Chapter

I Introduction and Overview

Author(s):
International Monetary Fund
Published Date:
December 1990
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Leslie Lipschitz

German economic policy has become exciting again.

In the fall of 1989 the economy of the Federal Republic of Germany (FRG) seemed set to embark on its eighth year of a steady but unspectacular upswing. The principal domestic economic issue was whether, despite a stubbornly high unemployment rate, capacity constraints in certain sectors of the economy might threaten price stability. The chief international economic issues were concerned with the size of the external surplus and the process of European economic integration.

The economic statistics of the German Democratic Republic (GDR) also did not reflect the extent of incipient turmoil in the system. The GDR differed from the other member countries of the Council for Mutual Economic Assistance (CMEA) in that its entire population had a guaranteed right of access to the west. As long as emigration was prevented, the GDR was a viable economy; but the opening of Hungary’s border with Austria in September 1989, coupled with political changes in the U.S.S.R., Hungary, and Poland, rendered the situation unstable.

On November 9, 1989 borders with the FRG were opened and later in the month Chancellor Helmut Kohl outlined his plan for unification. During the period January–October emigration from the GDR to the FRG had amounted to about 167,000. In the last two months of the year another 177,000 people emigrated. After continued mass emigration in the opening weeks of 1990, Chancellor Kohl, on February 6, proposed a currency union with the FRG. The “grand coalition” Government that took office in the GDR in April 1990 (after a conservative election victory in March) expressed its support for German economic, monetary, and social union (GEMSU) and rapid political accession to the FRG. The terms of GEMSU were negotiated in April–May, a State Treaty was signed in May and ratified by the legislatures in June, and GEMSU became effective on July 1, 1990. With economic unification virtually accomplished, the drive for political union accelerated: the German Unity Treaty was ratified by the parliaments in September, and the GDR became part of the Federal Republic of Germany on October 3. The first free all-German elections since 1932 were held on December 2, 1990.1

Thus, the process of German unification, from the initiating events until full political union, was completed within a year. In the course of this process the GDR ceased to exist as a separate state, the basic institutions of the east German economy were essentially demolished and replaced, and the Governments of the FRG and the GDR were forced to make myriad unprecedented decisions on the structure of the economy that would influence economic policies for a long time and give rise to many new and difficult challenges.

The economics of unification will dominate the German economic policy debate for the next few years. At this early stage, however, analysis and projection are frustrated by imponderables in essential areas—for example, the viability of east German industry in a market environment—and by the absence of a statistical base covering all of Germany. The second section of this chapter discusses the economic situation in the FRG and the GDR immediately before GEMSU. The third section considers some critical aspects of policy in the process of integrating the two economies. It focuses especially on the economic implications of German unification in the period through 1991. The final section contains a brief guided tour of the following chapters and some tentative conclusions.

The Two Economies on the Eve of Unification

The Situation in the FRG

The economic performance of the FRG in 1989, the seventh year of expansion in the current cycle, exceeded all expectations (Chart 1). The 4 percent increase in real GNP was the strongest thus far in the upswing. Investment accelerated in response to large profits, abundant internal company resources, strong demand, and high levels of capacity utilization. Despite a worsening of the external terms of trade, consumer price inflation remained below 3 percent and the current account surplus widened.

Chart 1.Federal Republic of Germany: Developments in 1980–89

Sources: Statistisches Bundesamt, Volkswirtschaftliche Gesamtrechnungen; and Ifo Institute, Schnelldienst.

1 Contribution in percentage points.

2 In percent a year.

3 The previous peak was at 100 in the fourth quarter of 1979.

4 Affected by widespread strikes.

Real growth in 1989 exceeded conventional measures of the rate of growth of potential. Moreover, given the longevity of the upswing, most estimates showed little or no spare capacity in the economy. The strength of business investment suggests, however, that supply constraints elicited a capacity widening response. This is confirmed by developments in the labor market: in 1989 more than 370,000 jobs were created (compared with fewer than 200,000 in each of the two preceding years) and the unemployment rate dropped sharply. But, even with the effects of large-scale immigration2 and buoyant investment on capacity, growth at the pace achieved in 1988–89 was unlikely to be sustainable over the medium term.

The stance of macroeconomic policies in 1989 was broadly restrictive. The budget deficit of the territorial authorities3 fell from 2¼ percent to 1¼ percent of GNP, the lowest level in the current cycle. The general government accounts (which include the social security system) showed a small surplus in 1989, the first since 1973 (Chart 2). Monetary conditions were also tightened: after three years of money growth exceeding its target, in 1989 broad money (M3) grew by 4¾ percent, compared with a target of about 5 percent. Against the background of a relatively weak deutsche mark in the first three quarters of the year and high and rising capacity utilization rates, the Deutsche Bundesbank increased official interest rates on various facilities by 2½ percentage points in the course of the year; short-term money market rates rose by slightly more. With a downward tendency in U.S. dollar interest rates, the short-term differential vis-à-vis dollar rates narrowed after April and was eliminated completely by the end of the year. The deutsche mark appreciated sharply both against the U.S. dollar and in effective terms in the last quarter of 1989; thus, although on average the effective value of the deutsche mark was 1 percent lower in 1989 than in 1988, in the course of the year it appreciated by 3¾ percent.

Chart 2.Federal Republic of Germany: Indicators of Fiscal and Monetary Policy, 1980–89

Sources: Statistisches Bundesamt, Volkswirtschaftliche Gesamtrechnungen; and Deutsche Bundesbank, Monthly Report.

1 National accounts basis; in percent of GNP.

2 In percent a year.

National accounts data for the first half of 1990 showed continued rapid growth: private consumption boosted by the long-planned tax cut, further buoyant investment in both equipment and construction, and, despite some drag on the economy from a weakening foreign balance, GNP almost 4 percent above the level of the first half of 1989. Inflation (the 12-month rate of increase of the consumer price index) was 2¼ percent in June, reflecting lower import prices and little upward pressure from domestic costs.

In January 1990 the long-planned tax reduction and reform package became effective: with the lowering of gross taxes offset in part by a reduction in tax preferences, the net effect was an injection of purchasing power equivalent to 1 percent of GNP. The Government also announced its decision to abolish the stock exchange turnover tax (Börsenumsatzsteuer) by January 1991 and the taxes on company equity issues (Gesellschaftsteuer) and on bills of exchange (Wechselsteuer) in January 1992, measures long advocated by the financial community.

Financial conditions in the first half of 1990 reflected a continued restrictive stance of monetary policy coupled with some uncertainty about medium-term prospects. The growth of M3 was close to the lower bound of the (4–6 percent) target range and short-term interest rates were more or less stable. Bond yields, however, jumped by a percentage point in the first quarter, partly in response to developments in the GDR and the February proposal for currency union. In the first six months of the year the deutsche mark was broadly unchanged in nominal effective terms; a strong appreciation against the U.S. dollar and the Japanese yen was offset by a weakening of the deutsche mark within the exchange rate mechanism (ERM) of the European Monetary System (EMS) and against the pound sterling.

The prudent policies of the Government of the FRG through most of the period of cyclical upswing and the strength of the economy in 1988–90 provided a solid foundation for unification. Thus, the starting position for GEMSU in the FRG had many favorable aspects:

  • a national saving rate that exceeded national investment by some 4½ percent of GNP;
  • a considerable improvement in company profits during the previous seven years and substantial liquid company reserves for investment;
  • a reformed tax system (in which taxes had been reduced by 2½ percentage points of GNP since 1985) and a balanced general government position in 1989;
  • low inflation and a credible anti-inflationary stance of policies;
  • net foreign assets of some US$300 billion.

Against these positive aspects one had to weigh the danger of overheating: the economy was already operating at close to full capacity and the critical question was whether the additional demand generated by GEMSU would succeed in eliciting a supply response without raising the rate of inflation. Clearly demand pressure in the FRG would be relieved to the extent that resources could be drawn in from other countries. But the flexibility of the labor market and of capacity constraints were essential considerations on which it was not easy to form a judgment.

The Situation in the GDR

It was difficult to assess the starting economic situation in the GDR. The GDR, with a population of 16½ million (a fourth that of the FRG), covered an area almost half the size of the FRG. Although the statistics on demographics and on the characteristics of the labor force and its distribution by sector were reliable, historical data on income, output, prices, and the financial situation of enterprises provided little guidance to the economic situation. The problem was fundamental: the data reflected a structure of prices set by the Government, and without a market-related set of relative prices it was impossible to come to any realistic assessment of the main economic aggregates. On the basis of the most recent estimates it appeared that the historical data presented an unrealistically positive picture of the strength of the economy and the welfare of the people. It was clear also that the economy had suffered serious setbacks during the period between the fall of 1989 and July 1, 1990.

Conventional estimates showed the following stylized facts on the GDR economy:

  • a GNP some 10 percent the size of that in the FRG;
  • a level of labor productivity 30–35 percent that of the FRG;
  • an average gross wage about one third and net takehome pay less than half of that in the FRG;
  • a heavily indebted enterprise system with considerable obsolescence in the structure of both capital and products;
  • enormous environmental problems, in particular in the chemicals and energy sectors;
  • a distorted structure of prices and wages coupled with an interventionist tax and subsidy system;
  • a history of strict curtailment on the range of products available, with “luxury goods” largely unavailable;4
  • more than half of external trade conducted with CMEA countries;5
  • net foreign debt in convertible currencies of some US$16¼ billion (about one tenth of GNP) at the end of April 1990.

Successful economic integration with the FRG would entail a comprehensive privatization program, large-scale investment in public infrastructure and private productive assets, the adoption of a tax and social security system virtually identical to that in the FRG, a relinquishing of monetary control to the Bundesbank, the establishment of a market-based financial system linked with that in the West, and an incentive system that succeeded in staunching emigration and encouraging capital inflows. It would almost certainly require substantial transitional unemployment and perhaps a hardening of living conditions for some as subsidies were removed and prices of basic goods rose. A critical question was how much of GDR industry was or could be made viable in a market system. Given uncertainty about wages, input prices, actual and potential demand, and financial resources available for restructuring, it was impossible to project income even on a firm-by-firm basis.

Dismembering the State in the GDR

It may be useful to focus briefly on the most fundamental aspect of the economic reform: the dismembering of the State. In the pre-GEMSU GDR most real assets were owned by the State and the banking system consisted chiefly of the Staatsbank (State Bank). There was, therefore, no effective demarcation between the Government as government, the business or enterprise sector, and the banking system. The principal components of a stylized consolidated balance sheet of the State would have included only the following items:

AssetsLiabilities
LandCurrency held by individuals
Social infrastructureBank deposits held by individuals
BuildingsForeign debt
Machinery and equipmentNet worth
Foreign exchange

In this consolidated balance sheet of the State, internal debts and credits between the Government, the enterprise sector, and the banking system have been netted out. Thus, banking system credit to enterprises or to the Government is treated as debt of one branch of Government to another with no real influence outside of the Government. Indeed, it could be argued that internal debtor or creditor positions were chiefly a reflection of government policy. Enterprise borrowing from the banking system was always with the permission of the Government, often at the behest of the Government, and sometimes even on behalf of the Government. On balance, it appeared at the time of GEMSU that the net worth of the State as a whole was positive—that is, the value of all real assets and foreign exchange was substantially larger than the outstanding liabilities to individuals and foreigners. The fundamental institutional task facing reformers was not seen, therefore, as administering a default (as was the case in the 1948 currency reform) but rather as determining how the State’s assets should be deployed in the first instance and how the Government should be separated from the banking system and the business sector. In this process of dismembering the State, decisions had to be made on how to handle internal debtor-creditor positions.

The negotiations leading up to GEMSU did not address the issue of consolidation of internal creditor and debtor positions. The enterprise system, with its debt to the banking system intact, was placed in a Treuhandanstalt (Trust Fund), which was given a mandate to privatize where possible, restructure potentially viable enterprises, and liquidate enterprises that were not viable. The banking system was separated from the State with its credit positions to the enterprises and the Government intact. Because, in the process of monetary unification, its assets were converted into deutsche mark at a rate different from that used for its liabilities, it required some capital infusion from Government.6 The Government was reconstituted with a more clearly limited economic role and its outstanding debt intact (but converted into deutsche mark at a rate of M 2 = DM 1).

The separation of institutions that resulted from the dismembering of the State raised some important policy issues. A consolidation of debt that cleared enterprises’ balance sheets of old debt would probably have facilitated privatization. In a situation of market imperfections and some ambiguity as to whether this debt might eventually be assumed by the Government, any uncertainties would prove counterproductive.7 Banks would also have been better set for the future if their balance sheets could have been purged of old enterprise debt of doubtful quality. In general, the criterion governing the separation of institutions should have been the objective of providing them with the best chance of subsequent viability without recourse to special governmental assistance. The fundamental policy question was how strictly the separation of institutions would be preserved—that is, whether, and to what extent, the Government or the Trust Fund would intervene to soften budget constraints and undermine market tests and penalties. For example, if enterprises in the initial phase proved unable to borrow on their own accounts, would the Trust Fund (and ultimately the Government) guarantee such borrowing? If existing bank credits to enterprises could not be serviced or repaid, would banks be allowed to bear the consequences or would the Trust Fund or the Government come to their rescue? Would the Trust Fund be allowed to liquidate enterprises on purely market principles, or would government concerns about unemployment intrude? Would Trust Fund losses be covered (and profits be appropriated) by the Government?

In the period leading up to GEMSU, government officials were prepared to answer these questions in principle: the objective was to subject the GDR economy as quickly as possible to market forces. But it was clear from the beginning that these principles would be severely tested in the practices that would evolve during the first 18 months of GEMSU.

Economic Policies

The Process of Economic Integration

The task of building new institutions in east Germany is fundamental to the success of economic integration. Much of the institutional engineering in GEMSU was set out in the State Treaty and the annexes to it. The architects of the Treaty on the FRG side placed particular emphasis on three themes:

First, GEMSU was a step en route to full political unification in accordance with Article 23 of the basic law of the FRG; this Article envisaged unification not as a merger of the FRG and the GDR but rather as the inclusion of the eastern Länder in the FRG. Similarly, economic integration in no way implied a mixing of the two institutional frameworks but rather the wholesale adoption by the GDR of the economic system of the FRG.

The second theme invoked the Erhardian principles that had guided the postwar economic “miracle” of the FRG. The process of unification would be guided by Ordnungspolitik—that is, the free play of market forces within a secure, unobtrusive, and well-understood institutional and financial framework. The objective was to establish a Soziale Marktwirtschaft—that is, a market economy within a social system that provided for certain basic needs such as pensions, medical services, and unemployment assistance. In a period of considerable uncertainty it was important to have a social safety net for workers. While there could be no comparable safety net for capital (i.e., firms), stable and predictable policies would reduce uncertainty and enhance the attractiveness of the GDR as a place to invest.

Third, great stress was placed on German unification not being in conflict with the FRG’s commitments to Europe and the rest of the world: German unification was seen as a “contribution to European unification”; its external aspects would take cognizance of the role of the four postwar occupation powers; GEMSU was seen as consistent with the principles of free trade and, indeed, it was hoped that the extra demand generated would elicit imports from the rest of the world; and Germany’s financial commitments to Eastern Europe and the developing countries would not be lessened.

Clearly, economic integration in Germany will dominate the domestic policy debate for many years. Foreigners, moreover, will be concerned about the international—and, so-called, systemic—implications of the process. In this context it is helpful that the German authorities have committed themselves to principles such as open markets, free trade, and Ordnungspolitik.

The numerical medium-term scenarios used to illustrate the orders of magnitude involved in the reconstruction of the east German economy and to gauge its domestic and international effects (Chapters IVVI) underscore the importance of these principles. The resource requirements of reconstruction will be enormous. Insofar as productive capacities are fully employed, accommodating these requirements will necessitate a crowding-out of other activities. Because financial markets are closely linked across countries, especially within the EMS, this crowding-out process will not be limited to Germany. However, its negative influence on output and employment in other countries will be offset by the positive effects of additional exports to Germany. The balance of these effects will depend on the openness of German markets to foreign goods and services and the ability of other countries to capitalize on the growth of demand in Germany. Overall the international implications appear to be relatively small.

For Germany itself, even the most sanguine scenarios envisage substantial transitional difficulties—in particular, large-scale unemployment and migration from east to west. In this context it is necessary that the “social” part of Soziale Marktwirtschaft be strictly limited and that these limits be widely understood. Without Ordnungspolitik as a basic tenet of the social and economic consensus, governments may be tempted to adopt short-term palliative policies which prove detrimental over the longer run.

Monetary Union

It is convenient to start with a discussion of monetary union and the banking system in the GDR.8 On July 1, 1990.

  • the deutsche mark became the sole legal tender in the GDR and the Deutsche Bundesbank the sole monetary authority;9
  • a market-based banking system was introduced in the GDR with unrestricted capital flows and freely determined interest rates;
  • wages, salaries, rents, and other recurrent payments were converted into deutsche mark at a rate of M l = DM 1;
  • residents of the GDR were entitled to convert marks into deutsche mark at parity in amounts of up to 2,000 marks for those under 14 years of age, up to 4,000 marks for those between 14 and 58, and up to 6,000 marks for those 59 or more years of age;
  • other domestic financial assets and liabilities were convertible at a rate of M 2 = DM 1;10
  • assets in marks of nonresident persons or institutions acquired before the end of 1989 could be converted at a rate of M 2 = DM 1, and those acquired after December 31, 1989 at a rate of M 3 = DM 1.

These aspects of the monetary conversion coupled with decisions on conversion rates for the other items on the balance sheet of the banking system meant that the assets of the banking system were converted into deutsche mark at an average exchange rate of about M 2 = DM 1, while the liabilities were converted at a lower rate. Clearly this would mean a substantial reduction in the net worth of the banking system.

Two measures were adopted to deal with this problem. First, a fund, which was derived from the difference between the official exchange rate and the commercial exchange rate on hard-currency trade and which was deposited with the State Bank, was written down to zero.11 Second, it was decided that, after adding up all the assets and liabilities of each banking institution and converting net worth into deutsche mark at M 1 = DM 1, each institution’s assets would be increased to the extent necessary to balance the books by issuing “equalization claims”—that is, assets that pay interest at the Frankfurt interbank offer rate (FIBOR). This meant simply that the GDR Government would top up the assets of the banking system as a whole by issuing government paper (at FIBOR) to the banks. The stock of government debt and future interest obligations would thus be increased, but no increase would be shown in the government deficit as normally measured in flow terms.

Besides these “accounting” problems, there were serious questions raised about the quality of bank assets and the likely official response to the emergence of substantial nonperforming assets. Insofar as the quality of credits to the enterprise sector (about half of all assets) and housing credits (almost a fourth of all assets) was questionable, the potential for defaults on a very large scale relative to banks’ equity could not be ignored. The officials of both the FRG and the GDR envisaged a significant taking-over of enterprise debt by the Trust Fund or the Government itself. A large part of enterprise debt had been incurred for noncommercial reasons and the Government might be seen as liable for this debt. In any event, the whole of the existing stock of enterprise debt would in effect be guaranteed by the Government directly or indirectly through the Trust Fund. In the opening months of GEMSU the banks would be asked to extend working capital loans to enterprises. As it would be still too early to assess the soundness of these enterprises, these credits would in effect be guaranteed by the Trust Fund. It was intended, however, that after these transitional arrangements, the risks associated with new credits would be borne by the banks themselves.

The stock of bank credits for housing was seen as less of a problem as the collateral value of the real estate exceeded the debt. Initially, however, with rents held down, there might be difficulty in servicing these debts, and the Government envisaged substantial contributions to the servicing of housing debt in 1990–91. Subsequently, as rents were allowed to rise, the housing sector would be able to service its debt without government assistance.

In effect, since July 1, 1990 the major west German banks have played a large role in the banking system of east Germany. Some banks have entered into joint ventures with the commercial banking arm of the State Bank and have taken over the operations of many branches; others have started their own operations de nova. The banking law is identical to that of west Germany and therefore subject in effect to directives of the European Community (EC) on banking and solvency;12 thus banks operate as universal banks and the system is open to participation by foreign institutions.

Since east German banks do not have assets of the quality required to engage in securities repurchase operations or to draw on the discount or Lombard facilities, they have been allowed transitional access to the Bundesbank’s discount window (up to quota limits) and the Lombard facility against equalization claims or “single signature paper” (i.e., banks’ own IOUs). In effect, the latter paper has been used in the opening stages because the issue of equalization claims has had to await final resolution of banks’ opening balance sheets.

As is evident from this description, the separation between the State, the enterprise sector, and the banking system, while clear in principle, was not an entirely clean break in practice. After July 1, enterprises needed liquidity loans to meet current obligations while banks were not yet in a position to evaluate enterprises’ creditworthiness. To keep the enterprises afloat, therefore, the Government authorized the Trust Fund to guarantee short-term bank loans. In each of the three months through September, loans amounting to almost DM 10 billion were processed in this way. It appears that this mechanism of guaranteeing bank loans will continue during the remainder of 1990 and into the first quarter of 1991, but that the allocation of credits will be more conditional on the viability of the enterprises. To the extent that loan guarantees were granted to moribund enterprises—a not insignificant amount especially in the first phase—the net worth of the Trust Fund was diminished or, alternatively, the stock of government debt increased. It is clear that the Government wishes its involvement in the banking system to be limited to correcting past errors and easing transitional difficulties; but it is unclear how long, in practice, the transition will last.

The Enterprise System, the Trust Fund, and the Real Economy

The dismantling of the economic arm of the State left the GDR Government in a net debtor position and the banking system with a small and precarious net worth; thus, the public assets of the GDR were, by and large, taken over by the Trust Fund.13 The State Treaty on GEMSU envisaged the financial resources of the Trust Fund being used, first, to restructure viable enterprises; second, to help consolidate the GDR Government’s financial position; and, third, to the extent that resources remained, to compensate savers for the losses they suffered as a result of converting their savings into deutsche mark at a rate of M 2 = DM 1 rather than at M 1 = DM 1. Thus, much of the net worth of the State was to be deployed in the first instance to cover the costs of economic integration and development. The Trust Fund would have three sources of financing: (1) capital income—that is, the proceeds of privatization; (2) operating income distributed by its constituent companies; and (3) borrowing—up to DM 7 billion in 1990 and DM 10 billion in 1991.14 The borrowing was seen as essentially a transitional means of financing Trust Fund operations pending the realization of funds from privatization; these funds would then be used to amortize loans.

The pre-GFMSU discussion of the Trust Fund left many unanswered questions. The first related to the value of its assets. In the past these assets had generated a substantial part of national income and most of the GDR Government’s revenue. The great imponderable of the entire reform process was the value of these real assets and their income-generating capacity in a free and open market. This would be a major determinant of income, employment, and the duration and hardship of the transitional phase of economic integration. Most analysts were relatively pessimistic on this score; it was thought that perhaps 30 percent of GDR industry was viable in a market economy, another 40 percent could be restructured with reasonable chances of success, and 30 percent was probably beyond redemption. The most pervasive problem was an obsolescent structure of production and capital—the products were not of sufficient quality (at given production costs) to compete with those in the west, and the machinery and equipment were not up to the task of upgrading product standards. In some sectors—most importantly chemicals and energy—environmental concerns were also a major cause for pessimism; given the new environmental code, many plants would simply have to be shut down and a costly cleanup would be required.15

The second major question related to the precise mandate of the Trust Fund: was it intended that the Trust Fund behave like a private investment fund with the narrow objective of maximizing the market value of its assets on behalf of its shareholders (in effect the people of the GDR), or like an agency charged also with some social function (for example, limiting unemployment) so as to ease the transition to a market system? There were instructive examples from other countries of public sector industrial holding companies that had been used as an instrument of employment policy at substantial cost to the economy at large. In most cases it had been difficult to put the operations of such institutions under independent management and to separate pure market considerations from those of politics and social policy. In the particular case of the GDR, where a wholesale restructuring of the economy was envisaged, there was a danger that a departure from pure value-maximizing criteria might entail uneconomic cross-subsidization—that is, employing the profits of viable enterprises to keep hopeless ones afloat. It was not difficult to imagine how mismanagement might squander the net worth of the Trust Fund. Moreover, the issue of whom the managers were responsible to was clouded by the lack of clarity about the ownership of the Trust Fund. In any event, wasteful management of the Trust Fund would leave the people of the GDR, and ultimately all Germans, worse off.

The third important set of questions related to the feasibility of the Trust Fund’s task. The sheer magnitude of the operation—in effect the privatizing and restructuring of the entire industrial sector of the economy—was daunting. Where would managers be found to undertake such a task, at what pace would markets be able to absorb share sales, and, without an independent, high-quality management team, might not the Trust Fund begin to take on the appearance of an industrial planning ministry with considerable monopoly power in some segments of industry?

It was widely accepted that the initial phase of GEMSU would see a period of “creative destruction”: many companies would be restructured, others would be liquidated, and unemployment would rise sharply. This was seen as a necessary step in the weeding out of obsolete economic structures so as to provide a solid foundation for future growth. Although the new social security system would be able to cushion some of the impact, this would be a painful period.

Within official circles there were different perceptions about how, in practice, the operations of the Trust Fund might be conducted. On the one hand, there was the conventional pyramid structure—top management would initiate most of the decisions on the basis of information culled from lower levels and from the market. In this view, the task for management was, indeed, enormous, and the feasibility of rapid restructuring and privatization had to be questioned. On the other hand, there was a more grassroots view—that is, managers of companies within the Trust Fund would themselves seek out partners for joint ventures or buy-outs; these deals would then be proposed to top management who would seek simply to ensure that shares or assets were sold at reasonable prices. In this latter view, which envisaged much greater reliance on grassroots entrepreneurship as individual companies sought to safeguard their existence, the tasks of the privatization program were spread more widely and appeared more feasible.16

In other areas of the real economy the changes expected were also radical. The services sector was underdeveloped; many parts of it would have to be built from the ground up. Public infrastructure was sorely inadequate and massive investment would be required in activities such as telecommunications. The agricultural sector in east Germany would have to adapt to the Common Agricultural Policy of the EC to ensure common producer prices; transitional adjustment mechanisms would be adopted. In signing the State Treaty, the Government of the GDR undertook to make available sufficient land to provide adequate facilities for foreign investors in industry, trade, and services.17

In the first three months of GEMSU all of the doubts raised in the pre-GEMSU discussion of the Trust Fund proved to be well-founded:

  • First, estimates of the proportion of GDR enterprises that would be viable in a market economy were revised downward.
  • Second, while registered unemployment had risen to 445,000 (5 percent of the labor force) by September, the number of short-time workers (in most cases disguised unemployment) had reached nearly 1¾ million. Together, unemployed and short-time workers constituted almost one fourth of the labor force.
  • Third, output declined sharply: in August industrial production was only one half of its level 12 months earlier. At the same time, extravagant wage demands were acceded to—a 60 percent increase in construction and a 25 percent increase in metal, electro-technical and chemicals industries—perhaps in the expectation of a government bailout.
  • Fourth, liquidation of uneconomic firms and privatization and restructuring of others did not take off. The Trust Fund—notably, for example, in the mining and chemicals industries—has been loath to take responsibility for a course of action that would entail a massive reduction in the workforce of any single large enterprise.
  • Fifth, besides the difficulty of pricing east German companies, investment and takeovers from the west were slowed down by the need, in each case, to allocate responsibility between the Trust Fund and the would-be investor in four critical areas: (1) property rights—who would be responsible for settling claims by previous owners; (2) clearing up the environment—who would bear the cost; (3) shedding surplus labor—new owners would be bound by costly restraints on large-scale dismissals in the German labor law; and (4) old company debt—who would pay this. Also, investors were concerned about the adequacy of supporting infrastructure for production and distribution.
  • Finally, the Trust Fund became enmeshed in the shortterm financial problems of its enterprises; the debate about guarantees for short-term bank loans diverted attention from longer-term objectives.

The task facing the Trust Fund involves liquidating or restructuring and privatizing some 8,000 enterprises with 4 million employees, a substantial debt burden, tight liquidity constraints, and, in some areas, dire environmental problems. All in all, such an undertaking looks even more daunting now than it did before GEMSU.

The Government and the Social Security System

The State Treaty required that the structure of public sector budgets in the GDR be adapted to conform with that in the FRG. Starting in the second half of 1990, the government budget would exclude the social security system (which would be budgeted for separately as in the FRG), business enterprises (which would become independent legal entities under the Trust Fund), and the railways and postal service (which would be constituted as separate entities with their own budgets). The social security system of the GDR would be adopted by and large from that of the FRG. Within the framework of general budgetary aid from the FRG to the GDR, it was envisaged that some start-up financial assistance would be given to the new unemployment and pension insurance schemes of the GDR.

In order to limit deficits and foster market mechanisms, the territorial authorities in the GDR would cut subsidies on goods (including food and agriculture generally), gradually reduce subsidies on housing, transportation, and energy, and undertake a substantial reduction in expenditure on personnel. All elements of expenditure would be scrutinized to determine their legal basis and the real need for them. The income tax laws of the FRG would be adopted,18 property and indirect taxes would be the same as in the FRG, and the GDR would adopt the customs laws, border taxes, and duties of the EC.

The institutional arrangements envisaged in the State Treaty did not anticipate full political unification by October; as a result, fiscal policy prescriptions for the GDR as a separate state were spelled out for 1990 and 1991. Quantitative limits were set on borrowing by the GDR Government on its own account and on borrowing by the Trust Fund. The size of transfers from the FRG to the GDR, for general budgetary support and social security assistance, was specified. Moreover, all decisions on public debt, borrowing, and equalization claims in the GDR were made subject to agreement between the GDR and the FRG.

The Stance of Policies

Fiscal Policy

In midyear, the territorial authorities in the FRG envisaged expenditure equivalent to 30½ percent of GNP in 1990 and a deficit of DM 53 billion (2.2 percent of GNP). This represented a doubling of the 1989 deficit; it reflected an acceleration in expenditures (to 6 percent, double the medium-term target rate) and a sizable tax cut (1 percent of GNP net of subsidy reductions), offset by the positive influence of faster-than-expected growth. In 1991 the deficit was projected to be virtually unchanged.

In the GDR borrowing by the territorial authorities was not to exceed DM 10 billion in 1990 (effectively the second half of the year) and DM 14 billion in 1991. Besides these figures, the total amount of government financing included the borrowing of the Fonds Deutsche Einheit (German Unity Fund)19—DM 20 billion in 1990 and DM 31 billion in 1991—and potential borrowing by the Trust Fund—DM 7 billion in 1990 and DM 10 billion in 1991.

On July 22, the parliament in the GDR passed a budget for the second half of 1990 which was consistent with the financing constraints laid out in the State Treaty on GEMSU. By September, however, it had become clear that budget financing requirements would be a great deal larger than initially envisaged.

First, the social insurance funds would require substantial additional financing. Payment of unemployment benefits would be far above budget, both because of higher unemployment—the budget had assumed an unemployment level of 270,000 with an additional 160,000 short-time workers20—and because of higher benefit levels owing to wage increases. The costs of medical services had risen more quickly than anticipated—doctors’ fees had increased and more expensive drugs from the FRG had replaced local products—so that the medical insurance system would require additional financing. Also, there were likely to be some delays and shortfalls in social security receipts because of administrative difficulties, problems faced by illiquid enterprises in remitting payroll taxes, and lower employment.

Second, difficulties had also arisen in the budget of the Central Government itself. Receipts had been adversely influenced by some of the same factors affecting the social insurance funds. On the expenditure side it appeared that the principal overruns would be in transfers and subsidies. Energy and transportation subsidies would be larger owing to greater consumption than anticipated in the budget and higher oil prices. Subsidies to support exports to the CMEA countries might also be significantly larger than budgeted21 and the difficulties in the agricultural sector might result in increased budgetary support. Also, an across-the-board expenditure cut (of DM 3½ billion) contained in the budget estimates seemed unlikely to be fully realized.

Although the fiscal situation in the GDR was turning out much weaker than budgeted, it was decided not to produce a revised budget as, with political unification, the central government functions in the GDR would be absorbed into their FRG counterparts. Instead, at the end of September, the FRG introduced a third supplementary federal budget that provided DM 26 billion in additional borrowing, of which DM 24 billion was related to the GDR. Similarly, although the State Treaty provided a framework for fiscal policy in the GDR in 1991 (in the form of a borrowing limit for the GDR Government and specified transfers from the FRG to the GDR), there would not now be any separate budget for east Germany in 1991. The magnitude of the fiscal imbalance in the country as a whole and the extent of the revisions in the budgetary outlook are summarized in Table 1.

Table 1.Germany: Borrowing Requirement of the Public Sector1(In billions of deutsche mark)
199021991
Original

(June)
Revised

(Sept.)
Original

(June)
Revised

(Sept.)
Borrowing by the FRG Government53}9453½}145
Borrowing by the GDR Government1014
Borrowing by the Unity Fund20203131
Borrowing by the Trust Fund37121013
Total90126108½189
Total in percent of all-German GNP
Source: IMF staff current services estimates—that is with unchanged tax rates and expenditure programs.

Including the Unity Fund and the Trust Fund, but excluding the social security system.

For the GDR the figures refer only to the second half of the year.

The revised figures for the Trust Fund reflect the limit set in the Unity Treaty.

Source: IMF staff current services estimates—that is with unchanged tax rates and expenditure programs.

Including the Unity Fund and the Trust Fund, but excluding the social security system.

For the GDR the figures refer only to the second half of the year.

The revised figures for the Trust Fund reflect the limit set in the Unity Treaty.

There are a number of caveats with respect to these estimates.

First, the figures in the table are current services estimates—that is, they make no allowance for any discretionary changes in expenditure or taxation. It is not unlikely, however, that the authorities will introduce significant expenditure cuts, thereby reducing the overall deficit.

Second, the figures exclude the capital infusion to the banking system by the GDR Government—perhaps some DM 26 billion in 1990—which, while not in the budget as conventionally measured, will add to the (still relatively modest) outstanding stock of government debt.

Third, the operations of the Trust Fund will influence the financial position of the public sector. Successful privatization will produce capital receipts and viable enterprises that are not privatized will produce income. On the other hand, there are bound to be additional Trust Fund liabilities to the banks related to guarantees of short-term bank borrowing by enterprises. To the extent that enterprises with such loan guarantees are liquidated, the Trust Fund will have to assume the liabilities. In principle, it would seem that the vast physical assets of the Trust Fund should be capable of earning substantial income—historically enterprise profits were the principal source of government revenue—but recent developments do not augur well for the earnings of the Trust Fund and call into question the net worth of the Fund.

Fourth, it is not inconceivable that part of the large stock of old debt of GDR enterprises and some of the old housing debt might be assumed by the Government. This, of course, would increase the stock of government debt and future debt service would raise budget expenditures.

However one analyzes these projections, it is clear that the first 18 months of economic integration will witness a sizable increase in government borrowing in the deutsche mark area. The question arises therefore as to how this should best be financed. The Government has indicated an aversion to increasing taxes to finance unification. While one might be loath to endorse a pledge of no new taxes, decisions on the appropriate method of financing would depend upon the duration and composition of the additional demands for public resources. An argument against tax increases would be strengthened to the extent that:

  • The large deficits are likely to be temporary—that is, they are projected to decline quickly after peaking in 1991.
  • The deficits are linked to public investment—that is, expenditures aimed at increasing the potential output of the economy—rather than to current expenditures aimed simply at easing the transition.
  • There is room for a substantial restructuring of expenditures in west Germany. For example, the Government estimates the cost of its support for the inner-German border areas and West Berlin at about DM 40 billion in 1990.22
  • Strict limitations on the scope for new taxation, combined with a rigorous antipathy for deficits, will help to contain subsidies. Ideally, subsidies in east Germany should be limited to self-correcting transitory support (e.g., unemployment benefits); subsidization of employment or investment will quickly be reflected in factor prices, embedded in investment decisions, and thus entrenched.
  • It is possible to extrapolate from the historical (econometric) evidence for the FRG, which shows that some 60 percent of any increase in public saving from higher taxes would be offset in the short run by a drop in private saving.
  • The external current account remains in surplus so that German saving continues to help finance investment abroad.

Clearly the case against taxation involves a great many conditions. There is a danger that the sequence of developments will influence the composition of public expenditure. Large public works programs that are necessary in their own right would also help to absorb unemployed labor; but initiating such programs will require many decisions at the state and local government levels and it may take some time before this decision-making apparatus is put in place. Without such programs concerns about prolonged unemployment might elicit costly and wasteful subsidies that subsequently prove difficult to remove. Moreover, a dearth of supporting public infrastructure will discourage private investment. The case against new taxation is critically contingent on the composition of government expenditure, as well as on the magnitude of financing required.

It is not difficult to envisage changes in the structure of taxation that would yield short-run revenue gains and would nevertheless be consistent with the medium-term thrust of German tax policy toward a more efficient system. There is scope for raising indirect taxes in a way that would be compatible with the process of harmonization within the EC. The benefits of such action would have to be weighed against the unfavorable temporary impact on prices.

Monetary Policy

In 1989 the restrictive stance of monetary policy was supported by a sizable reduction in the government deficit; nevertheless, real growth proved robust and interest rates rose. In 1990, even without the effects of GEMSU, fiscal policy would have eased, wage costs would have increased more rapidly, and capacity utilization rates would have risen—thus the task of containing inflation would have become more difficult. Given the added effects of GEMSU, the environment for monetary policy will be even more demanding.

In the FRG, the 18 months before GEMSU had seen pre-emptive monetary policy actions that had helped sustain the favorable economic performance. Growth of the monetary aggregates had been brought back into line with that of potential real output and an inflation rate of about 2 percent. There was some concern about the pace of growth of residents’ holdings of short-term bank bonds and Euromarket deposits—although these assets are less liquid than those included in M3—which would probably have argued for holding the growth of M3 (for FRG residents) to the lower end of the target range of 4–6 percent. In the second half of 1990, the Bundesbank intended to continue to maintain separate data for the FRG and the GDR as constituted before unification, and to target M3 in the (old) FRG.23

The currency conversion part of GEMSU was accomplished without disruption. The consolidated balance sheet of the banking system in the GDR for the end of June was not available for some time after the currency unification, and it was therefore not possible to quantify the effects of the currency conversion on the balance sheets of the banks or on the money supply with great precision. Equalization claims to compensate GDR banks for the asymmetric nature of the currency conversion would only be issued after the final resolution of opening balances.24 In the interim, the Bundesbank conducted its money market operations in the GDR primarily against single signature paper issued by the banks (i.e., bank IOUs). Given the favorable interest rate charged on discount operations, the initial discount quota (DM 25 billion) granted to the banks in the GDR was quickly utilized. Some banks also had recourse to the Lombard facility. Additional liquidity to the GDR financial markets came from fiscal transfers to the GDR and from FRG banks. Deutsche mark currency outstanding (including currency held by banks) at the end of July 1990 was 10½ percent higher than 12 months earlier.

The Bundesbank recognized that monetary union would exacerbate the difficulties facing monetary policy at both a technical level and a more fundamental level. At a technical level, monetary control would be made more difficult. With a free flow of people and capital between east and west Germany and the same banks operating in both, it would become increasingly difficult to segregate the monetary statistics. In the transition, with monetary targeting only in the west, the money supply in the east would be determined by demand. Financial flows would, therefore, accommodate sharp increases in certain prices and wages. These might be seen largely as an unwinding of relative price distortions. The eventual shift from targeting money in west Germany to targeting money in the whole deutsche mark area would involve venturing into unknown territory, since there was no history on which to base estimates of money demand in east Germany. The relative size of east Germany, however, was such that even fairly large errors in calculating money demand would not be that significant in the whole deutsche mark area.

The appropriate amount of liquidity to provide to east Germany was difficult to determine: that there was enormous potential for rapid growth from a very low base was obvious, but far from obvious were the bottlenecks that might emerge and the rate of growth that could be sustained without inciting sharp upward pressures on prices of nontraded goods. It would also be difficult to infer monetary conditions from interest rates: to the extent that returns on fixed capital investment in east Germany had risen, higher real interest rates might not dampen activity. But interest arbitrage would equalize rates over the whole deutsche mark area and (albeit less perfectly) in the ERM, and there was no clear consensus on an appropriate rise for the whole area. In these circumstances, the Bundesbank acknowledged that it would have to infer monetary conditions from a wide variety of indicators—not just the path of the monetary aggregates and interest rates, but also developments in exchange rates, wages, prices, demand, and output—and would err, if at all, on the side of restrictiveness. The credibility of the Bundesbank’s aversion to inflation was seen as an important asset that ought not to be put at risk and, from this standpoint, a strong deutsche mark was seen as a key ingredient of monetary policy in the period following GEMSU.

In the area of bank supervision and oversight there were also incipient problems. Much of the stock of state enterprise debt held by banks was of doubtful quality; however, it was not unlikely that these debts would be assumed or guaranteed by the Trust Fund or the Government. In the period following GEMSU banks faced considerable difficulty in finding criteria on which to base lending decisions to Trust Fund enterprises; it was near impossible to gauge the creditworthiness of the enterprises. Short-term bank loans to enterprises were guaranteed by the Trust Fund; this relieved the banks of the need to scrutinize the financial positions and prospects of enterprises. As (at least) some enterprises proved nonviable, the guarantees would be activated and the banks’ positions would have to be covered by the Trust Fund or, ultimately, the Government. This mechanism produced a soft budget constraint for enterprises that allowed a prolongation of illusions about the feasibility of uneconomic decisions on wages, prices, and products. It divorced certain decisions on credit from the relevant underlying economic calculations.

At the broad level of macroeconomic policy, GEMSU sparked concerns about the effect of the policy mix on the environment for monetary policy. If private investment in the GDR proceeded at the pace needed to successfully integrate the two economies and the budget turned out to be as expansionary as feared, the burden of containing inflation would fall disproportionately on monetary policy. It was difficult to tell whether this would mean higher interest rates—longer-term rates had jumped upon the announcement of currency union perhaps in anticipation of these resource demands—but even if high interest rates were warranted they would undoubtedly be unpopular. It was broadly accepted, however, that, without underutilized resources, successful integration of the GDR would have to entail some crowding out—if not by an interest rate mechanism, then via prices, taxes, or the exchange rate. The policy mix chosen would in any event have implications for exchange rate developments.

The Exchange Rate

Most scenarios envisage GEMSU eliciting more rapid growth and a more expansionary fiscal policy with continued monetary stringency. Such conditions would be consistent with higher real interest rates and some real appreciation of the deutsche mark. The appreciation would help to spread the additional demand from GEMSU to other countries and to reduce Germany’s current account surplus. At the start of GEMSU, it was difficult to tell whether these changes had been fully anticipated by market participants and were, therefore, already reflected in market rates. Some argued that they had not been fully anticipated so that a further appreciation was likely, while others thought that the market might have overshot its equilibrium so that some depreciation of the deutsche mark was possible.

The FRG authorities were skeptical of this latter position. They did not believe that an effective depreciation of the deutsche mark was warranted and were firmly of the view that a strong deutsche mark would be necessary to reduce the current account surplus, channel resources to the GDR, and contain the inflationary effect of GEMSU while spreading the beneficial real effects to the rest of the world. In particular, they did not envisage a depreciation of the deutsche mark against the U.S. dollar; this, they thought, would be contrary to the objective of narrowing current account imbalances. Events since the beginning of July 1990 have vindicated this view. Between June 30 and the end of September, the deutsche mark appreciated by 7 percent against the U.S. dollar and by almost 1 percent in effective terms.

Within the ERM, the deutsche mark was initially close to the lower intervention limit25 so that, in principle, some appreciation would have been possible without any change in central parities. Among certain participants there would be strong resistance to any change in central parities—in particular, France and the Benelux countries saw fixed central parities with the deutsche mark as essential to their macroeconomic policy stance.

A Guided Tour and Some Tentative Conclusions

A Guided Tour

Much of the foregoing material has been culled from the chapters that follow. Chapter II analyzes the economy of the FRG immediately before GEMSU. It discusses the combination of advantageous external developments and prudent policies that put the economy in an almost ideal starting position for GEMSU, but also highlights the limits to production capacity in the west that might constitute an important constraint on the process of integrating the eastern Länder. Chapter III describes the economy of the GDR before the rapid changes that began in late 1989; it also assesses the present economic situation and outlines the process of reform.

The picture of vast disparities between the western and the eastern parts of Germany that emerges from these two chapters shows economic integration to be a truly enormous undertaking. Moreover, decisions on institutions and structures that are taken in the first phase are extremely important: seemingly small details in institutional arrangements may have sizable and enduring effects.

Against this background the subsequent chapters analyze some key issues raised by the process of economic integration. Chapters IVVI attempt to quantify some of the macroeconomic effects over the medium term. The starting point is the question: What are the investment needs of the former GDR over the next ten years? The framework developed to answer this question entails a detailed specification of the supply side of the east German economy that relates productivity growth to capital accumulation and the efficiency of the use of labor and capital. The specific quantitative path depends upon an array of assumptions, but, by undertaking a variety of numerical experiments, it is possible to get some sense of the scale of the challenge.

The investment in the east may be financed by domestic saving or by grants or loans from the west. An analysis of the financial implications of economic integration requires a more comprehensive macroeconomic model. Such a model is developed in Chapter V and is used to examine alternative scenarios for the east German economy. In Chapter VI, to help assess how economic developments in east Germany might influence west Germany and other countries, the different scenarios for the east are used as inputs into the IMF’s global MULTIMOD model. In this experiment, some alternative assumptions about policies are used to generate different scenarios.

Given that west Germany is likely to bear the brunt of the increased demand from east Germany, the question arises as to how readily resources can be made available to meet this demand. There are two aspects to this question: first, how much additional output will be generated in west Germany, and, second, how much of this increase in output will be available to support demand in east Germany? These issues are taken up in Chapters VIIIX.

Chapter VII explores the relationship between potential output. the natural rate of unemployment, and the actual level of unemployment in west Germany. Its purpose is to explain the persistence of a rate of unemployment considerably above those of the 1960s and 1970s, and to estimate the margin of spare capacity left in the economy. The calculations in the chapter suggest that output was at about the same level as “quasi potential” (a measure based on actual underlying unemployment and reflecting the existing characteristics of wage bargaining) in 1988 but that full potential output (a measure based on the estimated natural rate of unemployment) was some 2½ percentage points higher. To realize the unused potential in a sustainable fashion would require changes in the system of wage bargaining, structural policy measures to reduce the power of “insiders” in the wage bargaining process, or a favorable supply or demand shock. The implications of this analysis are sanguine: they suggest that, with appropriate structural measures, there might be more spare capacity in the economy than is conventionally estimated.

Since 1988, actual output is estimated to have risen above “quasi potential.” The question arises therefore as to why more marked price inflation has not emerged. Notably, the econometric results in Chapter VII do not suggest that the capacity pressures seen thus far would have produced a substantial inflationary response. Moreover, long-term wage contracts negotiated in 1987–88 are still influencing wage developments; a number of important wage agreements reached in 1990 do indicate an uptick, though not an unmanageable one, in wage inflation. However, it is also possible that the growth of both quasi potential and full-potential output over the past few years has been greater than estimated. Increased flexibility in working arrangements may have added to the effective supply of capital in a way not captured by conventional measures of the capital stock. Moreover, large-scale immigration may have reduced the influence of insiders in the labor market in a way that could also have not been captured by historical relationships estimated over a period when immigration was considerably smaller.

The question of immigration and the importance of the behavior of insiders is also taken up in Chapter VIII, which examines the history of immigration into the FRG, its economic effects, and its policy implications. The model experiments reported in this chapter suggest that continued rapid economic absorption of immigrants will depend very much on the nature of wage bargaining. Even if east German labor stays in the east and capital flows east to take advantage of lower costs, there are likely to be consequences for labor incomes in the west (either reduced employment or lower wages relative to some baseline)—this is the counterpart of the increased rate of return that will be required by investors. To ensure that the supply-side implications are as favorable as possible—that is, higher output rather than increased unemployment—it is important that structural policies be used to enhance the flexibility of the labor market.

Chapter IX uses a model of saving and investment in the former FRG to examine the question of how much of the additional output generated by GEMSU in the west will be available to finance development in the east. It concludes that additional income in the west will give rise to increased saving that will be available to finance capital accumulation in the east; nevertheless, rapid capital accumulation in the east will require resources that far exceed those available from additional saving in west Germany. This raises a question as to whether fiscal policy should be used to offset some of the additional excess demand. The saving equation analyzed in this chapter suggests that the influence of increased government saving on national saving might be significantly dampened on impact. The estimates imply that, in the first year, 60 percent of increased government saving is offset by reduced private saving. Over time, the offset coefficient wanes, but it is still about a quarter in the third year. These results need to be borne in mind in considering the appropriate fiscal response to demand pressures from GEMSU.

Chapters IV to IX highlight considerations that should influence the priorities in policymaking over the coming years. The subsequent chapters (XXII) examine the roles of monetary, fiscal, and structural policies.

Chapter X takes up issues related to monetary and financial management during the transitional phase of GEMSU. Common misconceptions about the currency conversion are corrected: first, it did not, in itself, create a significant risk of inflation; second, the Bundesbank did not simply swap deutsche mark for marks, rather banks in the east had to borrow from the Bundesbank in order to supply their clients with deutsche mark, thereby increasing the seignorage revenues of the Bundesbank. The principal goal of the conversion can be interpreted as the reorganization of financial assets and liabilities in the GDR in such a way as to promote the establishment of a sound and efficient financial system subject to the constraint of an appropriate initial level of liquidity in the economy. It is against this objective that the results must be judged. At the macroeconomic level, to what extent might GEMSU threaten the integrity (that is, the real value) of the deutsche mark? At a microeconomic level, to what extent might the arrangements following GEMSU threaten the solidity of the major financial institutions?

Chapter XI describes the fiscal system that existed in the GDR prior to GEMSU and outlines how the planned reforms of the system are likely to affect government finances. Government finances will be sensitive to the evolution of the east German economy. Moreover, given a unified fiscal system and the urgent need to bring infrastructural facilities up to the level of the west, there is not much room for flexibility in fiscal policy in east Germany. Therefore, if economic growth is much less rapid than generally envisaged, the fiscal imbalances generated in the east German economy could remain large for quite some time.

Finally, Chapter XII analyzes the history of fiscal and structural policy in the FRG, and draws on this experience to evaluate alternative policy responses to GEMSU. At a microeconomic level, the guidance from the experience of the 1970s and 1980s is clear: expenditure and tax policies aimed at influencing the short-run allocation of resources and distribution of income run the risk of becoming entrenched and exerting a detrimental longer-run influence on the economy. On the other hand, the experience of the 1950s and the 1960s suggests that adjustment can occur efficiently when the Government limits its interference in the economy. The desiderata implicit in this analysis may be useful to policymakers overseeing the integration of the economies of east and west Germany.

Some Tentative Conclusions

In the discussion and debate on economic unification, the Germans have set themselves idealistically high standards. Ordnungspolitik—a clear institutional framework within which the free play of market forces guides the economy—is easier to describe in principle than to abide by in practice. But it is useful not to lose sight of guiding principles, to require that deviations from them be justified in each and every case as temporary aberrations, and to limit the scope and duration of such deviations.

Many untidy departures from Ordnungspolitik were left in the wake of the rapid process of unification. The separation of the banking system and the enterprise system from the State in east Germany was not a clean break; as a result, the delegation of responsibility in a number of areas remains ambiguous.

The banks will have on their books many old loans of dubious quality; the net worth of the banking system depends critically upon the extent to which the servicing and repayment of these loans is guaranteed by the Government.

New bank loans to enterprises have been guaranteed by the Trust Fund and, ultimately, the Government. This has relieved the banks of the responsibility of scrutinizing and assessing the viability of would-be borrowers. Moreover, to the extent that some of these loans have been made to moribund industries, the servicing and amortization obligations will eventually have to be borne by the Trust Fund or the Government.

The budgetary costs of unification will be substantially larger than initially envisaged. Moreover, if one adds to the budget (as conventionally defined) the increases in government debt related to equalization paper (issued to preserve the net worth of the banking system), a portion of the old enterprise debt on the books of the banks, some of the new debt guaranteed by the Trust Fund, and an allowance for correcting the environmental problems in parts of east Germany, the budgetary costs of unification become higher still.

To the extent that large budget deficits are a temporary phenomenon linked to the acquisition of public capital that increases productive potential, they should be acceptable. Moreover, the distinction between capital and current expenditures is not entirely clear—current expenditures to put in place certain administrative systems, for example, are in effect infrastructural investment. Nevertheless, there are grounds for concern in the present circumstances that sizable deficits could persist and that they may be related in significant part to transfers to support consumption rather than to public investment. Should these concerns prove warranted, the question of tax policy will have to be addressed. It would seem unwise to rule out categorically the possibility of tax increases; indeed, it is possible to envisage changes in the tax structure that might improve the efficiency of the tax system, help in the process of tax harmonization in the EC, and, while yielding additional revenues in the short run, allow for the possibility of future direct tax relief.

The Trust Fund has been assigned a task of enormous scope and complexity: the privatization, restructuring, and, in some cases, liquidation of 8,000 enterprises with 4 million employees. Even taking care of the short-run financial problems of these enterprises has proved daunting; the more fundamental task will be near impossible to achieve with any rapidity. It is, moreover, not clear that the Trust Fund as presently constituted is capable of taking difficult decisions on mass dismissals and liquidations. Very large post-GEMSU wage increases in a number of financially troubled industries might be taken to suggest that workers believe that their enterprises will be bailed out.

The pricing of Trust Fund enterprises for sale will entail difficult negotiations in each case that will need also to establish financial responsibility for settling claims on enterprise property, for cleaning up the environment, and for servicing and amortizing old enterprise debt. Beyond these issues, it will not be easy to privatize firms that are grossly overmanned as large-scale dismissals are very costly under German labor law. Thus, some restructuring will be required in almost all of the Trust Fund enterprises. To the extent that restructuring and liquidation is postponed, and that short-term financial mechanisms are used to maintain the status quo, the net worth of the Trust Fund will be eroded.

The mere fact that these issues are part of the public debate, of the ongoing assessment of mechanisms and modalities for economic integration, is a basis for optimism. It is important to appreciate, too, the strengths of the parties to this huge undertaking.

First, the starting point in the FRG was almost ideal: low inflation and a credible anti-inflationary policy, a balanced fiscal position, a high domestic saving ratio, a corporate sector in an unusually strong financial position, and an enormous wealth of resources (including foreign assets).

Second, the authorities have a formidable track record on fiscal discipline and generally prudent economic policies. There is also widespread political commitment to a restructuring of government expenditures so as to limit the budgetary effects of unification. One should not forget the almost legendary distaste of the general public in Germany for budget deficits or any other economic policies that threaten the integrity of financial savings.

Third, the deutsche mark is perhaps the quintessential hard currency. Given that it was precisely this access to a credible hard currency that was sought by the GDR in the currency union, it is unlikely that the Bundesbank’s anti-inflationary commitment would be eroded by the process of integration.

Fourth, perhaps the greatest asset of the former GDR is its human capital. All evidence suggests that the level of general and technical education of the east German labor force is high.

Fifth, while large-scale investments and the transformation of the old state Kombinate into market-responsive companies might appear slow, grassroots entrepreneurship in the east is booming. Some 96, 000 new businesses were registered in the first three months of GEMSU.

From an international economic perspective, it appears that the process of unification in Germany will not constitute a major shock to the system. To be sure, some German saving that would in the past have financed investment abroad will now be used for investment at home; this will mean somewhat higher interest rates. On the other hand, for many years the international community has voiced concern over the size of the FRG’s current account surplus and advocated measures to reduce it. The positive demand effects from a properly managed restructuring of east Germany should elicit imports from all of Germany’s trading partners and, for some countries, may help to moderate a slowdown in growth that had just begun at the start of GEMSU.

In the final analysis, the success of economic integration will depend on private initiatives: the readiness of private investors in west Germany and abroad to commit resources to east Germany and the development of homegrown entrepreneurship in the east. The great imponderables in the situation have to do with enterprises, wages, and migration: To what extent can existing enterprises be restructured so as to be viable in a market economy? Will wage demands that move ahead of productivity developments discourage investment from abroad? And will sustained wage differentials with the west elicit a resurgence of westward migration, especially of highly qualified personnel? These questions cannot be answered at this time. But it is clearly essential to the success of economic integration that capital flow east rather than labor flowing west, and that income growth and new opportunities are sufficient to meet reasonable aspirations on the part of the residents of east Germany. In seeking to realize these objectives, the Government should avoid ad hoc policy interventions in response to short-term problems; it should hold instead to policies based firmly on market principles and be willing to accept some transitional roughness in the passage to longer-term goals.

1

A full chronology of political and economic events is provided in Box 1 of Chapter III.

2

In the course of 1989 the potential supply of labor was boosted by more than 700,000 immigrants—about half from the GDR and the other half ethnic Germans mainly from Poland. On average in 1989, the labor force was increased by 210,000 as a result of immigration, while almost 200,000 potential workers were enrolled in language or vocational training courses.

3

The territorial authorities include the federal, state, and municipal governments, the Burden Equalization Fund, the European Recovery Program Fund, and the accounts of the European Community (EC).

4

Only about half of households in the GDR had color television sets and only 7 percent had telephones; the corresponding ratios in the FRG were 94 and 98 percent, respectively.

5

Official statistics showed about two thirds of external trade with CMEA countries and little more than a fourth with Western industrial countries. In reality, the share of CMEA countries was smaller, as a considerable part of external trade with the convertible currency area went unreported.

6

The process of monetary unification is discussed below.

7

Uncertainties about property rights—that is, the right of enterprises (old or new) to their real estate assets in the face of legal challenges by previous owners who had lost their property to government expropriation—proved an even stronger disincentive to prospective investors.

8

The State Treaty, after a preamble and a discussion of some basic principles covers monetary union (Chapter II and Annex I), economic union (Chapter III), social union (Chapter IV), and the government budget and finances (Chapter V). The Treaty is discussed in detail in Chapter III below.

9

There was, however, no provision for GDR representation on the Bundesbank Council.

10

The conversion rate was a matter of intense debate. In effect, based on the (end-May) consolidated balance sheet of the banking system, the average conversion rate was M 1.8 = DM 1, not very different from that proposed amidst much controversy by the Bundesbank. In the view of the author, the effective conversion rate was sufficiently depreciated to absorb excess (and potentially inflationary) monetary balances in the GDR. The relationship between the conversion rate and real wages is tenuous. As is clear from developments in the first few weeks of GEMSU, real wages are determined in the market; and the nominal conversion rate can exert, at most, a very temporary influence on them. These issues are examined in greater depth in Chapter X.

11

The difference between the official and the commercial rate of exchange could be seen as a tax on importers and a subsidy for exporters. Because imports exceeded exports, the fund for these taxes and subsidies was in surplus and this surplus—seen by the Government as a contingent liability to future exporters—was deposited with the State Bank. As the exchange rate system was changed with GEMSU, this liability of the State Bank was simply written down to zero.

12

However, in certain circumstances, the Banking Supervisory Office in the FRG has discretion to grant exemptions from the banking law to cast German banks.

13

The State Treaty required that an inventory of all publicly owned assets be taken. A substantial amount of real estate, both land and housing, would remain outside the Trust Fund. The land being used by enterprises in the Trust Fund would be considered part of the assets of these enterprises and, consequently, fall under the aegis of the Trust Fund. The question of land ownership was a difficult one because of the various waves of government expropriations after World War II. In some cases, land could be returned to its original owners. In others, the land was now committed to an alternative use and only financial compensation would be possible. Still other cases would be tied up by competing claims. It was likely that these matters would take quite some time to be resolved in the courts.

14

The borrowing limit was raised in the Unity Treaty to DM 25 billion for 1990–91. Borrowing of DM 12 billion was envisaged in 1990. It was not clear whether the ceiling would have to be increased again to accommodate the borrowing need in 1991.

15

Article XVI (2) of the State Treaty stipulates that new plant and equipment in east Germany has to conform to the safety and environmental standards prevailing in the west. Existing plant and equipment will have to be adjusted over a period of time to fulfill the same requirements.

16

The law establishing the Trust Fund (Treuhandgesetz) envisages the privatization program being conducted through a family of smaller funds. Each fund is responsible for privatizing, restructuring, or liquidating the companies in its portfolio; its decisions are to be based on economic considerations and are to be taken in consultation with banks and private financial consultants. It remains unclear whether in practice the Government will be able to influence decisions through the managers of the funds.

17

In some cases land sale prices may be made subject to renegotiation after a sufficient period has elapsed to allow an effective real estate market to have developed.

18

Annexes II—IV to the State Treaty, which list changes to the law of the GDR required to effect GEMSU, give some sense of the extent to which GEMSU entailed a wholesale adoption by the GDR of the FRG’s legal framework for the economy.

19

The German Unity Fund was set up to help finance unification. It will provide DM 115 billion over five years. Each year a certain (relatively small) amount will be financed directly out of the federal budget of the FRG and the rest will be borrowed in the market. The interest and amortization payments on these loans will be borne half by the Federal Government of the FRG and half by the state and municipal governments. At the time of GEMSU it was envisaged that in 1990, DM 22 billion would be transferred to the GDR by the Unity Fund; of this, DM 2 billion would be from the federal budget. In 1991, DM 35 billion would be transferred, including DM 4 billion from the Federal Government.

20

The direct cost of each additional 100,000 unemployed workers in the second half of 1990 would amount to DM 500 million. The cost of additional short-time workers would depend upon the proportion of time that they were out of work; payment would then be determined by the normal unemployment insurance rules (i.e., 63–68 percent of net wages). In addition, some employers would pay supplements under wage contracts for the nonworking period.

21

The currency conversion from GDR marks to deutsche mark involved a substantial real appreciation vis-à-vis the transferable ruble because of the deutsche mark nominal rate being set higher against the transferable ruble while wages were initially converted at the rate of M 1 = DM 1. Budgetary subsidies were, therefore, necessary in order to maintain supplies to CMEA countries.

22

The rationale for these subsidies should disappear with the lifting of the inner German border. Subsidy reductions in other areas would also help to contain deficits while exerting beneficial supply-side effects. Savings could also result from reductions in defense outlays.

23

The monetary aggregates are defined in terms of residency rather than currency.

24

Interest on these claims would be paid retroactively to July 1.

25

To some extent this was an anomalous situation—because of a policy mix in some countries that overburdened monetary policy, the other participants were clustered together in the lower part of the band with little room to move within the band.

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