Fiscal stimulus and German unification

by on March 26, 2009 at 7:48 am in History | Permalink

For all the talk about the Great Depression, we are missing one historical analogy for a program of large fiscal stimulus, namely Germany after the Berlin Wall came down.  The two countries united, lots of money was spent and lots of money was borrowed.  West Germany had a modern economy with both manufacturing and services.  At the time Germany had unemployed resources, especially if you count the labor moving from East Germany to West Germany as grossly underemployed and available for higher-return projects. 

The results were less than wonderful.  The higher demand boosted measured gdp growth in the short run (bananas and porn, plus reconstruction) but Germany fell into economic stagnation.  The new demands took the West German economy only so far.  The higher taxes and debt then kept the German economy down for many years.  Few Germans were happy with the economic fallout from this "stimulus."  And that was with a relatively well-functioning financial system and a reasonable amount of initial optimism.

You can list many dissimilarities between German unification and the current U.S. situation (and in the comments I am sure you will).  Still, as historical examples go, I believe this one has some relevance.  When European leaders are skeptical about fiscal stimulus, they have some reasons, some of them quite recent.

If you'd like a lengthy account of the economics of that period, along with lots of numbers, try this study.  Just read through the first few pages, you'll see statements like:

Economic theory suggests that a fiscal expansion financed by distortionary taxation could potentially generate substantial adverse growth effects after the initial positive demand stimulus dies down.

It is then estimated that the negative economic impact from the German stimulus may explain up to one third of the subsequent growth gap between Germany and comparable European nations.

Addendum: Don't be fooled by the topic-shifting comments on why East Germany didn't do better; this post is about how West Germany fared from so much stimulus.  Not so great.

1 MichaelG March 26, 2009 at 7:52 am

Actually, since no one really seems to know what to do about this, I’d be happy to see different regions take different approaches. Then if one region seems to be dealing with it better, others can learn from that example.

2 Dan Kärreman March 26, 2009 at 8:41 am

Hmm, I’m no expert on German unification but I seem to remember that the major sticking point at the time was how to convert the DDR currency to D-mark. If I remember correctly Kohl found it expedient to convert it at a frankly idiotic rate, thus dooming the manufacturing industry in East Germany and pricing out East Germany as a place for German industry, and other investors, to invest (the German car industry, for example, has invested more in Hungary and the Czech Republic, than in former DDR). So if we are thinking of a stimulus that are going to pay ridiculous amounts of money to workers in dying industries, then Unification probably shows that this is a bad idea. If you think that Wall Street is a dying industry, then the bailout would probably qualify as analogous to Unification. Otherwise, I’m hard pressed to see any relevant lessons for today.

3 Andrew March 26, 2009 at 8:56 am

Konstantin,

Isn’t it only insufficient capacity utilization in the sense that we aren’t producing what we were before? What if people don’t want what was produced before? Then, to push old products at the expense of new would be crowding out, no?

As political evidence, any lesson from other countries is going to be a hard sell. But, as a case study, that is an awesome example. Imagine trying to do such as a controlled experiment. Why would anyone waste time looking for dissimilarities?!?

I wonder how much the Germans thought that Easterners deserved economic equality from the get-go because they were denied it through no fault of their own. It seems any major upheaval is an opportunity for asinine policy. As Rahm Emanuel says “a crisis is a terrible thing to waste.”

4 ned March 26, 2009 at 9:19 am

I have travelled extensively throughout Germany, including the eastern part (former DDR) in the decade following reunification. The German government in Bonn (and later Berlin) poured money into the East. The results? A stunningly beautiful infrastructure, but little real economic growth. I rode sleek, high-speed trains over smooth new track through decrepit villages full of abandoned houses and factories. I drove on the autobahns past abandoned farms and decaying towns. Many of the residents of eastern germany have moved to the west, where the jobs are.

5 Phil P March 26, 2009 at 9:28 am

A brief quotation from The European Economy Since 1945 by Barry Eichengreen (pp. 320-1).

“From 1992 though 1994, the eastern Lander grew at an average annual rate of 9 percent, encouraging comparisons with the post-WW II Wirtschaftwunder. The reorganization of production, backed by new investment, raised gross value added per employee from barely 40% of the W. German levels at the beginning of the transition to nearly 70% by mid-decade. But growth declined to 5% in 1995, 4% in 1996, and 2% in 1997. Growth in the eastern Lander then average just 1.4% between 1996 and 2003, below the 2.3% of Germany’s West. … the key factor in the disappointing recovery was the evolution of labor costs…In effect, W. German unions and employers were allowed to set East German wages. Seeking to defend western jobs against low-wage competition from foreign firms interested in setting up in the ruins of the East, they advocated a policy of rapid wage adjustment toward western levels.”

You know, I’m a great fan of Tyler’s but it bugs me when economists outside the academic setting feel at liberty to engage in this kind of superficial argument. You can’t just say, “they did fiscal stimulus, see what happened† without controlling for all the relevant factors. Imagine if they did physics experiments of medical studies that way!

6 Ali March 26, 2009 at 9:52 am

Phil P and Dan Karreman nail it. East German workers were subject to West German wage bargaining (therefore minimum wages out of all proportion to their productivity), at the same time as premature currency union caused real appreciation in the East German currency. Taken together, these policies prevented East German workers from competing with their (more productive) West German counterparts in the way normal economic theory would suggest (price). Fiscal stimulus was bound to be ineffective when East German labour was so utterly mispriced. See e.g. http://www.ifw-members.ifw-kiel.de/publications/minimum-wages-and-employment-the-case-of-german-unification/kap1045.pdf
Helmut Kohl saw a political/moral imperative (East German workers must have the same rights as West German ones), and ignored the economic consequences. The result was stagnation.
As with Phil P, I’m a big fan of Tyler – but pretty sure he’s off base here…

7 Braden March 26, 2009 at 10:36 am

Rather than poke at the analogy, I would say we’re more like East Germany than most people realize. I’ve been to East Germany, and I happen to live in a Rust Belt town (Syracuse, NY) and the problems that afflict both areas are remarkably similar. The biggest issue is that economists often assume that structural adjustments occur relatively quickly, and that individuals that are displaced through structural unemployment rationally adjust to the circumstances and either move to another area where jobs are more plentiful, or accept another job at a lower wage (or both). In reality, unemployment and the attendant social problems linger for a painfully long time, making the city less attractive to alternative industries that might find the existing industrial infrastructure attractive.

Since our current unemployment figures appear to reflect an ongoing structural adjustment away from manufacturing and construction, we need to recognize that we’re on the cusp of another generational decline in real income for America’s lower middle class. Germany managed to weather the storm fairly well by propping up East Germany industry, despite heavy losses. Will we make the same decision? If not, what will we look like when individuals with a high school diploma are only able to find employment in low-paying service sector jobs? My guess is that we’ll look a lot less affluent than Germany is today.

8 Ali March 26, 2009 at 11:07 am

Entertaining ‘gotcha’ from John Pertz 🙂
That said, there’s nothing inconsistent about believing:
(i) wages should (and ultimately will) reflect marginal productivity (whether unions like it or not)
(ii) government spending can be an important source of demand when productive factors are underemployed
(iii) fiscal stimulus will have a dramatically smaller impact if the labour market is forced out of equilibrium by artificial wage floors – which is exactly what happened in East Germany after unification.

Picture two scenarios for (say) China, during the current crisis.
Scenario 1 – the Chinese government introduces a massive fiscal stimulus
Scenario 2 – the Chinese government introduces a massive fiscal stimulus and simultaneously introduces a $20/hour real minimum wage.

Now is Scenario 2 a fair template for evaluating the effectiveness of fiscal stimulus? Hardly. We’d expect the wildly unrealistic minimum wage (which would destroy millions of jobs) to swamp any stimulus effect. Pointing to the resulting unemployment and saying ‘aha, fiscal stimulus was tried, and failed’ doesn’t make for a compelling economic case. Ceteris just ain’t paribus, which is why I’m not at all convinced by Tyler’s analogy…

9 Colin March 26, 2009 at 11:30 am

There definitely some interesting parallels here. Spending on infrastructure to promote growth? Check. Promotion of clean energy investments as the economy of the future? Check. (http://www.nytimes.com/2008/05/16/business/worldbusiness/16solar.html?ref=business) Increase in taxes to pay for it? Check. (Germany had a 7.5 reunification tax)

And yes, the analogy does suffer to a large extent because of the labor issue — East German workers priced themselves out of the market. Well, we’re headed in that direction too with the Employee Free Choice Act that will boost our own labor costs.

For further reading on the reunification topic I would recommend this article from Der Spiegel:

http://www.spiegel.de/international/spiegel/0,1518,373639-2,00.html

And check out this graph:

http://www.spiegel.de/international/spiegel/0,1518,grossbild-515451-373639,00.html

10 Barkley Rosser March 26, 2009 at 12:09 pm

Tyler,

And the spending was not in West Germany; it was in East Germany. There is
the answer to your question.

11 Bob Knaus March 26, 2009 at 12:28 pm

Tyler, I re-read the post carefully. In the second paragraph, dealing with the results of reunification, you mention “Germany”, “West Germany”, “German”, and “Germans”.

So which is it? Are you talking about the costs and benefits of the reunification/stimulus to Germany as a whole? Or only to West Germany?

You could say the Apollo Program was a stimulus failure, if you look at the economy of Iowa during the 1960s. Or a huge success, if you look at the economy of central Florida during the same time.

12 Nathan Smith March 26, 2009 at 2:31 pm

Keynesians always have a way of dodging any apparent empirical refutation of their theory. Ultimately Keynesianism is unscientific in the Popperian sense: it is too vague ever to be falsified. To the extent that it could be falsified, it was falsified by the 1970s stagflation. But no natural experiment can ever really exhaust the Keynesian dodges.

assman is right. The burden of proof is on the Keynesians, and they can’t discharge that burden.

13 Thomas March 26, 2009 at 3:02 pm

Or to say it in much simpler words:

German unification involved giving money to somebody else without getting anything in return (apart from a “demand stimulus” and feeling good about helping your fellow countrymen).

A stimulus in the current situation involves spending money on yourself. Maybe not money perfectly well spent, but it’s still spent on the same people that are paying for it, and it either increases their utility (via consumption) or there future production capabilities (via infrastructure, human capital, production subsidies,etc).

You cannot compare the two.

14 Barkley Rosser March 26, 2009 at 3:20 pm

Nathan Smith,

In the chapter of the General Theory by Keynes (10) that Tyler discussed
most recently, Keynes made it quite clear that expansions of public works
spending (aka “fiscal stimulus”) in a fully employed economy is likely to
result in inflation. So, in what sense does the stagflation of the 1970s
“falsify” Keynesianism?

Thomas,

A lot of the demand stimulus flowed elsewhere. When East Germans stopped
buying their own Trabants, many of them shifted to Toyotas rather than VWs.

15 andthenyoufall March 26, 2009 at 5:44 pm

The status of East Germany really *is* essential. First, it was not West Germany that stagnated after reunification, it was Germany as a whole. Germany as a whole need to pay for the reconstruction of and welfare payments to East Germany, which had been systematically abused for economic and political reasons by the USSR for forty years. Naturally the tax base for this had to come from a very narrow part of the country, since there wasn’t much to tax in East Germany.

And remember, stimulus financed by tax hikes is not stimulus! Budgets can balance (or not) over the macroeconomic cycle rather than year to year. The goal of reconstructing East Germany was not stimulus, it was not carried out in a way or to a degree that would maximize a stimulus, and it’s success or failure was not to be judged by how stimulating it was. It’s as though we hiked taxes by 10% across the board to finance massive aid for Africa, and then judged stimulus in general by whether the economy grew.

16 M.G. in Progress March 27, 2009 at 4:49 am

Excellent. Try to explain that to Prof. Krugman! When Germans accuse somebody of “crass Keynesianism” they know what they are talking about! It’s not just what you read about Great Depression in books that themselves are written by somebody else. And let’s stop to ask somebody else to “make it bigger”…

17 Michael Gibson March 27, 2009 at 6:38 pm

Tyler, I wonder if you would comment on Fidel Castro’s policy choices after the Soviet Union fell. I believe the Soviets cancelled a $6 billion annual subsidy to our man in Havana. I’ve read the Cuban economy contracted 35 percent between 1989 to 1994. In response, Fidel instituted a set of policies called “The Special Period in the Time of Peace.”

Would Keynesian recommendations apply for those years in Cuba as well?

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