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.

berlin_wall_trabant_grafitti

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.