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Vol 3, No 3
22 January 2001
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Two Sides to this Coin
Part three: an analysis of Germany's economic union
Dr Bernhard Seliger

Read part one of this series
Read part two of this series

After the border of the German Democratic Republic (GDR) was opened in October 1989, uncertainty about the future lead to a mass migration from East Germany to West Germany. In half a year, between October 1989 and March 1990, almost 600,000 people left East Germany—mostly the younger and more flexible ones. East Germany's economy was close to collapse and West Germany wanted to put the brakes on migration.

Go west

Under these circumstances, the introduction of a common currency was seen as a major step towards preventing migration. In East Germany, demonstrators shouted, "If the Deutschmark does not come to us, we will come to the Deutschmark." Money in Germany had a symbolic value, ever since the currency reform of 1948. This reform ended a period of post-war inflation and created a stable currency, accepted world-wide. The currency was further linked to the post-world war German "economic miracle" in the minds of the German citizens.

It was this situation that lead Helmut Kohl to propose an early currency union while campaigning for the first free parliament of the GDR (the Volkskammer) in early February 1990. He was concerned not only with migration and the favourable effect on the conservative "alliance for Germany," a party which he supported, but also hoped that currency union would be an irrevocable instrument for unification. While the Gorbachev government in the Soviet Union was sympathetic to unification, the regime there was shaky and instabile. Kohl was suspicious of this and the failed coup d'etat in the Soviet Union of 1991 proved him right.

Rushing the union

While Kohl's announcement of early currency union was enthusiastically greeted by the people of the GDR, all economic advisors were united against it. The Bundesbank (the German Central Bank) in particular feared that monetary unification would not be able to achieve the three goals that it was meant to from an economic point of view. These three goals were to guarantee liquid assets to all of Germany, to allow East German industries to maintain competitiveness and to supply scarce capital for the building up of a new, modern capital stock in the former GDR.

Rent control—since 1937

Money in the GDR had a different function than in the western capitalist states. Prices did not reflect scarcities, but rather were set. Instead of price hikes, rationing of goods with fixed prices was applied, which led to the notorious queuing, often for hours, for scarce goods in the GDR. Rents were held for almost fifty years at the same rate as in 1937. The citizens accumulated money in their savings accounts which they could not spend on the rationed goods, and thus a so-called monetary overhang was created.

The Bundesbank set the conditions for monetary unification, which came into force in mid-1990. It was granted control over the currency union's monetary policy, and the West German banking system as well as the West German financial and economic regulation were transferred to the East.

Forced conversions

However, the most sensitive issue was the question of the conversion rate of the Ostmark (the currency of the GDR) to the Deutschmark. Before 1990, the official exchange rate for this currency, which was not traded freely, had been one Ostmark to one Deutschmark . However, the black market rate was anywhere from 1:5 to 1:10. The Deutschmark was a means to buy otherwise scarce goods, eg in the system of Intershops of the GDR.

Comparing the purchasing power to the exchange rate should have been more favourable and some economists even argue that the purchasing power of the Ostmark was higher than that of the Deutschmark. But this neglects quality differences in goods between East and West. In foreign trade, the GDR had applied a rate of Deutschmark to Ostmark of around 1:2.5 to 1:5, or sometimes even 1:8. Export prices were fixed independently from costs. The main goal was to fulfill the ever-growing thirst for hard currency.

So, while old comparisons held no use in order to determine the conversion rate, the problem was further complicated by a pre-election pledge of ex-chancellor Helmut Kohl to switch at a 1:1 rate. The formula actually taken was slightly more complicated: wages, prices and pensions were converted at a 1:1 rate, as well as the first 4000 Mark of savings (somewhat less for children, somewhat more for old aged persons). The remainder of savings and financial claims (company debts and housing loans) were converted at a 1:2 rate, and so-called speculative money acquired shortly before unification was converted at a rate of 1:3.

With this conversion rate, the Consumer Price Inflation could be held remarkably stable, at around 2,8 percent in 1990 and slightly above four percent in 1991 and 1992. But the costs for this were high and were called a "disaster" by the then Bundesbank president Pohl.

Suddenly, East German firms had to compete with western firms at the same level of prices, wages and costs—despite a much lower level of productivity. Industrial output dropped by 35 percent in one month, July 1990, and in the next month by another 15 percent. Therefore unemployment soared and migration did not stop. The hope of politicians to have one monetary area with two wage rates did not come true: In 1990 alone wages rose by around 40 percent and put additional strain on East German companies. Unemployment and falling tax income led to mounting budget deficits.

The Bundesbank fought against rising wages, budget deficits and a deteriorating current account position with interest rate hikes, which peaked in 1992 and were one factor in the crises of the European Monetary System (EMS) in autumn 1992 and July 1993. The alternative, to re-evaluate the Deutschmark, was not accepted by Germany's Western European partners in the EMS.

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In retrospect, monetary unification seems to have been inevitable in 1990, giving the uncertainty about the external situation and domestic development in East Germany. However, the chosen rate was also undoubtedly a major reason for de-industrialization and unemployment in East Germany. It seemed impossible to maintain low wage levels in a currency union and wages in East Germany have risen much faster than productivity up until this very day.

Transfer, not transformation economy

The political aim of unification and the economic goal of competitiveness could not be reconciled. As long as the productivity level of two countries is quite different, monetary union will inevitably end up with this problem: fast wage increases with a deterioration of competitiveness or mass migration in the case of persistent dramatic wage differences. Germany still suffers from both, 10 years after.

In the context of the transformation in Central and Eastern Europe, the dilemma of such a policy choice becomes clear: while East Germany could achieve by far the highest per capita net income in comparison to other transformation countries, the income is largely due to transfers from the West: East Germany is a transfer economy more than a transformation economy. The quest to catch up in terms of economic growth (as opposed to catching up in terms of income, which has almost been achieved) is a great policy challenge for the coming decade.

Dr Bernhard Seliger, 22 January 2001

The author works at the Graduate School of International Area Studies of Hankuk University of Foreign Studies and also does research at the University of Witten/Herdecke, Germany.

Read part one of this series
Read part two of this series

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