Sinn-Chapter 2 - German Unification PDF

# International Implications of German Unification ## Introduction * German unification has not only been an internal affair * It has accelerated the unification of Europe * It's economic consequences have severely affected the rest of Europe, if not the rest of the world. * Acceleration of Europ...

# International Implications of German Unification ## Introduction * German unification has not only been an internal affair * It has accelerated the unification of Europe * It's economic consequences have severely affected the rest of Europe, if not the rest of the world. * Acceleration of European unification has occurred because of the widely held belief that only a close integration of Germany into the European Community would make it possible to control and influence its economic power * The opposite view that European integration was a German trick aimed at controlling the rest of Europe, was rejected by most. ## Implications of German Unification ### Sinn * Germany had to buy the consent of France by sacrificing the deutsche mark (DM) * The unification of Germany has swept away the political barriers to a European currency union * It has created economic obstacles to a union * Germany has been soaking up resources from all over the world to feed the eastern Germans * Germany and it’s trading partners were affected by this * The German unification shock compares with the shock created by Regan’s policies and its impacts on interest rates, exchange rates, and the performance of the European Monetary System (EMS). ### Thirsty as a Giant * Though Germany is the largest country in the European Community (EC), it is not a giant. * The population is 80% larger, and China would make almost 15 Germanies. * Germany is however as thirsty as a giant, because eastern Germany absorbs far more resources than it produces * The rate of absorption has more than doubled and is still about 50% larger than the eastern German gross domestic product (GDP) * The eastern German economy absorbed DM 235 billion more in terms of consumption, investment, and public expenditure on goods and services than it produced. * About 1/3 of the excess absorption stemmed from private capital imports into the eastern German economy, with 2/3 being public transfers, primarily for unemployment benefits, pensions, and public infrastructure investment. * The total amount of public funds pumped into the eastern German economy in the first 6 years is DM 800 billion. * The funds include the deficit of the Treuhandanstalt. ### Excess absorption of German Unification * East Germans were promised the West German living standard, but the naive belief that the promise could be kept simply by raising eastern German wages to the western level has led to the virtual destruction of the eastern German manufacturing industry. * Four out of five jobs that were available in manufacturing before unification have disappeared. * Manufacturing output has declined by 2/3 and is recouping only gradually. * Most of the public funds involved in the transfers have been borrowed by the German government ## The Revaluation of the Deutsche Mark and the European Currency Crisis * The unification of Germany was a shock to the EMS, and it caused a crisis. * The high public and private demands for capital increased German interest rates relative to those in other countries, increased the deutsche mark’s attractiveness as an Investment currency, and created strong appreciation pressure. * The EMS was only temporarily able to prevent this influx of capital. * The EMS broke down, and the deutsche mark was free to revalue. * In the first quarter of 1995, the real exchange rate of the deutsche mark had returned to the OECD PPP value * The rate for the EMS countries was only slightly overvalued by 4% by April 1997, the time this study was updated. ## Implications for the Maastricht Treaty * On January 1, 1999, the Bundesbank will have lost its sovereignty, and the deutsche mark will no longer be a separate currency. * It will be only a subunit of the "euro," just as a pfennig is a subunit of the deutsche mark * The destinations of the other currencies joining the EMS will be similar * It is clear that Germany and France will not be able to keep out many of the other countries that violate the Maastricht criteria * In nearly all cases, it will be necessary to stretch article 104c of the Treaty in order to make membership possible. ## Alternative Explanations for the Currency Crisis * The unification shock is an obvious explanation for the EMS crisis and the subsequent revaluation of the deutsche mark. * Another explanation is popular among many German politicians and uses the revaluation of the deutsche mark as proof of Germany’s strength, of the soundness of its economic policy, and of the confidence of international investors. * Germany’s economic policy after unification has not been sound * Germany’s debt ratio and failure to meet the Maastricht criterion do not provide a basis for confidence in the strength of the German economy or in German economic policy. * Another possible explanation for the revaluation is that the German inflation rate is apparently low. * The excess of foreign inflation over German inflation built up a revaluation potential for the deutsche mark. * There is no tendency for the value of the deutsche mark to fall below the OECD PPP that might justify a revaluation ## Implications of German Unification * The exchange rates must be frozen at a level that would be appropriate for the current need to pump resources into Germany, but not appropriate for a more normal future when Germany's need for resources has been quenched. * Adjusting the exchange rates can occur only through diverging inflation rates or diverging deflation rates. * Either a deflation in Germany or an inflation in other European countries would be necessary to balance the trade flows. ## German Currency Union as a Warning for Europe * The former president of the Bundesbank, Karl Otto Pöhl, warned the European Parliament not to agree to a currency union because “it would be a disaster” as, he felt, the German currency was. * He was right about the German currency union, but wrong about the European one. * The similarity between the two currency unions is very limited. * A major reason that the German currency union turned out to be disastrous for eastern German industry was that it was combined with a real revaluation of the eastern German price level. * Before unification, a big hole in the iron curtain always existed for the purpose of active intra-German trade. * All prices and wages were fixed in numerical terms while debt contracts were cut in half. ## Conclusions for the Maastricht Treaty * The German-unification shock created substantial difficulties for Germany’s trading partners and triggered the crisis of the EMS. * A large number of currencies were undervalued relative to a long-run equilibrium that presumably lies in the neighborhood of PPP values. * Recent revaluations have largely eliminated those deviations * Judged by various PPP criteria, only the Mediterranean currencies seem to need modest revaluations before they can join the EMU. * The way toward a European currency unification is now more open. * There is less concern about the horrors of the kind created by Germany's internal currency unification not being repeated, as European currency unification will not be accompanied by realignment shocks or cross-border wage dictates. ## Real-Exchange-Rate Misalignments - Real-exchange-rate (RER) misalignment refers to a situation in which a country's actual RER deviates from some understanding of an implied “ideal” RER. - An exchange rate is “undervalued” is there is more depreciation than what is understood to be typical, and “overvalued” when it is more appreciated than what is typical. - Misalignments are widely believed to influence economic behavior. - Overvaluation hinders economic growth, and undervaluation provides an environment conducive to growth. - However, the ideal is not explicitly specified so the concepts of RER misalignment remain subjective. - Conceptually, RER is misaligned when it deviates from the underlying RER that would prevail in the absence of price rigidities. - Conceptually, an RER is misaligned when it deviates from the underlying RER that would have prevailed in the absence of price rigidities, frictions, and other short-term factors. - Misalignment uses the notion of an "equilibrium RER." - The theoretical RER that would prevail if the economy were simultaneously in internal and external balance. - Internal balance refers to the economy operating at full employment and at full-capacity output. - External balance refers to a sustainable current-account position given a country’s desired capital position as a net lender or borrower. - RER misalignment can then be defined as the deviation of the actual RER from this equilibrium RER. ## Figure 2.11 - Shows the exchange rates and PPPs for 12 countries. - Exchange rates are defined monthly, and PPPs are defined annually. - The value of a deutsche mark in terms of a foreign currency is shown. - A higher rate means the deutsche mark is strong. #### Caption for figure 2.11 - The exchange rates (monthly) and PPPs (annually) are defined as the value of a deutsche mark in terms of a foreign currency. - A higher rate implies a stronger deutsche mark. - The “German PPP” is based on the German basket, and the “OECD PPP” uses the OECD basket. - Specific country PPPs are based on the respective national baskets. The figures highlight the following countries: - Austria - Belgium - Denmark - Finland - France - Ireland - Italy - Netherlands - Portugal - Spain - Sweden - United Kingdom ## German wages * German wages used to be 7% of West German wages (in terms of deutsche marks); now they are about 70%. * They are much higher now if many Eastern German firms and workers had not rejected the wage decrees of their Western colleagues.