“I have this to say to my fellow Germans in East Germany: The introduction of the social market economy offers you every chance, in fact, even a guarantee, that (the East German states of) Mecklenburg-Western Pomerania, Saxony-Anhalt, Brandenburg, Saxony and Thuringia will soon become blossoming landscapes in Germany once again.”
-Helmut Kohl, 18 May 1990
As I put it in May: “Forget about blühende Landschaften [blossoming landscapes] in the former East Germany. Try depression.” Almost 20 years after former German Chancellor Helmut Kohl made his remarks, there remains a wide gulf between the DDR’s economic development and the development in the rest of Germany – this, despite a massive amount of money sunk into eastern German infrastructure and jobs programs.
On Monday I wrote Why Stimulus Is No Panacea, pointing to the misallocation of resources that stimulus can create. I see eastern Germany as the biggest real-time experiment in stimulus spending we have in the developed world. I want to use the experience as a case study in the limits of stimulus spending and jobs programs in ending a depression.
The State of Eastern Germany Today
When I was covering the Euro crisis earlier this year, I outlined the genesis of Germany’s labour markets in Germany’s 1990 currency union with my May post “The Soft Depression in Germany and the Rise of Euro Populism.” However, just yesterday Der Spiegel wrote a remarkably comprehensive piece on this topic that we can use as background. I have linked the full article at the bottom. It is in English and a must-read piece of journalism.
Here’s what they ask at the outset:
July 1 marks the 20th anniversary of the introduction of the deutsche mark in East Germany in the runup to full reunification. But the economic benefits that West German politicians promised failed to materialise. What went wrong?
We can get to what went wrong in a minute. But, detailing the problems is key to understanding how wide the gap is between east and west.
Today, the eastern German economy is still in a sorry state, and there are no indications that the situation will change. An estimated €1.3 trillion ($1.6 trillion) have flowed from the former West Germany to the former East Germany over the last 20 years. But what has that money achieved? Historic neighborhoods have been restored, new autobahns built and the telephone network brought up to date, but most of the money was spent on social benefits such as welfare payments. The anticipated economic upswing failed to materialise.
Some eastern cities, like Leipzig, Dresden, Jena and Erfurt, have experienced economic development. The state of Thuringia has a relatively robust auto industry, and there are successful high-tech companies in Saxony. Research institutes and universities are doing well, thanks in part to generous government subsidies.
But the success stories are rare. Most of eastern Germany has turned into an economically depressed region that lags behind the west in all respects:
- The per capita economic output in the east is only at 71 per cent of the western level, with a disproportionately high share of economic output attributable to the public sector. The economic output generated by the private economy is only at 66 per cent of the western level.
- To close the gap, the eastern German economy would have to grow more rapidly than in western Germany, but precisely the opposite is the case. Germany’s leading economic research institutes expect the economy in eastern Germany to grow by 1.1 per cent this year, compared with 1.5 per cent in the west.
- Since the fall of the Berlin Wall, the population of eastern Germany has declined by almost 2 million people, a trend that is continuing unabated.
- The proportion of household income derived from welfare payments is 20 per cent higher in the east than in the west.
- Of Germany’s 100 largest industrial companies and 100 largest service providers, not one has its headquarters in eastern Germany.
The Investment in Infrastructure and Jobs
So, it’s not that investments weren’t made. They were. Trillions were spent to upgrade infrastructure and create a modern environment in Eastern Germany. Eastern Germany has beautiful new airports and roads, which are better in many places than in the western states. Hundreds of Billions went into constructing and upgrading housing in eastern Germany too – so much so that housing is now being demolished due to the inventory overhang. Lots of money went into subsidies for aquatic resorts to boost tourism. For instance, in the state of Brandenburg alone, “close to €170 million in subsidies had been spent on swimming pools by 2005.”
And then there are the Arbeitsbeschaffungsmassnahmen, one of the longest words you will ever see. This is the German word for public works programs. And they were maintained in droves in the former DDR. Spiegel says:
The government came up with a series of publicly funded employment programs in the years after the fall of the Wall. But there was always an underlying contradiction. On the one hand, the jobs created under these programs were designed to resemble normal jobs as closely as possible, so that participants would be able to eventually return to the regular working world. On the other hand, this parallel labour market could not compete with the real job market.
It was not a success, as Germany’s Federal Audit Office concluded two years ago in a devastating assessment of one such program involving so-called “one euro jobs.” Under the scheme, the long-term unemployed could work a certain number of hours a week in, for example, old people’s homes, schools or parks. In return, they received compensation of €1 an hour or more on top of their regular welfare payments. But, according to the report, the government-funded ersatz jobs were displacing many regular jobs and even decreased the chances of participants finding real work.
For the majority of long-term unemployed people, the one-euro jobs did not “provide any measurable advantages” in terms of finding work, the auditors concluded. Hundreds of thousands of East Germans were “branded as second-class workers,” says Esther Schröder, a former SPD member of the Brandenburg state parliament.
Yet, per capita output is still less than three-quarters of that in the West – this, despite a large outflow of population from east to west.
What went wrong?
20 years is a long time. On Wednesday I noted in “Questions On Whether Internal Devaluation Will Work For Europe” that East German unemployment was still double digits today. The chart from Spiegel shows you the progression both of unemployment and relative productivity.
The Germans have been very diligent in making the investments. It’s not like Japan, where during their lost decade they continuously downshifted into deficit hawk mode. In my view, the investments made into the former DDR present the best case scenario one can hope for regarding stimulus and public works programs.
Why hasn’t it happened for eastern Germany? Claus’ piece Demographics and Macroeconomics – Part 1 (Wonkish) says there is a lot missing in Economics regarding growth theory. But here are some potential factors.
- Time: eastern German workers were living in a much less technologically advanced world than in the west. They face a challenge similar to the one the southern states in the US have faced for two generations in terms of raising productivity levels. Time seems to be bringing the south in line. I don’t have the numbers with me. But I believe there is still a gap – although greatly diminished. Perhaps someone can provide the numbers for me.
- Capital: if you look at the UK and productivity or GDP per capita, clearly there are is a huge gulf due to the lingering effects of de-industrialisation in the north. My sense is that more private sector capital has flowed to the south east (and into financial services) because of this. Perhaps the same is true in Germany i.e. less private sector capital flows to the east. The same could be said for the Ruhrgebeit in North Rhine Westphalia, which is Germany’s industrial heartland – where unemployment is high. But given the huge public sector and subsidised capital the east has received, you have to wonder if this has been malinvestment.
- Cost of labour: my suspicion is that eastern German workers priced themselves out of competitiveness vis-à-vis their more productive western brethren. And to the degree that the west’s labour costs were to high, there was always the lure to German firms of Poland, Romania or the Czech Republic where labour costs were lower than in the east. I see this as the fundamental problem. Once the cost of labour becomes too high, a vicious cycle of lowered productivity and emigration of human and private financial capital ensues. In the American south, we are now seeing the return of capital as new businesses have formed.
If anyone has other thoughts, please supply them in the comments.
Lessons for Other Countries
High debt levels and the structural adjustments due to the misallocation of resources are the major reasons we are in an economic fix right now in Spain, Ireland, the UK and the US. Until the structural shifts occur, nominal GDP growth will remain well below potential. And this is poison for an economy with high aggregate debt levels as it changes the psychology of households and businesses to a fixation on debt reduction, precautionary savings, and cash hoarding (see Chart of the day: Record Profits But Cash Hoarding In The U.S.). While increased savings is what we want over the long-term, the reduced consumption and employment that results from it means slower growth for the foreseeable future.
In Spain and Ireland, there is no way to get around the lack of competitiveness without internal devaluation given the Euro fixed exchange rate. In the US, we see massive out-migrations from depressed regions to more buoyant regions because of the common language that fosters a relatively greater labour mobility. Is this what we should expect from Spain or Ireland (or Greece)?
In Europe, the Euro is a major reason why I am siding with the Germans on fiscal consolidation. But the UK and the US have a lot more leeway. So, in the United States and the United Kingdom, because of the sovereign currency, the lessons of eastern Germany go to stimulus and work programs. My takeaway is that stimulus can indeed create new malinvestment. Reading the Spiegel article should give you the sense that all the new airports, housing, spas and swimming pool are not adding to productivity. Moreover, the investments must be maintained and this siphons scarce financial and labour resources away from other uses. China, as a developing economy, may be able to handle this. But the US or the UK cannot.
I do not support austerity. The reasoning seems to be: “we need to cut our spending now before the bond bears come a-calling and interest rates go through the roof.” I think the logic behind this is flawed as it relies on non-existent bond vigilantes jacking up interest rates (see here). Treasury yields are in freefall right now.
At the same time, while stimulus can prevent a deflationary spiral, its supposed benefits are overplayed. I like to think it can be a boost in the short-term as the economy “re-calculates.” Longer-term, there are negative side effects. I can point to the former DDR as a prime example of why. We are in a longer-term deleveraging that is only going to be exacerbated by the debt stress associated with high debt levels and low nominal growth rates, something Bill Gross seems to understand. There is no way around this via stimulus.
Source: Germany’s Disappointing Reunification: How the East Was Lost – Der Spiegel