The Rough Road to Reunification: Germany’s Struggles Toward Economic Convergence

The political reunification of Germany in 1990 moved at an astounding pace. Integrating the two regions economically, however, has proven to be far more difficult, and this process will certainly be ongoing for years to come.

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Image Description: This image, painted on a section of the Berlin Wall, depicts an East German Trabant (“Trabi”) driving through the Wall into the Western side, with the date of the fall of the Wall on the license plate. This little car, with an engine akin to that of a lawn mower, was a prized possession for East Germans (it took approximately 15 years of saving to get one) and has become an iconic symbol of East German culture.

Travelers arriving in Berlin are bound to notice that memories of the Cold War still linger in the city. A succession of stones marking the location of the Berlin Wall bisects the city, just as the Wall itself once did. The famous “Fernsehturm” (“TV Tower”) still stands in the eastern part of the city, although it no longer blocks television signals from Western Europe, as it was designed to do when half of Berlin belonged to the communist German Democratic Republic (GDR, also known as “East Germany”). Yet when the Cold War ended, the GDR ceased to exist and became part of the unified Germany that we see in Europe today. In many ways, eastern and western Germany are now one–they share the same political system, for example, and citizens on both sides of the former Iron Curtain enjoy freedom of movement within Germany and within the European Union as a whole. Economically, however, the two continue to be vastly different, leading some to wonder if the Iron Curtain was ever truly lifted.

The political process of German reunification moved at an astounding pace. By the end of 1990, a reunified Germany existed on the European landscape, a Germany that now included the five “new federal states” of Mecklenburg-Vorpommern, Brandenburg, Saxony, Saxony-Anhalt, and Thuringia, as well as the entirety of Berlin. Integrating the two regions economically, however, has proven to be far more difficult, and this process will certainly be ongoing for years to come. Remnants of the Soviet-style command economy used by East Germany have hindered the region’s development, leading Germany’s new federal states to trail the rest of Germany in almost every measure of economic prosperity. And although German taxpayers have poured more than $2 trillion into helping the former GDR develop, Germany’s new federal states continue to experience significantly lower labor productivity and significantly weaker private sectors than their western neighbors, which in turn has contributed to chronic high unemployment and lower average incomes. Furthermore, despite large investments in the new federal states, the former GDR has lacked opportunity relative to Germany’s western states, and a steady stream of outward migration has caused the region to lose almost two million people since the fall of the Iron Curtain. This large outflow of workers and their families has exacerbated the region’s demographic challenges, and the outflow of human capital dampened economic prospects for the region and for the East Germans who decided to stay.

Labor productivity in the former GDR (and in eastern Europe in general) has been, and continues to be, significantly lower than labor productivity in western European countries. In 1990, East German labor productivity was just two-fifths that of West Germany, despite the fact that education levels in the GDR were similar to those of western Germany, and perhaps even higher. This is largely because the GDR used outdated technology and capital stock, which prevented East Germans from producing as much per capita as their West German peers. This also required firms to take on a large labor force whose sole purpose was to service the equipment and keep it running. In the 1990s, funding from the German government allowed these firms to upgrade their capital stock, a much needed reform for a region whose firms would be competing on the global market. However, the presence of such funding eliminated the need for large service teams, ultimately costing many East Germans their jobs.

East Germany’s low labor productivity also meant that East German labor became quickly overvalued following reunification. During reunification, then-chancellor Helmut Kohl offered the East a monetary union in which East German marks could be exchanged for West German marks on a 1:1 basis. While the move was politically popular, it proved to be an economic disaster as firms in the former GDR quickly found themselves with a labor force that they could no longer afford. “Instead of one to one,” former German Interior Minister Thomas de Maizière recalled, “the exchange rate should have been one to three or one to four, to reflect the economic reality….” The shock that came from the 1:1 exchange rate forced eastern firms to lay off workers en masse–in the industrial sector, two-thirds of all employees were laid off in a short period of time.

It is important to note that over the past 28 years, the former GDR has made tremendous strides in improving labor productivity, and has fared far better than Germany’s eastern European neighbors. The benefits of Germany’s $2.34 trillion investment in the former GDR are certainly visible–in 2014, the productivity gap between eastern and western Germany hovered around 20 percent, whereas the productivity gap between eastern European countries and western Germany hovered around 60 percent. High labor productivity is crucial for any economy, without it, it becomes very hard for that economy’s workers to be competitive in a global market. Thus, the reforms that were made to increase labor productivity in the former GDR, while painful, have been necessary.

Since 1990, the former GDR has experienced significantly higher unemployment rates than Germany as a whole, largely due to the layoffs spurred by increases in labor productivity. The new federal states struggled with double digit unemployment figures throughout the 1990s and into the early 2000s, with unemployment peaking at 18.5 percent in 2005. In some states, the figures were even worse–throughout the 1990s, around 49 percent of the working-age population of the eastern state of Saxony-Anhalt was either registered as unemployed or participating in an employment initiative. Significant progress has been made in decreasing eastern Germany’s unemployment rate. Yet even in 2016, western Germany had an unemployment rate of 5.6 percent, while eastern Germany had a rate of 8.5 percent, a gap of 2.9 percentage points.

Despite the extensive financial support that the former GDR has received since 1990, eastern Germany also continues to experience structural weakness due to an underdeveloped private sector. Eastern German firms are typically half the size of the average western German firms, and out of Germany’s 500 largest firms, only 34 have their headquarters in former East Germany. None of those 34 are part of Germany’s authoritative DAX stock index. Large firms bring many benefits to the regions where they are headquartered by attracting skilled labor,  providing a variety of employment opportunities, and by crucially stimulating innovation. The lack of a large business presence in eastern Germany has thus caused the region to miss out on all of these benefits.

One side effect of eastern Germany’s weak private sector includes lower levels of research and development (R&D) funding, particularly from private sources. In western Germany, more than half of R&D funds come from private sources, whereas in eastern Germany, more than half of R&D funds come from universities and government grants. Although research funding as a whole has been increasing in the former GDR, private R&D investment has not increased at the same rate. In 2013, for example, the former GDR had reached 86 percent of the western German level of overall R&D spending, but only 50 percent of the western German level of R&D spending funded by private sources. Eastern Germany also sees relatively few patentable innovations, compared to western German states, producing only one-third as many patents as western Germany in 2010.

Much has been achieved thus far in the process of unifying Germany’s eastern and western regions. Standards of living in eastern Germany are approaching those of western Germany. Workers in eastern Germany have become much more productive since 1990, and the East’s GDP per capita has risen considerably as well. Average levels of life satisfaction, which dropped sharply in the early 1990s in eastern Germany, are now the highest that they have been in both regions since reunification. Even so, reunification has not been without its painful side effects.

The story of Germany’s reunification, while unique, offers lessons for countries, politicians, and individuals around the world, extending far beyond the boundaries of Germany itself. The experience of East Germans and the transition of eastern Germany is interesting because it offers guidance as to how to help countries formerly ruled by dictatorships succeed in the global market economy. Today, the European Union contains many countries that were formerly behind the Iron Curtain–Poland, Hungary, Slovakia, the Czech Republic, to name a few, who still have a long way to go to catch up to their Western European neighbors in the economic sense. Furthermore, given the planned accession of countries in the Western Balkans to the European Union, the story of German economic reunification could not be more relevant.

 

 

 

 

The EU’s currency conundrum: Macron hits a nerve

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Following Emmanuel Macron’s victory in the recent French presidential election, a wave of relief washed over many supporters of the European Union. Macron’s pro-EU stance won out against his right-wing opponent, Marine Le Pen, a sign that the recent populist surge may be subsiding. With the release of exit poll results, the euro hit a six-month high, buoyed by increased confidence that the EU would remain intact under a Macron presidency.

However, celebration of the EU’s preservation may be premature. As France’s newest president, Macron hopes to reform the EU and its currency to reduce the financial strains of EU policies on poorer members. These changes would come at the detriment of Germany and other EU countries with stronger economies, who have benefitted in recent years from a euro weakened by underperforming members. Challenging this currency advantage as the gap in member states’ economic performances widens, France’s new president may only have granted the EU a stay of execution if it continues to resist reform.    

On the surface, Macron’s proposals seem more likely to draw the ire of the French workers rather than other countries in the EU. Aimed at reinvigorating the struggling French economy, his labor reforms seek to improve the competitiveness of French business by reducing labor unions’ power and cutting corporate taxes. Macron’s sees free-market policies as the path to success for the French economy, currently held back by restrictive policies that restrict the workweek to just 35 hours and make firing workers a costly process. French laborers, currently some of the most expensive workers in the EU, would become more competitive, easing France’s economic troubles in the process. Macron hopes these domestic policies will assuage the current discontent and fight the appeal of anti-EU sentiment among a French labor force struggling under scarce job opportunities and a 10 percent unemployment rate.

Critical of the EU’s use of austerity in previous years, he has also called for reforms to the EU, including a common Eurozone budget designed to promote investment in member states whose economies remain stagnant. Since his inauguration, though, Macron has taken a less aggressive stance on these proposals, no longer competing for the presidency against his populist opponent, Marine Le Pen. He announced that he will focus on domestic reforms and will not demand EU members to take on any of the debt of their weaker members. But while his EU policies may be not be a priority for now, the underlying issues with the Eurozone will not be going away anytime soon, nor will the populist elements throughout Europe let the EU’s problems be quietly swept under the rug.

After all, Macron’s EU reforms take aim at economic issues inexorably linked to a defining characteristic of the European Union: the euro. To enhance economic integration within the EU, most member states adopted the euro as their currency but lost a great deal of control over monetary policy in the process. The shortcomings of this shared currency became highly apparent in the wake of the Great Recession and Eurozone debt crisis as some EU members recovered quickly while others like Greece and Spain struggled to return to pre-crisis output levels.

Member states’ divergence in economic performance led to an unintended consequence for Eurozone countries. During the recovery of stronger economies like that of Germany, economic growth typically leads to currency appreciation, which hurts exports and tempers continued economic growth. However, the presence of weaker economies under the same currency reduces currency appreciation, helping German exports. On the flip side, this also means that the weaker economies will suffer from weaker exports, as their currency is not able to depreciate as much due to the growth of other, faster-recovering economies like Germany under the same currency. Thus, the Eurozone’s shared currency provides an extra boost to already-growing members, while weaker states find it increasingly difficult to expand exports and improve their stagnant economies.

Opposition to reforms of this currency problem unsurprisingly comes mostly from Germany, a result of its vested interest in maintaining the current EU’s currency policies to safeguard its record-high trade surplus of $270 billion. With the largest economy of any EU member, Germany also possesses significant economic and political influence to protect this position. German Chancellor Angela Merkel has reflected these realities in her meetings with Macron, agreeing only to small changes in trade policy and defense but resisting more substantial changes to the EU. Opponents to Macron’s reforms argue his proposals would require changes to the EU treaty, but the unspoken objection is still Germany’s potential loss of its currency advantage.         

Though the populist surge may have settled for now, Germany cannot maintain this unfair situation for much longer, unless it offers some form of compensation to the weaker Eurozone members. If Germany continues to fight even Macron’s modest reforms, it runs the risk of galvanizing anti-EU sentiment across the struggling member states. Europeans may have been more understanding of EU intransigence in the response to earlier, radical populist movements. However, now faced with Macron’s moderate proposals to help weaker members, the EU can no longer escape blame for its failure to address the economic malaise of many of its states. Unless changes are made, the EU’s struggling member states will continue to resent the implicit subsidies they give to stronger economies like Germany through their linked currencies. If reform does not take place soon, this resentment may well give way to renewed, widespread calls for exits in numerous member states. Should this occur, Germany may not be able to salvage the EU again, but this time it will only have itself to blame.

Ireland’s Brexit Dilemma: How Britain’s Decision to Leave the E.U. Could Impact the Irish Economy

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British Prime Minister Theresa May speaks to Irish Taoiseach (PM) Enda Kenny

In the months leading up to the UK’s Brexit vote, Irish officials advocated for Britain to remain in the EU and stressed the close ties that Britain and Ireland have. However, the Brexit vote did not go as many in the Irish government had hoped. As the UK prepares to trigger Article 50 and formally begin the process of exiting the EU by March of next year, the Irish government is preparing to deal with the effects of one of their closest trade partners and neighbors leaving the largest trade block in the world.

In assessing the effects of Brexit, many analysts focus primarily on how the British economy would be impacted. Yet the effects of Brexit extend far beyond Britain itself. Ireland and Britain have close ties due to shared history and geographic proximity. Furthermore, when Britain and Ireland joined the European Economic Community in 1973, the Irish economy was still heavily reliant on Britain for many products that it was unable to produce itself. While Ireland has become much less dependent on the British economy over the last few decades, the two countries still have close economic relationships, and for Ireland, it looks like Britain’s departure from the EU is going to hurt. A recent study by the Irish Department of Finance estimates that Britain’s departure would cause Ireland’s GDP to drop by as much as four percent, with negative effects on wages and employment in Ireland lasting for the next 10 years.

Britain and Ireland trade heavily with one another, and a Brexit will likely damage the Irish export market and lead to higher import prices. Every week, Ireland and Britain trade approximately €1 billion worth of goods and services. Ireland sends 16 percent of its exports to the UK, the most it sends to any one country, and Ireland’s Economic and Social Research Institute estimates that bilateral trade between the two countries could decrease by as much as 20 percent after Britain leaves the EU. Overall, Ireland has a trade deficit in merchandise with the United Kingdom, and its agricultural and metals sectors heavily depend on exporting to the UK.

For instance, 50 percent of Irish beef exports go to Britain, as do 55 percent of construction and timber exports. The UK is also Ireland’s greatest source for merchandise imports, and as Ireland’s economy is small, it has fewer opportunities to substitute imports with locally produced goods. Once the UK leaves the EU, it will likely be subject to the EU’s import tariffs for imports coming from “third countries.” The institution of tariffs for imports into the UK from Ireland and vice versa, therefore, will likely lead to higher prices for goods sold in Ireland.

Both Ireland and the UK have expressed interest in keeping the Common Travel Area (CTA) that has existed along the border of Ireland and Northern Ireland since 1923. Over the past 90 years, this invisible border has facilitated trade between the two nations, allowed citizens to work in each others’ countries, and has contributed to political stability in Northern Ireland. However, once Britain leaves the EU, the border between Ireland and Northern Ireland will become the western border of the EU, which may require passport controls that would greatly restrict movement between the two countries. Currently, the British and Irish governments are exploring ways to keep the CTA after the Brexit occurs.

No one has a greater potential to gain from Brexit, however, than Ireland’s financial sector. The UK has the largest inward FDI (Foreign Direct Investment) stock of any nation in Europe and has a powerful financial services sector. Leaving the EU’s single market will likely damage that financial vitality and could spur many firms to relocate all or part of their operations to cities in other countries. As an educated, English speaking city that already has a sizeable financial sector, Dublin is definitely a strong candidate. Currently, Ireland is home to €3 trillion of investment and money market funds. With some additional investments in housing, communications and infrastructure, Ireland and Dublin especially would likely benefit from firms in Britain relocating abroad.

In her speech at the Conservative Party Conference in October, Theresa May declared that “Brexit means Brexit — and we’re going to make a success of it.” Both the Irish and the British certainly hope so. The less dramatic Britain’s departure from the EU is, the better off Ireland will be. As Irish political commentator Johnny Fallon notes, “Some in Europe would be very happy to see post-Brexit Britain collapse. Not Ireland. We’re very eager to see Britain hold up.”