Club Troppo

This is best viewed with its pair.

Twenty years on, where do East Germans stand in economic terms?

The Institut der deutschen Wirtschaft has reportedly published a study estimating that GDP per capita

has risen in the east from 30 percent of that in the west in 1991 to 70 percent today…By 2020, average GDP per capita in the east could reach 80 percent of that in the west and the most prosperous eastern states could have overtaken the poorest of their western counterparts.

This sounds like pretty much what you’d expect. But if it creates the impression of slow and steady convergence, it’s misleading. In fact, the sixty-percent threshold had already been reached by about 1997 (although household disposable income rose more than that due to transfers from the West), so the real question is why the convergence slowed to a snail’s pace after that.

Standard growth theory says that capital accumulation can only raise (per capita) growth up to a certain point. When the capital-labour ratio reaches that optimum, further growth will be solely due to technical improvement. This has two implications for developing countries. The first is that, given a sufficiently high flow of investment (much of which may be foreign), they can converge very rapidly in the initial stages of economic integration. The second is that this convergence may stop altogether once the steady state capital-output ratio is reached, unless the country in question has a higher rate of technical progress (total factor productivity growth, as we say in the trade). The country’s GDP per capita will then be determined by its ‘level of technical knowledge’.

Now, some kinds of knowledge are embodied in equipment and processes, and these will doubtless grow faster through ‘technology catch-up’, mediated for the most part by multinational companies. But another sort of knowledge is embodied in people, and can only be acquired through education, training and experience. These can’t be imported overnight, so they will only grow faster in the developing country if there is a higher rate of investment in human capital, as economists call it. But since the proportion of GDP invested in education is generally lower in poorer countries, this is unlikely to occur, therefore convergence — to the extent that it depends on overcoming human capital differences — may be very slow. Large foreign transfers for the purpose of education can speed up the process, but the right skills and mindset may need to be instilled over many years of schooling; hence there will still be a long lag before the gap is bridged, even with significant external funding of education.

East Germany is a unique natural experiment for examining this question, and in particular in quantifying both the contribution of human capital to GDP per capita, and the length of the lag. There was no constraint on capital accumulation. Unlike other transition countries, East Germany did not have to rely on domestic saving or nervous foreign investors, but received a flood of development aid, most of it government subsidised, from the West. In 1998 East Germany had a notional current account deficit equal to around 50 percent of GDP. Within a decade, capital-output levels were actually higher than in the western region in several sectors. At the same time, all the infrastructure of commerce, private property and governance were provided on a plate, so no lack of institutional development can be blamed for slow development, as it might in the case of, say, Hungary or Poland.

These circumstances led Erich Gundlach to hypothesise that

differences in human capital remain as the major reason for differences between the theoretical and the actual East German growth rate. Simulation results suggest that East Germany’s stock of human capital per worker reaches only about one third of the West Germany level. The main lesson from the East German experience for other EU accession countries is that catching up may come to a halt below the EU average, even under pretty favourable institutional and financial conditions.

He emphasised that conventional measures of human capital in terms of years of formal education don’t necessarily capture the ‘economically relevant variable’.

Fedor Kilin came to a similar belief, predicting that the gap could widen:

Due to the fact that before unification the educational infrastructure stock grew more rapidly in West Germany than in East Germany, the difference in human capital levels between the two parts of the country will continue to increase [while] the proportion of the population with education obtained after 1991 remains above a critical level.

Calculating that the ‘critical moment’, was due to arrive in 2007, Kilin concluded that

The cause of the temporary halt of convergence in 1996- 2002 is the deficient growth rate of educational infrastructure in East Germany between 1980 and 1990. The labor force with an education obtained in the eighties accounts for a major part of labor force at present. Therefore, the educational infrastructure level in 1980-1990 has a direct influence on the present East German economic convergence.

A great deal comes down to simple demographics, although retraining schemes for unemployed can play part.

An alternative explanation relates to the historically unprecedented ten-fold rise in wages in Eastern Germany after unification. This is referred to as the ‘mezzogiorno effect’, after the Italian predicament whereby the wages of the north were economically detrimental for the south. In the German case the wage rise was the combined effect of monetary union, incorporation of Eastern workers into Western collective bargaining, and the ‘Social Union’ policy that entitled East Germans to the same social assistance as their western counterparts. After investment subsidies expired East German workers found themselves priced out of the market. Obviously this has not depressed productivity — on the contrary it hastened the process of creative destruction, guaranteeing that only the most productive industries survived, and thus caused average productivity to rise. On the other hand, it reduced the employment rate (including hidden unemployment) and per capita wage income.

A third explanation, not incompatible with the others, is the skewed evolution of East Germany’s industrial structure:

Presumably, the strategy of fostering capital intensity hampered the development of viable industrial structures based upon human capital- and service-intensive products and production processes. The sectoral structure is distorted in favour of capital-intensive industries which are often indistinguishable from ailing smokestack industries. The flip side of the coin is the low weight of human capital-intensive industries and the disregard of intermediate service activities, which constitute an indispensable prerequisite for the provision of sophisticated industrial goods and the realization of high productivity growth rates.

Economic historians of the next generation will undoubtedly attribute East Germany’s slow convergence between these causes in the right proportions. In any case, it doesn’t all boil down to GDP per capita. Apparently nostaligia for the DDR is still strong. In the words of a certain Herr Arndt, ‘a retired engineer who runs the shop specializing in East German every day life merchandise’:

There might have been a lack of bananas, but I didn’t need a banana.

Younger people do need their bananas, and probably don’t pine for the good old days. But for males of coupling age there is apparently a more serious problem, namely a shortage of mates.