Ifo Viewpoint No. 41: Another Unification and More Illusions

Hans-Werner Sinn
Munich 08 January 2003

The Eastern enlargement of the European Union is the second reunification that western Germany has experienced within a short period of time. As with the first unification, it is part of the logic of history. The second is also fortunate for Europe because it overcomes the humiliation that many Europeans had to endure under Communist regimes, and it creates a long-term security zone and economic prosperity for the old Continent.

The difference between political wishful thinking and economic reality will certainly also be just as great as for the first unification. It is not politically correct to address the obvious economic difficulties. Again, politicians are driven forward by the force of their own rhetoric. Overwhelmed by the historical importance of the event, the warnings of economists go unheeded.

The truth is that Germany at least is not at all fit for European unification. Germany is in the midst of the worst post-war crisis. Economic growth has been feeble for decades, and the country is being overtaken by one European country after the other in per-capita income. The banks and the state itself are facing a financial crisis of major proportions. More and more employers are withdrawing from the encrusted labour markets. The number of insolvencies is increasing month after month and setting new records. Unemployment, even in western Germany, has been increasing on a linear trend that has been unchanged for thirty years. German unification has not yet been digested. A self-supporting upswing in eastern Germany is still not in sight even after a dozen years of waiting, and every third euro spent there still comes from the west.

Eastern enlargement will expand the EU by some 80 million people, many of whom will enter into wage competition with the west. At wage costs, which in virtually all countries, except for Slovenia, are less than 17% of western German labour costs, they will put the west German economy on great pressure and further reduce its already weakened competitiveness. Low-wage products from Eastern Europe will replace German products, and German enterprises, which are already waiting for the starting shot, will shift their investments to the east. In addition, massive migration flows will be induced by the great wage differentials in combination with German welfare benefits, which even with politically enforced quotas will hardly be brought under control, and even if so, only at price of an even more rapid outflow of investment capital. The fundamental problems of the German economy will become all the more obvious after Eastern enlargement.

The change would be smoother if Germany’s labour markets were flexible and if the local wage structures could react to the changed competitive situation. An economy with flexible labour markets would gain from Eastern enlargement because it would always remain competitive and be able to supply the itinerant workers with new jobs. The new possibilities for the markets for capital, goods and human labour would bring welfare gains for both the new and the present members of the European Union.

Unfortunately, this condition is nowhere close to being fulfilled. Industry-wide collective bargaining precludes the necessary downward wage adjustment, and the welfare state with its wage replacement benefits that define quasi minimum wages also prevents wage structures from flexibly adapting to the new circumstances. This means that jobs will be lacking, and unemployment will increase all the more rapidly.

A foretaste of what is to come is the recent rise in unemployment in Bavaria, which has been striking although Bavarian unemployment is still among the lowest in Germany. At a total of 300,000 unemployed persons, about 100,000 persons immigrated to Bavaria in 2001, of which the lion’s share came from Thuringia and Saxony, settling in Bavarian provinces close to the border. In the quickly turning labour-market carousel, the migrants took over jobs before the Bavarian unemployed were able to move there. In statistical terms the migration was a migration into unemployment.

Germany has two possibilities in light of these circumstances. The first, more probable one, is that it again ignores the warnings of the economists and waits for the problems to arrive. Then it will continue to fall behind, and we can only hope that the increasing unemployment will not bring about political instability that could threaten the state itself.

The other option is that it heeds the proposals of the specialists and acts while there is still time. The consensus among economic experts has never been so great as today. The Scientific Advisory Board of the Ministry of Economics, the German Council of Economic Advisors and the Ifo Institute have presented identical propositions for the creation of an activating welfare state to absorb the expected pressure on the labour markets and to initiate a positive development. On the table are also proposals for employee participation in their companies, the effective curtailment of social-welfare tourism, the restructuring of the tax system and a deregulation of the economy. Politicians need only implement them.

Hans-Werner Sinn
Professor of Economics and Public Finance
President of the Ifo Institute