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American Economic Association Factor Reallocation in Eastern Germany after Reunification Author(s): Michael C. Burda Reviewed work(s): Source: The American Economic Review, Vol. 96, No. 2 (May, 2006), pp. 368-374 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/30034675 . Accessed: 01/12/2011 14:31 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected] American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review. http://www.jstor.org GERMANREUNIFICATION: LESSONSAND LEGACYt FactorReallocationin EasternGermanyafterReunification By MICHAELC. BURDA* Fifteen years afterreunification,the economy of the former East Germany is on the mend. Industrial production excluding construction has expanded by more than 60 percent since 1995 and by 28 percent since 2000, compared with only about4 percentin West Germany,for the latterperiod. Real GDP has grown 3.5 percent per year since 1991 and 8.2 percent annually in the manufacturingindustryalone. More thanhalf of the measuredlaborproductivitygap and more than a thirdof the GDP per capitagap between East and West have been closed, in considerably less time than predicted by Robert J. Barro (1991). As Table 1 shows, convergence has been impressive on a wide array of indicators, although it has slowed in recent years and remains most difficult in the labor market. Despite this positive news, net migrationcontinues from East to West-about 70,000, or 0.5 percent of the population, per annum since 2000, especially concentratedamong 18- to 25year-olds. At the same time, new physical capital continues to flow into the East--80 to 90 billion euros, or about 20 percent of GDP each year. The reallocation of productionfactors is one of the most impressive aspects of German unification. Since 1991, more than 1.2 trillion euros of new investment (in 1995 prices) was Discussants: Hans-WernerSinn, CES-ifo and University of Munich; Nicola Fuchs-Schiindeln,HarvardUniversity; Claudia Buch, University of Tiibingen. * Faculty of Business and Economics, HumboldtUniversitaitzu Berlin, SpandauerStrasse 1, D-10178 Berlin, Germanyand Centrefor Economic Policy Research(e-mail: [email protected]).This researchwas supported by the Deutsche ForschungsgemeinschaftResearch Center 649 (SFB 649). I thank Olivier Blanchard,Maike Burda, and KurtHelmes for very useful discussions;ClaudiaBuch, Irwin Collier, and Nicola Fuchs-Schiindelnfor their comments; and Dirk Bethmann, Sebastian Braun, and Katrin Rusch for research assistance. 368 spent in the East, yet the workforce of East Germany shrankby roughly 1.2 million, or 15 percent,over the same period;employmentrose in the West by 4.1 percent. As Figure 1 shows, the intensity of factor movement was not constant, but ratherhigh at first, and declining into the 1990s. Migration was greatest in the early 1990s, falling until mid-decade, rising again until 2001, and declining since. In addition, a large fraction (two-thirds)of the cumulatedinvestment flow in Eastern Germany was dedicated to residential and business structures, compared with about one-third in business equipment. The large runup in investment spending on structuresis often blamed on distorted investment incentives, with possible longer-run consequences for the structure of output and factor demands (Hans-WernerSinn and Gerlinde Sinn, 1992). This intensive movement of productionfactors in opposite directionsis difficult to explain as a reaction to disturbances in technology, preferences,or demand.To use Horst Siebert's (1992) terminology,Germanywas hit by a massive integration shock.1 I offer the following definitionof economic integration:the achievement of the efficient productionpatternby two or more geographic regions made possible by their union, measuredat world marketprices.2 The German integration episode presents a unique opportunity to study this form of economic integration and the roles of the relative importance of adjustment costs in determin1 Several mechanisms are associated with economic integration:internalaccumulationof productionfactors in the poorer region, labor mobility from the capital-poorto the capital-richregion, capital mobility to the capital-poorregion, Heckscher-Ohlintradebetween incompletely specialized regions, and technology transfer.In the following, I focus exclusively on factor mobility. 2 See Barry Eichengreen(1990). VOL.96 NO. 2 GERMANREUNIFICATION:LESSONSAND LEGACY 369 TABLE 1-EAST GERMANCONVERGENCE, 1991-2004 (% of West German value) Year Consumption Nominal wages Labor productivity GDP per capita Unemployment rate Nonemployment rate Participation rate 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 74 74 76 78 81 83 82 82 83 83 83 82 83 83 50 65 71 72 74 72 76 76 76 73 74 74 75 75 44 57 67 70 71 72 72 70 71 72 72 73 73 N/A 49 53 60 64 66 67 67 66 66 66 65 66 67 67 170 261 240 224 206 198 206 207 211 233 248 243 236 231 103 112 111 108 106 106 106 107 107 109 110 110 110 109 137 121 111 108 108 106 107 107 106 104 102 102 101 100 Sources: Federal StatisticalOffice, Federal EmploymentOffice, author's calculations. ing the speed of efficient economic integration, as well as the interpretationof regional factor price differentials in the process of dynamic adjustment to a new steady state. The episode can serve as a foil for other integration episodes, such as the European Monetary Union or the recent wave of European Union accessions. Eastand awdVest kIresmtein Gqermay 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 GDP %of I. Elementsof a FormalModelof Factor Mobilityand RegionalIntegration 19f911.9 19 19 193 1l6 1997 199 1999 2100 21 20e2 Year Equipment-West Equipment-East Structures-West Structures-East Fraction ofGerman andPopulation inEast Employment 23,0 22,0 21,0 total 20,0 %of19.0 18,0 17.0 1991199219931994199519961997 1998199920002001200220032004 Year Fraction of employmentin East Fractionof populationin East A. Model Setup Two regions, East (E) and West (W), produce outputYtat time t, employingthe same neoclassical constant returnsproductionfunction, Yt = F(K,, G,, L,), with standardproperties.3Factor inputs consist of two types of capital-equipment (K) employed in productionand structures (G), both used to shelter enterprisesand households-and labor (L). Both types of capital are internationallymobile and depreciateat rates 6K and SG,respectively, with SK> 6G. The world rate of interest is exogenously given at r. In contrast, labor mobility is possible only between the two regions, and with total supply normalizedto 1. The populationof the East is denoted by LE, so under full employment FIGURE 1. INVESTMENT AND EMPLOYMENT IN GERMANY, 1991-2004 Sources: Federal Statistical Office, author's calculations. 3Thatis, FK> 0, FG> O,FL> 0, FKK < , FGG <, F, 0, and det(D2F)= 0. I also assumethatFi > 0 Vi * j. < 370 AEA PAPERSAND PROCEEDINGS assumptionsLw = 1 - LE.4 The model is deterministic,and economic growthis suppressed. Let f(k, g) = F(K, G, L)/L be the intensive form of F with per capita inputs k KIL and = g = GIL. With identical technologies in both regions, static efficiency in regional factor endowmentsis achievedalongthe granddiagonalof a three-dimensionalEdgeworthbox, with dimensions 1, k*, g*, where (k*, g*) is the solutionto fk(k,g) = RK r + 6K andfg(k,g) = RG r + 8G. All points on thatdiagonalare efficientin the sense that the marginalproductof capitalequals the worldinterestrateplus depreciation;the common real wage can be read off the factor price frontier(theresidualoutputaftercapitalis paidits gross marginalproductin competitivefactormarkets). The multiplicityof these allocationshints that an output-or welfare-maximizingtrajectory for the economy will be determinedby factor adjustmentcosts requiredto reachthe steadystate. Capitaladjustmentcosts for both types of capital are assumedto be externaland convex in the net changeof the capitalstock.I also assumeconvex costs of migration. In particular,these costs are borne fully by migrants (there are no externalities).Quadraticforms are chosen for tractability.5 B. Social Planner's Problem Because the economy I consider fulfills the conditionsfor the first and second welfare theorems,a decentralized,competitivemarketequilibrium can replicatethe migrationand investment policies in the East and West chosen by a hypotheticalsocial plannerwho maximizesthe present discountedvalue of nationaloutput(net of migration and investmentcosts).6 I seek functionsof time, t E [0, oo),governinginvestmentin equipment (Ihwand If) and in structures(Jtwand JE)in the West and East, respectively,as well as net to make migrationfrom West to East (Xt) 4I assume full employment throughout.Adding labor supply, search,and unemploymentadd little to the aspects I focus on in this paper. 5 See Andrew B. Abel and Olivier J. Blanchard(1983) and Abel (2001). 6 As long as production and consumption decisions are separableandthe world interestrateis given, there is no loss of generalityin focusing on the productionside. (1) MAY2006 Lw)GW, IW fe-"F(KW, + F(KE,GE,LE)_E _JE _ (E _ K)2 J(J _ 6GG)2 22Xdt G 2 _ as large as possible, subjectto initial conditions (at t = 0) on factor supplies in both regions. Gross and net migration flows are thus equal; negative values of X imply net migration from West to East. The positive parametersti1, tfj, and 0 capturethe intensity of adjustmentcosts. Labor and capital stocks obey the following equations of motion: (2) kI = I - SK' for i = E, W (3) G =J' - SG' for i=E,W (4) LE= -Lw = X,. By assuming that adjustmentof Westerncapital stocks is costless, I shift emphasis to relative adjustmentcosts in the East. These reflect bureaucracyand regulation,conflict over property rights, and the qualityof business-relatedpublic infrastructure. C. Planner's Optimumas MarketEquilibrium Define qE, E, and p as the costate variables corresponding to the constraints (2), (3), and (4). To simplify notation, superscriptsare used to denote regions when argumentsof functions are suppressed;time subscripts are suppressed whenever obvious. Necessary conditions characterizingthe optimal policy are, for all t 0: IE = (qE + K8KE (5) 1)/It, _ jE = (pE 1)/q + 6GGE (6) (7) (8) X= [ll qW= 1 VOL.96 NO. 2 GERMANREUNIFICATION:LESSONSAND LEGACY (9) FW = r + SK = RK (10) F (11) 4E+ F/ (12) pE + = r+ G = RG + K IKE (r + K)qE + G)pE F + 8JGE=(r (13) . + (FEc- Fw) = r/, as well as the equationsof motion(2), (3), and(4). Equations(5), (6), and (7) relate optimalinvestment in the East and migrationto the East as positive and linear functions of their respective shadow prices, which are sufficientstatisticsfor determiningthese activities.The greaterthe associated adjustmentcosts, the lower the respective investmentrates, ceteris paribus. Equations(8) and (9) representoutcomesin the absenceof adjustmentcosts. In the West, the static efficiency conditionobtainscontinuouslywith constantcapital-laborratio k* and structures-laborratio g* defined above. Migrants from the East are equippedupon arrivalwith the same level of capital used by otherWesternresidents,and earnthe Westernwage w = Fw. By assumption, the three-state variables in the model KE, GE, and LE cannot be changed instantaneously;the costate variables q, p, and t representthe marginalgain of moving them 371 to the East, given the economy is on the optimal adjustmentpath. Equations(11), (12), and (13) are arbitragerelations governing these shadow values. When integrated forward from initial values at t, with appropriatetransversalityconditions, qEand pEreflect the presentdiscounted value of presentand futuremarginalproductsof an additionalunit of capitalinstalledin the East. Similarly, the shadow value of a worker in the East, [k, represents the present value of the difference in future marginalproductsof labor between the East and West. Given the initial conditions kw > kEand g' > gE, pt is negative. The model implies a persistent wage gap between East and West which disappearsasymptotically as capital accumulatesin the East and labor migrates to the West. III. SteadyState and Dynamics A. Steady State The economy's steady state is given by constancy of KE, GE, and LE, so qE = 9E = 1, FE = RK,F = iG, and i = 00< F = FW = w. The dynamic propertiesof the linearizedmodel are encoded in the eigenvalues { ,-... , A6) of the 6 x 6 matrixrelatingchanges in the endogenous variables (qEE, p , , KE, GE, LE) to deviations from steady-statevalues: , r+ r2+2(A+ A2-4B) - r2 +2(A2(A + JWA--4B) 61r - Vr2+ --1 . . , 1-r 0, r,tr+ r r2+2(A- I A2-4B) , AZ-4B)] where A = -(lLFEK 0 and B = FjO-(E + +I-j1FGG + --1FE) FE - (Fi)2 + Iq(F KFG - (F~)2 1 FK(FF - (FKL)2> 0. + > For A2 - 4B 2 0, the model has meaningful solutions. By inspection, all eigenvalues are real-valued; three (A2, A3, A4) are always greater than zero, while two (As, A6)are negative. This correspondsto a typical perfect foresight model with saddle-pathstability, plus the importantnovelty of a zero root, implying hysteresis (path dependence). Initial conditions of Easternfactor supplies KE, GE,and LE,as well as the constellation of adjustment costs and other parameters,determinethe system's steady state. In a stochastic version of this model, 372 AEA PAPERSAND PROCEEDINGS temporarydisturbancesto initial factor allocations, such as migration or privatizationpolicies, could have permanent effects on the region's steady-statesize.7 B. The Central Role of AdjustmentCosts The results of the last section establish that adjustmentcosts are a key determinantof the resting point of the economy, since the path taken by the Eastern capital and labor stocks depends on correctly anticipatedfuturepaths of their shadow prices relative to their costs of adjustment.Inspection reveals that the two stable (negative) roots are increasingin the adjustment cost parameters qif, fj,, and <p,so the adjustmentspeed or persistence of the model is determinedby the largest negative eigenvalue, which is increasing in adjustmentcosts. In addition, adjustment costs enter multiplicatively and, thus, amplify each other's effect on persistence. Local concavity of the productionfunction, in contrast, accelerates adjustment. C. Implicationsfor Factor Prices and AdjustmentCosts Adjustmentcosts also have implications for the behavior of observed wages and the rate of return on capital in the integration process. Since factor supplies cannot move instantaneously, the capital-laborratios in the East, kE and gE, will remain below Western levels for some time. Throughoutthis period, wages will be lower and return on capital will be higher. Persistent factor price differentials are consistent with finite factor flows over time, disappearing only in the long run. With competitive factor remuneration,(11), (12), and (13) can be rewrittenas E- (14) (15) Eq RE= RK+ 85K qE RE== RG++5 G (E E 1 (16) wE MAY2006 + r - i. Since p < 0 and 1> 0, wage differentialsare consistent with a persistent wage gap across regions over time (wE < i). Similarly, qE > 1, cf < 0, andpE> 1; PE < 0 alongthe adjustment path,so RK> RKandRE > RG. These theoretical results can thus reconcile finite rates of factor movements with persistentlylower wages and higherratesof returnin EasternGermany. The model lends itself to back-of-theenvelope calculations of adjustment costs as well as shadow values consistent with recent historical experience. Suppose, for example, that r = 0.03 and the average rate of wage convergenceis A over some time period;the historicalrecordof EasternGermanysince 1991 suggests A = 0.07.8 Measuringthe Easternwage in units of the Westernequivalent, 1991 = 0.50. It follows that /-1991 = -5, i.e., the implied value of moving a worker from the East to the West was 500 percentof the annualWestern wage in 1991. According to the GermanFederal Statistical Office, net migrationto Eastern Germany was -165,000 in 1991.9 Using (7) plus the observed net East-West migrationin that year, I can compute the value of 0 consistent with that migrationflow, 5/165,000, or 0.00303 percent of the annual Western wage per person squared. Put in perspective, by 2004, wE = 0.75, so the wage gap had declined to 0.25, implying a shadow value of the marginal migrant of 2.5, or 250 percent, of the Western wage. Using this estimate of 0, the model predicts annual migration of 2.5/(0.0000303) = 82,500, compared with the average of 72,000 over the period 2000-2004 (in fact, net migration in 2004 had declined to -52,000). Net migrationcumulatesto about 1.7 million, or 10 + q)E qE + +E p 7 Blanchardand Lawrence F. Katz (1991) obtain a similar result in a model of regional unemploymentin which mobile labor is the sole productionfactor. 8 With initial condition and steady state wo and w-respectively, this approximation implies wE = woe-as + ii 0. The )e-As for s (1 - e-AS), or w - W = model's true adjustmentspeed will vary over time, (wEo - since both stable eigenvalues jointly determine persistence. For more precise details on calibrationsand implied dynamics, see my working paper (Burda, 2006). 9 Source: Statistisches Bundesamt, "Abwanderungvon Ostnach Westdeutschlandschwdichtsich weiter ab," press release, September28, 2005. VOL.96 NO. 2 GERMANREUNIFICATION:LESSONSAND LEGACY percent, of the initial Eastern Germanpopulation. In a more pessimistic scenario with A = 0.02, the region would lose roughly 3.5 million inhabitants. IV. Conclusion One of the distinctiveaspects of the reunification episode has been a significantreallocationof factorsof production.Germaneconomic integration has been a puzzle, with productionfactors moving in opposite directions,even as outputis rising. Real regional integrationis a macroeconomic process,which may be sufficientlyunique to merit special attention.I characterizeregional integrationas a mobilityrace between factorsof production,which is decidedby costs of moving them, even if these costs are not relevantin the long run.1' Steady-stateproductionhas constant returnsto scale, and agglomerationeffects are excluded a priori.Centralto the analysis are adjustment costs. While much attentionhas been paid to agglomerationeffects, adjustmentcosts associated with moving factors of production acrossspace have generallybeen neglectedin the formal study of economic integration."If at all relevant,these costs must be importantfor the massive redeploymentof labor and capitalassoof Germany.Unlike ciatedwith the reconstruction the economic integrationof the United States, Canada,andMexico,or the EuropeanUnion,German reunificationalso involves significantlabor mobility in addition to capital mobility and internationaltrade. Barriersrelated to language, institutions,and culturein unified Germanyare negligible; convergence of behavior in the past 15 years has been so significant that one can really speak of a common representative agent.12Yet even under these ideal conditions, factor price convergence has been incomplete. 10 Thereis no role for policy underconditionsconsidered here. If externalities arise from migration not reflected in market incentives, there might be a role for subsidizing capital formationin the East (or bribing workers to stay in the East). 11See Peter J. Neary (2001). 12 Recent research by MiriamBeblo et al. (2000), Burda and Jennifer Hunt (2001), and Nicola Fuchs-Schtindeln (2004) suggests convergence in the behaviorof Easternand Western Germansover time. 373 Clearly, there is much more to the reunification episode than factor mobility. The assumption of perfectly competitive factor markets is grossly violated. Table 1 suggests a convergence of labor supply behavior, with East German labor force participation falling from nearly 90 percent in the early 1990s and the West Germanrate rising from under 50 percent to converge to an almost identical value of 60 percent in the early 2000s. The fact that unemployment is higher in the East, despite almost identical participationrates with the West, suggests that labor markets are not functioning properly-not enoughjobs have been createdat current wages, wages are not set at marketclearing levels, or labor and product market rigidities prevent adjustment.Yet one can concede the importance of all these aspects, and still learn a great deal by abstracting from them-especially when what is left is sufficiently interesting. REFERENCES Abel, AndrewB. "Onthe Invarianceof the Rate of Returnto Convex AdjustmentCost." Review of Economic Dynamics, 2002, 5(3), pp. 586-601. Abel, AndrewB. and Blanchard,OlivierJ. "An IntertemporalModel of Saving and Investment."Econometrica,1983, 51(3), pp. 675-92. Barro, Robert J. "Eastern Germany's Long Haul," The Wall Street Journal. New York, May 3, 1991, sect. A, p. 10. Beblo, Miriam; Collier, Irwin L. and Knaus, Thomas. "The Unification Bonus (Malus) in Postwall Eastern Germany." 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