The purposes of this Occasional Paper are twofold: first, to review economic and financial developments in Germany since its reunification nearly five years ago; and, second, to analyze some critical issues that have featured prominently in the policy debate over this period and are likely to continue attracting attention in the years ahead.

The purposes of this Occasional Paper are twofold: first, to review economic and financial developments in Germany since its reunification nearly five years ago; and, second, to analyze some critical issues that have featured prominently in the policy debate over this period and are likely to continue attracting attention in the years ahead.

Germany at a Glance

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The discussion of economic developments is organized in many instances along regional lines. This is mainly because regional trends have shown large and persistent divergences, which have been of interest from a policy perspective. It needs to be stressed, however, that this separation is increasingly difficult to sustain statistically and is also less and less appropriate as the two parts of Germany become more fully integrated. Moreover, notwithstanding their divergence, the early postunification trends in east and west Germany have had some common causes. In particular, the large fiscal transfers from west to east, which have been instrumental in generating economic recovery in the new states of the Federal Republic, have also contributed markedly to the emergence of inflationary pressures and the subsequent recession in the old states.

Domestic Economic Developments

West Germany has experienced wide swings in economic activity since unification. These have reflected to some extent the effects of fluctuations in the international business cycle. More important, though, they have been influenced by the unexpectedly large costs of supporting incomes in and rebuilding the economy of the former German Democratic Republic, as well as the policies adopted to cope with the resulting strains on macro-economic performance and the public finances. Initially, transfers to east Germany were financed entirely through borrowing. The implied large fiscal expansion boosted demand at a time when the economy was already close to overheating. As a result, economic growth accelerated noticeably from an average of 3 1/2 percent in 1988-89 to nearly 6 percent in 1990 (Table 1-1). Inevitably, however, pressures on resources also became acute, and both wage and price inflation escalated rapidly.

Table 1-1.

Main Economic Indicators

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Sources: Deutsche Bundesbank, Monthly Report (various issues); Staustisches Bundesamt, Volkswirtschaftiche Gesamtrechnungen; and IMF staff estimates.

Data for GDP and components, employment, unemployment, and prices refer to west Germany.

Preliminary estimates.

Data for general government are on national accounts basis and incorporate east Germany from 1991. Debt data are end-of-year and include the German Unity Fund and east Germany from 1990.

West Germany until June 1990

Including supplementary trade items.

Monetary data include east Germany from end-June 1990, thereby distorting growth rates in both 1990 and 1991.

Subsequently, monetary policy was tightened in an effort to curb inflationary pressures, and action was initiated to reduce the fiscal deficit. Concurrently, foreign demand weakened. In response to these developments, the postunification boom gradually tapered off and gave way from mid-1992 to a deep recession. The recession was concentrated in the manufacturing sector and reached its trough in the first quarter of 1993, when real GDP was some 3 percent lower than a year earlier and industrial production was as much as 10 percent below its peak (Chart 1-1). It was accompanied by a large fall in employment as the effects of the decline in output were exacerbated by labor-saving restructuring, particularly in export-oriented industries.

Chart 1-1.
Chart 1-1.

West Germany: Output and Unemployment

Source: Deutsche Bundesbank; and IMF staff estimates.1Based on an estimated production function in which factor inputs are set at their assumed full employment levels.

With the growing slack in labor and output markets, inflationary pressures gradually receded. In particular, the increase in wage earnings decelerated sharply from an average of 6 to 7 percent in 1991-92 to 4 percent in 1993 and further to about 2 percent in 1994. The slowdown in the growth of unit labor costs was even more pronounced because of the large productivity gains associated with the cyclical recovery in output and labor shedding in the manufacturing sector. Consumer price inflation proved more resilient, mainly because of increases in indirect taxes, local authorities’ charges, and the cost of housing. Nevertheless, it too has been on a downward trend since late 1992, enabling the Bundesbank to allow monetary conditions to ease progressively.

The relaxation of monetary conditions, coupled with a gradual strengthening of foreign demand, provided the basis for a revival of economic activity. This was set in motion during 1993 but gathered significant momentum only in 1994, by which time many of the initial tensions created by unification had been overcome and both business and consumer confidence had recovered strongly. As in previous cyclical upturns, the revival in activity was led by a strong rebound in exports and was supported, after a lag, by a gradual pickup in business investment. With consumer spending also showing surprising resilience, in the face of declining real household disposable income, real GDP grew by an estimated 2 1/4 percent in 1994, reversing most of its decline during the recession. Employment growth, however, was slow to respond to the upturn in economic activity, and the unemployment rate remained close to its historical peak of 8 1/4 percent through the end of 1994. With output still well below potential and wage increases remaining subdued, the rate of inflation continued to decline.

In east Germany, real GDP fell by no less than one fourth in the 18 months to the end of 1991 (Chart 1-2). The fall in manufacturing output was even steeper, reflecting the collapse of traditional export markets in the former socialist bloc and a shift in consumer preferences toward higher-quality products imported from the west. The contraction in the production base of the new eastern Lander precipitated a sharp decline in employment. Despite substantial emigration to the west and the adoption of large-scale retraining and early retirement schemes, unemployment skyrocketed to over 1 million, or 15 percent of the dependent labor force, while the number of people in short-time work or job creation programs also rose markedly. Meanwhile, the rate of inflation shot up as prices began to converge to those in west Germany.

Chart 1-2.
Chart 1-2.

East Germany: Output and Employment

Sources: Statistisches Bundesamt, Volkswirtschaftliche Gesamtrechnungen; and Deutsche Bundesbank, Monthly Report.1Seasonally adjusted.

The decline in output came to a halt during the course of 1991 and has since been followed by a rapid expansion. This was at first concentrated in the nontradable sectors—construction and services—which benefited from the increased demand generated by the transfers from west Germany. But manufacturing too began to show signs of revival in late 1992. These became more clearly visible in 1993 and 1994, when output expanded by 6 percent and 9 percent, respectively. It is worth noting, however, that despite its robust growth over the past two years, net manufacturing output remains about one fourth lower than it was before unification. Moreover, little progress has been made so far in reversing the large reduction in employment experienced during the early 1990s, and the unemployment rate is still about 14 percent. On the other hand, the pace of wage convergence slowed and the rate of inflation decelerated progressively, as the price level approached that in the west. In fact, by the beginning of 1995 the east German rate of increase in consumer prices had fallen somewhat below that in west Germany.

Balance of Payments

The unification boom brought about a large shift in the pattern of saving and investment in Germany. The main features of the shift were a surge of investment activity in the new states, which led to a sizable increase in the investment ratio and a sharp drop in national savings, which was to a large extent accounted for by the deterioration in the public finances. The counterpart of these changes in saving and investment was a turnaround in the current account of the balance of payments from a sizable surplus (in west Germany), averaging more than 4 percent of GDP in the late 1980s, to a deficit of about 1 percent (in all of Germany) in 1991-92 (Chart 1-3). The emergence of the deficit was, at first, mainly a consequence of the excessive pressures on domestic resources, which boosted the demand for imports while simultaneously contributing to a diversion of some of west Germany’s exports to east Germany. Subsequently, a loss of competitiveness, resulting from Germany’s comparatively high rate of domestic inflation in 1991-93 and the steep nominal effective appreciation of the deutsche mark (especially during the European exchange rate crises of 1992-93), helped to sustain the deficit. The trade position strengthened somewhat in 1992-93 owing mainly to favorable cyclical effects, but there was an offsetting deterioration in the invisibles balance, which reflected in part a sharp reduction in net investment income from abroad.

Chart 1-3.
Chart 1-3.

External Developments

(Percent of GDP)

Source: Deutsche Bundesbank; and IMF staff estimates.1Data prior to unification refer to west Germany only.2General government balance minus borrowing by other public entities.

In 1994, Germany experienced a significant recovery in its competitive position. Domestic unit labor costs actually declined as a very modest rise in wage earnings was accompanied by exceptionally large productivity gains. At the same time, the upward trend in the nominal effective exchange rate of the deutsche mark was interrupted. The improvement in competitiveness, in combination with the strong cyclical rebound in foreign demand, helped to strengthen the trade balance. However, the current account deficit remained about 1 percent of GDP as net investment income from abroad continued to decline. Thus, in a small way, Germany continued to have recourse to foreign savings to finance the rebuilding of the east German economy.

Developments in the capital account of the balance of payments and in external reserves were dominated by the large swings in speculative Hows around the time of the 1992-93 crises in the European exchange rate mechanism (ERM). In addition, changes in the tax treatment of interest income had at times a significant impact on portfolio investment and the foreign position of the banking sector. On balance, Germany experienced a modest capital inflow over the 1990-94 period, which was sufficient to finance its current account deficit as well as a small buildup of official external reserves.

Financial Policies

Fiscal developments in the early 1990s have been dominated by the large budgetary and extrabud-getary transfers to east Germany. These turned out to be far greater than initially expected, averaging well over 4 percent of total German GDP in the four years to 1994. From a position of broad balance in 1989, the general government accounts deteriorated markedly to show a deficit of more than 3 percent of GDP in 1991, notwithstanding the strong boost to revenues from the overheating economy. In addition, borrowing by other public entities, including the Treuhandanstalt, rose rapidly to exceed 1 percent of GDP by 1991.

A first phase of adjustment (entailing mainly a temporary income tax surcharge and a 1 percentage point increase in the standard value-added tax rate) was initiated in 1992, but its impact coincided with powerful offsetting effects of the automatic stabilizers. As a result, the general government deficit did not show much of a fall, while borrowing by other public sector entities rose further to 1 1/2 percent of GDP in 1993.

In early 1993, agreement was reached on a second phase of fiscal adjustment, in the form of a “Solidarity Pact” between the federal and the state governments and the opposition parties. The pact provided for new arrangements for revenue sharing between the Federal Government and the local authorities and included a package of measures to be implemented over the medium term with a view to restoring a sound fiscal position. This package of consolidation measures was subsequently strengthened by the Government, and the bulk of it was enacted by the end of 1993. Key elements of the package were the reimposition of a 7 1/2 percent solidarity surcharge on income tax obligations effective in 1995, a reduction in unemployment benefits as of 1994, and an increase in the fuel tax in 1994 with the proceeds to be used to finance a reform of the railways. In addition, several steps were taken to streamline family assistance programs, to cut other discretionary spending, and to reduce tax shelters and loopholes. Partly as a result of the implementation of some of these measures, the general government deficit declined to 2 1/2 percent of GDP in 1994 and is set to fall further over the next two years, notwithstanding the rebudgetizalion of outlays (such as the servicing of Treuhand and railway debt) that hitherto had been off budget.

Thus, within a relatively short period of time. Germany has made major progress in redressing the fiscal imbalances created by the costs of unification and is already satisfying the fiscal convergence criteria of the Maastricht Treaty. An important drawback, however, is that the fiscal consolidation has been achieved at the cost of a significant increase in the overall tax burden (Chart 1-4). This has weakened economic incentives and risks depressing the economy’s potential over the medium term and undermining Germany’s attractiveness as a location for investment and production. This risk is well recognized by the authorities. Indeed, lowering the tax burden is high on the Government’s agenda for the current legislative period (1995-98). However, the means of achieving this objective, and the requisite expenditure cutbacks, have not yet been spelled out in detail.

Chart 1-4.
Chart 1-4.

General Government Finances1

(In percent of GDP)

Source: Federal Ministry of Finance; and IMF staff projections.1Data prior to unification refer to west Germany only.

The fiscal strains and overheating attendant upon unification led the Bundesbank to move firmly to tighten monetary conditions. Official interest rates were raised repeatedly from early 1990 to August 1992 to peak at close to 9-10 percent. Money market rates moved in concert with official rates. Thus, by August 1992, the three-month interbank rate had risen to 9.8 percent, compared with about 8 percent at the beginning of 1990. Subsequently, inflationary pressures abated and the Bundesbank was able to allow monetary conditions to ease. The process of easing was gradual and at times interrupted by a perceived need to reassure financial markets, as well as participants in the wage bargaining process, that the authorities continued to attach the highest priority to restoring price stability. Nevertheless, by mid-1994, official rates had fallen about 5 percentage points below their 1992 peaks while market rates followed a broadly similar path. Thereafter, official rates remained virtually unchanged but market rates firmed somewhat as the recovery in economic activity gathered strength.

Bond yields rose sharply during the first half of 1990 as the markets anticipated that unification would increase inflationary pressures and the demand for capital to finance reconstruction in east Germany. After unification, however, yields began to fall, notwithstanding the massive recourse by the public sector to the bond market and the progressive acceleration of inflation. The fall was at first gentle and appears to have reflected mainly the downward trend in bond yields abroad, which increased the relative attractiveness of German securities. Since the end of 1991, however, the decline in the return on German bonds accelerated as investors became increasingly confident that the Bundesbank would succeed in its efforts to safeguard the domestic and external stability of the currency. Thus, the yield curve, which had been inverted since 1991, steepened considerably. Bond yields reached a low of 5.5 percent in January 1994 and have since increased by 2 percentage points, contributing to a normalization of the yield curve. The increase, however, was considerably less pronounced in Germany than in most other industrial countries. This tends to support the view that it reflected the effects of the worldwide buoyancy of economic activity and investment rather than any concerns about a rekindling of domestic inflationary pressures.

The evolution of the monetary aggregates in the postunification period has become difficult to interpret. This reflects both uncertainties about the properties of money demand in east Germany and temporary distortions associated with the currency crises in the ERM and changes in the tax treatment of interest income. Notwithstanding these difficulties, the Bundesbank has retained the practice of announcing target ranges for the growth in M3 deemed consistent with its objective of lowering inflation to no more than 2 percent over the medium term. However, in the face of the aforementioned distortions in monetary behavior, it showed flexibility in pursuing its targets. Indeed, the growth of M3 was allowed to exceed the upper bound of its target range by a significant margin in each of the three years to 1993. Overshooting of the target range continued in the early months of 1994, but subsequently M3 virtually ceased to grow and by the end of the year it was within the target range (Chart 1-5).

Chart 1-5.
Chart 1-5.

Interest Rates and Broad Money

(In percent)

Source: IMF Data Fund.1Monthly average data.2Logarithmic scale.

Structural Reform

Since unification, the German economy has also undergone a profound structural transformation. The most sweeping changes have occurred in eastern Germany, where the bulk of the state-owned enterprises has been placed in private hands and massive infrastructure investment has been undertaken, laying the foundation for economic convergence with the west. In western Germany, the deep recession forced industrial enterprises to increase productivity in an environment of high costs and mounting international competition. The industrial shakeout was mirrored in the policy debate, which began to focus on keeping Germany attractive as a location for investment. There has also been a rethinking of the proper division of labor between the private and public sectors, and the switches have been set for an eventual privatization of the railways and the state-owned postal and telecommunications companies.

Outline of Paper

The remainder of this paper is organized as follows. Chapter II takes up the issue of whether the appreciation of the deutsche mark in recent years and the rise in labor costs have had a significant adverse effect on the competitiveness of the German economy and its export performance. It examines various measures of competitiveness, including conventional indicators and some that are less widely used. The chapter finds that the deterioration in Germany’s external competitiveness has almost certainly been exaggerated by standard indicators, such as relative unit labor costs in manufacturing, and that recent export performance and the export outlook do not appear to have been seriously impaired.

Chapter III examines the link between high unemployment and labor market institutions in Germany. It argues that labor markets in Germany have become increasingly segmented between high- and low-productivity workers and that only a small part of the unemployment problem is cyclical in origin. Reform of income support for the unemployed, a re-examination of social assistance, and some relaxation of employment protection could facilitate the reintegration of lower-skilled workers into the economy.

Chapter IV analyzes the relationship between economic growth, on the one hand, and the size of the public sector and the tax burden, on the other. In addition, this chapter uses the IMF’s MULTIMOD economic model to explore the macroeconomic effects of changes in the structure of the public finances. The results suggest that a reduction in the size of the public sector may be beneficial, as may a lesser reliance on wage taxes.

Chapter V presents an empirical analysis of different monetary indicators in order to shed some light on the issue of whether the overshooting of the broad money supply target in recent years raises the specter of a renewed acceleration of inflation. The analysis suggests that in the period preceding unification a monetary conditions index (MCI), constructed as a weighted average of real short-term interest rates and the real effective exchange rate, would have provided useful early warning signals for inflation, broadly similar to those emanating from the behavior of broad money. However, neither indicator would have predicted developments in inflation around the turn of the decade very well. This is perhaps not a surprising result given the unprecedented nature of the demand shock to the west German economy associated with unification.

More interesting is the finding that during 1992-93, when money growth increased significantly, the MCI indicated that monetary conditions remained fairly tight. Since there were good reasons to suspect that the monetary data were distorted by special factors, the behavior of the MCI at this time suggests that the policy of cutting official interest rates during 1993 and the first half of 1994, even in the face of further surges in monetary growth, was appropriate. The validity of this policy is also borne out by the subsequent slowdown in monetary growth in the second half of 1994 and the favorable evolution of wage and price inflation.

Finally, Chapter VI investigates the prospects for self-sustaining growth in eastern Germany. This subject has important ramifications for economic performance in Germany as a whole—including the public finances and the balance of payments. Following an analytical overview of the principal forces likely to sustain or impede economic growth in the east, the chapter develops a two-sector growth model that links investment, the labor market, and technological change. This framework is used to assess the evolution of potential output in eastern Germany and to gauge the effect of excessive wages on the demand for labor. The simulations show that the economy is likely to expand at a rapid rate for a number of years but that the large imbalance in the labor market poses a risk to this outlook.

The First Five Years: Performance and Policy Issues