Investment

The standard neoclassical view of economic growth is that in the very long run, when the economy has reached a steady state, the growth rate of per capita income depends on the rate of technological innovation. During the transition to the steady state, when the economy is undergoing a process of capital deepening, the growth rate also depends on the rate at which capital is accumulated.

The east German economy at the time of unification was far from a steady state. The inherited capital stock was of little value in a market economy, and technology lagged behind the west by perhaps two decades. Productivity and per capita incomes were substantially lower than in west Germany.

Neoclassical theory implies that economic growth in east Germany will be driven for a considerable time by capital accumulation. The speed of this process, and hence the rate of economic growth, will depend largely on the amount of new productive investment. The propensity of private enterprises to invest depends, in turn, on a multiplicity of factors affecting the rate of return on capital. These include the degree of political stability, the efficiency and honesty of public administration, the condition of the infrastructure, the availability of a labor force that is technically skilled and diligent, and the level of wages.

An important objective of economic policy in the region, therefore, has been to create an environment conducive to private investment. A considerable effort has been devoted to rebuilding east Germany’s public infrastructure, especially in the critical fields of transportation and telecommunications. Moreover, the Government has made available generous assistance to potential investors in the region, including special tax allowances, accelerated depreciation, and subsidized credit. Several laws were passed to ensure that the property rights of investors took precedence over the restitution claims of former owners. Finally, the Treuhand has required buyers of its enterprises to make a contractual commitment to a specified volume of investment.²

These policies appear to have met with some success, although it is difficult to know how investment would have performed in their absence. There has been a marked increase in gross fixed investment, from less than 20 percent of GDP in 1990 to around 50 percent of GDP in 1993 (Table 6-2). There has also been a shift in the perceptions of investors. Early surveys showed that bottlenecks in public administration, a lack of market opportunities, uncertainty about property rights, and an inadequate transportation and telecommunications infrastructure were seen as important obstacles to investment. In more recent surveys, these concerns have moved to the background.

Wages and Employment

Instead, the high level of wages in east Germany has assumed greater prominence in the surveys on the obstacles to investment. This section examines the relationship among the level of wages, employment, and the incentive to invest.

The sharp increase in wages following unification can be attributed to a desire of labor unions to eliminate the wage differential with west Germany. The ostensible motivations for this policy were equity (“equal pay for equal work”) and the desire to reduce migration to west Germany.’³ As a result, wage rates have been far out of line with productivity. Not only is the average wage rate substantially higher than the marginal product of labor but the share of labor in national income exceeds 100 percent, implying that the aggregate current profitability of the business sector is negative (Table 6-2).

Excessive wages affect both the level of output and the propensity to invest. The effect on the level of output results from the reduction in the demand for labor. Indeed, employment has declined every year since unification (Table 6-2). Although some initial decline in employment was to be expected, if only because labor force participation under central planning was artificially high, employment has continued to fall even though production bottomed out in the course of 1991.

The effect of excessive wages on the propensity to invest, and hence on the growth rate of output in the medium term, is of greater consequence. For any given level of total factor productivity, both the real wage and the real implied return on capital are determined by the capital-labor ratio. When a profit-maximizing firm increases its capital-labor ratio in response to higher wages, which in the short run can be accomplished only by cutting employment, the implied rate of return on capital declines, reducing the incentive to invest. In principle, extremely high wages could completely stifle new investment unless offsetting measures are taken.

As mentioned above, the Government has taken a number of measures to stimulate investment. In addition, direct and indirect labor subsidies are widespread in east Germany. They have helped to mitigate the adverse effect of high wages on investment and growth. Workers in special labor market programs accounted for about one fifth of total employment in 1991-93.⁴ Moreover, the Treuhand has required buyers of enterprises to make a commitment to maintain employment at a specified level for some years. In exchange for these commitments, the Treuhand provided a subsidy by reducing the price charged to the buyers.⁵

There is a growing recognition that these measures may not be sufficient and that wage moderation and greater wage flexibility may also be needed to forestall a further significant rise in unemployment and to enhance the incentive to invest in east Germany. Numerous enterprises have left the employers’ associations, and there is evidence that many have been paying wages below the official tariff without much protest from the unions. Moreover, many labor unions have now distanced themselves from the objective of achieving wage parity with west Germany in the next few years. There has also been a somewhat greater willingness on the part of the labor unions to permit the negotiation of special wage concessions at the plant level when jobs are in jeopardy.

Composition of Demand and Output

While the adequacy of aggregate investment and labor market conditions are the most fundamental determinants of economic growth, the composition of demand and output also provides information on the likely pace of economic expansion. Aggregate demand in east Germany currently exceeds output by a wide margin, and there is a substantial trade imbalance (Table 6-3). Demand is sustained by large net transfer payments and by a substantial inflow of capital. The capital inflow partly finances private investment and partly finances the borrowing of state and local governments and the Treuhand.⁶

Table 6-3.

Eastern Germany: Trade and Payments

Sources: Daca supplied by the authorities: and IMF staff calculations.

Table 6-3.

Eastern Germany: Trade and Payments

		1990	1991	1992	1993
		(In billions of deutsche mark)
Goods and nonfactor services
	Exports	35.1	46.9	52.1	54.9
	Imports	91.6	199.2	246.8	261.6
Foreign balance		–56.5	–152.3	–194.7	–206.7
Balance of factor services		2.0	8.0	10.8	9.4
Balance of transfers		…	107.0	117.0	138.0
Current balance		…	–37.3	–66.9	–59.3
Implicit capital account balance		…	37.3	66.9	59.3
		(In percent of CDP)
Goods and nonfactor services
	Exports	16.1	22.8	19.8	18.0
	Imports	42.1	96.7	94.0	85.7
Foreign balance		–26.0	–73.9	–74.1	–67.7
Balance of factor services		0.9	3.9	4.1	3.1
Balance of transfers		…	51.9	44.6	45.2
Current balance		…	–18.1	–25.5	–19.4
Implicit capital account balance		…	18.1	25.5	19.4

Sources: Daca supplied by the authorities: and IMF staff calculations.

View Table

Table 6-3.

Eastern Germany: Trade and Payments

		1990	1991	1992	1993
		(In billions of deutsche mark)
Goods and nonfactor services
	Exports	35.1	46.9	52.1	54.9
	Imports	91.6	199.2	246.8	261.6
Foreign balance		–56.5	–152.3	–194.7	–206.7
Balance of factor services		2.0	8.0	10.8	9.4
Balance of transfers		…	107.0	117.0	138.0
Current balance		…	–37.3	–66.9	–59.3
Implicit capital account balance		…	37.3	66.9	59.3
		(In percent of CDP)
Goods and nonfactor services
	Exports	16.1	22.8	19.8	18.0
	Imports	42.1	96.7	94.0	85.7
Foreign balance		–26.0	–73.9	–74.1	–67.7
Balance of factor services		0.9	3.9	4.1	3.1
Balance of transfers		…	51.9	44.6	45.2
Current balance		…	–18.1	–25.5	–19.4
Implicit capital account balance		…	18.1	25.5	19.4

Sources: Daca supplied by the authorities: and IMF staff calculations.

Put differently, east Germany’s massive trade deficit is the necessary counterpart of the inflows of transfers and capital. The domestic tradable goods sector (which consists principally of manufacturing industry) was simply unable to satisfy the surge in demand brought on by these inflows. Moreover, the east German manufacturing sector was uncompetitive. Many goods were of low quality, at least initially, and costs were, and in some cases remain, excessive.⁷ Compared with 1990, the share of manufacturing in value added has fallen sharply, to less than 20 percent (Table 6-4). Although it has recovered somewhat since 1990, it remains well below the industrialized country norm. In west Germany, for example, the share of manufacturing in value added has been around 30 percent in recent years.

Table 6-4.

Eastern Germany: Gross Value Added by Sector

Source: Dcutsches Institut fur Wirtschaftsforschunsg.

Table 6-4.

Eastern Germany: Gross Value Added by Sector

			Percent Changes			Percent of Total
			1991	1992	1993	1990	1991	1992	1993
Agriculture and forestry			–66.1	18.8	41.1	2.9	1.3	1.4	1.9
Industry			–34.3	14,3	11.1	41.5	35.8	37.6	39.2
	Mining and energy		–13.8	–12.2	–5.0	6.9	7.8	6.3	5.6
	Manufacturing		–49.1	17.2	10.6	24.4	16.3	17.5	18.2
	Construction		–12.8	28.1	19.2	10.2	11.7	13.8	15.4
Total services			–13.6	5.4	3.3	55.5	62.9	61.0	59.0
	Trade and transport		–36.9	–3.0	7.5	18.4	15.2	13.6	13.7
		Trade	–40.4	–0.2	5.7	12.6	9.9	9 1	9.0
		Transport	–29.0	–8.2	11.2	5.7	5.3	4.5	4.7
	Other private services		11.3	16.7	2.7	16.3	23.7	25.5	24.5
	Public sector, private households.
		and nonprofit organizations	–12.5	–0.5	1.3	20.9	24.0	21.9	20.8
Gross value added			–23.7	8.8	6.7	100.0	100.0	100.0	100.0

Source: Dcutsches Institut fur Wirtschaftsforschunsg.

View Table

Table 6-4.

Eastern Germany: Gross Value Added by Sector

			Percent Changes			Percent of Total
			1991	1992	1993	1990	1991	1992	1993
Agriculture and forestry			–66.1	18.8	41.1	2.9	1.3	1.4	1.9
Industry			–34.3	14,3	11.1	41.5	35.8	37.6	39.2
	Mining and energy		–13.8	–12.2	–5.0	6.9	7.8	6.3	5.6
	Manufacturing		–49.1	17.2	10.6	24.4	16.3	17.5	18.2
	Construction		–12.8	28.1	19.2	10.2	11.7	13.8	15.4
Total services			–13.6	5.4	3.3	55.5	62.9	61.0	59.0
	Trade and transport		–36.9	–3.0	7.5	18.4	15.2	13.6	13.7
		Trade	–40.4	–0.2	5.7	12.6	9.9	9 1	9.0
		Transport	–29.0	–8.2	11.2	5.7	5.3	4.5	4.7
	Other private services		11.3	16.7	2.7	16.3	23.7	25.5	24.5
	Public sector, private households.
		and nonprofit organizations	–12.5	–0.5	1.3	20.9	24.0	21.9	20.8
Gross value added			–23.7	8.8	6.7	100.0	100.0	100.0	100.0

Source: Dcutsches Institut fur Wirtschaftsforschunsg.

The decline in the share of manufacturing and other tradable items was mirrored by a marked shift in the structure of production toward nontradables, such as private services and construction; these activities have made a substantial contribution to the growth of output in east Germany in 1992 and 1993. However, there has been concern that, as transfers to east Germany stabilize, the impetus these transfers have imparted to the nontradables sector will also level off. With little further expansion in the nontradables sector, even a relatively rapid increase in the output of manufactures and other tradables would produce only slow economic growth, given the small share of the tradables sector in overall value added. In sum, there would be a deceleration in economic growth as transfers from west Germany level off or decline.

An assessment of this observation would begin by defining the (disposable) income of the east German economy as the sum of domestic net production and net transfers. It then becomes apparent that in 1992-93, the share of income absorbed by nontradables amounted to only 54 percent, substantially below the comparable ratio for west Germany (64 percent). Hence, there is considerable room for a further expansion of the nontradables sector. The extent to which the slackening of transfer payments to east Germany is likely to constrain economic growth is taken up in the quantitative framework developed below.

Overview of the Model

Three sectors are distinguished: tradables, private nontradables, and public nontradables.⁸ Output in each sector (denoted by i) is represented by a Cobb-Douglas production function and indexed by time period t:

where Q_ti is output, A_ti is total factor productivity, K_ti is capital stock, and L_ti is labor input. The production elasticities of the factors, denoted by α, are the same across sectors.⁹ As indicated in the previous section, the overall income of the economy is the sum of output and net transfers:

where Q_t is output, TR_t are transfers, and the subscripts T, NP, and NG refer to tradables, private nontradables, and public nontradables sectors.

The government sector is assumed to be essentially static, with value added remaining constant in real terms for most of the forecast horizon and increasing in step with value added in the other sectors in the longer run. For the sake of simplicity, the projections also assume that net transfers remain constant in real terms over the entire horizon. Moreover, the share of the nontradables sector in overall income is assumed to converge to the equilibrium share according to a partial adjustment process:

where the parameter σ is chosen to achieve the bulk of the adjustment in 20 years or so. Then, income is determined as

The next task is to determine output in the tradable goods sector, which requires a model of investment and the demand for labor. With this model in hand, overall income and output can be determined, as well as the distribution of factors across sectors.

Derivation of the Investment Function

The investment function is based on the solution to the profit-maximization problem of a representative firm. Profits are maximized subject to the constraint of technology (the production function) but also subject to a term representing costs associated with changes in the capital stock. The solution to this problem (see the Appendix at the end of this chapter for details) produces a formula for investment that can be recognized as a partial adjustment model:

In the limit, assuming r_t, goes to r = constant, K_t, asymptotically increases each period by a factor of z and the marginal product of capital equals r + γ, the sum of the real rate of return on capital and the rate of depreciation. It is easy to show that the parameter z – 1 is the steady-state growth rate of the economy: that is, the rate at which the capital-output ratio remains constant.

The investment function was calibrated on the basis of west German data (again, details may be found in the Appendix). For the purposes of the simulations, the following related, and relatively simple, form was used:

It might be noted that calibrating the investment function on the basis of the west German experience may understate the volume of investment that can be expected in east Germany. In particular, investment in east Germany is unlikely to be constrained by the availability of domestic savings as may have been the case in west Germany in the period 1960-90. The estimates also do not take account of the large subsidies for investment available in east Germany and so may again understate the propensity to invest in east Germany.¹⁰ On the other hand, the fact that Germany was a net exporter of savings for much of the period suggests that the savings constraint may not have been binding. In any event, it is probably safer to underestimate investment than to overestimate it.

Calibration of the Production Functions

Before proceeding to the more complex task of calibrating the multisector model, it is worth making some observations about the overall situation. Aggregate labor productivity in east Germany, as measured by real GDP per employed person, was about 34 percent of the west German level in 1990. In terms of the Cobb-Douglas production function used here, lower labor productivity can be explained by a lower capital-labor ratio, by lower total factor productivity, or by some combination of both.¹¹ As there is no reliable information on the level of the capital stock in east Germany around the time of unification, it is not possible to determine both the capital-labor ratio and total factor productivity. One or the other will have to be arbitrarily set based on broad considerations of plausibility and consistency. In this connection, it should be noted that for any given level of labor productivity, there is an inverse relationship between total factor productivity and the implied capital stock. Table 6-5 illustrates this point (assuming YIL equals 28.40, the 1990 value for east Germany).

Table 6-5.

Range of Initial Conditions in Eastern Germany

Table 6-5.

Range of Initial Conditions in Eastern Germany

	Range
Total factor productivity (in percent of west German level)	20.0	40.0	60.0	80.0	100.0
Capital stock (ratio to real GDP)	18.7	3.7	1.5	0.7	0.4

View Table

Table 6-5.

Range of Initial Conditions in Eastern Germany

	Range
Total factor productivity (in percent of west German level)	20.0	40.0	60.0	80.0	100.0
Capital stock (ratio to real GDP)	18.7	3.7	1.5	0.7	0.4

Thus, the range of estimates for the initial capital stock varies by a factor of ten or more. Some of the more extreme estimates are easily ruled out on the basis of plausibility considerations. The well-known inefficiency of resource allocation in east Germany’s planned economy and the outmoded technology widely used there make it unlikely that total factor productivity reached 100 percent, or even 80 percent of the west German level. It is also improbable that the capital-output ratio greatly exceeded comparable values in west Germany, where it ranged from about 1.4 in 1960 to 2.0 in the late 1980s. Plausible estimates would put total factor productivity in east Germany at about 50 to 70 percent of the west German level.

Of course, total factor productivity should be expected to increase quickly from this initial level, eventually converging to the west German standard. Substantially improved technology has begun to be employed, and there has been a large influx of west German specialists in management, marketing, and finance. In the manufacturing sector, there are many examples of new facilities established in east Germany that incorporate the most advanced technology. Indeed, most of these enterprises are more productive than the average west German facility. By contrast, in the nontradables sector, less efficient enterprises may be able to persist for a considerably longer period of time.

In the final analysis, total factor productivity in the initial year (1990) in both the tradables sector and the private nontradables sector was set at 60 percent of the west German level. By 1994, total factor productivity in the severely diminished tradable goods sector is assumed to reach 77 percent of the west German level, and it increases to 100 percent of the west German level over the next 15 years. In the larger nontradables sector, it increases to 70 percent in 1994 and then rises much more gradually, not reaching 100 percent of the west German level until 20 years later. Although these assumptions are somewhat arbitrary, there is no alternative to making judgments of this kind if the objective is to provide a quantitative assessment of the growth prospects in east Germany.

Modeling the Labor Market

The production functions, combined with estimates of the initial level of the capital stock, allow for the derivation of sectoral labor demand functions that take the following form:

where w_u, is the real wage.¹² As mentioned earlier, the level of employment currently seen in east Germany is higher than would be consistent with this labor demand function; this reflects the operation of various labor market support schemes. For the purposes of the simulation, it is assumed that these support schemes will continue to be phased out during the 1990s. In the model, this is represented by a progressive narrowing of the gap between notional labor demand, given the exogenously determined path of wage adjustment, and the actual level of employment.

Once the labor market gap has been fully eliminated, the pace of wage adjustment is set so as to allow for convergence of the unemployment rate to the NAIRU (assumed to be 10 percent) within a number of years.¹³ After the NAIRU has been reached, wages are determined endogenously to keep the unemployment rate constant.