The German economy outpaces its neighbours in the eurozone showing that - despite a painful, tortuous process - 20 years after reunification the country has recovered from the heavy financial burden of reconstruction in the east. Rodrigo Amaral reports.

After posting spectacular rates of growth in the first half of the year, Germany has become the eurozone’s best hope of economic recovery. It is hard to imagine that, not long ago, the German economy was more like a ball and chain hindering the progress of its European partners.

Throughout the 1990s and for much of the noughties, Germany was an economic laggard that failed to take advantage of a strong global environment. And the main culprit for underperformance was an event that, at the time, was hailed as an historic victory for the German people: the reunification of the country after a tragic 40-year division.

Two decades on, the unified Germany is a stable state that asserts itself on the global stage. Its economic prowess should not hide the fact, however, that there is still plenty of work to do to achieve complete unification in the economic arena too.

”Roads, buildings, machinery and other essential things had been more or less worthless”

The case for political reunification was not a difficult one to make. The partition of Germany was instigated by the winners of the second world war, which was later exacerbated by the tensions of the Cold War. Families and friends were kept apart as the communist East was gradually separated from the West. But the argument for bringing the six eastern Länder (states) into the same economic and monetary framework of their 10 western counterparts was less clear.

East Germany, known as the German Democratic Republic (GDR), was an economic powerhouse by the standards of the Iron Curtain, but in absolute terms that was not saying much. When the communist bloc fell apart, it became evident that the GDR was a backward and unproductive region, contrasting unfavourably with the world-beating West German export machine. (article continues below)

Experts warned at the time that the prompt economic integration of the East would be a difficult task that was likely to cause much harm to the former communist region. Twenty years have passed since Germany was officially reunified on October 3, 1990, and the eastern side still has to catch up with the west. But Chancellor Helmut Kohl decided to proceed with the economic and monetary union despite widespread opposition. Kohl argued that East Germans were strongly attracted by the prospect of being part of the West’s economic miracle. A placard that proliferated in demonstrations as the GDR crumbled stated bluntly: “If the Deutschmark comes, we stay, if it doesn’t, we’ll go to it.” That the decision was more political than economic can be surmised from a statement by Theo Waigel, who was by then West Germany’s finance minister. He said then that it was necessary “to give the people of the GDR a clear sign of hope”.

And hope was what East Germans badly needed. Hans Modrow, the head of the GDR’s Council of Ministers right before reunification, lament­ed that the economy of the country was “finished” and “there was no longer a way out” for it. Even so, the extent of East Germany’s economic malaise stunned many people. “After 40 years of communism, East Germany’s capital stock was in ruins,” says Johannes Mueller, the chief economist at DWS in Frankfurt. “Roads, buildings, machinery and other essential things had been more or less worthless.”

Germany’s federal government has invested heavily in reconstruction in the East during the past two decades. According to Udo Ludwig, from the Halle Institute for Economic Research, the amount of transfers of money to the six former communist Länder reached more than €1.2 trillion (£1 trillion), most of which was spent in the 1990s. By imposing a heavy burden on the state budget, they greatly contributed to a slowdown in the economy in that decade. “Transfers to the East represented a heavy load for the German economy in the 1990s,” Ludwig says. “But it has adapted to the situation.”

”Transfers to the east represented a heavy load for the German economy in the 1990s”

Despite the apparent largesse of the west, many east Germans resent the whole process. Recently Matthias Platzeck, the governor of Brandenburg, one of the former communist Länder, expressed the feelings of many of his fellow citizens by saying that the integration had been an annexation of the GDR by the West.

The inflammatory words sounded even more shocking as Platzeck employed the word “Anschluss”, which invokes the Nazi era, to describe the whole process. “I don’t know what there is to celebrate,” he told Der Spiegel, a weekly magazine. His views are shared by many. In 2009, a survey found that fewer than half of east Germans consider that they have better standards of living than before reunification. And many of them say they are second-class citizens in the unified Germany. East Germans are more likely to be out of a job and earn lower incomes than their peers in the west. They have also been voting with their feet. It is estimated that more than 2.6m have moved west in the past two decades, and up to 50,000 continue to take the same route every year.

Nostalgia for the GDR way of life, has been much in vogue and the real grievances of easterners should not be taken lightly. But the numbers tell of a more nuanced story, one where Germans from the east have had a tough time to reach the living standards of their western cousins, but are gradually achieving them. The fact that many people take basic improvements for granted could be blurring the memory of how hard it was to face the day under communist rule.

Consumption is an inadequate measure of living standards, but some numbers can give a good idea of the progress made in the past 20 years. For instance, in 1993, only 49% of easterners enjoyed the benefits of a landline telephone, while in 2007 the proportion had reached 96%. Only 15% had a microwave oven and 3% benefited from a dishwasher at home three years after the reunification. Now 68% of east Germans can cook a ready meal in fewer than 10 minutes, and 54% do not even need to wet their hands to wash the dishes afterwards. And that is without even considering the poor quality of Eastern Bloc consumer goods. While people in East Berlin had to endure cranky Trabants that belched more fumes than a chain-smoking character from the Mad Men television series, their western cousins were enjoying quality brands such as BMW, Mercedes-Benz and Volkswagen.

Data also suggests east Germans are closer to the West than they were during the communist era. Michael C Burda, from Humboldt University in Berlin, points out in a paper that average consumption per head in the east today amounts to about 85% of the levels in the west. That is roughly equivalent to the inequalities prevailing in the western half alone, where consumption levels are higher in the richer south than in the north, he points out. In another paper, Tilman Brück, also from the Humboldt University, and Heiko Peters, from the German Council of Economic Experts, concluded that the negative income gap between the two halves of the country narrowed from 33% in 1993 to 22% in 2002. Although it had risen again to 26% by 2007, such numbers are evidence that some convergence has taken place in the past 20 years.

The gargantuan investments made in the former communist regions are also beginning to revive a local production sector, according to the experts. In the long run, that is prob-ably the good news that east Germans need to hear. Their higher ability to consume was a consequence of transfers of money to households that, according to Ludwig, represented about €1 out of every €3 sent to the east in the past 20 years.

”There is still a lack of certain kinds of capital, mostly intangible, like R&D activities and human skills”

But sustained employment creation and economic growth has always been more likely to come from the development of viable industrial and service sectors that can generate wealth in the region. The task of establishing an efficient production base in the eastern Länder after reunification was difficult. Economists pointed out that four-fifths of the GDR industries would go out of business once they had to adopt the Deutschmark and the competitive traits that such a strong currency entailed. The result of the exercise was the comprehensive devastation of the industry base in the east. In addition to higher costs derived from the new currency and stricter labour standards, they also lost its captive markets in a soviet bloc that was fast disintegrating.

“For the eastern part, the reunification meant a dramatic cutback, as GDP shrunk very strongly,” Ludwig says. “It was a long way before it could start growing again.” But the investments have paid off as the region posted average rates of growth of 2.7% a year, and 3.7% if Berlin is excluded, from 1992 to 2008, while the west posted a meagre 1.5% growth rate. Burda notes in his study that “the deindustrialisation of the east has been stopped and reversed to a surprising extent.” Real growth rates in the manufacturing sector, he notes, have reached 8.1% a year since 1992, if Berlin is not included.

“An industrial infrastructure is taking shape in east Germany,” says Mueller. “It took longer than expected, but things are happening there.” The German government has revealed that high-tech clusters in industries such as renewable energies, security, microelectronics and optical technologies have already taken root in the region. Companies such as Volkswagen have also set up units there to take advantage of more flexible operating conditions and tax incentives offered by the state. Employment has improved as a result of the progress, and the region has created jobs faster than the west. Mueller notes that, by 2005, unemployment was close to 20% in the former GDR, compared with about 10% in the rest of the country. Since then, the rates have fallen to less than 12% and 6.5% respectively.

However, the rate of unemployment should not be interpreted without taking into account that the workforce in east Germany has dwindled owing to mass migration to the west of the country. The Brück and Peters study points out that underemployment in the region doubles the levels in the rest of the country. The authors also discovered that the younger east Germans are, the lower their income. This looks like an aberration because older workers are, at least in theory, less well prepared, as they had to go through the communist education system, while their younger peers have enjoyed the improved standards post-unification. According to the authors, the phenomenon suggests that young and skilled easterners still find plenty of reason to vote with their feet. That 20 years of massive investments have not reversed that trend should give pause to policymakers in both sides of the country.

A brain drain looks especially damaging as one of the challenges faced by the east is to reinvent itself as an innovation centre where big companies, from Germany and abroad, will be eager to set up shop. They have a long way to go. A study by Deutsche Bank Research has concluded that four out of the five eastern Länder (Berlin is excluded as most of it was part of West Germany during the Cold War) have a poor record of innovation. Meanwhile, their 10 counterparts in the west are performing well. Only one of the states in the east, Saxony, is making “very strong” progress in this area.

Labour productivity is another concern. East German workers are only 79% as productive as their western comrades. Although huge progress has been made since 1991, when the ratio was 45%, much more needs to be done. Worse, there is a sense that it will be harder to bridge the productivity gap, as the ratio has hardly changed since 2001. “The east German economy is still in general less productive than the west,” Burda says. “Despite the investment and the modernisation, there is still a lack of certain kinds of capital, mostly intangible, like R&D activities and human skills in areas like leadership and management.” An eastwards migration of corporate headquarters would signal that the productivity barrier has been breached, Burda points out.

Ludwig says that plenty more investments would be needed to carry on boosting the regional economy, but they are unlikely to occur in the current political climate. With the federal government favouring austerity at home and abroad, not even the fact that Angela Merkel is the first chancellor born in the GDR will change this situation. “To promote large investments to help the east to catch up is not a reachable target for politicians any more,” Ludwig says.

”The corporate sector has benefited from the reunification”

Maybe this is understandable. West Germans may be suffering from transfer fatigue after the €1.2 trillion redirection of resources. But it could prove short-sighted too. Ludwig notes that the western economy has benefited from the whole process too. He and his colleagues from the Halle Institute have estimated that three out of every four euros transferred to the east by the government ended up in the coffers of western companies, as consumers rushed to buy the goods they manufacture and their technical expertise was called up to help rebuild the shattered communist infrastructure.

“The corporate sector has benefited from the reunification,” Mueller points out. “Now they have access to a larger market and in some cases have been able to move production units to the east, taking advantage from the tax benefits offered.”

The reunification has brought some unexpected benefits to the German economy too. The sluggish 1990s forced lower wages on workers. By not seeing their incomes grow and feeling less secure, households restrained their consumption and refrained from borrowing money to fund a better way of life, as Americans, Britons, Irish and Spaniards did. When the global financial crisis struck, debt was not a burden for Germany as it was in other developed economies. And wages were not a hurdle for the country’s export sector to recover its vigour when the global economy took off. The German economy was badly hit by the economic downturn, shrinking by 4.9% last year, but was able to recover swiftly when other parts of the world began to grow again.

The eastern region has also helped Germany’s labour market to be more flexible, as Brück and Peters point out. At first, the powerful western-based trades unions opposed wage cuts in the region following conversion to D-marks, as they feared competition from lower-paid eastern workers. A hike in unemployment followed, which weakened the power of unions in the east. Companies in the region later grew tired of the costs created by the collective bargaining system that has characterised German labour markets in the post-war era and began to negotiate salaries with workers themselves. As a result, labour costs have fallen significantly, creating a competitive advantage for the local industry. “The labour force is apparently more co-operative in the east, but that’s happening in the west too, so it’s a spillover effect,” Burda remarks.

The former GDR can also play an important part as Germany adapts its economic model to the new order that is emerging from the global crisis. The gloomy prospects of eurozone countries that provide the main export markets for the country have highlighted the relevance of emerging economies like China, India and Brazil for the capital goods and other articles in which German firms excel.

”Domestic demand will recover, contributing to rebalance the economy of the eurozone”

Another source of export growth comes from the east, as former communist countries such as Poland, Slovakia and the Czech Republic have developed fast during the past decade. German firms have invested heavily in those economies, and they have responded by becoming more reliant on German products and technology. Burda does not dismiss the possibility that the growing prosperity of eastern Europe will have a more direct impact on the former GDR. “This may be the ultimate triumph of economics over nationalism when east Germany begins to benefit from inward foreign investment by Polish and Czech firms,” he writes in his study.

At the moment the west benefits from the export-­led boom that Germany is enjoying: the 2.2% GDP growth achieved between April and June this year was the best quarterly performance posted by the country since reunification. But Ludwig says that the eastern Länder need to invest more in the development of technology and human capital if it wants to eat a larger slice of the cake. Things could improve if the country reduces its dependence on exports by boosting domestic consumption, creating more demand for consumer goods produced in the lower-cost east.

For outsiders, that could sound unlikely in a land renowned for its thriftiness. But Mueller refutes this stereotypical view. “German households are not natural savers,” he says. “They spend what they earn. But for a long time their incomes stagnated, they were not expanding consumption spending.” He says that, with economic growth back to strength, wages should start to rise. “Domestic demand will recover, contributing to rebalance the economy of the eurozone,” he adds.

A more confident Germany has also finally emerged from the reunification process, experts say. At the beginning, the economic underperformance of the 1990s dented the influence of the country within the European Union. But as the economy seems to be strongly back on track, Germany has shown an increasing assertiveness by urging its eurozone partners to show fiscal responsibility and by announcing a set of austerity measures, even though there was strong pressure from elsewhere for it to do otherwise.

“At least behind the scenes, Germany has been trying to convince other eurozone countries to reform,” Burda notes. That looks wise: even though Asian markets have compensated for lower demand from the eurozone, a crisis in a country like Greece, Ireland or Portugal would surely have dreadful consequences for the eastern and western halves of Germany alike.