Transition of East Germany

by Mike Roemer

by Stephen Cincotta

A Summary of

"East German Economic Reconstruction"

by Mike Roemer

In November 1989 the Wall came down. Less than a year later the former German Democratic Republic (GDR) had fully adopted the West German economic, legal, and institutional framework. In July 1990 the currency reform took place, and by October of that year the German Democratic Republic had ceased to exist. The economic, monetary and social union had finally been accomplished.

The immediate effect of unification on East Germany was extremely radical. By 1992 the five new states were in the midst of a depression that economically dwarfed the Depression of the 1930's. GDP had fallen by almost thirty percent, and industrial production stood at less than fifty percent of the 1989 level. Unemployment, including short time and public works programs, exceeded thirty percent of the labor force. By 1993, however, this economic decline began to reverse, due in part to massive transfers (DM 139 billion in 1991 and DM 180 billion in 1992). At this point the challenge for Germany became how to move from here to a viable economy that entails higher productivity, higher employment, and sharply reduced transfer payments.

Everyone knew, of course, that this could not be accomplished in a year or two, but what about ten or fifteen years (Dornbusch and Wolf, p. 155-156)? To begin, I believe we must look at the issue of conversion in three areas; the balance sheets of firms and banks at the time of monetary reform, the appropriate rate of conversion for monetary assets of the public, and finally the choice of conversion rate for current payments (i.e. wages).

On the asset side, the balance sheet of East Germany contained state-owned property ranging from "...real estate and forests to shops and pharmacies..." (Dornbusch and Wolf, p.158). On the liability side were the monetary holdings of the public and external debts. At this stage, internal debts did not represent a net liability of the public to the government. In the consolidation of banks and firms, both state-owned, they simply canceled out. Also, since these had no impact on the future earning capacity of the firms, and since their cancellation would not represent any moral hazard, they should simply have been written off. Had these debts been canceled, it is probable to believe that the banks and firms would now have cleaner balance sheets and debts would not be and unnecessary burden on the system. As it stands now, firms employ debt as a negotiating point, assuming debt sporadically to make enterprises more attractive to potential buyers. Because of this, the debt will end up in the federal budget anyway (Dornbusch and Wolf, p.158).

The second aspect concerns the conversion of monetary assets. The reason this point is of such importance is that, for most East German households, money constituted the dominant part of overall asset holdings. With few exceptions, other financial instruments did not exist. In the year prior to reform, the black market rate " ostmarks to the deutsche mark, slowly falling off toward the conversion date in response to the public discussion of likely conversion rates" (Dornbusch and Wolf, p.159). The actual conversion rate - on average 1.6 ostmarks per deutsche mark - resulted from a one to one rate of conversion for assets up to a certain level, and a rate of two to one for remaining assets. The monetary conversion did not involve a transfer from the West to the East. In the East, ostmarks were simply redenominated into deutsche marks. Actual deutsche mark cash needed to meet withdrawals was borrowed from the Bundesbank at the discount rate. With this arrangement, the choice of conversion rate involved a redistribution among various holders of monetary assets, and an intergenerational redistribution. Favorable rates of conversion for households redistributes wealth toward the current generation, encompassing a reduced incentive to save which, in the short run, increased the burden for the West and underwrites the solvency of the system. While this burden might be paid out of net revenues from the operation and liquidation of state property, that process appeared to be increasingly illusory (Dornbusch and Wolf, pp.158-159).

In the race to the monetary union, one of the most pressing concerns was the rate chosen for wage conversion. The main question was how wage parity without matching productivity would work for growth and productivity. At the time of conversion, East German wages were almost one-third of those in the West (on a one to one exchange rate), and correspondingly East German productivity was one-third of that in the West. The Bundesbank argued strongly against a one to one conversion. In their view, a two to one conversion was necessary to make East Germany competitive and to avoid an employment or fiscal disaster. As it turned out, however, the one to one conversion rate had no lasting effect on wages. Since then conversion wages in the East have increased steadily, and outright parity was the avowed objective of unions on both sides. The push towards wage parity was the outcome of a game between "...unions aiming to minimize labor market competition and a government that is essentially forced to underwrite employment" (Dornbusch and Wolf, p.159).

We must now analyze the collapse of output immediately following the unification. The rapid transition resulted in a severe initial decline in production. Output in the manufacturing sector fell by half within a few months. The decline in production was matched by an inevitable decline in employment. Total employment had fallen by more than two million; a further 1.6 million employment relationships were conditional on public support. As a whole, the active labor force declined by forty percent between 1989 and the end of 1991. Employment in the service sector, contrarily, remained fairly constant, with substantial increases in highly skilled professions. As a result of wage increases in excess of productivity increases and declines in producer prices, wage bills for a large fraction of the East German enterprises exceeded net value added at factor costs. The net losses were covered by Treuhand liquidity loans and asset sell-offs.

According to Dornbusch and Wolf, explanations for the fall in industrial output included the following: markets disappeared in the former CMEA (Council for Mutual Economic Assistance) trading partner countries; consumers shifted to Western goods because of availability or cost competitiveness; firms were caught in a cost-price bind where they could no longer profitably produce. Production might have declined simply because management was unable to cope with the breakdown of the traditional organization of input supply and output marketing, which gave way to the market economy. Few observers could have predicted such a dramatic fall in production (Dornbusch and Wolf, pp.160-165).

East Germany confronted the dual problem of overall capital deficiency and misallocation of existing resources. Ideally, the privatization process solves these problems by channeling resources to salvageable firms while freeing inefficiently allocated resources through the liquidation of nonviable enterprises. The survival of many enterprises in the transition economy depended on "...their ability to attract a foreign investor willing to transfer process knowledge along with management and marketing skills" (Dornbusch and Wolf, p.169). Privatization plans tended to include a roll for majority share holders. After an extended period of preparation, privatization had begun in earnest with around thirty sales a week.

Privatization of small and medium scale enterprises is by now nearly complete. The transfer of utilities to local authorities proceeded basically on schedule. The privatization of large industrial firms was a much more tedious and drawn out process, suffering undoubtedly from obsolete capital stocks, substantial overstaffing, environmental risks, and rapidly disappearing export markets remaining sluggish. The availability of West German financial and personnel support, political stability, hard currency, and EEC membership greatly facilitated the East German privatization process.

The real danger over the next few years is the continued support of the newly privatized firms without real hope for survival. By pursuing the policy of postponing bankruptcy of a significant fraction of East Germany's industrial sector, the THA (Treuhand) is allocating scarce resources to the "...stabilization of obsolete economic structures in preference to providing assistance to salvageable sectors" (Dornbusch and Wolf, p.171). While the cushioning of the adjustment process is desirable, the social safety net must be directed towards reconciling the consequences of the necessary structural adjustment, not toward presenting the adjustment itself (Dornbusch and Wolf, pp.169-171).

From the summer of 1989 to unification, 540,000 East Germans moved to West Germany. Between unification and 1994 another 200,000 movers followed. In addition, approximately 500,000 East Germans commute to work in the West, bringing the total post-unification labor force shift to more than 1,000,000 workers. According to Dornbusch and Wolf, the gains from working in the West were indisputable: both the commuter and the migration households real income gains far in excess of the gains achieved by households remaining in East Germany. Yet survey evidence on the migration behavior of the economically active young males, the dominant migration group, suggests that the income gap was not the only or even the dominant incentive for migration. Short-run mobility, furthermore, was quite small. Among the reasons given, unemployment dominates, followed by concerns about the environment, with income differentials coming in only third. Rapid monetary union, with the entailed real appreciation, and rapid wage equalization may have on balance increased rather than reduced the mobility of East German workers. The East German capital-to-labor ratio at present lies substantially below the West German ratio (Dornbusch and Wolf, pp.173-174). With free factor mobility, equalization will occur over the medium run. Two possibilities arise: an eastward movement of capital or a westward movement of labor. More westward labor migration is unavoidable and even more desirable.

The last question that begs to be asked is the following: is East Germany now economically better off? The transition was naturally presupposed on the idea that a market economy would make the economy better off - goods more readily available, efficient production translating into low prices and high wages, and a maximum of opportunity. If there were to be losers, it was believed that there would be more than enough to compensate them. Yet there remains doubt: mass unemployment and relative prices sharply different from what they were in 1989 leave room for a large question mark. However, East Germany is in fact far better off. Real disposable income is up, and consumption has increased 17 percent, not including the welfare improvements that result from an increased variety and far more convenient availability of goods. The remaining problem for Germany is making sure that these gains are widely distributed so that everyone can realize them.

1. Dornbusch, Rudiger and Wolf, Holger C. "East German Economic Reconstruction: The Transition in Eastern Europe." Chicago : University of Chicago Press, 1994.


Transition to the Market Economy

The East German Strategy

by Stephen Cincotta

There is no question that transition from a centrally planned economy to a market economy is a difficult, time consuming, and often times painful task for all parties involved. The transition in East Germany, however was a very special case because of the re-unification with West Germany. The process of transition in the former German Democratic Republic (GDR) was a much different process than in any other former socialist country that made the transition to the market economy. The transition in the former GDR however still had a great deal of problems. It is still today not yet complete, and one can be sure that all of the difficulties have not yet been solved.

In 1989 after the SED (Socialist Unity Party) resigned, due to continuing failures to provide what it had promised in the way of economic progress, the Berlin wall was taken down, and the first steps towards a united Germany were taken. Though many people believed a re-unification of Germany would not occur (or at least not soon), the process was accelerated with the adoption of a monetary union, and then finalized with the signing of the unification treaty, on August 31, 1990. Germany officially became united again on October 3, 1990.

The rush to unity, however, was just the first part of a huge project that would have to be undertaken in order to bring the former GDR economy into the present. Though the accelerated program brought many quick changes to Germany, much quicker than in other former socialist countries, it was not known the extent to which West Germany would have to pay in order to help East Germany create a viable economic system. Some of the problems were, a greatly distorted economic system in the former GDR, consisting of monopolies, excessively large factories, disproportionate production, and huge amounts of environmental problems due to the lack of technological progress and government control by the SED. As well as economic problems there were problems with the entire infrastructure of East Germany. Public buildings and houses all needed repair. Pollution to the land, air, and rivers, was an ecological disaster. All of this was topped by an absurd system of subsidies set up by the previous government, which caused incredibly cheap use of raw materials, energy, and public transportation. Other problems existing in the East German economy which created problems in the transition were the age of many of the factories and power plants, some over 20 years old. Also the lack of experience of East Germans with the market economy created a huge void of suitable managers for the newly privatized businesses, which was hard to fill with West Germans alone. The former GDR also had only a very small integration into the world economy, with exports being only 25% of GNP.

In order to deal with all of these problems (and to reach the eventual goal of having the economy of East Germany equal the economy of West Germany in production), West Germany set up many programs to help with the economic transformation. To start the privatization of businesses an agency known as the Treuhandanstalt (or Treuhand) was established. The job of this agency was to privatize the bulk of East German companies and sell them into the market economy. As well the Treuhand had to break down many large-scale factories which were owned by the state. Finally it was also responsible for the liquidation of companies that were deemed economically unsalvageable. By the end of 1993 the Treuhand had managed to privatize (fully or partially) 90% of the companies in East Germany. All told over 12,000 companies had been prepared for privatization and then privatized b the Treuhand. Also over 2000 businesses were liquidated. The agency had spent around 50 billion DM for the redevelopment of companies under its control. As well other payments to account for company debts and securities for companies totaled more than 85 billion DM. By 1993 in true rapid transition style most of the East German companies had been privatized, at a cost of around 155 billion DM.

The problem of property rights was very hard to deal with because it was very difficult to obtain all of the title deeds. Most property that could be returned was. This was done rather than paying compensation when possible in order to help undo the injustices done to property owners by the SED. Of course along with this many felt there were injustices being done to people who had used the property under the communist system and were now no longer allowed access to it.

Wages and productivity were and are still a large problem. The quick raising of wages in the East German economy to about half that of the average in the West German economy led to a great deal of unemployment. On the basis of productivity standards, however, the East German economy produced less than a third of what was produced by the West German economy. These overall high real wages led to an unemployment rate of around 15% in 1993, and a rate that is still high today when compared to US standards.

The East German economy due to its re-unification with West Germany has enjoyed a far superior amount of financial help to all of the other former socialist countries. The superior West German economy has contributed huge amounts of money to try and get the East German economy on a level playing field. As well the East German economy, after its re-unification with West Germany, also enjoyed the benefits of the European Union. These were all benefits in terms of financial help that no other former socialist country had access to. This financial help also made the East German economy a more stable investment and thus East Germany gained further financial help. The application of the laws and regulations of the market-oriented West Germany also further facilitated the transfer to the market economy. Thus it seems that East Germany had a far better chance at more immediate economic gains than any other former communist country. Of course East Germany did also suffer greater initial losses due to the affects on wages and the tougher standards (such as environmental standards) of West Germany.

East Germany today is in a much better position economically than it was at the start of the 1990’s. In less than 10 years the economy has advanced greatly. Soon the former GDR will be entering into the first phase of a monetary union of the European community. To even get to this point to be ready to enter into a monetary union with other highly developed countries of the European Union in less than 10 years is truly a miracle. However, the question remains is Germany really united. Though tensions between West and East Germans have died somewhat they still exist to a certain extent. West Germans have always felt that they gave too much money to help East Germany and that East Germans showed no gratitude for the assistance they were receiving. East Germans on the other hand always saw West Germans as too controlling in the ways they tried to tell East Germans how to run their businesses and their lives. The newly united Germany is truly an economic powerhouse that will be a huge part of the world economy for years to come. The country itself however will not be truly united until its people learn to consider themselves equals. This may not occur until both the East and West German economies reach a level playing field of production.

Works Cited

Haus, Marius D. The Transformation from a Centrally Planned to a Market Economy – The Experience of the Eastern Part Germany. Proceedings of Seminar on Transition from a Central Planning Economy to a Market Economy (pp. 7-27). Seychelles Institute for Democracy, October 16, 1993.



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