GEORGE A. AKERLOF University of California, Berkeley ANDREW K. ROSE University of California, Berkeley JANET L. YELLEN University of California, Berkeley HELGA HESSENIUS University of California, Berkeley East Germany in from the Cold: The Economic Aftermath of Currency Union AT MIDNIGHTon June 30, 1990, Germaneconomic, monetary,and social union occurred: the mark of the German Democratic Republic was replacedby the deutsche mark;trade barriers were lifted;legal, tax, and social insurancesystems were harmonized;and all existing barriersto capitaland labormovements were removed. Withindays a severe price- cost squeeze was apparent.East Germanproducers could not profitably sell their goods at prices that buyers-East German,West German,or foreign-were willing to pay. Moreover, demandfor domestically pro- duced outputfell as consumersdiverted their spendingtoward Western products. As a result, there was a severe decline in output; unemploy- ment and short-timehours rose rapidly. One of the worst and sharpest depressionsin Europeanhistory had begun. It continues unabated. We are indebtedto Daniel Gross for outstandingresearch assistance and to Thorsten Wassermeyerfor his assistancein administeringthe survey. We thankLewis Alexander, Peter Bachsleitner, Irwin Collier, Doris Cornelsen, Barry Eichengreen, Renate Filip- Kohn, Heiner Flassbeck, Robert Flood, Jeffrey Frankel,Joseph Gagnon, Jane Garnet, ReinerGohlke, BerndGorzig, GregoryGrossman, Holle Grunert,Dale Henderson,Ben Hermalin,Peter Isard, Helmut Kaiser, Anil Kashyap, Lawrence Katz, Michael Katz, 1 2 Brookings Papers on Economic Activity, 1:1991 This paper will document the basic facts of the depression: the behavior of output, employment, wages, prices, vacancies, and other macroeconomicaggregates. We then explore the twin reasons for the depression: producers cannot supply products at market prices and cover their short-run variable costs; and there were declines in the demandfor domesticallyproduced consumer and investmentgoods. We examinethe consequences of the price-costsqueeze forthe goods, labor, and asset markets. In the market for goods, we calculate the fraction of East German conglomerates that are unable to sell their productsat world marketprices while meetingtheir variablecosts. Our estimates are based on unique unpublisheddata, which give the mark expense that each majorconglomerate in the GDR incurredin 1989 to earna deutschemark of foreigncurrency through trade with nonsocialist countries. We adjustthese expense figuresto take account of important changesthat have affectedthe costs of East Germanfirms since currency union. The adjusteddata show that firms employing only 8 percent of the labor force were "viable" after union, in the sense that they could earn sufficientrevenue to cover short-runvariable costs in the absence of significantproductivity improvements. These calculationsundermine priorestimates of high productivityin socialist countries. The second consequence of the price-cost squeeze has been the high incidence of unemploymentand short-timework, a labor-marketdevel- opment that is expected to continue. In the state treaty authorizing MichaelKeren, Horst Kern, HenningKlodt, ReinerKoenig, OtmarLang, David Levine, PaulMasson, DonoghMcDonald, Jurgen Muller, Assaf Razin, Horst Reichert,Christina Romer, David Romer, Garry Schinasi, Holger Schmieding,Rolf Schneider, Elisabeth Schreiber,Hans WernerSinn, David Soskice, Lars Svensson, GianniToniolo, Stephan Vocke, Jurgenvon Hagen, Rudolf Zwiener, and our discussantsand participantsat the BrookingsPanel Conferencefor their help and comments. We are especially indebtedto the librarystaff of the East GermanStatistical Office for theirassistance with this project. We gratefullyacknowledge the financialsupport we have received from the National Science Foundationunder grant SES 90-09051administered by the Institutefor Business and EconomicResearch at the Universityof California,Berkeley, the Centerfor German and EuropeanStudies of the Universityof California,the Institutefor Policy Reform,and the SloanFoundation. Andrew Rose thanksthe Boardof Governorsof the FederalReserve System and the InternationalMonetary Fund for financialsupport. [Mostof the datapresented in this paperwere assembledby the authorsfrom a varietyof officialand unofficialsources, includingtheir own surveys. Consequentlythe paperhas not undergonethe verificationthat data in the BrookingsPapers usually receive. The authorshave madeevery effortto check the datafor accuracy.-EDS.] George A. Akerlof, Andrew K. Rose, Janet L. Yellen.,and Helga Hessenius 3 currency union, wages in mark were converted into deutsche mark at par. At the time of currencyunion, these wages were well above market clearing, so that firms could not profitablyemploy much of their labor. With this large, and growing, slack in the labor market, downward pressureon wages mighthave been anticipated.Instead wages climbed still higher in the wake of currencyunion as labor unions pressed for a scheduleto attainwage paritydespite the economic collapse in the East. For example, a pattern-settingcontract signed in Marchwith the metal workers'union, IG Metall, achieves parityin 1994.In arguingfor higher wages, the unions have said that such wage hikes are needed to keep qualifiedEastern workers from migratingto the West. We conducted a survey of East Germanworkers in order to determinetheir propensity to migrateand the factors likely to influencetheir decisions. We found that few workers will migratefor higherWestern wages; most preferto work in the East in spite of the wage differentialand most are prepared to wait for new jobs there if they become unemployed.They will accept jobs in the East that pay significantlyless than those in the West. Thus the survey results suggest that the real cause of most migrationwill be the lack of Easternjobs-not the wage differential.Higher wages will cause more migrationby increasingunemployment than they will deter by closing the wage gap. Unless policies are undertaken to lower unemployment,a significantproportion of the populationwill migrate. Migration, then, together with investment, will eventually cure the Easternunemployment problem. We also examine the consequences of the price-cost squeeze for the Treuhandanstalt,the newly formed agency that holds the shares of former state-owned enterprises of the GDR in trust for the German government and is charged with privatizingthem. The task has gone slowly. Bureaucratic problems and confusion over property rights account for some delays, but they are not the fundamentalcauses of the Treuhand'sdifficulties. The fundamentalimpediment to privatizationis that the majorityof East Germanfirms have negative value if they are operated, since their costs exceed their revenue. Such firmscan be sold for their real-estate or scrap value, but not to individualsor firms who will operatethem. Currentlythe Treuhandanstaltis faced with a choice of either subsidizingor liquidatingsuch money-losingfirms. At the present time the Germangovernment is offering subsidies to encourageinvestment spendingin the East. They are also financingthe 4 Brookings Papers on Economic Activity, 1:1991 budgetdeficits of the EasternLander (states) to permitthem to pay their bills and make needed infrastructureinvestments. Infrastructureinvest- ments are importantbecause they constitute a preconditionfor private investment on a significantscale. Moreover, these job-creatinginvest- ments are especially cheap at present. They enable individualswhose support would otherwise be provided by the government to support themselves. If a typical individualmoves from unemploymentto em- ployment, the governmentbudget benefits by an estimated79.1 percent of his or her previous compensationbecause of reduced payments for unemploymentcompensation and increased revenue from social insur- ance and tax contributions. So far, however, the package of policies that has been enacted fails to deal realisticallywith the questions of how to preserve existingjobs, how to speed new job creation, and how to make existing companies viable enough to be privatized. The majorproblem is that wages in the East are too highfor most formerstate-owned enterprises to cover their costs. High wages also deter new investment. This creates an obvious need for governmental measures to close the gap between the high privatecost of labor,caused by highEastern wages, andthe low marginal product of labor, caused by outmoded capital and technology. We propose a program of self-eliminatingflexible employment bonuses (SEFEBs) to eliminatethis gap. Ouranalysis shows that such a program would give many workers a chance to keep theirjobs and would also raise the level of new job creation throughfaster private investment. Accordingto our estimates, even deep wage subsidies (for example, an employment bonus equal to 75 percent of current wages) would have very low budgetary costs. They might even reduce budget deficits- largelyfor the same reason that infrastructureinvestment is not costly: the governmentis already committedto a high level of income support even if workers are unemployed. By making many Treuhand firms profitable,employment bonuses would permittheir rapidprivatization. Privatized firms will speed the transition to a modern economy by introducingWestern management, technology, and work habits. To promotethese ends we proposetwo policies: a rapidinfrastructure investment program and a program of employment bonuses. These policies address the twin East Germanproblems of insufficientdemand