A look back at how German unification appeared in 1993

I just came across something I wrote dated 11/08/1993 about the state of German unification at that time.

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A report in the 11/15/93 Business Week provides a good illustration of the wishful thinking about European competition so common in the American business press. The article, "Germany: Is Reunification Failing?" by several staff writers, talks about how eastern German economic performance has disappointed the Kohl government's early predictions of a fast transition for the eastern states.

Contrary to the optimists' hopes, the article accurately notes, industrial production in the old East Germany was far worse than the west had estimated, and environmental problems far more severe. Then, it offers its diagnosis of the policy failures in terms common to American economic policy disputes:

But west German leaders were also to blame. They exported their high wages, generous benefits, and stifling regulations to the east - just when this brand of capitalism was beginning to flag under global competition. They also wrongly assumed billions in public investment would spark a big private investment boom. Moreover, the privatization of old state-run companies didn't create a new entrepreneurial class as quickly as hoped. It often shut down factories and wiped out jobs. And western Germans argue that their new compatriots cling to an entitlements mentally developed under 40 years of communism.

This capsule version of the business press' conventional wisdom about German unification suffers from some serious defects, from the standpoint of American leaders evaluating Europe's competitive strengths:

1. "They exported their high wages, generous benefits, and stifling regulations to the east - just when this brand of capitalism was beginning to flag under global competition."

It seems to be a eternal conviction among business writers that well-paid workers are a bad thing for a country to have. But businesses in practice base their hiring on the reality that, if Worker X produces 10 widgets at $10/hour, and Worker Y produces 30 widgets as $20/hour, Worker Y will produce more bottom-line profit ford the company. Worker Y's labor-costs per widget is $.67. Workers X's cost per widget is $1, even though Worker X is paid 1/2 the salary of Worker Y.

In economists' terms, labor productivity (output of product per unit of labor input) is more important for profitability than absolute wages. Yet here we have America's leading business periodical pushing the simplistic notion that high wages are bad for the economy.

In fact, productivity has been more of a problem in eastern Germany than absolute wages. In new eastern factories, like Opel's state-of-the-art Eisenach plant mentioned later in the article, productivity is extremely high, in which case western-scale wages are economically justified. If Opel's expectations that the Eisenach plant can be 50% more productive than the best western German plant, even higher wages could be justified.

There is also the very practical reality that, if German workers in the east must expect drastically lower wages for the indefinite future, many of them will migrate to the west, exacerbating social and economic problems in old and new states alike. In fact, emigration from the old eastern states to the west has slowed dramatically, which has be counted as a policy success.

How relative wage rates affect a country's international standing is indeed a real issue for Germany, as it is for the United States. North Carolina is happy to have Mercedes Benz putting facilities there to take advantage of their relatively cheaper labor. Yet, do Americans really want to become like a Third World country, marketing ourselves as cheap labor? Germany, like America, is grappling with a dilemma of development: as the economy develops, unskilled labor tends to migrate to lower-wage regions and lower-wage countries.

This produces some very real economic and social problems. But do either Americans or Germans want to solve them by trying to turn their country into a low-wage haven for foreign investment? In any case, Germany's economy is heavily export-oriented and has been remarkably successful at it in the recent past. German capitalism has indeed "flagged" since 1992 - due to a serious cyclical recession. But for Americans to assume that Germany's brand of export capitalism is failing in international competition would be wishful thinking of a high order.

2. "They also wrongly assumed billions in public investment would spark a big private investment boom."

This notion is true in one sense, but over-simplified to the point of having little meaning. The huge transfers of public money to the new (eastern) German states have not produced as large an investment boom as expected.

The problem had to do with several major factors, including the law on property claims and the method of currency conversion (see below). There was a real problem with the public investment program, namely, most of it was not investment. Most of the transfers have been to subsidize consumption, like compensation to the large numbers of unemployed. A more .accurate conclusion would be that massive public subsidy of consumption has not produced an private investment boom. Had these same amounts been spent on public infrastructure or used to directly leverage private investment, there is every reason to think different results would have occurred.

3. "Moreover, the privatization of old state-run companies didn't create a new entrepreneurial class as quickly as hoped. It often shut down factories and wiped out jobs."

This statement is more puzzling than anything, suggesting that the writers confused Germany with other former Communist countries like Russia or the Czech Republic, where a new capitalist class had to be encouraged. German has plenty of successful companies and capitalists , and privatization could and did proceed at a very rapid pace in Germany.

But investment in eastern Germany has failed to meet early hopes. One of the most serious problems in this regard was the way the law on compensation for previous property owners was written. A company can scarcely risk large amounts of capital buying a factory to use or retool if they don't have clear title to the property. But the law governing post-unification property claims allowed former owners, not only from the pre-Communist period, but from the pre-Nazi period as well, to actually take possession of the property. The resulting long-range uncertainties over land titles has proved a major hindrance to outside investment in the east.

And privatization itself did not cause the massive layoffs. One of the Kohl administration's key mistakes in unification was to allow the old east German mark to be translated into the western mark in 1990 on a one-to-one basis. Economic studies at the time indicated that the Ostmark was worth only about one-third of the Deutschmark in the world market . Converting on a one-to-one basis meant that huge sections of east German industry became uncompetitive in world markets overnight. Converting the mark on a basis closer to market reality would have meant that many eastern companies could have sold their goods at much lower prices, and therefore continued to operate.

4. "And western Germans argue that their new compatriots cling to an entitlements mentally developed under 40 years of communism."

Much has been written on the mutual suspicions between "Ossis" and "Wessis" in the new Germany. The "Ossis" are accused of being lazy, undisciplined, unambitious, looking for handouts, etc. The "Wessis" are accused of being arrogant, greedy, and materialistic. It's a little reminiscent of Californians' contempt for the "Oakies" in the 1930s. No doubt, in a few years some German popular singer will be proclaiming, "I'm proud to be an Ossi from Jena" or something similar. And the Ossi/Wessi conflicts will be largely forgotten.

Americans in the wake of German reunification sometimes seemed to think that West Germany had annexed Bangladesh. In fact, eastern Germany was an industrialized country with a well-trained, highly literate workforce. When east German industry is modernized, unified Germany and the European Economic Community stand to reap the full competitive advantages of their strong human capital base.

The "bottom line" is that American business writers waiting for the United States' European competitors to self-destruct are indulging more in wishful thinking than in realistic economic analysis. And some stale cliches - low wages are good for the economy, government spending never helps private investment - add to the confusion.