Ifo Viewpoint No. 12: A Transfer Economy

Hans-Werner Sinn
Munich, 30 June 2000

The tenth anniversary of the Economic, Currency and Social Union marks the day of the prosperity miracle in the new Länder of east Germany. Ten years ago, real wages in the GDR were only about 30% of wages in the Federal Republic, and nominal wages, calculated on the basis of exchange rates, were only 7%. Today, nominal wages in east Germany are 70% of the western level and nominal household income is 80%. Retirement benefits from the state social insurance system per household are 110% of the western level.

However, what has arisen in east Germany is a transfer economy and not a functioning market economy. GDP in the new Länder is presently about DM 440 billion and total public and private consumption of goods and services - the absorption - is about DM 650 billion. One third of east German consumption, or some DM 210 billion, is financed by the west; of this amount DM 140 billion flows through public budgets and about DM 70 billion are private capital exports, of which, however, DM 10 billion are loans to finance the Länder budgets in east Germany.

These transfers were necessary since east Germany's catching-up process came to an abrupt end in 1996 after the expiration of the Law for State-Assisted Regions (Fördergebietsgesetz). The main reason for this failure was doubtlessly east German wages. The wages that were negotiated in 1991, between employer and employee representatives who were all from the west, were much too high. Today east German payroll costs are more than 70% of the level in the west compared to an east German overall labour productivity of only about 55%. The reverse is needed to create jobs and economic growth. Productivity must not lag behind wages, but lead them.

The rewards of wage restraint can be seen in Ireland, where overall productivity has risen from 27% of the west German level when Ireland joined the EU thirty years ago to 85% today. This robust growth was the result of wage increases lagging behind the expansion of productivity. Even today, wages are still 30 percentage points below productivity if we compare both variables with those of west Germany. The result is that Ireland has a current account surplus, and not a deficit amounting to 50% of GDP as in the new Länder in east Germany.

The strategy of hasty wage harmonisation has been justified by unfounded arguments, such as the creation of additional demand or incentives for exceptional productivity gains in east German factories. A very misguided argument was that wages had to rise so rapidly to prevent a mass migration. First of all, the migration caused by wage-induced unemployment took place anyway, and secondly this was anything but bad. Instead of working in the east on outdated machinery or idly waiting for new jobs to be created, a temporary migration to the west and employment in productive jobs in the west was certainly the better alternative.

The current wage restraint that has been induced by market forces gives cause for hope. It is also surely needed if the economy in the new Länder is to remain competitive after EU expansion in Eastern Europe.

Hans-Werner Sinn
President of the Ifo Institute