Article

The Macroeconomic Effects of German Unification

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1991
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Germany is united again. Beyond the certainty of this union lie many questions about its economic effects, domestic and foreign. In order to obtain a clearer understanding of these effects, it is useful to examine them within a detailed quantitative framework. A study done within the International Monetary Fund recently (see box on publication), and whose results are summarized here, concludes that the path taken by east Germany will have major implications for the economy of the united Germany but that the international effects of unification may be relatively moderate.

Transforming the eastern economy

Will the evolution of the east German economy over the next decade reveal a new Wirtschaftswunder (economic miracle) or the emergence of another regional problem within the European Community (EC)? In many respects, the prognosis is favorable. For example, the saving surplus in west Germany represents a ready source of financing for the investment needs of the east. Moreover, it may be possible to revive quickly the pre-World War II tradition of enterprise in the eastern part of the country, despite its long suppression by central planning. But capital is scarce in east Germany, and it will be some time before west German wage levels can be supported in the east. This creates obvious tensions. A slow closing of the earnings gap between the east and the west might result in a migration of the most skilled workers to the west, while a premature narrowing of the gap could well discourage investment; either situation might endanger the process of economic recovery in the east.

To analyze these issues, IMF staff developed a detailed macroeconomic model of east Germany’s economy (see box on model). Major uncertainties shroud the initial conditions in the east, the likely response of foreign investors, prospective migration patterns, the ability of east Germany to absorb large-scale investment (particularly in the initial years after unification), and the policy and institutional framework. The scenarios constructed with the model, therefore, are not predictions; rather they illustrate possible developments under carefully selected assumptions. They take as their starting point a profile of the economic situation in east Germany in the second half of 1990, assuming that, immediately prior to unification, underlying labor productivity in the east was about 30 percent of the level in west Germany. The growth rates required in the east to narrow the productivity gap over the next decade depend not only on the size of the initial gap but also on the increase in labor productivity in west Germany. The scenarios assume that labor productivity in west Germany will grow at about 2½ percent a year, or cumulatively by close to one third, between 1990 and 2001.

For productivity in east Germany to rise to west German levels by 2001, output in the east would have to increase at a rate of 13 percent a year, assuming that the labor force in east Germany declines by 10 percent (as a result of migration and lower labor force participation rates). Elimination of inefficiencies in the use of capital and labor would make a significant contribution to growth. However, even making some allowance for the benefits that might be associated with the relatively newer capital stock in east Germany, a cumulative net investment of some DM 1,800 billion (in 1990 prices) would also be needed over the period 1991-2000, an amount almost as large as the net national product of west Germany in 1990. A less ambitious target might be to achieve a productivity level in east Germany by 2001 that is 80 percent of the level in west Germany. This would produce a productivity gap similar to that currently existing between the three poorest states of west Germany and the eight more prosperous ones. It would entail a cumulative net investment of DM 1,100 billion and an average output growth rate of 10½ percent, still a rather formidable goal.

Scenario A, the more optimistic of the two scenarios discussed here, is consistent with this latter target (see chart). While unemployment is initially high—one fourth of the labor force in 1991—it falls rapidly and by the end of the scenario is at about the same level (6 percent) as is assumed for west Germany. Gross investment averages a very large 43 percent of GDP in east Germany in 1991-92. This is financed entirely by external resources (including fiscal transfers from west Germany); indeed, external resources amount to about 150 percent of net investment as consumption in east Germany substantially exceeds net output. Over the period 1991-2001 as a whole, three fourths of net investment is financed from outside east Germany (including fiscal transfers from west Germany). This estimate of external resource needs is, however, sensitive to the balance between fiscal transfers and other forms of external financing. The calculations here assume that government current account deficits in east Germany are wholly financed by transfers from west Germany.

New publication on Germany

The IMF has recently published Occasional Paper No. 75, “German Unification: Economic Issues” $10 (see back cover for ordering information). The scenarios for east Germany outlined in this article are drawn from Chapters IV, “Investment Needs in East Germany,” and V, “East Germany: The NewWirtschaftswunder?,”both authored by Donogh McDonald and Gunther Thumann. The assessment of the implications for west Germany and the rest of the world is based on Chapter VI, “Domestic and International Macroeconomic Consequences of German Unification,” by Paul Masson and Guy Meredith. The other nine chapters of the occasional paper cover a range of topics including fiscal and monetary policy, the labor market, and the behavior of savers and investors, as well as the challenges of systemic reform in east Germany.

Under Scenario A, imports into east Germany of goods and nonfactor services are initially of the order of DM 120-130 billion per year, or 5 percent of GNP in west Germany. Over time, these net imports decline and are close to zero by 2001. This happens partly because investment requirements fall in relation to output, but, more important, because the saving rate rises. Though private saving increases, the principal source of the stronger external position is the improvement in the government accounts. The general government deficit in the east is, in the early years, very large (almost one half of GDP in the east in 1991), but drops steadily with a primary budget surplus emerging in 2000.

Scenario B (also plotted in the chart) is less optimistic, with productivity in east Germany in 2001 at only 60 percent of that in west Germany and large-scale migration from east to west. Lower investment than in Scenario A and a slower reduction of inefficiencies in the use of labor and capital produce this less robust economic performance. Net investment in 1991-92 is only 60 percent of that in Scenario A, and this relative weakness persists throughout the scenario as the initial hesitancy of investors is reinforced by aggressive wage demands and by structural weaknesses in the economy. The fiscal imbalance starts out worse than in Scenario A and remains stubbornly high as low growth restrains revenue and boosts social expenditure relative to GDP; in the year 2001, the primary fiscal deficit in east Germany is around 9 percent of GDP. Larger accumulated deficits also increase interest payments, but given the assumption on transfers from west Germany, those interest costs are recorded in the government accounts of the western part of the country. Reflecting these fiscal developments, the imbalance in the external accounts is much larger than in Scenario A.

World saving

In a world of high capital mobility, investment can tap an international pool of saving, rather than being restricted to a local capital market. A useful starting point in gauging the effects of unification beyond east Germany is to consider the extent to which increased investment and higher social spending in east Germany would draw upon global saving. Scenarios A and B produce broadly similar figures for east Germany’s average net import demand over 1990-94 (averaging $60 billion a year)—lower output in Scenario B is offset by lower demand over this period. These net imports compare with world saving of $4 trillion. Clearly, the external resource needs of east Germany are relatively small—less than 2 percent of total world saving. An important issue is the extent to which those needs can be satisfied by higher saving in west Germany, and, in particular, by higher output there. This will depend on supply capacity in west Germany, which, in turn, is influenced by the growth of the labor force there.

Scenarios of the effects of German unification(Deviations from baseline)
Optimistic Scenario (A)Less optimistic Scenario (B)Indirect tax increaseEMS realignment1
German variables2
GDP (In percent)
19900.60.60.60.6
19912.41.62.22.4
1992-44.22.23.94.2
200114.58.114.514.5
Rate of change of GDP deflator (In percent)
19900.20.20.20.2
19910.70.81.70.5
1992-40.20.40.30.3
2001-0.2-0.1-0.2-0.2
General government balance (In percent of GDP)
1990-2.2-2.2-2.2-2.2
1991-4.4-4.8-3.7-4.4
1992-4-2.7-3.8-2.0-2.6
2001-0.6-3.30.3-0.7
Current account balance (In percent of GDP)
1990-1.3-1.3-1.3-1.3
1991-2.7-2.6-2.6-2.6
1992-4-2.3-2.6-2.1-2.3
2001-0.9-2.3-0.5-0.6
Variables for other European countries3
GDP (In percent)
1990-0.2-0.2-0.2-0.2
1991-0.1-0.10.6
1992-4-0.4-0.3-0.3-0.1
20010.20.10.30.2
Rate of change of GDP deflator (In percent)
1990-0.1-0.1-0.1
19910.1-0.11.3
1992-4-0.10.1-0.11.0
20010.30.30.30.4
Source: International Monetary Fund, Occasional Paper No. 75, German Unification: Economic Issues, Chapter VI.

With a loss of credibility of “hard currency” policies by those countries in the Exchange Rate Mechanism (ERM) of the European Monetary System.

Results for unified Germany.

Members of the ERM.

Source: International Monetary Fund, Occasional Paper No. 75, German Unification: Economic Issues, Chapter VI.

With a loss of credibility of “hard currency” policies by those countries in the Exchange Rate Mechanism (ERM) of the European Monetary System.

Results for unified Germany.

Members of the ERM.

Unification has re-established free mobility between east and west Germany. The resulting migration from the east can be expected to lead to increases in both aggregate demand and supply in west Germany. In Scenario A, net migration from east to west Germany is assumed to be 320,000 in 1990, falling to 70,000 in 1992, and 20,000 per year after 1993. As a result, potential output is projected to be l’A percent higher in west Germany by the year 2001 than it would have been in the absence of migration, assuming that investment increases sufficiently to maintain the capital to labor ratio. In Scenario B, net migration is assumed to be the same in 1990-91, but to be considerably higher from 1992 onward: 270,000 in that year, and declining to 90,000 in the year 2001. This boosts potential output in 2001 by 3½ percent in the west. However, in the early years, the increase in potential output less increased consumption of the migrants and the higher investment mentioned above will, under both scenarios, be small relative to the external resource needs of east Germany.

Scenarios for east Germany, 1991-2001

Source: International Monetary Fund, Occasional Paper No. 75, German Unification: economic Issues, Chapter V

1 For 1991, growth is measured using output in the second half of 1990 as a measure of the underlying value of output for all of 1990 Because of the sharp drop in output in the second half of 1990, official data wilt show negative growth in 1991.

2 Including the effective period of unemployment for those on short-time work.

Effects in Germany and abroad

To quantify the impact of unification outside east Germany, various paths for net import demand, fiscal imbalances, and migration in east Germany were used as inputs to the IMF’s global macroeconomic model, MULTIMOD (see box explaining model), and scenarios were calculated relative to a baseline that excludes the effects of unification. Some of the main channels for the transmission of those effects can be sketched. With a rise in global investment relative to saving, real interest rates rise worldwide, though the size of the increase varies from country to country. Increased demand from east Germany is directed partly toward west German goods, which boosts output in west Germany, raises the price of German goods relative to foreign goods (appreciates the real exchange rate of the deutsche mark, through both higher prices in Germany and a stronger currency), and lowers combined German net exports.

The extent of these effects depends on a number of factors. For example, how will unification affect the conduct of macroeconomic policy in Germany? Here, it is assumed that the Bundesbank continues to resist excess demand pressures in the same way as it has in the past, tax rates are unchanged, and increased budget deficits are financed by government debt.

The influence of the level of capacity utilization on inflation is also important. In MULTIMOD, productive capacity is not an absolute constraint on output. Instead, the higher the rate of capacity utilization, the greater are the upward pressures on inflation that result from an increase in demand. In the simulations presented below, the starting point for capacity utilization is high, but it is still below historical peaks reached in 1972-73 and 1979-80. Moreover, as discussed above, further migration from the east tends to increase output capacity. The pressures initially put on capacity in west Germany will also depend on the geographical distribution of east Germany’s import demand. Here, two thirds of the increase in demand is assumed to show up, in the first instance, in increased exports by west Germany, and the remainder in other countries’ exports (allocated on the basis of historical shares in imports of the Federal Republic of Germany).

The assumed path for net imports into east Germany is illustrated in the chart. Under Scenario A, this stimulus to demand leads to an increase in the rate of growth in west Germany of 0.6 percentage points in 1990 and 1.3 percentage points in 1991. In subsequent years, output growth is lower than it would otherwise have been because the rate of change of net imports from east Germany is negative and because of lagged effects of increased interest rates and currency appreciation. Nevertheless, the level of output in the west is higher because of favorable supply effects, and output growth of Germany as a whole is persistently stronger (see table). Inflation pressures, however, are also larger: output prices rise by about one half of a percentage point faster on average over 1990-92 than in the baseline.

Output effects on other countries in the Exchange Rate Mechanism (ERM) of the European Monetary System are negative, but small, while they are slightly positive on non-ERM countries. Both sets of countries are affected to some extent by higher interest rates. The ERM countries, because of the assumed fixity of their central parities, also experience a real effective appreciation (as their currencies increase in value against the dollar and the yen along with the deutsche mark), which, combined with the interest rate increase, off-sets the stimulus from stronger exports to Germany. On balance, Scenario A suggests that the international effects of unification are not very large and that increased demand does not put unmanageable strains on German productive capacity. However, higher government spending in Germany leads to an increase of 16 percentage points in the combined government debt/GNP ratio by 1999, which thereafter tends to decline back toward its baseline path.

Scenario B presents a less favorable picture for Germany as a whole, though not for west Germany alone, where output growth is boosted by greater migration from the east. There is a larger deterioration in the combined fiscal balance as a ratio to GNP, due to increased unemployment benefits, slower revenue growth, less rapid output growth in the east, and higher interest payments on larger cumulated indebtedness. As a result, government debt reaches 19 percent of combined GNP above baseline by 1995, and 30 percent by 2001. Despite this, effects on financial markets and on other countries differ little from Scenario A, and inflation effects are also similar.

Models used in this study

The modeling exercise described in this article is based on information available in October 1990 and does not incorporate subsequent economic developments and policy announcements. East Germany is treated as a separate economy; there is, for example, a completely separate fiscal sector. While this approach is clearly not consistent with the institutional features of the united Germany, it facilitates the analysis of the effects of unification without causing any fundamental distortions. The scenarios for east Germany are based on a detailed model that integrates the demand, supply, and income sides of the economy. The model is described in Occasional Paper No. 75.

To assess the effects of unification outside east Germany, the results of the scenarios for east Germany have been fed, as an external influence, into the Fund’s MULTI-MOD model. MULTIMOD constitutes an integrated framework with separate submodels for each of the seven largest industrial countries (of which the model for Germany is, however, based on data for the Federal Republic before unification), for the remaining industrial countries as a group, and for developing countries (divided into capital-exporting and capital-importing countries). It is described in MULTIMOD MARK II; A Revised and Extended Model, by Paul Masson, Steven Symansky, and Guy Meredith, Occasional Paper No. 71, International Monetary Fund, July 1990.

Policy issues and uncertainties

The effects of German unification on government deficits and debt in Germany have been a central feature of the recent policy debate. In particular, the possibility of persistently high government deficits (see, for instance, the less optimistic scenario described above) has caused concern in many quarters. There is a consensus that expenditure reductions in west Germany, particularly of subsidies, are the preferred way of limiting these deficits. However, if sufficient budgetary savings cannot be achieved through expenditure measures, a tax increase may need to be considered. Because of the recent reform of income taxation, raising direct taxes might be counterproductive. Increasing value-added tax rates would appear to be a more attractive alternative; it would be consistent with the government’s objective of improving the efficiency of the tax system and would help to bring German VAT rates closer to the EC average.

Scenario A was, therefore, simulated in MULTIMOD with a rise in indirect tax receipts of DM 20 billion in 1991, corresponding to an increase in VAT rates by a little under 2 points in west Germany (additional revenue from a similar VAT increase in east Germany would be some DM 3 billion). The Bundesbank is assumed to raise its monetary target to take into account the initial effect on prices of higher indirect taxes. The additional revenue helps to limit the medium-run budgetary impact of unification: instead of an increase relative to baseline in the combined government debt ratio of 16 percent of GNP in the year 1999 in Scenario A, it increases by only 10 percent in this simulation. The simulated tax increase leads to higher inflation for a while: relative to the baseline, the GNP deflator rises 1.7 percentage points faster in 1991 (one percentage point more than in Scenario A). Since such price rises might kindle fears that inflation would continue, an increase in indirect taxes would have to be weighed carefully.

Scenario A, which assumes that central exchange rate parities within the ERM are unchanged, leads to slightly lower output in other ERM countries. This might be avoided by a realignment of their currencies vis-â-vis the deutsche mark. However, negative effects on the credibility of the “hard currency” policies of ERM countries—that is, the commitment of monetary policy to price stability—would also have to be taken into account. In particular, through tight monetary policies and by avoiding realignment of their exchange rates against the deutsche mark, other ERM countries have, in many cases, succeeded in lowering their inflation rates in recent years close to the German level. Devaluation of their currencies against the deutsche mark might give rise to doubts concerning their anti-inflationary commitment.

The table shows the results of a scenario in which a depreciation of the other ERM currencies against the deutsche mark (by 4 percent) in 1991 induces expectations of further realignments (assumed to equal IV2 percent a year) and consequently of higher inflation in future years. Other ERM countries experience greater inflation than in Scenario A, but also somewhat larger output. The effects on Germany are only slightly different.

Conclusion

Given the uncertainties involved in the transition from a centrally planned to a market economy in the former German Democratic Republic, the model simulations presented above must be seen as only rough quantifications of possible effects of German unification on other countries. In addition to uncertainties concerning economic policies and the behavior of individuals and firms in united Germany, there are other structural changes underway that may modify these results, including moves to greater integration of economies associated with the Single Market Program for the EC.

The general picture that emerges from the scenarios is that the international effects of German unification are relatively moderate. Moreover, these effects are not particularly sensitive to the success of the process of economic transformation in east Germany. This is hardly surprising given the small size of the resources needed in east Germany relative to global saving. But the path the east German economy takes over the coming years will have substantial implications for the now united Germany and may provide important lessons for other Eastern European countries.

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