Chapter

4 The Transformation of a Socialist Economy: Lessons of German Unification

Author(s):
Georg Winckler
Published Date:
September 1992
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Author(s)
Horst Siebert, Holger Schmieding and Peter Nunnenkamp 

I. Economic Transformation: The Principal Tasks

Last year’s euphoria about democratization and economic liberalization in Central and Eastern Europe has largely vanished. Current news on the region is dominated by reports on inertial transformation processes and the economic as well as social adjustment burden. This does not apply only to countries like Czechoslovakia, Hungary, or Poland, but also to the former German Democratic Republic where an immediate second German Wirtschaftswunder was widely expected until recently.

Considerable transition problems can hardly be avoided once fundamental economic reforms are implemented in countries characterized by macroeconomic instability, pervasive government encroachment on investment and production, seriously deficient incentive systems, the lack of appropriate institutions, and infrastructural decay. But the degree and duration of transition problems could be contained if economic reform programs were credible and tailored to the specific starting conditions, and serious inconsistencies among reform elements were avoided by economically sound timing and sequencing. Major areas of reform are institution building and privatization; macroeconomic stabilization; and micro reforms directed toward internal regulation and external liberalization.

  • The institutional infrastructure relates to the rules to be followed by economic agents, that is, the economic constitution of a country (for a more detailed presentation, see Siebert (1991a, p. 6ff.)). Important elements of what the Freiburg school calls the Wirtschaftsordnung include the legal system (Privatrechtsordnung), most notably contract and company law, a two-tier banking system with an independent central bank, the delineation of government and private sector, as well as clearly defined and enforceable property rights. The latter provide the institutional device by which decisions can be decentralized and microeconomic costs and benefits are related to the specific producer.
  • Macroeconomic stabilization encompasses the elimination of a monetary overhang as well as the reduction of unsustainable fiscal and current account deficits. Monetary reform aims at creating a stable and convertible currency, which is mandatory for the functioning of the price mechanism and efficient resource allocation. Excess domestic demand has to be removed by expenditure-reducing policies such as monetary and fiscal restraint. Government expenditures must no longer be financed by printing money, and an appropriate tax system has to be developed. International competitiveness may be improved by devaluation-induced expenditure switching.
  • Reforms at the micro level relate to the various facets of the soft budget constraint that characterizes the typical socialist firm, for example, its ability to achieve rents because of noncompetitive markets and to shift to the government firm-specific costs and risks (Nunnenkamp and Schmieding, 1991). A comprehensive set of measures is required to tackle this problem. Most notably, price deregulation has to be accompanied by intensified competition via the breakup of monopolies and the abolition of the strict market segmentation. Competitive pressure should be further increased by external liberalization. The dismantling of trade barriers provides strong incentives for enterprises to specialize according to their comparative advantages; and capital account liberalization helps to attract more investment funds. Additionally, factor market deregulation is necessary for optimizing the allocation of both capital and labor.

Third World experience suggests that structural adjustment programs are highly likely to fail if attempts to reform remain piecemeal and inconsistent (Papageorgiou, Michaely, and Choksi, 1991). Hence, the question of timing and sequencing figures prominently in the ongoing debate on economic transformation in Central and Eastern Europe. It is now widely accepted that the institutional infrastructure has to be established without delay. But controversies persist on whether large-scale privatization should proceed quickly because it provides the basis for other reform steps (Lewandowski and Szomburg, 1989), or rather be postponed until after macrostabilization has been achieved and micro reforms have been implemented (Lipton and Sachs, 1990). It is no longer disputed that stabilization attempts are not credible unless they are closely related to the principal micro reforms (for example, Kornai, 1991). Nevertheless, stabilization is considered to be of priority by some economists, especially with significant macroeconomic disequilibrium (for example, Edwards, 1989). Different views also exist on the phasing and degree of trade and capital account liberalization.

It is thus not surprising that countries in Central and Eastern Europe have followed different avenues of transition to a market economy. Hungary has a fairly long history of piecemeal reforms, with the credibility of the recent more comprehensive attempt presently at stake. Poland is suffering from a considerable adjustment crisis in the aftermath of its far-reaching stabilization and liberalization program of early 1990. Until recently, Czechoslovakia focused on developing the institutional infrastructure required for a market economy, while the implementation of economic reforms was delayed. In sharp contrast, an unprecedented shock approach has been applied in the former German Democratic Republic.

The major reform elements mentioned above were implemented in one stroke once the state treaty had been concluded by the two German governments in May 1990. Thus, German unification provides a “laboratory experiment” as regards the economic policy of transition, with real adjustment being at the core of the problem.

It is still too early to judge conclusively the relative success or failure of the different approaches toward economic transformation. Moreover, the specific starting conditions of the post-communist economies render easy generalizations impossible. The peculiarities of the German case in particular may seriously limit the scope of lessons to be drawn for other reform-minded countries. This is evident from the summary presentation of the German economic, monetary, and social union (GEMSU) in Section II and the discussion of the advantageous conditions under which the market economy is implemented in the former German Democratic Republic. Nevertheless, strong similarities exist among the countries in transition as regards the basic problems of real adjustment, for example, sectoral restructuring, reorientation of trade, the behavior of the socialist firm and transformation of ownership, and improvement of infrastructure (Section III). Similarities also prevail with respect to short-term transition costs; Section IV actually reveals a relatively strong decline in economic activity in the case of the former German Democratic Republic. The causes of this slump are analyzed in Section V. Section VI concludes and summarizes the lessons to be drawn from the German approach toward economic transformation.

II. Economic, Monetary, and Social Union: The German “Experimentina Favorable Environment

Major Elements

Notwithstanding strong evidence that transition costs can be reduced by appropriate timing and sequencing of reforms, the policy course followed in reality by governments is determined not only by economic rationality; it is rather the result of a broader set of politico-economic considerations. This is clearly so for Germany, which provides a rather unique experience in the sense that, from the very beginning, the political decision makers viewed the economic integration of the two parts of Germany as part and parcel of political unification. Arguably, economic decisions have even been instrumental in achieving the principal aim of making the process toward unification irreversible (Hoffmann, 1991). It can be hypothesized that, because of such broadly defined politico-economic rationality, the transition costs in terms of production losses and employment problems are much more pronounced than they would have been if pure economic logic had prevailed.

The surprise move in February 1990 of the west German chancellor toward a quick currency union provides a case in point.1 In the aftermath of the March 1990 election in the German Democratic Republic, the terms of the German economic, monetary, and social union (GEMSU) were negotiated, the corresponding state treaty was concluded in May, and GEMSU became effective on July 1, 1990.2 The sweeping economic integration of the two parts of Germany subjected the centrally planned economy of the former German Democratic Republic to an unprecedented shock. Three months prior to unification, the deutsche mark (DM) became the sole legal tender, replacing the east German mark (M). The conversion rate of M 1 = DM 1 applied to recurrent payments, most notably wages, was heavily debated; frequently it was argued that a more realistic rate, which might have helped further segments of east Germany’s industry to achieve international competitiveness, would have resulted in socially unacceptable wage gaps between east and west Germany and fueled westward migration. By contrast, a conversion rate of M 2 = DM I applied to domestic financial assets and liabilities, except savings of east German residents of M 2,000-6,000 per capita (depending on age), which were converted at the preferential M 1 = DM 1 rate. At the same time, the government of the former German Democratic Republic lost its monetary autonomy. Given the Bundesbank’s traditional anti-inflationary stance, monetary destabilization was unlikely to become a major problem in the aftermath of the currency union (see also Lipschitz, 1990, pp. 6 and 16). With the introduction of the deutsche mark, east Germany participates in the benefits of a fully convertible currency.

Economic and social integration was achieved by the wholesale adoption by the former German Democratic Republic of west Germany’s concept of a “social market economy” with only a few exceptions.3 According to the state treaty, central planning and pervasive state interference in the east German economy were abolished and replaced by the principles of private property, competition, free prices, as well as free movement of labor, capital, and goods and services. Microeconomic deregulation was even more embracing than in west Germany in 1948 (for details, see Schmieding (1991a)). Apart from rents and public utilities, all price controls were lifted, and wage determination was left to collective bargaining of employers and labor unions. Moreover, sweeping liberalization took place on the external front. The former German Democratic Republic became fully integrated into the European Community and world capital markets. The isolation of the economy from international competition ended abruptly.

Among institutional reforms, the introduction of a market-based banking system in east Germany (with unrestricted capital flows, freely determined interest rates, and full access to world capital markets) figures prominently.4 The reorganization of existing firms, that is, demonopolization of the so-called Kombinate, efficiency enhancement, and privatization, constitutes another crucial prerequisite to help real adjustment. Demonopolization was at least partly achieved by splitting up 316 Kombinate into 8,000 legally independent firms, which were placed in a Trust Fund (Treuhandanstalt). The mandate given to the Trust Fund included the liquidation of nonviable firms, the restructuring of potentially viable enterprises, and privatization where possible. It was decided that, in principle, companies expropriated after 1949 (and before 1945), as well as expropriated land and real estate, would be returned to the previous owners. Compensation would be paid, however, if restitution was not feasible or constituted a major deterrent to private investment.

East Germany’s Advantages

Until German unification, the east German economy was no special case in Central and Eastern Europe. The economic order as well as the political system were of the standard Soviet type. East Germany was roughly comparable to the Czech lands (Bohemia and Moravia) in terms of most socioeconomic indicators, notably living standards, the level of economic development, industrial traditions, the state of the infrastructure, and the extent of environmental damage. With the collapse of communism, however, east Germany became a place apart; it had the opportunity to make use of one fundamental advantage: west Germany. It is rather small in comparison with west Germany with its well-established and advanced market economy (26 percent in terms of population, 8-10 percent in terms of GDP). Hence, regardless of the details of the policies adopted, German unification implied per se that the pains of political and economic transformation were to become mere regional problems of a much larger economic unit. United Germany’s overall stability was unlikely to be affected significantly by whatever difficulties the switch to a market economy in the eastern part would entail.

By virtue of German unification, east Germany could import the political stability and legitimacy of west Germany. In a similar vein, GEMSU meant that the regime switch in east Germany was absolutely credible and definitely irreversible. Furthermore, east Germans gained access to the highly developed social security system of the western part so that real adjustment costs could be automatically cushioned by public transfers. These factors are not only advantages per se; they imply a far greater freedom to conduct first-best economic policies than in all other post-communist countries. In Hungary, Poland, Czechoslovakia, and beyond, the short-term repercussions of potentially painful economic policies on the fragile political system have to be one of the major concerns of the reformers. As the March 18 elections in east Germany had revealed overwhelming support for rapid political and economic unification, there was much less need for an arduous process of internal consensus building than elsewhere. Decisions could be taken swiftly and implemented instantaneously.

In particular, the east German advantages relate to the institutional infrastructure as well as to macroeconomic policies and the prospects of real economic adjustment. The institutional infrastructure of a market economy has to be built from scratch in other post-communist countries. East Germany simply adopted the well-established laws and regulations of west Germany, which did not even need to be translated (for the inherent flaws of this approach, see Section V). Together with the establishment of the west German judicial system in the east, this implied that the fundamental institution of capitalism, that is, private property rights, would be fully and lastingly respected. Uncertainty of economic agents was reduced to the question of whether previously expropriated property would be restituted. Many west German institutions extended their reach to east Germany, and other institutions in the east could be remodeled in the western image. Some transfers of human capital and administrative staff as well as other kinds of technical assistance were supposed to facilitate the implementation of the institutional reforms and the application of the new rule book. The cultural proximity to west Germany and the dense net of contacts is likely to make it easier for east Germans to get used to the rules of the market quickly.

The macroeconomic stabilization problems of the former German Democratic Republic were de facto solved with GEMSU. With the deutsche mark replacing the east German mark, the accumulated east German monetary overhang was spread over a much larger currency area. Hence, the threat of a rising price level after price liberalization was diminished;5 the future east German inflation rate is given by the rate of price increases for tradables in the united Germany and the relative rise in prices for east German nontradables.6 East German fiscal problems were greatly eased by unification. Even to the extent that budget deficits of the new Länder will not be directly financed by western transfers, east German public authorities are likely to benefit from the creditworthiness of the west, at least as long as the lenders can confidently assume that these credits are implicitly guaranteed by the Federal Government. Furthermore, the problem of east Germany’s external debt de facto vanished by courtesy of unification.

Even with respect to the process of real economic adjustment, east Germany’s starting conditions appeared to be favorable. As far as adjustment at the micro level is concerned, the critical question is whether firms can be privatized soon and whether managers of state firms do—or can be made to—react to market signals in a textbook manner and to care about long-run profitability almost as if they were controlled by private owners.

Privatization should be much easier in the eastern part of Germany than elsewhere in Central and Eastern Europe owing to political stability, generous social security provisions, unrestricted access to the world capital market, a fully convertible currency, and the transfer of administrative know-how; and by virtue of German unification, the pool of talents from which new managers for private enterprises and state firms can be drawn is much broader. Also, with regard to firms that remained in the hands of the state for the time being, there was reason to expect a comparatively flexible and efficiency-oriented reaction to market signals (for the strategic choices open to managers of state firms after the demise of central planning, see the next section). Because of the clear irreversibility of the regime switch in east Germany and the political stability that may promise to make a rational discussion about the future for members of the old nomenclature easier than elsewhere in post-communist Europe, the incentives to adopt an efficiency-oriented adjustment strategy appear to be comparatively strong for east German managers.

All in all, it is hard to dispute that the GEMSU has laid the ground for economic recovery of east Germany in the longer run. Moreover, it has helped to ease the social burden of adjustment. At the same time, however, the demonstration effect of advanced living standards in the west has given rise to particularly high expectations for the people in the east, notwithstanding that east Germany suffers from the common problems of post-communist economies as far as real adjustment in the short run is concerned. Insofar as the particulars of the GEMSU fostered unfounded expectations about a quick catch-up in living standards, they may even have caused an extraordinarily severe transition crisis, as will be discussed in the following sections.

III. Basic Similarities: Problemsof Real Adjustment

The clear advantages east Germany has in managing economic transformation, relative to other reform-minded countries, led to overly optimistic scenarios on short-run economic recovery. Also, the comparatively favorable endowment of skilled labor, though constituting a major asset in the longer run, made many observers underrate the serious obstacles to real adjustment in the transition period. As concerns some critical adjustment problems, east Germany reveals strong similarities with its neighbors in Central and Eastern Europe.

First, the physical and administrative infrastructure suffers from serious decay. Social overhead capital in transportation and communication is particularly deficient. For example, 45 percent of the equipment in postal and communication services is more than twenty years old (Institut für Internationale Politik und Wirtschaft, 1990). The public administration lacks experience in dealing with markets and with the institutional framework of a market economy. Recording of land titles and the licensing procedure for firms are good examples. A similar mismatch between the sweeping establishment of the institutional infrastructure and the much more difficult task of developing the human skills required to handle the system efficiently is to be observed in the juridical sphere.

Second, the sectoral structure of the east German economy is heavily distorted. It is biased toward agriculture and, to a lesser extent, manufacturing, and against nongovernment services (for details, see Siebert, 1990, p. 35). In 1989, 47.2 percent of total employment was in agriculture, energy and mining, and manufacturing; the respective share amounted to only 37 percent in west Germany. Employment in manufacturing was reduced by 13 percent during the 1970-89 period in west Germany, while it expanded by 10 percent in east Germany. Moreover, employment in east Germany is heavily concentrated in sunset sectors and branches that have been declining rapidly in the west.7

Third, integration into the international division of labor is significantly below world standards. The share of exports in GNP is estimated at 25 percent, while the share for western economies of a comparable size amounts to 40-50 percent. As a result of the intra-bloc specialization philosophy of the Council for Mutual Economic Assistance (CMEA), about 70 percent of exports from east Germany were directed to these less demanding markets (in west Germany, less than 5 percent). The incentives to strive for quality improvement, technological progress, and better marketing were thus largely eroded. CMEA trade flows were determined by political bargaining so that the pattern of specialization did not (necessarily) reflect the comparative advantages of the former German Democratic Republic (Stehn and Schmieding, 1990).

Fourth, the capital stock is technologically outdated, physically run down, and economically and ecologically obsolete. Only about one fourth of industrial equipment has been installed in the last five years (in west Germany, 39 percent); more than half is older than ten years (west Germany, 30 percent), and 21 percent is even older than twenty years (Institut für Internationale Politik und Wirtschaft, 1990).

Most of these deficiencies that characterize the current situation in east Germany, and in Central and East European countries in general, can be traced back to the inherent flaws of an economic system of the Soviet type and the typical behavior of the socialist firm (Siebert, 1991b). The socialist firm has been inefficient for a number of reasons: It was steered by quantity signals and protected from competition by central planning, market segmentation, and import barriers. In factor and goods markets, prices were either nonexistent (capital, environment) or determined through the central planning process. Most important, efficiency was eroded by the soft budget constraint, that is, the socialist firm’s access to subsidies and related privileges.

The transition to a market economy represents an unexpected shock to the socialist firm. This cosmic shock was particularly pronounced in east Germany with all prices freed, complete integration into international trade and world capital markets, the conversion rate of M 1 = DM 1 for current payments, and the nonexistence of the exchange rate as a shock absorber. Such a dramatic change clearly reveals the inefficiency of the socialist firm. As a result, output and employment are bound to fall. While transition problems cannot be avoided, their severity depends critically on the reactions of managers to the reform program. Under the pressure of declining traditional demand, private enterprises would seek new markets, cut costs, launch new products, and look for alternative channels of distribution. But this does not necessarily happen in post-communist economies (Winiecki, 1990, p. 773). It depends on the inefficiency of existing firms, the speed and methods of privatization, the progress in establishing new firms, and the conditions of economic restructuring whether a dip, a valley, or a deep gorge will be experienced before output and employment start to rise again.

After the demise of central planning, rational self-interested managers of firms that are still in the hands of the state have a choice of three strategies (which are not always mutually exclusive—Schmieding, 1991b).

Wait and See

Given their experience with piecemeal reform efforts in the past, managers might expect that present reform programs also will be diluted or completely abandoned once transition problems emerge. Their major interest then is to keep their jobs and avoid painful decisions. They will pin their hopes on subsidies and use their time to clamor for such subsidies from the state. This would probably result in the most unfavorable outcome envisaged by adjustment theory, that is, significant cuts in output along with maintaining the overstaffing of firms. While the likelihood of reform reversal appears to be extremely low in the German case, readily available subsidies may still make this option attractive for managers.

End Games

Managers expecting that policy reforms will be sustained and afraid that they will lose their jobs in the near future anyway have a particularly strong incentive to use their remaining time to enrich themselves at the expense of the state-owned firm. This may be achieved by means of ordinary theft or some more sophisticated variants of “spontaneous privatization.”8 In this way, the firm’s ability to adjust may be further eroded, since the funds required for maintaining and modernizing its capital stock are diverted away from the firm. On the other hand, some variants of spontaneous privatization—disregarding the unpleasant distributional implications—may lead to the emergence of efficiently run private firms.

Reputation Building

Managers may run the firm as if it were already privately owned, at least within the confines in which they have to operate, if a future career in the management of a private firm is considered likely.9 They may then try their best to establish their credentials through some kind of adjustment efforts in the private sector. Only this strategy would imply economically efficient behavior.

The built-in inefficiency of the socialist firm and the ambiguous incentives of managers suggest that privatization of existing firms should not be delayed unduly, in order to help real adjustment in the transition period. Private ownership is an important prerequisite for ensuring that decisions in the firms are dominated by economic considerations, managers are controlled by the capital market, capital is allocated efficiently, and structural change is initiated (Siebert, 1991a, 1991b, and 1991c; Collier and Siebert, 1991). A major issue is by which institutional arrangement privatization can be achieved (Schmieding and Koop, 1991). The options available differ especially with respect to the time they require: providing access to the stock market is fairly time consuming in post-communist economies and subject to many preconditions even if firms are viable. By contrast, informal selling can proceed without delay, but runs the risk of selling prices that are “too low” with only one party on the buyer’s side. The disadvantages of both extremes can be avoided by a formal bidding process that guarantees competition among potential buyers, quick injection of fresh capital, and provision of new management. A voucher system represents another alternative (Lewandowski and Szomburg, 1989). Vouchers defining titles to all state-owned enterprises would be handed out to the population and, at a later stage, exchanged against shares of specific firms.

The conditions for privatization differ among reform-minded countries in Central and Eastern Europe. In Germany, monetary stabilization has already been achieved, and the risk of policy reversal and exchange rate risk is largely absent. The potential to attract new private capital is relatively large. This potential should be tapped quickly, given that the opportunity costs of delayed privatization are particularly high in the German case: any prolonged divergence in production and employment levels between east and west Germany would necessitate additional official transfers and may lead to an inefficient and costly structural policy.

Under the German conditions, the political and economic arguments in favor of distributing the privatization receipts directly and equally among the population are of less relevance than in other Central and East European countries. The voucher system in particular is not to be recommended. With widely spread shares, an effective monitoring of managers by the shareholders is hardly possible, so that the incentives of the former to enhance the firm’s efficiency remain weak (Hinds, 1991, p. 113). Hence, the approach of the Treuhand, acting as a privatization agency, to identify potential buyers and to initiate a bidding process is more promising.10 The process of privatization may be further accelerated if firms and potential buyers are given the right to propose a sale and, thus, initiate an open bidding process themselves. In addition, a semi-stock market with less formal stock exchange admission regulations may be established to allow economically viable east German firms easier access to the capital market, with suppliers of capital assuming greater risk.11

The establishment of a privatization agency does not preclude governments attempting to confuse privatization with structural policy. The temptation to smooth the adjustment for individual firms and to reduce short-term unemployment problems by subsidizing old lines of production is evident in the German case. The objective to improve the efficiency of firms before they are privatized is explicitly stated in the law on the privatization and reorganization of state-owned property (Treuhandgesetz). Owing to political pressure, this objective is likely to gain further importance in the future; German politics are presently at the crossroads, with growing sentiments that the Government should intervene more strongly in the adjustment processes (Sachverständigenrat, 1991). However, it is mandatory that Treuhand concentrate on privatization, simply because it does not have reliable information on the economic viability of the 8,000 firms in its portfolio. Privatization is a promising means of making firms efficient. Enterprises not taken over by private owners even after inherited debt and environmental damages have been cleared by the Government must be closed down, instead of wasting the receipts from privatization by subsidizing nonviable firms. The living standard of the people affected should be protected by social rather than by structural policy, since the former does not interfere with an efficient allocation of capital.

Apart from privatizing existing firms, the creation of new firms is crucially important in alleviating the transition crisis, containing unemployment problems, and promoting the restructuring of the economy. Hence, barriers to market entry must be abolished, location space supplied, and finance made available, especially for smaller firms.

The destruction of property rights during communist rule constitutes the most serious hindrance to privatization and investment in new firms. In some East European countries, especially the U.S.S.R., it has still to be clarified to what extent individual property rights will be reinstated as an institutional device in the transition toward a market economy. In this fundamental sense, property rights were immediately established in east Germany. Nevertheless, uncertainty with respect to ownership continued. This uncertainty appears to be largely due to the principal decision by the two German governments in 1990 to reinstitute the previous owners whose property had been expropriated in the former German Democratic Republic since 1949 (see also Siebert, 1991b, p. 13ff).12 Previous owners were to be compensated, however, if restitution was not feasible because expropriated property had been used for other than its original purpose, for example, in construction, infrastructure, or industrial activities.13 Remaining ambiguity with respect to restitution or compensation as well as administrative bottlenecks rendered it extremely difficult to overcome ownership uncertainty. First, property titles were not documented adequately for forty years in east Germany. Second, previous owners were inclined to demand restitution instead of compensation and to go to the courts when the market value of the expropriated property exceeded the financial compensation offered; the transition process would be seriously delayed while waiting for the final court decision, which might take several years. Third, in many instances, a large number of claims related to one particular firm that had acquired various pieces of property over the last four decades. In early 1991, the sale of a firm was actually blocked in the case of claims on part of its assets by previous owners. As a consequence, Treuhand could not proceed with privatization.

Ownership uncertainty has to be removed as quickly as possible to contain the transition crisis. Most important, a clear preference should be given to financial compensation of previous owners. In this regard, some progress has been achieved very recently, especially when restitution undermines productive operations by economically viable units. In a new law on property issues (Vermögensgesetz), passed in March 1991, investment and job creation are given priority over restitution; and financial compensation is offered to previous owners. In cases of conflicting claims, a previous owner may be installed preliminarily in his ownership rights until a final court decision is reached. The ruling of the Constitutional Court of April 24, 1991, provides some guidelines on compensation. In addition, administrative capacities have to be improved to accelerate the settlement of ownership issues. This may be achieved by delegating administrative staff from the old to the new Länder, to set up appropriate title records and manage the licensing procedures for new firms.

IV. Economic Performanceof East Germanyin Perspective

Two conclusions emerge from the above discussion. First, major adjustment problems cannot be avoided in the transition from a centrally planned toward a market economy. Second, the temporary decline in output and employment is likely to depend on the severity of the initial distortions, the speed and methods of privatization, and the opportunities for new firms to start operations. The principal problems of real adjustment in east Germany reveal strong similarities with other Central and East European countries. It is thus not surprising that east Germany also suffers from a severe transition crisis.

The current economic malaise there is clearly reflected in the data (Table 1), although statistical measurement is loaded with various conceptual difficulties for economies undergoing fundamental changes in the economic regime.14

  • Open unemployment rose significantly during 1990. Moreover, unemployment is seriously underestimated by the ratio of 6.1 percent reported for the fourth quarter of 1990. This is because the more generous application of regulations on short-time work in east Germany (probably at least until end-1991) induced many firms not to lay off the work force; short-time work, with working hours frequently reduced to zero, became a common feature. Appendix Table 1 reveals that unemployment would be more than twice as high as the officially recorded unemployment ratio if the number of short-time workers, weighted by the proportion of idle working time, was added.
  • Apparently, the recent boom in registrations of firms, amounting to about 30,000 a month in the second half of 1990 (Appendix Table 2), had at best a limited impact on labor markets, given significantly declining employment figures and the small number of vacancies. To a large extent, the registration numbers refer to the reregistration of existing firms rather than to the increase of new ones; and most of the new firms are very small and have not yet started operating. Interestingly, the number of canceled registrations also increased, from 6.4 percent of total registrations in July 1990 to 16.2 percent in November 1990.
  • The development of gross wages was not at all related to the unfavorable employment situation, nor to the level and trend of labor productivity. Labor productivity in east Germany was estimated at one third (or even less) relative to west German standards (Siebert and Schmieding, 1990). A further decline is reported for the third quarter of 1990; subsequently productivity recovered to the 1989 level (Table 1).15 In sharp contrast, nominal wages increased significantly after the GEMSU had been concluded; within six months, wages soared by 30 percent.
  • While investment fell, private and government consumption was decoupled almost completely from east German production (see also Gabrisch and others, 1990, pp. 16f.). Comparing the fourth quarters of 1989 and 1990, consumption was higher by 3-8 percent with GDP down by more than 30 percent and imports doubled (Table 1).16
  • The dramatic fall in production was most pronounced in industry, which experienced a slump of about 50 percent in the third against the second quarter of 1990. According to Appendix Table 3, all major industries suffered from a drastic decline in production immediately after the GEMSU. The slight improvement observed in September, October, and November 1990 may be due to “better organized support of the Treuhandanstalt” (Gabrisch and others, 1990, p. 17). The December figure indeed indicates that industrial production has not yet reached bottom. In particular the expiration of the previous contracts for exports to CMEA countries is likely to result in a further decrease of industrial production.
Table 1.Economic Development in East Germany, 1990(1989 = 100 unless stated otherwise)
1990
1989Total yearFirst quarterSecond quarterThird quarterFourth quarter
Persons employed, all sectors110089.997.093.481.571.9
Unemployment
(in thousands)228.013.083.0309.0506.0
(in percent)2.60.10.93.56.1
Short-time workers (in thousands)758.00.00.01,295.01,736.0
Commuters (in thousands)76.015.027.079.0183.0
Gross wages per fully employed person100124.6103.1113.2134.9147.1
Productivity per working hour10095.295.898.184.9102.0
Production at current prices2
Agriculture and forestry10067.325.720.0105.360.0
Manufacturing and mining10071.196.892.946.450.4
Construction10093.089.8114.398.0102.0
Transport and trade10076.390.588.655.261.9
Services and government100106.598.1100.6105.8110.4
Private consumption2,3100107.094.494.493.0103.2
Government consumption2,3100105.289.593.998.9108.3
Fixed investment2,310090.873.592.873.592.8
Exports2,3100112.692.8110.1113.7125.9
Imports2,3100160.787.1111.8165.7197.8
Gross domestic product2,310080.892.191.866.968.8
Source: Deutsches Institut für Wirtschaftsforschung (1991).

Half of the workers on short time are counted as employed (see also Appendix Table 1).

For quarterly figures, fourth quarter 1989 = 100.

Current prices.

Source: Deutsches Institut für Wirtschaftsforschung (1991).

Half of the workers on short time are counted as employed (see also Appendix Table 1).

For quarterly figures, fourth quarter 1989 = 100.

Current prices.

Notwithstanding subsidies from west Germany of considerable magnitude, the transition crisis in the east is of unprecedented severity by international standards (Table 2). Comparing 1990 with 1989, the decline in industrial production and GDP was more than three times the decline observed for the average of Central and East European countries. Moreover, the annual change for east Germany tells only part of the story, because the transition shock is still blurred by the pre-reform era until mid-1990. The awkward situation of east Germany is not at all surprising relative to countries such as Czechoslovakia or the U.S.S.R., where comprehensive economic reforms have been delayed and the transition crisis still lies ahead. Remarkably, however, the economic downfall after the GEMSU was even more pronounced than in Poland, where industrial production in the state sector declined by about 25 percent in the aftermath of the far-reaching stabilization and liberalization program launched in early 1990 (compared with minus 50 percent after the GEMSU). This suggests that the advantages of the former German Democratic Republic mentioned above in managing economic transformation were outweighed, at least in the short run, by specific transition problems and policy failures there.

Table 2.Industrial Production in Central and East European Countries, 1990(Annual percentage change against corresponding period in 1989)
First Two QuartersFirst Three QuartersTotal Year1 (Estimated)
East Germany-7.0-29.0-29.0(-22.0)
Bulgaria-11.0-13.0-13.0(-12.0)
Czechoslovakia-3.0-3.5-3.5(-3.0)
Hungary-9.6-10.0-10.0(-5.0)
Poland-30.1-27.1-25.0(-17.0)
Romania-18.0-21.0-21.0(-15.0)
U.S.S.R.-0.7-0.9-5.0(-3.0)
Yugoslavia-10.9-10.6-10.6(-10.0)
Total-5.3-6.7-9.3(-6.3}
Source: Gabrisch and others (1990)

Estimated GDP growth rate in parentheses.

Source: Gabrisch and others (1990)

Estimated GDP growth rate in parentheses.

V. Causesofthe East German Slump

From the comparison with Poland, interesting insights may be gained on the causes of the particularly strong decline in output in east Germany. For both countries, some decrease in output was to be expected for two reasons. First, some of the goods produced under socialist conditions (notably many investment goods) had no positive economic value; unless generous subsidies were paid to maintain this absurdity, the switch to a market economy would give rise to welfare-enhancing cuts in value-distracting production activities. Second, the regime switch induces a transition crisis that becomes evident in a temporary drop in production.

In other respects, east Germany and Poland differed markedly: on the one hand, Poland had to eradicate hyperinflation at the beginning of 1990, while east Germany in mid-1990 imported the macroeconomic stability of the Federal Republic. As drastic stabilization programs tend to go along with a deep recession, the slump in production was likely to be more severe in Poland. On the other hand, the crisis in east Germany was likely to be front-loaded, since the sweeping external liberalization took place without paying attention to complementary policies that could have improved international competitiveness. Contrary to what was required, external liberalization was accompanied by a significant rise in local production costs. First, the terms at which the deutsche mark was introduced on July 1 resulted in an overvaluation of east German economic output.17 Second and more important, unrealistic expectations of a quick and pronounced improvement in living standards were fueled by political promises. As a result, nominal wages soared during the course of 1990. The ensuing east German economic crisis was not surprising, given that the region has undergone a sharp increase in production costs and full competitive exposure to world markets at the same time. By contrast, Poland at the beginning of 1990 devalued the zloty to a realistic rate close to the black market rate and has since enjoyed an export boom.18

Politicians and some economists have frequently argued that, with all legal and institutional barriers to labor mobility removed, an east German wage level that was in line with the low level of labor productivity in the tradable goods sector would have caused an unwanted surge in migration to the west. This argument may be challenged for a variety of reasons:

  • Economically, migration of workers to locations of higher productivity is not necessarily damaging. There may be externalities of migration that harm the people in the emigration region. But unlike cross-border migration of labor, intra-German migration gives rise not only to the higher individual welfare of migrants, but also to an increase of Germany’s GNP and, hence, to higher tax revenues that may benefit the region of origin. These extra tax receipts can be utilized to improve the investment environment in east Germany, for example, by means of a more rapid buildup of the physical and institutional infrastructure. Consequently, the economic case for artificially slowing down migration is not as strong as frequently suggested (see also Mayer, 1990b).
  • The adverse effects of wage hikes across the board, most notably in terms of higher unemployment and the ensuing uncertainty about the economic future of the region, may well be a stronger incentive for emigration than wage differentials (Akerlof and others, 1991), whereas productivity-oriented wage levels would have provided ample scope for the differentiation of wages needed to tailor them to the pattern of labor demand. Migration to the west has actually increased in the aftermath of the currency union.
  • Politically, there may be sound arguments for generous transfers to allow east German citizens to enjoy a standard of living far greater than warranted by the value of their labor productivity. Exaggerated wage levels, and the ensuing high social transfers required to cushion the unfavorable employment consequences, however, are an inefficient means of persuading east Germans to stay put. In this way, the profitability of production is reduced, resulting in an unnecessarily sharp decline in output and locally generated income. With more realistic wages and a smaller drop in domestic production, higher levels of both living standards and investment could have been attained in the east with a given amount of transfers from the west.

Principally, the conversion rate sets only the initial wage rate, while equilibrium wages can be attained in subsequent wage bargaining (Schinasi, Lipschitz, and McDonald, 1990). However, unfounded expectations were encouraged by the conversion rate, and nominal wages in east Germany proved to be inflexible downward. Indeed, fostered by the political promise to narrow the gap in living standards between the two parts of Germany, east German wages have risen sharply since the currency union while at the same time production collapsed. While Poland had levied punitive taxes on wage increases exceeding the rate of inflation (or a certain percentage of price level increases), there were no constraints on collective bargaining agreements in east Germany. Note that the east German wage hikes can hardly be interpreted as the result of a market-determined process of wage setting: wage increases were in most cases granted by managers of state firms who have no strong incentive to care for the long-term profitability of their firms. Furthermore, both employers and employees had good reason to assume that the firms would operate under a soft budget constraint so that excessive cost increases would be compensated by additional subsidies (for similar reasoning, see Lipschitz, 1990, p. 16).19

As it turned out, the political promise to narrow gaps in living standards quickly and the failure to devise ways of doing so without causing a slump in east German production have wiped out the chances of profitable production in most existing plants on the basis of current physical and institutional infrastructure. Although it continues to exist in physical terms, much industrial capacity has been made economically obsolete. The inevitable cuts in production automatically reduce tax revenues. And most locally produced goods have simply disappeared from east German shelves because they no longer command a price advantage over qualitatively superior western imports.

Because of the cost explosion, investment to improve the existing plants can hardly succeed in quickly attaining the high level of productivity that corresponds to the inflated wage level. Hence, modernization of the east German economy has to take place via the lengthy and costly route of rebuilding the major part of production capacity almost from scratch (Schmieding, 1991a). There seems to be less need for going this way in Poland. Unfortunately, this already daunting task is greatly complicated by another feature of German economic unification: almost all of the intricate complexities of west German laws and regulations have been introduced in east Germany. These administrative hurdles to investment may be bearable in the advanced west, where administrators have learned to cope with these rules over the course of time. Naturally, their east German counterparts who have grown up with a completely different system are still struggling to understand the immensely complicated details of the new rule book, let alone apply them sensibly.

The necessary rebuilding of the east German economy is delayed by a variety of hurdles to investment. In addition to remaining ownership uncertainty, the cumbersome west German laws and regulations about the appropriate planning procedures for infrastructure and housing projects contribute to the reluctance of investors. Furthermore, the insufficient provision of suitable land and of shop and office space has turned out to be a major obstacle to the establishment of new firms. Apart from ownership disputes, this is caused by the fact that east Germany does not yet have a normal real estate market, but only a residual market with artificially inflated prices and rents. Similarly, the housing shortage caused by the absurdly low level of the respective rents is a major constraint on the mobility of workers within east Germany. Perversely, this may well imply that some east German workers looking for a new job have to go west even if they could have found a suitable job in east Germany.

West German labor market regulations, including lay-off constraints, are another issue. For instance, the rule that existing labor contracts also hold for new owners of an enterprise (Article 613A of the German Civil Code) renders the purchase of an existing and typically overstaffed east German firm unattractive. This rule holds even if the firm in question is part of a larger unit that has gone bankrupt. It fosters the tendency among western investors to erect new plants instead of purchasing and modernizing existing ones—or to shun east Germany altogether.

Taken together, many of the developments in east Germany are only explicable in terms of a soft budget constraint for the whole region. In a way, the supposed advantage that east Germany became part of a much larger and wealthier unit—whose overall economic situation would be only moderately affected by developments in the east—has turned out to have some unfavorable consequences. Politically desired decisions could be taken without proper regard for their economic consequences. To a much greater extent than would have been feasible in other Central and East European countries, political considerations could prevail over economic logic.

Both the amount and the type of transfers from the west to the east may have undesirable ramifications. It remains to be seen whether private initiative and the motivation of the people will be impaired by the sheer size of transfers and credits (amounting to roughly two thirds of east German GDP in the second half of 1990, and, probably, in 1991 as well).20 More important, many of the present transfers take the form of selective subsidies for individual firms, which may distort the pattern of production.21 And, finally, the subsidization of capital through tax credits and grants, amounting to up to 33 percent of investment outlays (up to 42 percent for buildings), or through an immediate write-off of 50 percent in the first year plus a 12 percent tax-free investment subsidy, is a questionable means of stimulating economic recovery. It may lead to an artificially high capital intensity of production. Instead, public resources should be concentrated on areas that are the true preserve of the state, that is, on improving the investment environment. Most important, the various bottlenecks in east Germany’s administrative and legal system and in its infrastructure ought to be eliminated quickly. In this way, far more private capital may be encouraged to go eastward.

VI. Lessonsfor Centraland Eastern Europe: Summaryand Policy Conclusions

The success of economic transition toward a market economy will ultimately depend on private initiatives, that is, the readiness of foreign investors to commit resources to post-communist economies and the development of domestic entrepreneurship (see also Lipschitz, 1990, p. 16). Broadly speaking, we are living in the age of Schumpeter and not in the age of Keynes; supply-side rather than demand management measures are required. In the medium run, economic liberalization and opening up to world markets will clearly result in higher potential rates of return in Central and Eastern Europe so that capital will flow east. During the transition period, however, much depends on whether short-term uncertainties about the prospective rate of return—generating a weaker response by foreign and domestic investors—can be contained. To succeed in real adjustment, macroeconomic stabilization must be achieved quickly, an efficient microeconomic incentive system must be installed, the institutional framework has to be supportive to individual initiative, and the absorptive capacity for private investment has to be strengthened.

In several respects, the longer-run prospects for economic recovery in east Germany are enhanced by relatively favorable starting conditions, compared with other reform-minded countries. Most notably, monetary stabilization was no longer a major problem after the GEMSU, the institutional framework was easily available from the west, and the risk of policy reversal was largely absent. Moreover, “the saving surplus in west Germany provides a large pool of resources from which the investment needs of east Germany can be financed” (McDonald and Thumann, 1990, p. 78). At the same time, however, some of these advantages prove to be a two-edged sword in the short run.

With monetary stabilization achieved through the currency union, the exchange rate was no longer available as a shock absorber. A particularly strong transition crisis is by no means surprising when, as in the case of east Germany, comprehensive trade liberalization is accompanied by currency revaluation and higher local production costs, that is, a price-cost squeeze (Akerlof and others, 1991; Gabrisch and others, 1990, p. 16ff.; and Hoffmann, 1991); this is also evident from developing country experience (Papageorgiou, Michaely, and Choksi, 1991). Hence, a first lesson for Central and East European countries can be drawn: the east German experience should not be misinterpreted as an argument against sweeping trade liberalization. But governments are well advised not to stick to an overvalued exchange rate, which is frequently considered an anti-inflationary device; they should rather use the exchange rate tool to improve international price competitiveness and, thereby, to smooth the transition crisis. As a corollary, the world economy should not be protectionist vis-à-vis Eastern Europe. More specifically, the European Community (EC) should integrate the East European countries in an appropriate way (Siebert, 1991d).

Although easily available, the ready-made institutional infrastructure of west Germany may not be appropriate under east German conditions. It can even be argued that the unification provided the chance to dismantle restrictive regulations in the west, rather than extending the inherited overregulation to the east. Some elements of the regulatory framework adversely affect the economy’s adjustment flexibility, urgently needed especially in the difficult transition period. An example is the application of west German labor market regulations, in particular lay-off constraints, in east Germany. More generally, the sophisticated legal and institutional framework of advanced western economies appears much too complicated for economies in transition that do not possess the administrative capacity to handle such a system efficiently. The second lesson for Central and Eastern Europe is thus to implement only a limited set of basic rules and regulations that are essential for the transition to a market economy, not to interfere with the flexibility of the adjustment process, and not to put too much strain on the public administration. Contrary to the German unification, such a policy was followed in 1948 in west Germany by implementing the so-called Leitsätzegesetz through which some basic rules and intentions were established.

Owing to the “by and large satisfactory state of government finances” (Mayer, 1990a, p. 170) in west Germany, there was ample scope for fiscal support of economic transition and alleviation of the social adjustment burden. However, public financial support and subsidies may well be counterproductive. There is the risk that the pressure for adjustment is reduced, existing economic structures are preserved, and the flexibility of labor markets is impaired. This may suggest a third lesson: Central and Eastern Europe should attempt to attract private risk capital imports in the first place. External public support should be focused on protecting the unemployed people by transfers and qualification programs, rather than on rescuing inefficient enterprises (Sachverständigenrat, 1991). Moreover, technical assistance in managing the transition process may significantly enlarge the absorptive capacity of reform-minded countries for private investment (Kostrzewa, Nunnenkamp, and Schmieding, 1990).

The east German experience also underscores some typical transition problems that are more or less common to economies undertaking fundamental changes in the economic regime. A major prerequisite for creating an economic environment supportive of individual initiative is a clear delineation of responsibilities of the public and private sectors. It is not sufficient to establish the basic rules and the institutional infrastructure; it is also necessary to assign property clearly. In some cases, most notably the U.S.S.R., it is still to be decided to what extent individual property rights will be reinstated and enforced.22 But even after property rights per se have been firmly established, uncertainty about ownership may well continue and scare away private investors, as happens now in east Germany. Hence, as a fourth lesson, ownership uncertainty should be overcome as soon as possible, for example, by preferring financial compensation over reinstitution of previous owners of assets expropriated under communist rule and by accelerating the process of reinstitution in the cases outstanding.

The fifth lesson refers to the methods of privatization (for a more detailed discussion, see Schmieding and Koop, 1991). The German experience suggests that an unambiguously superior privatization approach does not exist. For example, the arguments in favor of distributing the privatization receipts directly and equally among the population are less relevant in east Germany than in other Central and East European countries (Siebert, 1991b). The Treuhand approach seems more appropriate in the German case. But it cannot be concluded that it is the optimal approach toward privatization in other countries. In any case, however, the institutional arrangements should ensure that privatization proceeds without undue delay to strengthen the supply response to market signals, and managers are controlled effectively by shareholders. Privatization is the most promising means of making firms efficient. Remaining ambiguity about the cleanup of environmental damage and old debt inherited from the communist era must be removed. To overcome the reluctance of would-be investors, it should be clearly specified in privatization contracts to what extent old liabilities will be taken over by the government. Privatization receipts should be distributed in a way that public support is maintained and the financial position of the government is not further eroded.

To speed up privatization, a sixth lesson should be followed, which again relates to the demarcation of responsibility between the public and the private sectors. Privatization must not be confused with structural policy; adjustment processes should be left to the market. Ultimately, an explicit structural policy might repeat the mistakes of the central planning system, that is, soften the budget constraints, postpone adjustment, and perpetuate inefficiency. Agencies such as the German Treuhand do not have reliable information on the economic viability of the firms to be privatized. Consequently, a restrictive stance should be applied to government bridging loans or public guarantees for new bank credit as possible restructuring devices prior to privatization. Guarantees may be justified, however, if enterprises do not have access to bank loans because unsettled property issues result in a lack of collateral.

In addition to common transition problems, the economic transformation of east Germany is subject to specific constraints resulting from the economic and political unification of Germany. The demonstration effect of the “rich brother” in the west gives rise to particularly high expectations by the people in the east, thereby undermining economically prudent wage and government expenditure policies. Obvious tensions are created by the intensively discussed trade-off between price competitiveness, westward migration, and wage policy (see, for example, McDonald and Thumann, 1990, p. 78; and Mayer 1990b). Wage concessions exceeding productivity gains further erode international competitiveness, thereby discouraging private investment and adding to unemployment in east Germany. On the other hand, wage restraint is in conflict with earlier government promises that the earnings gap between east and west Germany would soon be narrowed. It is also said to fuel migration, which, especially for highly qualified employees, may adversely affect the absorptive capacity for private investment funds. As far as migration is concerned, however, two arguments against excessive wage demands should be kept in mind:

  • Persistent and significant income differentials between different regions of west Germany suggest that it is not necessary to eliminate the wage gap between east and west Germany to stop migration (Akerlof and others, 1991; and Mayer, 1990b, p. 135).
  • It is open to question whether the income gap or additional unemployment owing to wage hikes provides a stronger incentive for westward migration.

The German solution to this conflict might be a more pronounced wage differentiation with regard to skills, sectors, and regions within east Germany. Other Central and East European countries do not face this particular trade-off, with labor being considerably less mobile across boundaries. Nonetheless, two final conclusions might be drawn from the German discussion on this issue. Wage increases should be moderate, to improve international competitiveness and to generate additional employment opportunities in the production of tradables. This refers in particular to countries where, similar to east Germany, the wage rate has to assume the role of the exchange rate in maintaining competitiveness, that is, where the exchange rate is (mis-) used as a nominal anchor to contain inflation. Wage demands may be checked by employers interested in the long-term viability of firms. This indicates that market-oriented and efficient wage setting and the privatization issue are closely intertwined, owing to the observation that the management of socialist firms is more likely to concede excessive wage increases.

Finally, the governments bear great responsibility that political demands for immediate income increases remain moderate. Experience suggests that unrealistic forecasts and promises about fast economic recovery during the transition period have fed overly optimistic public expectations on the speed with which living standards could be improved after a change in the economic regime. But the size of the adjustment problem is enormous, given the cosmic shock to which the inefficient socialist firms were subjected. Economic transition raises supply-side issues in the first place, for example, encouraging investment, creating new firms and products, setting up new production processes, and identifying new markets and marketing channels, all of which require time to be solved. The government’s temptation to conceal the short-term transition costs will ultimately add to such costs, by giving rise to additional problems in real adjustment of firms and by undermining the government’s credibility in the medium term. With lack of credibility becoming a major problem, reform programs are bound to fail, and the economic transformation of Central and Eastern Europe may be seriously delayed. Therefore, governments are well advised not to trifle with the expectations of people.

Appendix
Appendix Table 1.Employment Data for East Germany,1 July 1990-Mareh 1991
19901991
JulyAugustSeptemberOctoberNovemberDecemberJanuaryFebruaryMarch
Unemployment (in thousands)272361445537589642757787808
Short-time workers (in thousands)6561,5001,7291,7041,7101,7941,8561,9462,001
Working time lost per short-time worker
(in percent)43.644.647.048.251.855.056.0
vacancies (in thousands)2820242524222336
Source: Deutsches Institu für Wirtschafts forschung (1991); Frankfurter Allgemeine Zeitung, March 7, 1991, and April 5,1991.

End of month; Berlin (east) included.

Source: Deutsches Institu für Wirtschafts forschung (1991); Frankfurter Allgemeine Zeitung, March 7, 1991, and April 5,1991.

End of month; Berlin (east) included.

Appendix Table 2.Registration of New Firms in East Germany, 19901
First QuarterSecond QuarterJulyAugustSeptemberOctoberNovember
Total16,89683,98335,84930,79029,76829,36629,072
(…)(…)(33,542)(27,866)(26,127)(25,204)(24,351)
Handicrafts213.811.910.910.28.8
(…)(…)(12.4)(10.1)(9.2)(9.0)(76)
Trade and restaurants252.656.653.348.846.8
(…)(…)(53.4)(58.0)(53.9)(48.3)(45.9)
Source: Gemeinsames Statistisches Amt der neuen Bundeslander (1990).

In parentheses, net of cancellations.

In percent of total.

Source: Gemeinsames Statistisches Amt der neuen Bundeslander (1990).

In parentheses, net of cancellations.

In percent of total.

Appendix Table 3.Industrial Production in East Germany,1 October 1989- December 1990(1985 = 100)
TotalEnergyChemical IndustryMetallurgyConstruction MaterialsMachinery and Transport EquipmentElectrical EquipmentLight IndustryTextilesProcessing
1989
October113.4104.6109.5105.8109.7115.7137.6110.8113.8111.7
November110.8111.8110.4101.5105.9105.7133.2112.5111.3110.8
December108.3118.6105.0102.193.0110.5135.4106.3108.9108.8
1990
January104.1112.2103.1101.896.2105.5127.0109.8107.496.5
February107.5108.1101.3101.8103.0112.5136.0111.6108.399.2
March109.2102.3101.8102.2107.3115.8141.1114.0112.099.3
April108.090.2102.099.6110.0121.6141.6108.5111.798.9
May102.689.293.597.1112.1117.3139.3100.291.494.2
June95.981.189.783.3111.8123.4132.587.683.175.1
July62.455.067.542.167.481.995.155.553.442.7
August53.247.953.235.544.873.173.549.849.038.3
September54.555.952.635.839.173.977.253.351.539.1
October55.161.251.731.837.071.677.654.149.447.2
November56.669.655.334.235.371.273.655.747.748.4
December50.8
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1

For an overview on the background and plans for reform in the former German Democratic Republic, see Mayer and Thumann (1990).

2

Subsequently, the drive for political union accelerated. According to the Unity Treaty, the German Democratic Republic became part of the Federal Republic of Germany on October 3, 1990.

3

Among the exceptions, the different treatment of short-time work is noteworthy.

4

In effect, the major west German commercial banks have played an important role in east Germany’s banking system since July 1990.

5

With the currency union, the deutsche mark money supply (M3) increased by 14.5 percent (Deutsche Bundesbank, 1990, p. 4) while the production potential of the deutsche mark currency areas was enlarged by roughly 8 percent. The difference constitutes a potential for overall German inflation, albeit a manageable one. The Bundesbank may well succeed in neutralizing this unwarranted surge in the money supply by an appropriately restrictive monetary policy. Furthermore, the very fact that German unification has led to an exceptionally severe adjustment crisis may well induce east Germans to keep involuntarily accumulated money balances as voluntary savings for the time being.

6

The latter will be a by-product of rent liberalization in the first place; and over the course of catching up with the west, market prices for nontradables in the east will increase relative to those of tradables.

7

Taken together, agriculture, forestry and fishing, mining, clothing, and textiles accounted for 16.2 percent of the east German labor force, as opposed to merely 6.4 percent in west Germany.

8

Various opportunities exist in this respect. For example, managers of state-owned firms have created private enterprises while still in office. They have then transferred part of the state-owned firm’s assets to their own enterprises by establishing close links between both units and specifying contract terms at the expense of the state-owned firm still managed by them (Schmieding and Koop, 1991, p. 8).

9

Some adjustment of this sort has actually been observed, for example, in Poland (Jorgensen, Gelb, and Singh, 1990).

10

Some particulars must be laid down in the contract that provides the basis for the bidding process, most notably the allocation of environmental vintage damages, the treatment of old debt and other liabilities, and, possibly, investment and employment guarantees.

11

A disadvantage of this option might be that it makes it easier for the old management to stay in power.

12

Meanwhile, about 1 million applications for restitution from previous owners are under consideration, about 10,000 of which relate to medium- and small-sized firms.

13

It was also decided that expropriations carried out during the time of the Soviet military government (1945-49) would not be reversed.

14

For example, indices of production refer to obsolete price weights, and statistics on the pre-reform era are likely to be deliberately embellished.

15

To some extent, this productivity increase simply mirrors higher wage costs in the government sector that are directly financed by western transfers.

16

Moreover, the nominal consumption figures significantly understate the substantial rise in real living standards. They do not capture the effect that substandard east German tradables were largely replaced by cheaper and qualitatively superior western products.

17

The foreign currency coefficient that indicates the value of domestic inputs in east German marks needed to earn one deutsche mark in exports stood at 4.4 in 1989. Admittedly, however, this figure presents a highly deficient yardstick of the competitiveness of east German exports to the west.

18

At the end of 1990, those east German workers who were still fully employed earned roughly six to eight times more than their Czechoslovak and Polish counterparts.

19

Somewhat cynically, one may even argue that the behavior of trade unions in east Germany is quite rational from an east German perspective regardless of the nature of the budget constraint for individual firms and the resulting drop in employment. Unions trying to maximize the sum of wages and unemployment benefits in east Germany have an incentive to push for west German wage levels, regardless of the local level of productivity, as the overall costs of unemployment are shifted onto nonresidents, that is, the west German taxpayer, and as east German unemployment benefits rise with local wage levels.

20

East German public sector deficits amounted to roughly DM 68 billion in the second half of 1990, DM 40 billion of which were financed by western transfers, the remainder by credits explicitly or implicitly guaranteed by the west. The figure for 1991 is forecast at roughly DM 150 billion, DM 120 billion of which will probably be covered by outright transfers (Boss, 1990).

21

For example, subsidies for production and exports to former CMEA countries amounted to roughly DM 6.5 billion in the second half of 1990 (Hoffmann, 1991). Substantial subsidies are also granted for firms that the Treuhand deems viable in the long run or on whose fate the Treuhand has not yet decided.

22

It is sometimes even unclear in this case whether the whole union or the republics own the firms to be privatized.

Comments

Leslie Lipschitz

Messrs. Siebert, Schmieding, and Nunnenkamp have written a very good paper but one that is rather difficult to discuss: there is little in it with which I can forcefully disagree. I should like, therefore, to start with a suggestive format and to proceed indirectly to comment on the paper.

Even at the time of the original treaty on German economic, monetary, and social union (GEMSU), it was possible to distinguish between two types of problems. I shall call the first type economic management problems—that is, those that could be overcome by good management and appropriate institutional engineering—and the second type, politics-and-prayer problems—that is, those that were fundamental to the new situation and could be addressed only by wise political leadership and propitious circumstances. In the papers my colleagues and I wrote at the time we identified both types of problems, but we had most to say about the first type. This is true also of the paper by Siebert, Schmieding, and Nunnenkamp. And this is not surprising, for it is much easier for economists to discuss issues of economic management and to arrive at sensible conclusions than it is to solve the more difficult and more fundamental problems.

The economic management problems we referred to as deviations from Ordnungspolitik. The term Ordnungspolitik refers to the setting up of a secure, unobtrusive, and well-understood institutional and financial framework within which market forces are given free play. The “deviations” referred to instances in which the institutional framework was set in an unclear or ambiguous way, or in a fashion that would impede the workings of the market and therefore require subsequent government intervention. Let me give four examples and illustrate them using both the paper by Siebert, Schmieding, and Nunnenkamp and a collection of papers written in the IMF (henceforth IMF).1

First, the initial dismemberment of the state into an administrative system, an enterprise system, and a banking system was problematic. Banks were left with bad old enterprise credits on their books that would eventually require a government bailout, and enterprises were left with bad old debts—sometimes owing to borrowing at the behest of the Government—which would also require government bailouts. Thus neither banks nor enterprises were set up to operate on market rules (see IMF, pp. 4-5). On page 63, the present authors focus attention on the need for an institutional structure by means of which economic “decisions can be decentralized and microeconomic costs and benefits … related to the specific producer.” And they express concern that the new setup may permit shifting to the Government “firm-specific costs and risks.” I am in complete accord with these concerns.

Second, the mandate of the Trust Fund (Treuhandanstalt) was unclear. Prior to GEMSU, we had envisaged mechanisms that would put Treuhand enterprises into private hands, with the holding companies (or funds) managing the assets mandated only to maximize their value. In fact the way that the Treuhandanstalt was actually established almost guaranteed that its mandate would be broad, that it would operate as an instrument of social policy, and that its social policy function would interfere with rational structural policy. Instead of limiting its social mandate, the Treuhandanstalt has tried to keep a variety of problematic enterprises afloat and has offered all sorts of guarantees that, I would argue, have given rise to unrealistic expectations and unreasonable wage demands. I would therefore fully endorse the authors’ conclusion (p. 75) that

Enterprises not taken over by private owners even after inherited debt and environmental damages have been cleared by the Government must be closed down, instead of wasting the receipts from privatization by subsidizing nonviable firms. The living standard of the people affected should be protected by social rather than by structural policy, since the former does not interfere with an efficient allocation of capital.

Third, the problems of privatization. The authors make a strong case for rapid privatization based on an analysis of problems in the incentive structure for managers of Treuhand companies prior to privatization (pp. 72-74). I would agree with their view that privatization should have proceeded as fast as possible. But as discussed in depth at the time of GEMSU (see IMF, p. 9), it was clear that, besides the difficulty of pricing east German companies, privatization would be obstructed by the need, in each case, to allocate responsibility between the Treuhand and the would-be investor in four critical areas: (1) property rights—who would be responsible for settling claims by previous owners; (2) cleaning up the environment—who would bear the cost; (3) old company debt—who would pay this; and (4) shedding surplus labor—new owners would be bound by costly restraints on large-scale dismissals in German labor law. There has since been some clarification of the first three of these issues, but the Treuhand has added to the legal difficulty of shedding surplus labor (and to the problem of low productivity) by seeking to build job guarantees into many privatization deals.

Fourth, the sequencing of transfers. This is a lesson from German unification that is perhaps not sufficiently covered by the present authors. It is terribly important in the east German case to get infrastructural investment, financed by transfers from the west, off the ground quickly. Large public works programs that are necessary in their own right would also help to absorb unemployed labor; but such programs require many decisions at the state and local government levels and this decision-making apparatus has taken time to put in place. As argued at the time of GEMSU (IMF, p. 11), without such large-scale public investment projects, concerns about prolonged unemployment would elicit costly and wasteful subsidies that would subsequently prove difficult to remove. Moreover, a dearth of supporting public infrastructure would discourage private investment.

This indeed is what has transpired. Old industries have fired workers or put them on short-time work while there has been insufficient new activity to absorb them. Consider the implications of DM 50 billion in public works programs. To take an extreme example: suppose it all goes into construction. About half of construction is value added, of which labor gets two thirds—that is, in this example, DM 17 billion. If each employee costs DM 25,000 (about half the west German level, including social security and benefits), this would mean 680,000 jobs. There would also be significant additional employment from increased demand for construction materials plus the second-round multiplier and accelerator effects. Of course, these figures are too high—telecommunications and railways, for example, will have larger import content and lower value added. But the figures do illustrate the importance of increasing investment early in the game and of easing the administrative constraints on absorptive capacity.

Now let us consider the second type of problem: what I have called politics-and-prayer, or fundamental, problems. The most fundamental problem in German unification has to do with wage differentials, income aspirations, investment, and migration. To encourage private investment flows into east Germany, wage rates and productivity need to be such that the rate of return on investment compensates for the risks entailed. Without such investment there can be no sustainable closing of the income gap between east and west. But in an area with open borders, a common language, and a common basket of goods available, there is no way to deal with unreasonable wage expectations except by trying to forge a realistic political consensus on the issue and by letting the market take its toll.

In the course of 1990, wage rates in east German industry are reported to have risen by more than 40 percent; this increase has imposed a profit squeeze on enterprises such that some potentially viable firms will now almost certainly have to be liquidated. Economists always are most at ease when they can clearly identify the erroneous government policy behind any particular problem; I believe that in the present paper Siebert, Schmieding, and Nunnenkamp have succumbed to this tendency in assigning so much of the blame for the dire circumstances of the east German economy to the initial rate of conversion from east German marks to deutsche mark. To attribute the profit squeeze in east Germany to the initial conversion rate is to confuse real and nominal phenomena. The problem was not the initial exchange rate, but rather the fact that wage demands, couched in real terms (that is, in terms of the west German consumption basket), were far out of line with productivity. Let me be categorical. If workers in Bangladesh decided that they were going to set their wages at two thirds of the west German level in real terms, Bangladeshi companies would go out of business no matter what the nominal exchange rate. If there was a policy problem in east Germany, it was that workers were allowed to entertain unrealistic aspirations. But this has little to do with the initial nominal conversion rate.2

Finally, one technical point. It is wrong to infer anything about the appropriate nominal conversion rate from the Richtungskoeffizienten (that is, the internal exchange rate of DM 1 = M 4.4 in 1989 set by the former German Democratic Republic government) as is suggested in the paper. Using data on enterprise costs provided in a recent paper,3 it is possible to conclude that after conversion (but before the wage increases) the average domestic resource cost of DM 1 was M 1.45. If this were true, about one fifth of firms would have been viable at a conversion rate of one to one before the wage hikes. Given that the old system incorporated substantial incentives for overstating costs, perhaps the reality was not very different from the conventional wisdom at the time that about one third of the existing firms would prove viable at a conversion rate of one to one. The problem, therefore, was not with the conversion rate but with excessive real wage demands, employment guarantees that reduced the considerable scope for cutting costs, and with the government’s failure to inculcate a sense of realism in east German aspirations.

Dariusz K. Rosati

The paper deals with the economic problems of German unification, but conclusions are put in a broader perspective. Important lessons are drawn from the German experience in transformation that are applicable for other reforming countries of Eastern Europe. Though only nine months have elapsed since monetary union was established, and only six since the formal unification treaty, the paper provides a wealth of observations and is impressive in the depth of its analysis.

The paper starts with a general discussion of the transformation process. Three principal tasks of the transformation include (a) change in the institutional framework; (b) macroeconomic stabilization; and (c) microeconomic reforms.

In the reform process some fundamental policy dilemmas emerge, such as the speed of adjustment, the sequencing of measures, and the composition and level of policy parameters. The paper discusses various approaches to reform, ranging from piecemeal and inconclusive reform attempts in Eastern Europe in the 1970s and 1980s to painful adjustment programs undertaken in some developing countries. However, the introductory part of the paper fails to address some important questions such as what is the relationship between the three main areas of reform or how the above-mentioned policy dilemmas should be solved.

It may be argued that the three main tasks of the transformation process should essentially be addressed by three different categories of policy instruments, and that these tasks can be implemented only gradually. Macroeconomic stabilization is the most immediate task, and should be achieved by reducing subsidies, eliminating budget deficits, and a restrictive monetary policy. This is essentially a short-term goal. The new institutional framework may normally be established in the medium term, although in the case of the former German Democratic Republic we have witnessed a rather exceptional “wholesale” adoption of west German institutions. Finally, various instruments of industrial policy should be applied to reallocate resources and restructure the economy—which can be achieved only over a longer period of time. While “goals” may be realized only after some time, the policy decisions should be taken as soon as possible to ensure the early initiation of the process and to allow for unavoidable time lags.

The central section of the paper deals with German unification (GEMSU—German economic, monetary, and social union), with the emphasis on specific initial conditions in the former German Democratic Republic. The authors observe that the policy course followed was a result of a broader set of politico-economic considerations, with political ones playing the dominant role. The most important single decision was perhaps the adoption of the biased conversion rate of one to one for east German marks. The rate was obviously overvalued for political reasons; but the authors do not elaborate on these reasons. On the other hand, it may also be argued that inherent risks connected with the GEMSU were minimized because of the idealistic confidence in the traditional anti-inflationary stance of the Bundesbank.

It is true that east Germany seemed to be in an exceptionally good position initially, at least compared with other East European countries. Relatively high living standards, a common language and historical tradition, and skilled manpower were seen as important factors that would alleviate the costs of adjustment. Adoption of the west German institutions and laws virtually overnight saved time and money needed for the preparation of reform, and the massive public transfers from Bonn raised expectations for quick and successful transformation.

But the early results are very disappointing. An economic slump of such proportions in east Germany is something that nobody had expected (see Table 1). The contraction of output is much deeper than in other East European countries, and unemployment has reached socially intolerable levels. The authors point out that, contrary to earlier expectations, the specifically east German advantages have been largely outweighed by specifically east German problems (such as obsolete capital stock, worn-out infrastructure, distorted economic structure, pollution, and a bias in trade toward countries of the Council for Mutual Economic Assistance (CMEA)) as well as policy failures. Although some decline in output has been unavoidable and in fact desirable, the recession is far too deep, fundamentally because of the overvalued conversion rate for the east German mark.

The German experience is sometimes used as an argument against any kind of “shock” transformation. But what it really demonstrates is not that the shock approach does not work but rather that the program design and implementation have been wrong. Politically motivated decisions on the conversion rate completely distorted the adjustment mechanism. First, no allocation of loss has taken place, as it was prevented through generous conversion of east German savings. With savings of individuals thus protected, enterprises were bound to be the main losers. In Poland, the policy was the opposite: individuals incurred losses through erosion of real wealth, while enterprises were protected (though inadvertently) through price liberalization and wage controls. Both extremes should probably be avoided.

Table 1.Comparative Analysis of Shock Therapy in East Germany and Poland, End-December 1990(1989 = 100, unless otherwise specified)
East GermanyPoland
Employment (1989(IV) = 100)71.983.3
Unemployment (in percent)6.1 (14.2)16.1
Industrial output50.4276.5
Individual consumption103.2 2,384.0
GDP80.8 287.0
Average wage147.168.5
Exports112.6132.2 4
Imports160.787.6 4

Including short-time workers.

Compared with fourth quarter of 1989.

Current prices.

Convertible currency trade only.

Including short-time workers.

Compared with fourth quarter of 1989.

Current prices.

Convertible currency trade only.

Furthermore, the conversion rate adopted did not allow for real wage adjustment. Under inflexible wages the restoration of market equilibrium requires massive unemployment, the competitiveness of domestic producers necessarily deteriorates, and foreign investment is discouraged. Again, in Poland, the approach was entirely different: real wages declined sharply in 1990 (by 30 percent), contributing to high competitiveness in the tradable sector. Table 1 provides data on the results of shock therapy in east Germany and Poland in comparative perspective. As can be seen, the trade-off between real wages and unemployment has been solved differently.

Third, real devaluation is needed at the initial stage of transformation to allow for the “crowding in” effect under conditions of general financial restraint. This effect was absent in the former German Democratic Republic, and no protection was provided after unification. The result was that under the downward inflexibility of wages, the one-to-one conversion rate dealt a fatal blow to the state enterprise sector. The interesting question remains, however, whether the monetary union was in general premature, or whether under a different conversion rate it would have been more successful.

The authors formulate six principal lessons for other East European countries. First, while drawing lessons from the German experience, it is essential not to misinterpret the results obtained. Specifically, the contraction following the GEMSU should not be used as an argument against trade liberalization. With the conversion rate established at an excessively high level and without real devaluation, some second-best policies were necessary (subsidies). But the first-best approach (real wage reduction) was thus deliberately ignored for noneconomic reasons.

Second, the authors suggest that instead of replacing the old system with a sophisticated west German institutional infrastructure, a limited set of basic regulations should initially be introduced, with further reforms implemented only gradually. This conclusion, however, may not be valid for other countries where a different situation prevails: too few institutional reforms implemented hamper the speed of the transformation This is particularly visible in Poland, where the slow pace of privatization is perhaps the most important single obstacle in the reform process.

The third lesson is that the priority in foreign investment policy should be to attract private capital inflows. Private investments are generally more efficiency oriented and are more likely to yield higher returns quickly. Public capital inflows should in turn concentrate on infrastructural projects and on financing technical assistance.

Fourth, the German experience demonstrates that uncertainty over property rights and ownership regulations should be overcome as quickly as possible. Foreign investment and privatization can only be speeded up if claims of assets by previous owners are cleared through financial compensation rather than through reinstitution.

Fifth, methods and techniques of privatization should be country specific rather than universal. For instance, in Germany no voucher system for giving free state-owned assets seems desirable, but in other countries the acute shortage of domestic capital may justify various voucher schemes.

Finally, privatization should not be confused with restructuring. Specifically, the government agency responsible for privatization (for example, Treuhandanstalt) should not be charged with designing industrial policies and allocating restructuring credits.

While these lessons can by and large be accepted, I would add three more important conclusions. First and most important is that the unexpected failures of the GEMSU in the early period should not be attributed to the shock approach adopted, but rather to politically motivated assumptions on the conditions of unification. Thus the argument is not against completing transformation in one stroke, but against voluntarism in the decision-making process. Second, stabilization without excessive recession requires flexible wages and a competitive exchange rate. Both were missing in east Germany, and this fact may explain the deeper recession than that in Poland, despite the relative abundance of capital. Third, political considerations move the transforming economy away from economic optimality (in the Pareto sense). If pushed too far, they contribute to economic collapse and disillusion, which may produce political and social unrest, thus increasing the overall cost of transition. The important lesson is twofold therefore. The government should avoid making excessive promises, even though this action may be tempting politically. On the other hand, the necessary hardship should be imposed up front, without hesitation, as popular enthusiasm erodes quickly, and the readiness to sacrifice current consumption for future (uncertain) gains declines over time.

Summary of Discussion

The discussion on Mark Allen’s paper mainly centered on the experience of Poland, although with more general implications. The failure of the economic policy programs to generate an adequate supply response was considered the biggest problem, and attempts were made to identify possible causes (for example, slowness of institutional reforms, wage restrictions as impediments to restructuring, and delays until budget constraints become binding) and remedies (tightening the budget constraint and reducing administrative control).

It was generally indicated that macroeconomic stabilization implies microeconomic restructuring. The presumption was expressed that firms in formerly centrally planned economies might not yet show the same price/output reactions as firms in developed market economies, especially since the former might not yet believe in the hard budget constraint and might expect the government ultimately to bail them out.

There was no general consensus among the discussants on the most pressing measures to overcome the present collapse in production. Opinions ranged from strong supply-side measures to expansionary demand management. The question of demand-side policies was hotly debated. Some argued for a devaluation to restore the competitiveness of Polish industry that was lost as a consequence of high inflation. Others pointed to the likely consequences of demand stimuli without prior restructuring, namely, current account problems and accelerating inflation. (The reflationary attempts in Poland during the second half of 1990 were a case in point.)

An attempt was made to shed some light on the main reasons for persistent inflation despite the relatively small monetary overhang. The relative price adjustments necessary to align the distorted price structure to market conditions combined with a general downward rigidity of prices were not considered sufficient explanations for the large increases observed. The plethora of possible—not mutually exclusive—explanations included the persistence of inflationary expectations, the strong increases in energy prices and indirect taxes (cost-push inflation), wage indexation, as well as the continued existence of monopolistic structures.

It was widely agreed that the former German Democratic Republic constituted a very specific case and could therefore not serve as a model for other economic transitions. Nevertheless, some lessons were considered valuable also for other countries. The special relationship to west Germany was judged to be a two-edged sword. Almost unlimited financial transfers without conditionality, and the transfer of a highly developed and sophisticated legal system to a country in transition have both created special problems. The former postponed adjustment pressures, bolstered real consumption, and distorted factor prices; the latter overburdened the firms as well as the bureaucracy, creating inflexibility as well as adding to legal uncertainty.

A question that received considerable attention in evaluating the transformation of both Poland and the former German Democratic Republic was the “right” exchange rate. For Poland the initial depreciation was criticized as being too strong, because the monetary overhang had been overestimated. As a possible alternative, a two-stage approach to finding the correct rate was suggested. For east Germany, the discussion about this issue centered on the question of whether the lack of competitiveness of companies was caused already by the nominal conversion rate between the east German mark and the deutsche mark or only afterward by the strong wage increases.

The question of whether the sheer size of the transfers to the former German Democratic Republic gives an indication of the enormous amounts of resources needed for the transformation of all the countries of Central and Eastern Europe was raised. But it was pointed out that the German case represents an upper limit, as the cost push and the profit squeeze (wages in the industrial sector of the former German Democratic Republic rose during 1990 by about 40 percent) made especially large transfers necessary to keep the affected firms from collapsing. Governments alone would not be able to cope with these financial needs. Domestic savings as well as private inflows will have to complement public funds.

1

Leslie Lipschitz and Donogh McDonald, eds., German Unification: Economic Issues, Occasional Paper 75 (Washington: International Monetary Fund, 1990).

2

It was argued at the time of currency conversion that the more appreciated the rate of conversion, the more contained would be the subsequent wage demands. There was thus little or no nominal illusion on the part of east German workers, and one cannot attribute the real profit squeeze that is fundamental to the east German problem to the initial conversion rate. I would not argue, however, that the conversion rate was unimportant; it had important influences on distribution and allocation (see IMF, Chapter X).

3

George A. Akerlof, and others, “East Germany in From the Cold: The Economic Aftermath of Currency Union,” paper presented at the Conference of the Brookings Panel on Economic Activity, Washington, April 4 and 5, 1991.

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