growth for 1991, one should bear in mind that it is calculated using the second half of 1990 as base, with output in the second half of 1990 taken as a measure of the underlying value of output (i.e., output marketable in an open trading environment). Assuming that the underlying value of output was broadly similar in the first half of 1990, the growth figure for 1991 can also be interpreted as indicating the rise in output relative to the average level of marketable output in all of 1990. In contrast to the calculations shown here, the official data for 1991 will almost inevitably show a decline in output in 1991, as a result of the large negative statistical carryover from the second half of 1990. Output in the second half of 1990 has fallen sharply in reaction to the competitive pressures resulting from GEMSU. For some details of output developments in 1990, see Chapter III, section on “Recent Economic Situation.”

24

The question of absorptive capacity is, however, difficult to judge and might affect the distribution of investment in the early years of GEMSU. The broad time pattern of investment would nevertheless be expected to be similar to that in Table 2. Specifically, over the longer run, an important consideration in the time profile of output and the capital stock is that, as productivity conditions in the two economies converge, rates of growth of important macroeconomic variables such as the capital stock and output should also converge.

25

The higher saving rate in east Germany is reflected in enterprise saving, used to finance the still high investment ratio.

26

The interest costs on the borrowing to finance fiscal transfers to east Germany are reflected in the fiscal accounts in west Germany. Assuming lower fiscal transfers from west Germany would be equivalent to incorporating the corresponding interest costs in the east German fiscal accounts. This would reduce national saving in east Germany as a result of higher external interest payments. From a longer-run perspective, one might want to estimate fiscal transfers and the distribution of the interest costs between east and west Germany on the basis of who will ultimately pay. Reducing expenditure in west Germany would, for example, have a different incidence than servicing the increased debt through cuts in expenditure affecting all of Germany or through increased tax rates.

27

This would correspond to a borrowing requirement of about DM 150 billion for the territorial authorities in all of Germany (including the German Unity Fund).

28

Lower income levels interacting with the progressive tax structure result in a smaller direct tax ratio, while the higher saving ratio reduces indirect tax collections relative to GDP.

29

It is assumed that resources of the compensation fund are used to compensate those who suffered financial losses as a result of the nationalization of private property in the GDR.

30

It is assumed that, after 1991, transfers to enterprises for restructuring purposes are handled by the subsidiary holding companies and do not appear on the books of the Trust Fund.

31

Given the many uncertainties surrounding the financial situation and prospects of the Trust Fund and also the need for compensation payments, it is extremely difficult to anticipate either the financial resources that will be available to the Trust Fund or the extent to which these could be directed to reducing general government debt. Here, for simplicity, it has been assumed that no funds are available for this latter purpose.

32

This could reflect, for example, unresolved questions of property rights, a slow unwinding of institutional rigidities left over from central planning, and a more cautious view on expected profits.

33

Migrants are disproportionately from the working-age groups.

34

In addition, it is assumed that the Trust Fund takes on an extra DM 10 billion in debts owed by companies that are liquidated.

35

While federal government functions no longer exist separately in east Germany, important questions affecting businesses are dealt with at the level of the Länder and community governments.

36

It is interesting to note that significant real wage growth coincided with high unemployment in the FRG in the 1950s, when a less developed social safety net than assumed for east Germany in these scenarios would have been expected to strengthen the negative relationship between unemployment and wage growth (see Box 1).

37

Most workers in east Germany are likely to be eligible for compensation, on average, at 67 percent of the last net wage. In west Germany, only one half of the unemployed receive full benefits.

38

Where domestic production is a good substitute for imports or where export markets have been developed, the increased output might be absorbed through changes in the foreign balance: relative prices could, in principle, move to encourage the appropriate shift in demand, with the relative price shift needed not being particularly large in a small economy well integrated in the world economy. However, in the environment such as that likely to exist in east Germany in the first year of GEMSU, with large changes in the composition of demand and supply, major institutional developments, and substantial market disequilibria, questions arise as to what degree of downward pressure on wages would be necessary to encourage employers to increase employment. Effective labor supply, at the margin, may not be easily transformed into goods that are in demand due to the skill composition of the unemployed, the areas in which capital is concentrated, or because of problems with informational flows.

39

Such links are already obvious, for example, in Berlin. In the context of these links, some may find puzzling the persistence of low real wages relative to west Germany in scenario B. This aspect of the scenarios can be interpreted in two ways. First, the migration that occurs on a larger scale in scenario B is principally of highly skilled workers, and this lowers the average productivity of those remaining, who have less opportunity to migrate. Second, the low relative wage level can be interpreted as an indication of the tensions that might arise in the system, leading, for example, to pressures for higher government subsidies.

40

Data on household saving behavior in the FRG in the 1950s can be found in Box 1.

41

Fiscal issues related to GEMSU are discussed also in Chapters I, VI, XI, and XII.

42

In west Germany, about 20 percent of the net capital stock is in the hands of the general government and in scenario A about 20 percent of the cumulative net investment is assumed to be carried out by the general government. This does not include capital transfers to public bodies outside general government (e.g., the post office or the railways).

43

The implications of these scenarios for the fiscal accounts of all of Germany can be seen in Table 4 of Chapter VI.

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Cover German Unification
German Unification
Economic Issues Occasional Paper No. 75
ISBN:
9781557752000
ISSN:
0251-6365
Publication Date:
04 Dec 1990
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557752000.084
Pages:
192
Chart 1.

Scenarios for East Germany, 1991–2001