Germany in the 1990’s: Managing Reunification Briefing

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Harvard Business School 9-793-033 Rev. July 9, 1998

Professor I.J. Alexander Dyck prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. It is an updated version of a case prepared by Research Associate James Ragsdale, with the assistance of Research Associate Robert W. Lightfoot, under the supervision of Professor George C. Lodge.

Copyright © 1992 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

Germany in the 1990s: Managing Reunification

On November 9, 1989, East and West Germans joined forces to smash the Berlin Wall. Within 11 months, West Germany embraced East Germany, integrating it into the Federal Republic. In an election campaign, German Chancellor Helmut Kohl boldly declared that reunification would cause only minor pain and promised no tax increases.

To ease the transition from a centrally planned to a market economy, the West German government poured aid across the border. In 1991, unification-related expenditures reached 6% of German GDP, and projections suggested equally high levels of expenditure in the next four years. Continued deficit spending could only fuel growing inflationary pressures. Other member nations of the European Monetary System (EMS), facing stubborn unemployment and recession rather than overheating, worried about potential intervention by the Bundesbank to raise interest rates to defend the value of the Deutschmark. Higher German interest rates would force EMS members to raise their rates to maintain agreed-upon exchange rates or to leave the EMS. Neither were attractive options. On July 16, 1992, European fears were realized. Bundesbank president Helmut Shlesinger announced the bank’s decision to squeeze domestic inflation by raising the discount rate by three- quarters of a point to 8.75%.

Within two months, the EMS was in tatters. Currency traders speculated that the restrictive Bundesbank policy, continued competitiveness problems of some EMS members, and declining public support for the EMS would be too much for some governments. They would be forced to drop out of the EMS. Speculators such as George Soros of the Quantum fund bet heavily against the pound, while others focused their attacks against the lira. Losing foreign exchange reserves and the support of other European central banks (the Bundesbank alone doled out DM 70 billion in a few days to support the pound and lira), the British and Italian governments took their currencies out of the exchange rate mechanism (ERM) on September 16. The value of the pound plummeted, the DM/pound exchange rate falling by more than 14% within three weeks. By betting heavily on devaluation, the Quantum fund made a profit of $1 billion within two months.

Germany’s trading partners blamed Kohl’s reunification strategy for the demise of the EMS. Could a different strategy have achieved Kohl’s objectives without risking the EMS?

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Division

The division of Germany into two countries with different economic and political systems came gradually and was certainly not foreseen in the closing days of the Second World War. Following a plan drawn up in 1944, the Allied powers divided Germany into four zones of occupation, each under the command of a different power—the United States, the United Kingdom, France, and the Soviet Union. As the capital of defeated Nazi Germany, Berlin was similarly placed under four-country control, even though it was located entirely within the Soviet region.

In the Soviet zone, the Soviet military command centralized economic power, confiscating land of the Prussian nobility and nationalizing banking institutions and Nazi-owned industrial plants. Having suffered huge losses under Nazi invasion, the Soviets exacted crippling reparations from their region. The Soviets’ dismantling of German industrial plants and transportation of these plants back to the Soviet Union reduced East German productive capacity by an additional 26% above the damage done by bombardment.1 Political centralization followed this economic centralization, with active support for Moscow-trained German Communists and increasing restrictions on non-Communist parties.

Following an initial plan to “pastoralize” Germany, the western Allies changed direction and increasingly promoted economic development in their regions. To further economic growth, the British and American zones were joined, and following a Harvard graduation speech by U.S. Secretary of State George Marshall in June 1947, the United States promised large amounts of aid through the European Recovery Program, also called the Marshall Plan. The western powers emphasized democratic political reform on a local level, creating a decentralized political system.

On June 20, 1948, partly to facilitate the distribution of Marshall Plan aid, the Allies introduced a major economic and currency reform in their region. At first, the Soviets responded by initiating their own currency reform, but then on June 24, they pushed for greater separation by blocking all land contact between West Berlin and the western regions of Germany. The initial response to the provocation was the Berlin airlift, a massive program by the western Allied powers to carry all required supplies to Berlin. The blockade also hastened plans to integrate the western Allies’ German regions under a new constitution. In April 1949, the western regions formed the Federal Republic of Germany, dedicated to a free-market economy and a democratic political system under the protection of western powers. In October, the Soviet authorities announced the creation of the new Soviet satellite and centrally planned economy, the German Democratic Republic. An iron curtain had settled along the inter-German border.

With the division of Germany nearly completed, the Soviets again allowed land links between the Federal Republic and West Berlin in May 1949. Between 1949 and 1961, an estimated 3.5 million East Germans took advantage of the open border between East and West Berlin to seek greater opportunity in the West.2 On August 12, 1961, the division between East and West Germany was sealed when the East German government built the Berlin Wall.

Germany’s division met with mixed responses. Some commentators welcomed a weaker Germany, closer in size and economic power to other European nations. French novelist François Mauriac succinctly captured this sentiment, stating, “I love Germany so much, I’m glad there are two of them.” Yet, to many Germans, the split was tragic, severing families and friendships. The preamble to the West German constitution testified to the lack of acceptance of this division by many Germans, appealing to the “entire German people . . . to achieve in self-determination the unity and

1 Mary Fulbrook, The Divided Nation: A History of Germany, 1918-1990 (New York: Oxford University Press, 1991), pp. 153-154. 2 Ibid., p. 195.

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freedom of Germany.” Nonetheless, the two portions of Germany developed along very different paths.

The East German System

In theory, the East German government was similar in structure to a western democratic government. A president oversaw the executive branch which included the Council of Ministers, the industrial ministries, the state planning commission, and state-owned enterprises. On the legislative side, citizens elected representatives to the People’s Chamber (Volkskammer). In practice, the Socialist Unity Party (SED), the East German Communist party, held almost all power. The People’s Chamber met rarely and simply rubber-stamped ministerial decisions. Party members occupied all important ministerial posts, and the party was represented in every organization of appreciable size. The SED’s power over the media, the education system, and the powerful internal security force, the Stasi, ensured the government’s control of the citizenry.

Soviet forces, followed later by German communists, transformed the previously affluent eastern provinces into a model of central planning. State control was pervasive, affecting production, employment, investment, prices, money and credit, and private consumption. As elsewhere in the Soviet bloc, following the advice of the Communist party leadership, the government, not firms, set prices for all goods. Moreover, the government did not allow prices to adjust to equalize demand and supply, so price changes could not signal where to direct resources. Instead, company policies were determined by government organs, primarily the Central Committee of the Communist Party and the Central Planning Ministry, which set output and input targets.

Input and output plans were conveyed to firms through ministries and large industrial groups, called Kombinate. After 1971, the importance of the Kombinate increased steadily. On the eve of unification, the government had incorporated 100% of all industrial production in the 173 centrally administered Kombinaten and the 95 locally administered Kombinate. Each Kombinat consisted of a number of predominantly large, horizontally and vertically integrated enterprises. The Kombinat structure insulated firms from domestic competition while state control over foreign trade and coordination in the eastern European trading bloc known as the COMECON insulated firms from foreign competition. Accordingly, East Germany’s economic structure reflected the planning priorities of both the state and the broader COMECON network (see Exhibits 2 and 3).

For the eastern bloc, East Germany exhibited tremendous success. East Germans enjoyed an extensive state-sponsored safety net with a constitutional right to a job. A government-supported price structure kept prices for consumer goods low and fairly stable. Most local services, such as healthcare, daycare, and recreational facilities were provided at low prices to workers through the large state-owned firms. In 1982, the Communist party secretary, Erich Honecker, reported that East German productivity was roughly equal to that of Britain and Italy and only 30% lower than West Germany’s. East German statistics also suggested fairly strong growth since 1982, averaging 4% for the 1980s. Official western sources estimated the East’s industrial productivity to be lower, but a still respectable 50% of the West’s.3

Relative to West German economic standards, however, East Germany was falling further and further behind. East Germans’ reception of West German TV and radio broadcasts and visits from West Germans in their expensive cars only served to highlight East Germans’ relative poverty. Consumer goods in East Germany were often of inferior quality and durables were scarce. Only half of East German households owned color TVs or automobiles, considered standard in West German

3 Figures quoted in Arthur Stahnke, "The GDR economy and the question of reform," Pressures for Reform in the East European Economies (Washington: Congress committee report, U.S. Government Printing Office, 1989), II, pp. 243-247.

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households, and only 16% had telephones.4 While housing was provided at low cost, more than a quarter of East German households lacked an indoor toilet in 1989, and a fifth possessed no bath or shower. Worse still was the infrastructure, with unreliable telephone and rail networks, roads in need of repair, and massive environmental contamination.

The West German System5

West Germany thrived under the social market economy during the postwar period. The tension between the requirements for high productivity and the fulfillment of high living standards had been successfully managed by an institutional system that created powerful private incentives and encouraged “give and take” among West Germany’s major players: industry, labor, and government. Low unemployment, high productivity, and strong exports all testified to the success of this system (see Exhibits 4 through 7). The independent German central bank, the Bundesbank, contributed to German macroeconomic stability and, since the 1980s, increasing stability in European interest rates and exchange rates.

The government had a federalist structure, with decision-making power shared between the federal government and the states, or Länder. The legislature was bicameral, composed of the Bundestag, elected by direct vote every four years, and the Bundesrat, the upper house representing the Länder. The chancellor presided over a cabinet at the top of the executive branch. Economic policy-making was shared by the Ministries of Finance and Economics.

Three main parties, the Christian Democratic Party (CDU/CSU), the Free Democratic Party (FDP), and the Social Democratic Party (SDP), played a prominent role in German political life. Power shifted periodically between the CDU/CSU, a center-right party with close ties to business and churches, and the SDP, a center-left group with strong ties to organized labor. The FDP, a champion of small business and professional interests, played a pivotal role, alternating its support between these two major parties and participating in almost every cabinet. A fourth party, the Greens, gained popularity with a pacifist and environmental message but had failed to play a role in a ruling coalition.

The business sector presented a strong and united voice in dealing with government and labor. All German firms were required to be members of local chambers of commerce. Perhaps more important, most firms joined national industry associations. The industry associations voiced their concerns to the government, influenced training of apprentices, and were by the Constitution responsible for conducting wage negotiations with unions without government influence. National federations of chambers of commerce and employers associations brought together business’s concerns and expressed them in public-policy decision making.

Labor unions in West Germany were large and strong. They were organized along industry lines, negotiating wage agreements with industry associations on which they were able to deliver. The system of “co-determination” gave workers representation on supervisory boards of large firms and significant rights at the shop floor level through work councils. These councils’ consent had to be granted before firms could appoint or dismiss workers or introduce overtime.

Monetary policy in West Germany was the exclusive domain of the Bundesbank. Established in 1957, its primary objective was to maintain the purchasing power of the Deutschmark, a task it took extremely seriously. Germany had suffered from hyperinflation in 1921-1923 that

4 See statistical yearbooks of East and West Germany. 5 This section has drawn significantly from John Goodman, and Andrew Tauber, "West Germany: The Search for Stability," an earlier HBS case now out of print..

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dramatically reduced the middle class and, some claimed, created an environment ripe for Hitler’s rise to power. To ensure its ability to maintain the Deutschmark’s value, the Bundesbank was given remarkable independence from government influence.6

In the pursuit of price stability, the bank possessed several tools. The main instruments were refinancing policy (fixing conditions and rates for central bank loans to German banks), open market policy (purchases and sales of securities for its own account in the open market), and minimum reserve requirements (mandating the level of reserves that each German bank was required to deposit in the Bundesbank).

The Bundesbank primarily used refinancing policy to affect the money supply on an ongoing basis. The two primary tools in this policy were the discount rate and the Lombard rate. The discount rate was the lowest rate at which commercial banks could borrow from the Bundesbank if they needed funds to meet their reserve requirements. The Bundesbank limited such lending and most banks borrowed up to their limit. More important for banks was the Lombard rate. At this higher rate, the Bundesbank placed few limits on borrowing. Because banks knew that they could borrow at this rate, interest rates in private capital markets closely tracked changes in the Lombard rate.

For 35 years, the Bundesbank had used its tools and its autonomy to deliver a remarkable record of price stability. In the 1980s, Germany had the lowest inflation rate in Europe, and the Deutschmark had appreciated significantly against the dollar since the first experiment with floating exchange rates in 1971.

The second half of the 1980s was characterized by slow, steady growth and macroeconomic stability in West Germany (see Exhibits 5, 6, and 7).

Germany and Europe

Since the 1970s, Germany was the economic powerhouse of western Europe. Part of its influence stemmed from the size of its economy. Germany’s dominant position was reinforced by the central role of the Bundesbank in the EMS. Many observers argued that the Bundesbank de facto set European monetary policy. Moreover, the Maastricht treaty, signed in December 1991, seemed to institutionalize the dominant position of the Bundesbank.

In theory, all countries were treated identically under the exchange-rate mechanism of the EMS. In case two countries’ actual exchange rate reached the lower end of their exchange rate band, central banks of both member nations were required to step in and use their foreign-exchange reserves to push the exchange rate back within the band. In fact, the lion’s share of responsibility lay with the nation at the bottom of its exchange-rate band. The stronger nation had a virtually unlimited ability to meet the demand for its currency, for it could print that currency. The weaker nation, however, had to use its foreign-exchange reserves. Because these reserves were limited, the weaker nation was usually forced to adjust its economic policies to raise the value of its currency before the stronger nation.

A typical source of movement in exchange rates was a relatively higher rate of inflation in one member nation. The bias in the EMS for weaker members to change their policies to reduce

6 In contrast to other central banks, Bundesbank board members were hired for a fixed term (of eight years), a minority of board members were appointed by the government (only 10 of 21), and the central bank was prohibited from purchasing bills on the primary market, limiting the ability of the government to monetize public sector deficits. See John Goodman, Monetary Sovereignty: The Politics of Central Banking in Western Europe (Ithaca: Cornell University Press, 1992), pp. 10-11.

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exchange-rate pressures here encouraged the weaker nation to adjust its monetary policy to lower inflation. Because Germany had the lowest average inflation rate of EMS nations since the formation of the EMS in 1978, it effectively set its monetary policy independently while other member nations adjusted their fiscal and monetary policies to maintain their mandated Deutschmark exchange rates. Germany’s dominant position was reflected in member nations’ accumulation of Deutschmarks as their foreign-exchange reserves and the tendency of other nations to adjust their interest rates to track German changes.

Throughout the 1980s, indeed, Germany’s influence in the EMS expanded as other members successfully reduced their inflation rates close to German levels (see Exhibit 8). While tensions occasionally arose because of differences between the Bundesbank policy and that desired by other member nations, these tensions did not lead to political fights since fluctuations in the level of business activity in Germany coincided closely with business fluctuations of its European neighbors.

Reunification

Since 1971, First Secretary of the SED Erich Honecker presided over East Germany. The lack of a strong domestic opposition to the Communist government prompted most commentators to predict little radical change. A report to the U.S. Congress published two weeks before the breakup of the Berlin Wall even predicted that “systemic reform (i.e., departure from the traditional centrally planned economy) is most unlikely to be considered seriously in the near future by GDR leaders.”7

Change began slowly but soon could not be constrained by Communist party leaders. The exodus of thousands of East Germans in early 1989 to West Germany through newly democratic Czechoslovakia and Hungary testified to the extent of many East Germans’ dissatisfaction with their totalitarian government and slow reform. On October 9, 1989, the people of Leipzig took to the streets to demonstrate against the regime. With the implicit approval of Soviet reformer Gorbachev, the SED attempted to respond to the winds of change, deposing Honecker and appointing a new group of leaders dedicated to economic and social reform. Protests only increased, and the new SED leadership became more desperate. On November 9, 1989, a government spokesman casually announced that effective immediately exit visas would be made more accessible to East German citizens.

East Berliners seized this offer and flooded the few designated checkpoints into West Berlin. Confused border guards had not been informed of any change in policy. The mass of people convinced them, and spontaneously East and West Berliners began to tear down the Berlin Wall. Given this freedom, others were quickly demanded. In the first free multiparty elections in March 1990, East Germans revealed the extent of their disaffection with the socialist system as a majority voted for parties dedicated to rapid integration into the Federal Republic of Germany.

The integration of East and West Germany required international consultation, for Berlin was still officially under four-nation control, and western and Soviet troops were stationed in both parts of Germany. By July 1990, the four nations agreed to unification and made provisions to remove all 350,000 Soviet soldiers by August 1994. Nonetheless, the prospect of reunification raised some foreign fears. Germany, long roughly equal in population to France, Italy, and Britain, would grow by 15% and would have an even greater economic dominance (see Exhibits 1 and 2). Günter Grass, a celebrated West German author, captured the sense of unease:

7 Stahnke, op. cit., p. 243.

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In the end, we’ll number eighty million. Once more we’ll be united, strong and our voice—even if we speak softly—will be loud and clear. Eventually, because enough is never enough, we’ll succeed, with our strong currency and after formal recognition of Poland’s western border, in subjugating economically a large chunk of Silesia and a small chunk of Pomerania, and so once more—following the German fairy-tale pattern—we will be feared and isolated.8

The first major step along the path to union was the treaty on German Economic, Monetary, and Social Union (GEMSU). Signed by the finance ministries of East and West Germany in May 1990, it was implemented on July 1, 1990. From that day, East German marks were exchanged for West German marks, East German companies could be fully owned by West Germans, and there was free exchange of goods and services between people in East and West Germany.

An important element of this treaty was the conversion rate between East and West German marks. A high conversion rate for the East mark would raise the purchasing power of accumulated assets and increase wages and consequently take-home pay for East Germans. Higher East German incomes might stem the flow of citizens streaming from the East to the West. These flows, coupled with the large number of German-speaking immigrants from the other Eastern bloc countries, were straining housing and services in West Germany. However, setting a high level for the conversion rate would also make East German goods and services expensive, reducing the markets for East German goods, increasing unemployment in the East, and consequently encouraging even greater flows of individuals from East to West. Ultimately, Chancellor Kohl opted for a high conversion rate, agreeing to transform wages at a 1:1 rate, while exchanging debts and savings of East German marks at an average rate of 1.6 East marks for 1 Deutschmark.9

Massive price changes followed in the wake of currency union. These price movements unsettled East German citizens as well-established prices for goods changed overnight, some rising by up to 20 times, while others fell. The government initially insulated citizens from the shock of western-level rents, heating costs, and public transit, but these prices were also scheduled to rise.

In August, a Unity Treaty was signed, and as of October 3, 1990, East Germany ceased to exist. East German states applied to become part of an expanded Federal Republic of Germany, rather than calling for a conference to negotiate a new constitution for unified Germany. Integration made most West German laws immediately applicable in East Germany. These laws included the West German commercial code, as well as laws pertaining to West German taxation and social security systems and the fairly strict environmental laws of the Federal Republic of Germany.

Reunification dramatically changed some of the most well-established relationships in eastern Germany, western Germany, and Europe. Most directly affected, of course, were eastern German citizens. To compete and adapt to the western German social and economic system, eastern German firms needed to become more productive, requiring changes in well-established employee relationships. Western German interest groups, faced with the unexpectedly large bill for reunification, began a public battle to decide on payment. The debate brought into question the tradeoffs that defined the German institutional system. Finally, Germany’s budgetary difficulties and attempts by the Bundesbank to maintain the value of the mark threatened prospects for future European union.

8 Silesia and Pomerania are regions of the Czech Republic and Poland that were part of German territory before World War II. "Short Speech by a Rootless Cosmopolitan," in Two States—One Nation? (New York: Harcourt Brace Jovanovich, 1990). 9 Debts were translated at a 2:1 rate, while savings were translated at 1:1 for low levels of savings and 2:1 for higher levels.

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Eastern Germany and Integration

In eastern Germany, unification brought dramatic social and economic changes (see Exhibit 9). Production and employment plummeted in response to western German and foreign competition, coupled with the pressures of wage convergence. At the beginning of 1991, industrial firms produced only half of what they had a year earlier—a drop in economic activity almost without historical precedent.

This pattern was seen in other sectors and was reflected in a staggering decline in employment in a nation whose citizens had not faced job uncertainty for 40 years. By July 1992, employment in eastern Germany had declined from a high of 10 million to 6 million. Many left the labor force, and only extraordinary labor market programs kept the official unemployment rate at 14%. The “shortfall from regular employment,” which includes those citizens in make-work programs and early retirement, offers perhaps a more accurate measure of the reduction in employment. By this measure, unemployment increased to 35%, a full 10% higher than unemployment during the American Great Depression. Unemployment contributed to social and political tension reflected in growing violence against foreigners.

The opening of markets in East Germany and the adoption of the West German institutional system contributed to the drop in output and employment. At once, East German producers experienced a decline in demand for their products, an uncontrollable increase in labor costs, and a reduction in their ability to produce to meet new consumer needs.

Given freedom from planning, consumers, not the state, now dictated what goods to produce. Rapidly, eastern Germans gravitated to new, brightly packaged western goods that entered tariff-free from western Germany and other European Community countries. More devastatingly, some products lost all demand as consumption started to replicate western German patterns. Eastern bloc consumers added to this domestic decline in demand, reducing their purchases of eastern German products as eastern Europe fell into recession and firms now needed hard currency to purchase eastern German goods. Finally, the state began to reduce credits and allow bankruptcy. These changes had multiplier effects as a decline in demand in one sector reduced demand for other domestic inputs.

Labor costs also increased. The possible advantage of low wage costs was denied to eastern German producers by two decisions. Kohl’s decision to convert wages at a 1:1 rate made the average eastern German wage about one-third of the average western German wage (while eastern workers’ productivity was estimated at 38% of western workers’ productivity by German experts). More important, newly created eastern German unions (under the influence of western union negotiators) and eastern employers agreed to a schedule of future wage increases that were not linked to changes in productivity. For example, IG Metall, the large, powerful metal industry union, negotiated a phased equalization of wages in the metal industries between East and West. This agreement specified that wages were to rise to 65% of western German levels by the end of 1991 and to parity by 1994.10

Critically, firms had great difficulty responding to these changed demand and supply conditions. The capital stock of many eastern German firms was made obsolete overnight. Capital machinery was designed for large-volume production of identical products to be shipped to the East, not for products to fill niche markets as demanded in the West. An indication of the obsolescence of the old capital stock is seen in a revaluation of the assets of a chemical producer in eastern Germany

10 See W. Franz, "German Labor Markets after Unification," a paper presented at a CEPR conference on German unification, November 1991. This agreement did not provide for the short work week, extended vacation, and generous benefits common in the West.

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from 2 billion to 200 million marks after an audit by western experts.11 Equally as important, eastern German managers did not know how to restructure firms. Trained in a system that encouraged plan fulfillment, they simply were not familiar with basic western managerial skills like marketing, financial and cost accounting, and financial decision making, not to mention the peculiarities of the western German institutional and legal systems.

Privatization

In March 1990, under the leadership of reform communists, the East German government began to dismantle the Kombinat structure. The most important step taken was the transfer of ownership of almost all East German state assets to the newly created Trust Administration of the People’s Property, known as the Treuhand. For a short while, this holding company, which employed 4 million people in 7,900 firms, was the largest firm in the world.

Following GEMSU, Chancellor Kohl began to exert his influence. The Treuhand was given a new legislative objective, to “encourage the structural adjustment of the economy in line with market requirements through fostering competitive enterprises and privatization . . . and to create efficient market structures through deconcentration and divestiture.”12 Under the leadership of the new Treuhand president, the experienced western German manager Detlev Rohwedder, the Treuhand grew from a small organization of 200 employees to one with more than 4,000 employees devoted to rapid privatization. Ironically, to fulfill its new mandate the Treuhand took over the labyrinthian offices of the former state planning commission and industrial ministries.

Privatization was difficult. By western German standards, firms were oversized, concentrated in unprofitable sectors, and very expensive to run. An initial evaluation by Treuhand officials suggested that a third of the firms could be privatized as is, one-third needed some initial restructuring but were capable of being sold, and one-third would have to be shut down. A noted study by American economists was more pessimistic, showing that after unification, only 8% of firms could cover their short-run variable costs.13 These difficulties, as a result of 40 years of socialist management, were exacerbated by the German government’s decision to return property to former owners, to impose complicated western German laws designed for a fully developed market economy, and to follow a complicated sales procedure for Treuhand firms.

In an effort to promote justice, the government included as part of the unification agreement a Restitution Act that returned land confiscated by the Nazis or during the socialist period to its previous owners. The Restitution Act introduced much uncertainty into firms’ investment decisions because it was difficult to determine who, if anyone, previously owned a given piece of land. Land registries had not been maintained and in many cases had been significantly modified. Finally, the same property had sometimes been confiscated numerous times, producing multiple claimants. A law passed through Parliament in March 1991 significantly reduced but did not eliminate this danger of post-privatization loss of property.

West German environmental and labor laws were immediately introduced with official unification on October 3, 1990. Environmental laws required that the present owner be responsible for environmental contamination regardless of when the pollution was created. Legal compliance raised huge potential costs for investors. Labor laws raised the cost to firms of firing workers, further

11 Speech by Mr. Werin, CEO of BASF, 1991. 12 Gesetzblatt of East Germany, June 17, 1990. 13 G. Akerlof et al., "East Germany in from the Cold: The Economic Aftermath of Currency Union," Brookings Papers on Economic Activity, Microeconomics, Volume 1, 1991.

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increasing the costs of purchasing firms. For example, workers who lost their jobs were, by German law, normally entitled to six months’ compensation.

Finally, the Treuhand did not simply try to maximize sales revenue, complicating the sales process:

[T]he Treuhand’s primary objective is not maximizing price, although price can also be important . . . the purchasers development plan may well be the most crucial document of all. An investor who is ready to inject new management and substantial new investment into the company, and, crucially, is prepared to keep or create a substantial number of jobs, is likely to take precedence over an investor who is offering only a higher price.14

On the other hand, the government encouraged privatization and restructuring. The government and the European Community offered various subsidies and tax advantages for investment in the East (up to 33% of value of investment). To facilitate sales the Treuhand would assume the political and economic cost of firing employees. The Treuhand also forcibly split up enterprises to make firms more attractive.

Despite the considerable obstacles to privatization, firms were rapidly sold. Since the spring of 1991, the sales pace averaged more than 20 firms privatized per working day. Two years after initially assuming control, the Treuhand had privatized 8,175 companies, leaving 4,340 firms to be sold or shut down. Most firms were acquired by western German companies in the same line of business. Only 5% of privatized firms were acquired by foreign purchasers. Of the 18% of privatized firms purchased by eastern Germans, most were small or medium-sized enterprises.15

The Treuhand’s efforts to privatize and restructure eastern German enterprises angered many Germans, who saw only declines in employment and plant closures. Dr. Rolf Schmachtenberg, a department director in an eastern German state government, expressed the common complaint that rapid privatization using the complicated auction mechanism was a thinly veiled attempt to favor established western German businesses: “The Treuhand stresses privatization for one simple reason: rapid privatization, unconstrained by concern for the East’s economic viability, is what is best for West German industry, and West German industry is effectively in control of the Treuhand’s priorities.”16 The deplorable assassination of Treuhand President Rohwedder by western German extremists in spring 1991 testified to this anger.

Reunification and Western Germany

In western Germany, industrial production experienced an initial boost from unification. Government-induced spending in eastern Germany further increased demand for western German goods during a period of healthy economic growth. Employment in western Germany reflected this increased demand as unemployment dropped to just 4.2%. This drop in unemployment came despite the increased flow of immigrants, including eastern commuters taking advantage of higher wages in the West and the lower cost of living in the East. Employees gained from the increased demand, negotiating wage increases of 5%-6% in spring of 1992. But by the summer of 1992, the initial economic boom had evaporated. Disconcertingly, the economy began to overheat, as was

14 See "Sale of the Century," Treuhandanstalt, Treuhandanstalt Press Office, 1991, p. 27. 15 Treuhandanstalt, Informationen, #15, August 1992. 16 Quotation from Kristin Lundberg and John Donahue, "The Treuhandanstalt: Taking a Nation Private," Kennedy School of Government, Case #C16-92-1120.0, 1992.

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reflected in the rise in wages and prices. By July 1992, output had started to stagnate. Both fiscal and monetary authorities became concerned.

To combat the real dislocation in the East and to prevent a further inflow of easterners to western Germany, the government borrowed massively and transferred these resources to the East (see Exhibits 10 and 11). In 1991 alone, transfers amounted to an unprecedented 5.8% of GDP, not to mention the obligations for future payments.17 Extensive privatization raised rather than lowered government deficits. Original estimates of sales revenue of DM 600 billion from privatization proved hugely optimistic.18 The quick sales pace brought in revenues of just DM 30.7 billion, and on net the Treuhand’s activities produced large losses.

The government financed these massive expenditures on eastern Germany through public borrowing. Public deficits climbed to 4.4% of GDP, leading directly to an increase in debt. This deficit came despite a one-year 7.5% surtax on corporate and private income introduced in 1991. In June 1992, the Ministry of Finance had unveiled an “austerity budget” to rein in the deficit while maintaining eastern development financing. The proposed federal spending level, however, was a 2.5% increase over the already high fiscal year 1992. The Kiel Institute for International Economy projected that without change the national debt would reach 51.4% of GDP by the end of 1995, a full 5.6% of GDP above existing levels.19

Western Germans began to grumble. They had been told that reunification would be costless, and it was now clear that both now and in the future their taxes would have to rise to pay for these expenditures.

In 1989, anticipating increased demand for German goods as a result of reunification, the Bundesbank advocated an upward adjustment of the Deutschmark in the EMS. With a higher exchange rate, foreigners would reduce their demand for German products, reducing German inflationary pressures. This policy was not implemented, as the French, with their franc fort policy, rejected this request and deprived the Bundesbank of the unanimous approval of all EMS members required for currency realignments.20

As it became clear that the economy was overheating and that the fiscal authorities were not prepared to raise taxes, the Bundesbank had rapidly raised short-term interest rates (see Table A). High interest rates were having their desired effect as output declined in July 1992. The high interest rates also raised the value of the Deutschmark and affected trade and capital flows (see Exhibit 6).

17 In 1990, the Treuhand assumed responsibility for interest payments on DM 100 billion of previously incurred debt. Government-owned firms in the West also committed DM 75 billion to investment projects in the East within the next four years (environment, DM 5 billion; transport DM 15 billion; post (also responsible for telecommunications) DM 55 billion). Treuhandanstalt, "Sale of the Century," op. cit. 18 Treuhand President Rohwedder in a speech to the Bundeskammer in Vienna, October 19, 1990. Cited in Hans Werner Sinn, "Privatization in East Germany," mimeo, University of Munich, 1991. 19 Reported in The Economist, May 23, 1992, p. S5. 20 Barry Eichengreen and Charles Wyploscz, "The Unstable EMS," Brookings Papers on Economic Activity, 1993, Vol. 1, p. 77.

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793-033 Germany in the 1990s: Managing Reunification

Table A Short-Term Interest Rates, 1987-1992

1987 1988 1989 1990 1991 May 1992 Europea 8.4% 8.2% 10.6% 11.4% 10.8% 10.7% Germany 4.0 4.3 7.1 8.4 9.2 9.5 France 8.3 7.9 9.4 10.3 9.6 10.4 United Kingdom 9.7 10.3 13.9 14.8 11.5 9.6

Source: EC, European Economy.

aEurope is a trade-weighted average of all 12 EC members.

Together, the deficit increase and the appreciation of the Deutschmark put pressure on the German institutional system. Postwar German success had arguably been built on four pillars: private property and market dominated allocation of goods, capital, and labor; coordination and cooperation between labor and business; responsible fiscal and monetary policy; and a generous social system coupled with high tax rates. Now, reunification pitted labor and business against each other. The business lobby argued for wage restraint to combat high wage costs that had increased relative to their competitors’ as a result of the rising exchange rate. Employers suggested that perhaps Germany could no longer afford high wage rates, a short work week, and extensive vacation packages. Unions, on the other hand, wanted to maintain their real wages in the face of growing inflation (see Exhibits 12 and 13).

Reunification, Europe and the Downfall of the EMS

Reunification also threatened growth in other European nations and the future of the EMS. Increased German spending raised the demand for all European goods and services in 1990 and 1991. This effect was soon overwhelmed by the retarding effect of higher German interest rates. In 1989, EMS nations allowed their interest rates to follow German rate increases to avoid devaluation. In 1991 and 1992, EMS nations were forced to maintain these rates, as Germany fought domestic inflation. This rise in interest rates coincided with a decline in European economic activity.

Many governments feared continuing high interest rates. Their economies were already weak, suffering from stubbornly high unemployment, and higher interest rates would likely lead to a decline in output and deflationary pressure. EMS nations also feared the costs of not following Germany’s lead and devaluing their currencies relative to the Deutschmark or changing exchange- rate bands, as allowed by the exchange-rate mechanism. Monetary policy coordination and convergence had improved steadily since the introduction of the EMS in 1979. Parity rates had not changed since 1987. Moreover, the Maastricht treaty on EMU set clear goals for eventual complete monetary unification, including the provision that parity rates could not change in the previous two years. A change in rates, therefore, could slow the drive to union.

Reunification was not the only problem facing EMS nations. While inflation rates of EMS members had converged, some nations such as Italy continually ran higher inflation rates than their EMS neighbors, raising their unit labor costs (see Exhibit 12). The resulting decline in competitiveness weakened these members’ currencies independent of Bundesbank policy. The appreciation of EMS currencies against the dollar further exacerbated such competitiveness problems. Finally, there seemed to be a decline in political support for Maastricht and EMU. This

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Germany in the 1990s: Managing Reunification 793-033

was seen in the Danish rejection of the Maastricht treaty in a referendum held June 2, 1992, and weak support for Maastricht in France where a referendum was scheduled for the fall.

Whether motivated by Bundesbank restrictive monetary policy, competitiveness problems of some EMS nations, or due to declining political support, the EMS began to unravel in summer 1992. Already in July, the pound and the lira were weak relative to other currencies. (The weekly publication of the EMS grid by the Financial Times of London on July 13, 1992, reproduced in Exhibit 14, revealed this vulnerable position.) In August and September, these weaknesses were exaggerated as currency traders speculated that a realignment was inevitable. Central bankers tried to work against traders, the Bank of England reportedly spending $20 billion to support the pound and the Bundesbank doling out DM 70 billion in a few days to support the pound and lira.21 On Friday, September 11, Chancellor Kohl traveled to Frankfurt to discuss the EMS crisis and continued Bundesbank intervention with Bundesbank President Helmut Shlesinger. Following these discussions, Shlesinger negotiated with other EMS members to reduce German interest rates if other EMS members would agree to a realignment.22 When this request was rejected, the fate of the EMS was sealed. Almost deprived of foreign exchange reserves, the British and Italian governments removed their currencies from the ERM on September 16. Prospects of monetary union had dimmed appreciably.

21 Ibid., Vol. 1, p. 59. 22 Ibid., p. 111.

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793-033 Germany in the 1990s: Managing Reunification

Exhibit 1 Map of Unified Germany

Hamburg

Berlin

Bremen

Hannover

Dusseldorf

Bonn

Dresden Leipzig

Chemnitz

Frankfurt

Stuttgart

Munich

Nuremburg

SCHLESWIG- HOLSTEIN

NORTH RHINE- WESTPHALIA

RHINELAND- PALATINATE

SAARLAND

HESSE

BADEN- WURTTEMBERG

BAVARIA

THURINGIA

SAXONY-ANHALT

BRANDENBURG

MECKLENBURG

DENMARK

NETHERLANDS

BELGIUM

LUX.

FRANCE

SWITZERLAND

AUSTRIA

CZECHOSLOVAKIA

POLAND

Baltic Sea

North Sea

Germany

SAXONY

BREMEN

LOWER SAXONY

Dortmund Essen

Cologne

0 100 Miles

100 km0

Former border between East and West Germany

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Germany in the 1990s: Managing Reunification 793-033

Exhibit 2 Profile of the Two Germanys

West Germany East Germany Land area (1,000 sq. km) 249 108 Population in 1990 (millions) 62.7 16.2 Economic Indicators GNP in 1990 (DM billions) 2,426 232 GNP/capita (DM) 38,742 14,061 GNP/capita ($) 23,915 8,679 Real GDP (% change, 1989) 4.5% 0.7% Real GDP (compound annual % change, 1980-1988) 1.7% 4.2% Employment by Sector, 1989 (percentage)a Agriculture, forestry, fishing, energy, and mining 5.3% 13.1% Manufacturing 30.7 34.1 Construction 6.6 6.1 Trade 13.4 7.8 Transportation and communications 5.7 6.8 Financial institutions and insurance 3.5 0.7 Services, public administration, defense, and others 34.8 31.6

Sources: Basic data from L. Lipschitz and D. McDonald, German Unification: Economic Issues (Washington, IMF, 1990). Employment data from German Statistical Yearbook 1993.

aTotal may not add to 100% due to rounding errors.

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793-033 Germany in the 1990s: Managing Reunification

Exhibit 3 Industrial Sector Comparisons, East and West Germany, 1988

A. Industrial Employment by Firm Size (% of industrial employment) West

Germany East

Germany More than 1,000 employees 39.1% 75.7% 501–1,000 employees 13.3 12.2 201–500 employees 18.3 8.6 101–200 employees 11.5 2.4 21–100 employees 16.9 1.0 1–20 employees 0.8 0.1 B. Industry Size Breakdown (% of all industrial firms) More than 1,000 employees 2.4% 24.7% 501–1,000 employees 3.1 16.3 201–500 employees 9.6 25.1 101–200 employees 13.4 15.2 21–100 employees 59.2 15.2 1–20 employees 12.3 3.5 Number of industrial firms 43,960 3,408 Industrial employment (millions) 7.1 3.2 Average number of employees/enterprise 161 929

Source: Statistisches Bundesamt, Statistical Yearbook of East Germany, Statistical Yearbook of the Federal Republic of Germany. Found in R. Berger, “Unternehmenische Aufgaben and Perspektiven bei der Restrukturierung der ostdeutschen Wirtschaft,” in Betriebswirtschaftliche Forschung und Praxis, April 1992.

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793-033 -17-

Exhibit 4 National Income Accounts for West Germany (% of GDP)a

1975 1980 1985 1986 1987 1988 1989 1990 1991 Government consumption 20% 20% 20% 20% 20% 20% 20% 19% 18% Private consumption 57 57 57 55 56 55 55 55 54 Increase in stocks -1 1 0 0 0 1 1 0 0 Gross fixed-capital formation 20 23 20 20 19 20 20 21 22 Exports of merchandise and services 26 29 35 33 32 33 35 37 39 Imports of merchandise and services -23 -29 -31 -27 -26 -27 -31 -30 -32 Gross National Product (DM billions 1985) 1,473.0 1,733.8 1,834.5 1,879.4 1,902.3 1,971.8 2,050.3 2,149.8 2,226.8 Deflator (1985 = 100) 69.8 85.2 100.0 103.3 105.3 106.9 109.7 113.5 118.2 Net household savings as percent of disposable

income

15.1%

12.8%

11.4%

12.3%

12.6%

12.8%

12.5%

13.9%

13.7%

Sources: OECD, OECD Economic Outlook, June 1992; IMF, International Financial Statistics, OECD, National Accounts.

aTotals may not add to 100% due to rounding errors.

Exhibit 5 Population, Employment, and Wages for West Germany

Year

Population

(000)

Total Employment

(000)

Unemployment

as Percent

Consumer Prices

(% change)

Nominal Compensation per Employee

(% change)

Real Compensation per Employee

(% change) 1984 61,126 26,393 7.1% 2.4% 3.4% 1.0% 1985 60,975 26,489 7.1 1.8 2.9 1.4 1986 61,010 26,856 6.5 -0.3 3.6 4.0 1987 61,077 27,050 6.3 0.7 3.2 2.5 1988 61,450 27,264 6.3 1.4 3.0 1.6 1989 62,063 27,635 5.6 3.0 2.9 -0.1 1990 63,254 28,442 4.8 2.8 4.7 1.9 1991 64,074 29,173 4.2 3.8 5.8 2.0

Sources: EC, European Economy, 1994.

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793-033 -18-

Exhibit 6 Balance of Payments—West Germany until July 1990, then Unified Germany (billions of current $US)

1985 1986 1987 1988 1989 1990 1991 Current Account: Merchandise: exports FOB 173.65 231.02 278.48 308.62 324.96 391.31 378.19 Merchandise: imports FOB (145.08) (175.27) (208.28) (228.85) (247.22) (319.61) (354.73) Trade Balance FOB 28.58 55.75 70.20 79.77 77.74 71.71 23.46 Service and income-credit 50.11 67.47 82.45 87.39 100.49 132.94 142.55 Service and income-debit (51.68) (70.63) (90.06) (98.33) (102.59) (135.44) (149.21) Private transfers (3.73) (4.90) (5.72) (6.39) (5.71) (7.01) (6.87) Official transfers (6.25) (7.61) (10.60) (11.68) (12.24) (15.88) (29.46)

Current Balance 17.02 40.08 46.28 50.76 57.70 46.32 (19.53) Capital Account: Capital Account Balance (16.13) (38.54) (25.93) (69.20) (68.30) (40.87) 21.67 Direct investment (3.21) (9.78) (7.71) (11.83) (7.66) (19.43) (14.87) Portfolio investment 1.77 23.59 (1.88) (43.82) (4.59) (2.41) 24.46 Other long-term capital (1.91) (0.08) (3.58) 4.27 0.04 (16.04) (21.98)

Basic Balance 13.67 53.81 33.11 (0.62) 45.49 8.44 (31.92) Short-term capital (15.81) (53.81) (11.77) (20.28) (60.81) (18.14) 22.84 Errors and omissions 3.04 1.37 (0.99) 2.46 4.71 15.15 11.22

Overall Balance 0.89 1.54 20.35 (18.43) (10.62) 5.46 2.14 Total change in reserves (0.89) (1.54) (20.35) 18.43 10.62 (5.46) (2.14)

Total Reserves (Stock) 49.90 58.80 87.40 66.20 68.80 77.10 72.00 DM/$ Exchange Rate (period average) 2.94 2.17 1.80 1.76 1.88 1.62 1.66

Source: IMF, International Financial Statistics.

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Germany in the 1990s: Managing Reunification 793-033

Exhibit 7 Comparative Macroeconomic Data

1986 1987 1988 1989 1990 1991 GDP (billion $US at current prices and current exchange rates) Germany 886.6 1,107.4 1,193.5 1,183.2 1,496.4 1,574.3 France 731.9 887.9 962.8 965.4 1,192.2 1,196.4 United Kingdom 562.1 689.7 832.3 838.7 980.9 1,018.0 United States 4,268.6 4,539.9 4,900.4 5,250.8 5,522.2 5,677.5 Japan 1,985.6 2,408.9 2,898.4 2,871.8 2,932.1 3,346.4 Exports of Merchandise (% of GDP)a Germany 33.2 32.0 32.7 35.4 36.5 38.8 France 21.2 20.7 21.3 22.9 22.6 22.7 United Kingdom 25.7 25.4 23.1 23.9 24.3 23.5 United States 7.5 8.0 9.1 9.7 10.1 10.5 Japan 11.4 10.4 10.1 10.7 10.8 10.4 Current Account Balance (% of GDP) Germany 4.5 4.2 4.2 4.9 3.1 -1.2 France 0.3 -0.5 -0.5 -0.6 -1.2 -0.5 United Kingdom 0.0 -1.1 -3.5 -4.2 -3.0 -1.1 United States -3.5 -3.6 -2.6 -1.9 -1.6 -0.1 Japan 4.3 3.6 2.7 2.0 1.2 2.2 Government Deficit/Surplus (% of GDP) Germany -2.0 -2.0 -3.0 -0.3 -2.6 -4.2 France -3.4 -1.2 -2.3 -1.9 -2.1 -1.4 United Kingdom -2.4 -0.7 1.2 1.2 0.8 -1.3 United States -5.0 -3.2 -3.2 -2.7 -3.9 -4.8 Japan -4.8 -3.5 -2.6 -2.9 -1.6 NA Gross National Savings (% of GDP) Germany 23.8 23.5 24.3 25.7 24.6 22.8 France 20.1 20.0 21.1 21.7 21.2 20.9 United Kingdom 16.4 16.3 15.8 15.8 15.6 13.7 United States 14.9 14.6 15.4 15.6 14.4 15.4 Japan 32.0 32.6 33.9 34.3 34.6 35.0

Source: IMF, International Financial Statistics, March 1993; OECD, OECD Economic Outlook, December 1992; and Bundesbank, Reuters Economic File.

aGDP and export data are seasonally adjusted at annual rates.

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793-033 Germany in the 1990s: Managing Reunification

Exhibit 8 Inflation Rates for Select EMS Nations

-5

19 79

19 80

19 81

19 82

19 83

19 84

19 85

19 86

19 87

19 88

19 89

19 90

19 91

In fla

tio n

R at

Germany France Italy EMS 8

Source: Figures based on data from K. Froot and K. Rogoff, “The EMS, the EMU and the Transition to a Common Currency,” NBER Macroeconomics Annual 1991. Additional data from IMF, International Financial Statistics.

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Germany in the 1990s: Managing Reunification 793-033

Exhibit 9 Economic and Labor Market Statistics, Eastern Germany

1/89 1/90 1/91 1/92 Economy GDP, 1991 DM billiona 149.1 150.1 85.0 92.8 Annual % change na 0.7% -43.0% 9.2% Private consumption/GDP 55.0% 55.0% 99.8% 99.1% Government consumption/GDP 26.0 29.5 45.2 45.9 Investment/GDP 19.0 19.1 46.8 55.5 Net exports/GDP -3.0 -2.5 -87.0 -96.2 Value added/GDP in . . .

manufacturing 30.6% 28.2% 17.2% 18.8% services 14.4 14.9 25.5 28.1 government 15.0 17.9 26.2 22.8

Labor (thousands)b Migration to West Germany 49 257 102 94 Commuting to West Germany na na 446 451 Total employment 9,932 9,130 7,369 6,354 Treuhand firm employment 0 4,000 2,115 1,070 Unemployment rate (%) na 1.6% 9.5% 14.2% Employed in labor market measuresc (%) na na 22.0% 21.0% Shortfall of “regular” employment (%) na na 31.5% 35.2%

Source: EC, Employment Observatory East Germany, No. 10, February 1994.

aSemiannual figures seasonally adjusted at annual rate. bThe working-age population in January 1989 was 10,721,000. cIncludes job creation measures, retraining, short-time, and early retirement.

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793-033 Germany in the 1990s: Managing Reunification

Exhibit 10 Western German Financial Transfers to Eastern Germany (billions of current DM)

1991 Financial transfers to regional and local authorities 108.3

German unity fund 35.0 Unification-related federal expenditures 59.2 VAT revenue sharing of state governments 10.8 Transfers from state governments 2.0 Unification-related Western Germany revenue losses 1.3

Financial transfers to social insurance funds 20.9 Total budgetary financial transfers 129.2 Borrowing by the Treuhandanstalt (nonbudgetary) 19.9 Effective financial transfers 150.1 (as percentage of GDP) 5.8%

Source: Data from German Institute for Economic Research, Five Research Institutes Report, 1994.

Exhibit 11 West German Public Debt and Deficit, by Branch of Government (billions of current DM)

Public Deficit Total Of Which: Debt as as % of Public Special % of GDP GDP Deficita Federal State Local Fundsb 1989 41.6% 0.6% 12.6 20.0 7.8 2.1 1.1 1990 43.6% 2.2% 52.5 23.9 19.5 3.8 22.2 1991 44.8% 4.4% 114.7 53.2 29.5 3.6 36.6

Source: Statistisches Bundesamt, Statistical Yearbook for Germany, various issues.

aSocial insurance surplus or deficit included in total. bThese include European Community funds and funds for German unity.

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Germany in the 1990s: Managing Reunification 793-033

Exhibit 12 Real Unit Labor Costsa

aCompensation of employees adjusted for share of self-employed in occupied population per unit of GDP.

Exhibit 13 Hourly Labor Costs in Manufacturing for OECD Countries (1991)

Source: Institute on the German Economy, Cologne.

*Includes: health care, pensions, and workers compensation.

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793-033 Germany in the 1990s: Managing Reunification

Exhibit 14 Exchange Rate Pressures, July 10, 1992

European Monetary System: Sterling begins the week firmly at the bottom of the grid after dropping 2-1/4 pfennigs against the D-Mark last week. The pound’s weakness is underlined by the 1.51 percentage point differential that separates it from the Italian lira, the next-weakest currency. The Portuguese escudo remains the strongest currency, despite indications by the Bank of Portugal last week that it intends to soften interest rates.

The chart shows the member currencies of the exchange rate mechanism measured against the weakest currency in the EMS’s narrow 2.25 per cent fluctuation band. In practice, currencies in the EMS narrow band cannot rise more than 2.25 per cent from the weakest currency in that part of the system. Sterling and the Spanish peseta operate with 6 per cent fluctuation bands.

Source: Financial Times, July 13, 1992.

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