The East German productivity paradox

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.

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9 Responses to The East German productivity paradox

  1. Interesting, I had always thought that Communist countries performed fairly well on education (and on social welfare) for their income level. Is the 1980-90 shortfall evidence of the final crisis of the regime?

  2. Russ says:

    James, what level of convergence is actually expected?

    I ask this, because, there are going to be geographical variations that aren’t related to ‘level of technical knowledge’ but to ‘access to markets’, the same as in West Germany now. The rich parts of West Germany are clustered to the west, along the Rhine and close to densely populated parts of the UK, Benelux, France, Switzerland, Austria and Italy. East Germany backs onto relatively sparse and poor Poland. It was a poorer area before communism began, and it shouldn’t be a surprise if it remained so.

  3. James Farrell says:

    Thanks for these comments.

    Geoff: My understanding is that Soviet Bloc education levels were greatly overstated in international statistics because of the numbers of teenagers enrolled in ‘technical’ colleges that looked on paper like secondary schools but in fact provided extremely narrow occupational training. For the one-fifth or so that did real secondary study, preparing students for the professions, the education was more likely comparable to Western standards. But I’m not an authority on the DDR case.

    Russ: I don’t believe that’s actually true about the Rhine etc. The richest German states (apart from the city states of Hamburg and Bremen) are Hesse and Bavaria. But the general issue is worth raising. Given that the poorest western states have average incomes of about 75% of the richest, is it significant that the average of the eastern states is in turn about 75% of the former? Geographical explanations for wealth have a tendency to veer towards tautolgy — Luxemburg is so rich… well, because it’s Luxemburg). But of course history is important, and the pre-WW2 configuration of the European economy must play a big part in what we observe now. Perhaps some eminent expert on German regional economic disparities will drop in on this thread and enlighten us.

  4. Patrick says:

    FWIW I know a number of Communist-educated people and they (ok, the girls) are all excellent hula-hoopers, be they from China, Uzbekistan, Kyrgystan, Romania, Russia or the Ukraine. So on that score at least Communist education was/is certainly consistent.

  5. James, the “high wage” explanation is fleshed out at this link which just turned up on an email list. Have not had time to digest at this stage.

    http://www.voxeu.org/index.php?q=node/4177

  6. Tel_ says:

    There has been East to West migration that creates a positive feedback effect. East Germans who have a bit of initiative, and useful skills are attracted to move into wealthy West German regions where they can get a job. This in turn makes the West German businesses more successful and more attractive to future employees, and makes life more difficult for anyone starting a new business in the East.

    Once a given geographic region gets a headstart cause by whatever historical coincidence (trade routes, natural resources, war, etc) then keeping ahead no longer depends on the original advantage, because of infrastructure, migration, reputation, inertia, and other positive feedback effects.

  7. Nadine Wolf says:

    Beeing German, or more precisely East German, I can´t really share the hypothesis concerning the educational problems of the GDR. In fact, apart from some special communistic contents of teaching (e.g. the so-called civics), the educational system of the GDR was better than today’s. It began at the créche (EVERY child went to a créche and was educated there – today: in Eastern Germany 40%, in Western Germany only 8% of the children are put up to such an institution) and after that every children went to a kindergarten (today: Eastern Germany: 93%, Western Germany: 89%) where they learnt how to learn. Nowadays teachers often bemoan that school children are no longer capable of sitting at a table for 45 minutes listening to a teacher. One might argue that its parents should teach a child. Of course, a child is able to learn those things at home as well. However, some parents just aren´t capableof teaching their children simple things such as: speaking proper German, social competencies, simple rules… When I was little I went to school 6 days a week, sitting at a table for six hrs every day, afterwards we had to attend different sports clubs. And do you know what: it didn´t harm me at all. I remember all my teachers as friendly people, not really pressurizing the kids.
    The best school systems (according to PISA results) are based on all-day schools. Today, in Germany children are asked at school: “Do you want to play or study today?” Well, we all know the answer. However, there are still differences between the methods of teaching between Estern and Western Germany, because some of the East German teachers or kindergarten workers are still from the “old school” using their GDR methods. The result is just amazing: Eastern German pupils reach way better results in the PISA studies than Western German pupils do. Coincidence?
    Also, in GDR every person had to participate in some kind of education (the bad thing: only every second generation was allowed to study at a university). Today, 20% of the economically active pupoluation has no education at all (besides secondary school which is obligatory to visit). No surprise: In Eastarn Germany, that rate is lower.
    I could go on like that, finding many arguments against that hypothesis. Besides regime-oriented paradigm, we had no educational problem in Eastern Germany before 1990. We are having educational problems today. Although the share of university graduates is rising: companies bemoan more and more each year that secondary school graduates are not able to fulfil the simplest requirements anymore… We are not only having an economic crisis, we have an educational crisis as well. And that´s just alarming!

  8. James Farrell says:

    Thanks very much for sharing your first hand experiences, Nadine. I didn’t anticipate that this post would come out of dormancy. I notice that your comment was mostly about early schooling, and I don’t think that the researchers I mentioned are identifying that as the problem. Rather, they refer to technical and university education. The guy from Chemnitz talks about infratructure, by which he must mean facilities and equipment, and maybe that’s what handicapped vocational and professional training in that 1980-1990 period. The usual argument about socialist economies, is that technical training was for specific jobs operating with particular machinery, and that it didn’t impart general skills and flexibility. I know that what applies to, say Bulgaria, might not apply to the DDR, biut if that’s basically right, East Germans over 40 years old would have trouble competing for jobs as engineers, architects, financial managers and so on, in the globalised post-unification enviroment. I wonder what your experience has been — if you’ve worked in high-tech companies in the East How many of the senior positions were held by 40+ Easteners? At the end of the day, statistics on GDP per capita can be expected to match our experience of people around us are earning (except in places like Dubai).

  9. Nadine Wolf says:

    I admit, the academic education concerning „economics“ or „business adminstration“ was just rediculous. However, there´s more than that, right? A person named Juri Gagarin was the first human in outer space. Somehow the Eastern block states managed to construct a space shuttle before other nations did. Anyway, besides the poor education regarding business sciences I don´t think that the GDR lacked of high quality education in other areas. My father, for instance, studied medical science in Eastern Germany and Romania: he´s a fantastic physisician and to my amazement he still remebers lots of things he learnt in the 1960’s. He even received some docaration from the German Medical Association due to his medical performance and knowledge.
    I don´t think that education worsened in the 80’s. And of course, there are many former GDR citizens in senior positions nowadays. There just one structural difference to Western Germany: in Eastern Germany economy is only (or rather even more) driven by small and medium sized enterprises. All those companies do have senior managers and most of learnt their trade in the educational system of the GDR. Of course, there are some corporations as well and of course, some are lead and founded by former GDR citzizens. Knut Löschke, for example (my former boss), he studied physics, chemistry, mathematics, material science and information technology in the GDR. He invented the so-called Microsoft Frame Agreements in Germany and founded PC-WARE, a listed corporation, employing 1.600 people in 25 countries of the world. Believe me, that guy is nothing short of his Western Germany collegues… rather the opposite. Since I worked in his Investor Relations Department, I can tell you: he´s not only really smart, he´s also very, very successful.
    Anyway, in my opinion the reason that Eastern Germany lags behind the Western part of the country from an economic point of view is not poor education. It´s a structural problem. The Sowjet Union has exhausted this part of Germany for many years. Maladminsitration hindered economic growth for decades. After the fall of the Wall, many well educated Eastern Germans fled. They still do. We didn´t have many profitable companies and the economic structure is still different. People don´t want to work in companies called “Mr. Miller’s Pastries” in Dresden; they want to work at Volkswagen, Porsche and L’oreal. That´s more fashionable (and better paid, anyway). It is a vicious circle, because even the demographic structure has changed over the years. Surplus of (uneducated) men: Well-educated women can´t find attractive spouses (I mean not concerning looks) here anymore and therefore they just go away to Munich and Hamburg. Cities like Hoyerswerda are just dying off. But I think that´s all going to change. Eastern German cities are becoming more and more attractive and some day there will be economic growth on the Western German level.

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