Review of International Economics 10, 2002, pp. 113-128, CESifo Working Paper No. 247, February 2000, NBER Working Paper No. 7586, March 2000.
A political miracle occurred when Germany was reunited, and at first glance an economic miracle has fol-lowed. Real incomes in the eastern area have now reached the western level, and investment per capita hasbeen much higher than in the west. However, every third deutschmark spent in the east has been comingfrom the west, investment in equipment has fallen below the west German per capita level, and convergenceseems to have come to a halt at an overall labor productivity of only 59% of west Germany. Excessivelyhigh wages coupled with investment incentives that made the cost of capital negative rank high among thepossible explanations. This paper describes reforms of the labor market that could help to make convergence continue.