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East Is East and West Is West

Twenty years ago West German institutions were exported to East Germany following the fall of the Berlin Wall. One outcome has been the halting of convergence between the two.


East Is East and West Is West

Romar Correa

compared with 29,839 euros in the West. Differential factor intensities can be responsible. Relative to total stock of employees, capital intensity was 83% of the level of the West in 2004. In another cal-

Twenty years ago West German institutions were exported to East Germany following the fall of the Berlin Wall. One outcome has been the halting of convergence between the two.

Prepared in connection with a commemoration of the 20th anniversary of the fall of the Berlin Wall at the University of Mumbai, 27 November 2009. I am grateful to Vibha Surana of the Department of Economics, University of Mumbai, for the opportunity.

Romar Correa ( is with the Department of Economics, University of Mumbai.

he expectation of any analytical s ocial structure is that it embraces heterogeneity and respects variety. Otherwise put, impulses towards homogenisation and sameness must be looked at critically. In the present context, this means valuing the different histories and cultures of states in both East and West Germany. The priors we are concerned with are the following. Businesses in c ommunist East Germany were founded on an obsolete pre-second world war techno logy. The whole capital stock had to be built. The formal qualifications of East Germans were high and there were few unskilled workers. Reunification devalued many of these diplomas in the commercial area that had been set up under the c ommunist regime. Coming to the West, in the late 1980s, efforts were underway to reform institutions that had begun to a trophy.

Criteria for Evaluation

At the same time, the coming down of the Berlin Wall gave economists almost a laboratory experiment to test an economics expectation, that growth rates b etween the two would converge. When the wall came tumbling down, factor price differentials induced the migration of capital, labour and commodities. People moved from East to West and capital in the reverse direction. In one study that controls for differences in geography and public policy, the findings run in the opposite direction (Buch and Toubal 2009). It is true that the immediate aftermath of the unification was a boom created lar gely by the “regional development loan” (Fördergebietsgesetz), in turn, an outcome of generous government subsidies. Until the mid-1990s, the growth rate in the East exceeded that of the West. Since then, the growth rates of the two have been low and similar. The convergence of per capita income between East and West has tapered off.

Nominal gross domestic product (GDP) per capita was 20,812 euros in 2006 culation, while the West, including West Berlin, grew by 14.6% in 1995-2005, the East, including East Berlin, grew by 13.7% in real terms (Sinn 2007). If West Berlin is treated as a part of East Berlin, as it is in official statistics, the difference is higher.

To be sure, much of the relative decline must be attributed to the shrinking construction industry. Indeed, manufacturing output has done well. It grew by 86% in real terms in 1995-2005 while the West German manufacturing, including West Berlin, grew by only 17%. However, information and technology (IT) sector is only a tiny part in the East German economy. In 2005, the IT industry employed only 2% of the active labour force.

After Unification

Unification halted the efforts at mechanism redesign in the West and their institutions were transplanted wholesale onto the erstwhile German Democratic Republic (GDR). In the view of the government of the day, it was not possible to rejuvenate moribund institutions and embrace the East simultaneously. In the early 1980s, small firms had begun to exit employer associations in the metal industries. Union membership was waning. Social security contributions started to increase in the early 1970s. After unification, federal subsidies to the social security funds had to increase as well, so as to prevent contributions rates from becoming even more unsustainable by moving beyond 40% (Streeck 2009). Public debt and debt services had been rising sharply since 1974. The last official estimates of transfers were undertaken by the German Council of Economic Advisers in 1995 (Siebert 2005).

A distinction was made between gross or unconsolidated transfers from the different layers of the states and net transfers. The net transfers eliminated double counting and took into account government revenue like tax collections in the new states. In 1995, the gross transfers were 4.6% (unconsolidated) and 3.6% (consolidated) of the German GDP. The size has risen.

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True, there has been growth and the tax base has increased. With higher personal incomes, increasing contributions to the social security system need not be too painful. Unemployment, though high, has receded. Government unemployment programmes have been scaled down. Specific investment subsidies for the private sector have been discontinued so that the regional support system in West Germany applies. All the same, transfers are still a steady stream; from the government to the enterprise sector, from the federal government to the public budgets of the federal states in East Germany (vertical revenue-sharing), and revenue-sharing among the federal states (horizontal revenue-sharing). A third of the euros being spent on goods and services in the East is not earned there, but provided as loans or gifts mainly in the form of West German social security contributions. The national and international firms know that the ballooning interest burden of the state will impinge on them, and consequently, the investment rate in Germany is low.

In July 1990, the East German ostmark was exchanged one-to-one for the West German deutschmark. Departmental stores and mail-order houses in the former GDR which had been selling their goods to West Germany were crippled as the contract conversion quadrupled their wage costs. The ground was laid for the high unemployment rates and falling economic activity in the East. While wages were only 30% of the West German level, they rose inexorably. East German wages surpassed Ireland’s in 1992, Italy’s in 1995 and France’s in 1996 (Sinn 2007). Since then they have equalled France’s and exceeded Italy’s. The use of social protection under an egalitarian wage-setting regime took surplus labour out of the market. “Model Deutschland” with its central coordination of wage setting within unions and employer associations would not countenance regional differences in incomes and living standards.

The constitutions also enjoined the federal government to ensure equal living conditions across the Länder. It took several years for the employers of the metal industry to realise that the equaliser agreements with the union not only

Economic & Political Weekly

january 2, 2010

destroyed industry in the East, but also

ravaged their own organisation. Social se

curity contributions are intended to sub

stitute for taxes. The implication is that

the costs of restructuring have to be borne

by the social security funds. In other

words, they were paid, in effect, by em

ployed workers from payroll taxes. The

outcome was declining employment in

both sides. Implanting West German

wage-determination arrangements into

the East German fabric resulted in unit la

bour costs turning out to be 140% of the

West German level to start with and stay

ing above 100% thereafter.

In neoclassical economics, full employ

ment is assured by the marginal produc

tivity of a worker equalling the real wage.

There was a thick wedge between the two

in East Germany (Siebert 2005). It was

0.41 in 1991. In other words, the real wage was 1.41 times of productivity. The number was approximately equal to the hiatus between wage income, the gross wage per head, and the unit labour costs of both the Germanies. Alternatively, while the East German productivity per hour was 42% of the West German level, wages per hour were 59% of the West German level. The result was fewer jobs.

Employment Scenario

Unemployment in the East has continuously been greater than the West. East Germany suffered from unemployment at a rate of about 25% in 2005, and was about as high in percentage terms as the unskilled unemployment in West Germany. The bargaining model and the intermediary organisations grafted were responsible. Business and workers in the West could not permit a low-wage enclave to emerge in the East. Thus, joint efforts went underway to set up a regional bargaining machinery and a works council followed by escalator clauses that would equalise East and West German wages. The West had eliminated the communist factions in the intermediary organisations. The unions of the East had, therefore, to conform and purge their communist

o fficials. Since the productivity of East German workers was low, the equalising of wages between East and West created problems in the East similar to wage c ompression among the unskilled in the

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West. The case for high wages was l eapfrogging over the West German level of technology.

A few resounding successes were reported in Dresden, Sömmerda, and elsewhere. However, hi-tech industry is c apital-intensive. The East German economy would have benefited from broadbased growth, slowly building up simple, labour-intensive processes. Somebody has to produce shoes, washing machines, glass, tin, food and machine tools. East Germany has yet to recover from the zeal of the Treuhand (the privatisation agency) that laid three-fourths of all manufacturing jobs waste. The share of the publicly employed and workers in the manufacturing sector is about two-thirds that of the West. Relative to the West, a very large share of East German workers are government employees. However, here too employment declined from 9.8 million before the fall of the wall to 6.1 million in 2007.

Reservation Wage

Government unemployment benefits and social welfare benefits provide income to out-of-work individuals. This number provides a floor, a reservation wage. The increase in income provided by the government is an increase in the reservation wage. Studies show that the reservation wage is at 120% of the wage received by the unemployed worker when previously employed. The reservation wage does not fall with the duration of unemployment. Consequently, job search and willingness to accept a job is attenuated. The lower part of the demand curve for labour is thus burnt off. Demand-supply equilibrium at lower levels is ruled out, so too wage differentiation. In addition, the mirror of the minimum wage is the increasing social security outlays that underpin it. Since these contributions must come from de facto taxes on labour, wage compression is aggravated. Wage differentiation is a bsent. Such a distribution is necessary, if qualifications of workers and jobs demanded by firms are to match.

The collective wage contracts militate against the unemployed. The more protected the insider, the lower the incentive to hire the outsider. In wage cartels,


parties are not responsible for outcomes in the labour market. There are strong limitations on the individual worker’s freedom to exit. He/she can deviate from the contract only in the case of a favourable pecuniary incentive. The right to reject the contract is absent. Likewise, a firm is not free to accept the decision of its workers to work more and accept a cut in wages!

Trade Shares

Before the fall of the wall, East German trade with the former communist countries of central and east Europe was extensive. Exports were 40% of GDP, higher than West Germany in 1989. However, this exchange took place at arbitrary prices and the necessary reorientation of trade had not taken place. Integration with the West has exceeded more than with the rest of the world. The export shares of all the East German states were significantly lower than the West German states in 1992. The average trade share was 37% of GDP in the West and 16% of GDP in the East. By the 1990s, the share of the former was 20%, the latter 51%.

Trade shares reflect different orientations towards foreign investors and specifically, historical industry clusters. For instance, the region around Dresden in Sachsen is an area of hi-tech production and a convergence to an earlier pattern of regional specialisation seems to be taking place. Foreign direct investment (FDI) and multinational activity are almost entirely the prerogative of the West. The East German multinationals accounted for less than 1% of the total turnover, the volume of FDI, or the number of employees in German multinational firms. In 2003, East German firms accounted for 0.2% of outward FDI and 2.7% of the inward FDI. All of these were below the share of East Germany (excluding Berlin) in German GDP of about 11%. The explanation here is that firms enter foreign markets through exporting. FDI follows later. The relatively low export share of the East is the reason. In addition, the average size of firms in the East is much less than the West. The evidence is that presence in foreign markets and firm size are correlated. Besides, in the aftermath of the second world war, headquarters of firms came to be located in the West.

For a Variegated Capitalism

What can be done? More autonomy for individual firms was proposed in 1994 by the German Monopoly Commission, the legal arm of the Federal Cartel Office charged with safeguarding competition. In particular, greater leeway in collective bargaining was recommended. Structural unemployment was declared as the prime enemy because the attendant bankruptcies were high. In 2002 and 2003, Germany experienced a wave of banking crises unknown in the post-war period.

Investment wage is another German remedy. The idea is to remunerate workers partly in shares, thereby insulating them from losses from international lowwage competition. In the 1960s and 1970s, an animated debate ensued around workers being co-owners of companies. The Christian social philosopher, Oswald von Nell-Breunig and the union leader and later minister of construction, Georg L eber, developed the idea. The conversion of wage concessions into participation claims has the following merits: While the old owners sacrifice ownership, they gain in terms of the lower wages of the e mployed. Since the hourly wage bill of fresh workers drops, firms have an incentive to employ them. Old and new owners share equitably in rising profits. Clearly, new hires benefit since the alternative is u nemployment.

In Germany, there are thousands of firms with partner participation models including BMW (automobiles and motorcycles), Otto (mail order), Bertelsmann (media), TVI (travel). These contracts range from direct stock purchases in large firms to loans and participation certificates in small firms. Participation certificates are claims against the company that consist of a profit portion and a guaranteed minimum interest. All these models involve a spread between the income of insiders and the unemployed outside. The difference permits the wage reduction necessary to hire new recruits without imposing losses on the insiders.

The Activating Social Assistance programme is a way to create not just jobs, but activity of a socially desirable kind.

According to the scheme, benefit levels for people who are not gainfully employed are lowered by a third. The saved funds are redistributed to low-wage earners who accept a paying job. Those who cannot find a job may be employed by the loan employment programme of their local community at a wage equal to the prevalent social assistance rate. The local community then leases their labour to private business at a fee which can be zero. As long as they collect some monies, the measure is superior to paying for social assistance and receiving nothing in return. With the reduction in labour costs, additional jobs will be created.

What might be the point of introducing flexibility in institutional arrangements? In the erstwhile GDR, Thuringia, Saxony and Saxony-Anhalt were home to the most productive and innovative companies in Europe. From the airplane industry with Junker in Dessau to the motorcycle and automobile industry with DKW/ Audi in Zschopau and BMW in Eisenach, to the optical industry with Zeiss in Jena, the East was the hub of enterprise. The southern part of the Mitteldeutschland was their hi-tech centre of the world. The chemical industry in Schkopau, BRABAG in Schwarzhheide, and IG Farben in Bitterfield and Ceura were world-renowned. Conse quently, Mitteldeutschland’s productivity was 27% greater than the West. Changes are required for them to converge, not diverge.


Buch, Claudia M and Farid Toubal (2009): “Openness and Growth: The Long Shadow of the Berlin Wall”, Journal of Macroeconomics, Vol 31, No 3, pp 409-22.

Siebert, Horst (2005): The German Economy (Princeton: Princeton University Press).

Sinn, Hans-Wener (2007): Can Germany Be Saved? (Cambridge: MIT Press).

Streeck, Wolfgang (2009): Re-forming Capitalism ( Oxford: Oxford University Press).

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