Peter Bofinger

Peter Bofinger, an economist at the Landeszentralbank inBaden-WQrttemberg, Germany, was a visiting scholar at theFederal Reserve Bank of St Louis. Scott Leitz providedresearch assistance.

The German MonetaryUnification (Gmu): ConvertingMarks to DaMarksl

I

JIHE MONETARY and economic unification ofthe East and West German economy is a taskwithout precedent in peacetime economic histo-ry. It not only merges two countries with strong-ly divergent income and productivity levels, butalso unifies two economies with radically dif-ferent economic structures—the German Demo-cratic Republic’s (GDR) centrally planned econo-my and the Federal Republic of Germany’s (FRG)<‘social market economy.” Although conventionalwisdom calls for gradualism in the process ofmonetary and economic unification of capitalisteconomies and in the transition process fromsocialism to a market economy, in the Germancase, these tasks will be accomplished virtuallyovernight.~

The legal basis for the unification process isthe treaty ratified by the East and West German

parliaments on June 21, 1990, which took effecton July 1, 1990. The agreement outlines theprinciples for monetary union, the economicand social community of the two states and thefiscal reform of East Germany.

The arrangements for monetary union, whichinvolved the replacement of the East German“Mark” (M) by the West German “DeutscheMark” (DM), established the rates at which EastGerman financial stocks and flows would beconverted from their Mark values to D-Markvalues. A 1M:1DM rate was applied to East Ger-man wages, salaries, rents, leases and pensions.Savings accounts of GDR citizens were con-verted at a IM:1DM rate up to a limit of M4,000 (approximately $2,425 at the currentDM/$ exchange rate) for persons between 15

and 59 years of age. The corresponding limit

lAt the present time, discussion and analysis of the Gmuhas appeared primarily in German newspapers. I do notquote these articles explicitly in the paper. Publications ofthe Deutsche Institut fuer Wirtschaftsforschung, Berlin, ofNorbert Kloten, Karl Otto Poehi, Helmut Schlesinger andHorst Siebert provided valuable insights and analysis. Ihave profited from many discussions with Norbert Klotenand members of the Research Department of the FederalReserve Bank of St. Louis and of the VolkswirtschaftlicheAbteilung der Landeszentralbank in Baden-Wuerttemberg.

2For the standard arguments, see Committee for the Studyof Economic and Monetary Union (1989), (“Delors Commit-tee”). In the debate on economic transformation ofsocialist countries see, for instance, Daviddi and Espa(1989). There seems to be, however, a growing awarenessthat partial reforms generate only limited success; see Roeand Roy (1989).

18

was M 6,000 for older persons and M 2,000 foryounger persons. A 2M:1DM rate was used toconvert all other financial assets and liabilitiesof GDR residents. Mark assets held by individualswho live outside the GDR were converted at a3M:IDM rate.

The legal framework for the economic com-munity between the two states and for thetransformation of East Germany’s economicorder involves nearly a complete adoption ofthe FRG’s economic laws and regulations byEast Germany. These changes include therestoration of private property and competitionin East Germany and the free movement ofgoods, services, labor and capital between Eastand West Germany. In addition, social welfare,pensions, unemployment and health insuranceprograms similar to those in West Germanywere introduced into East Germany; any deficitsin these new programs will be financed tem-porarily by the FRG. Pensions in East Germanywere converted to DM values based on net EastGerman incomes; an East German worker cani-eceive a maximum pension of 70 percent of hisor her net income after 45 years of employ-ment. The agreement also guarantees that theDM value of East German pensions cannot fallbelow their former Mark equivalents.

Under the agreement, the East Germangovernment will abolish its old system of hightax levies on state enterprises and introduce, in-stead, a system of income and value added taxesconsistent with those of West Germany. Futuredebt issues by the GDR government must beissued directly via the Deutsche Bundesbank orwith its approval. The FRG will finance twothirds of the East German deficits from 1990through 1994. For this purpose, a “German Uni-ty” fund of DM 115 billion was launched; it willbe financed by a combination of bond issues(DM 95 billion) and expenditure reductions inthe FRG central government budget (DM 20billion).

3See the detailed report of the Institute for InternationalFinance (1990).

4oata for the GNP are not available.“The lower figure is an estimate of the Kid Institute forWorld Economics; the higher figure was estimated by thefive leading economic research institutes of the FederalRepublic in their report of April 12, 1990.

“At the present DM/Dollar exchange rate of about 1.65 DMper Dol~ar,this equals $9,000 to $13,000. For comparison,1989 per capita income in the United States was $21,000.

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The paper starts with a short analysis of theeconomic situation in East Germany after thefall of the Wall. It tries to identify both thegoals of the East German people and those ofthe West German government which togetherhave led to the present unification of both Ger-manys. A brief outline of the reforms necessaryto transform the East German economy arediscussed first. The rest of the paper focuses onmonetary unification, certainly the most con-troversial issue in the debate over unification.

East GIa’r Pp t canoms ~iitpI~

the •‘~ Fell

The deep economic malaise of the East Ger-man economy provides a good example of thegeneral failure of the centrally plannedeconomic systems of Eastern Europe.3 Prior toWorld War II, the part of Germany that nowmakes up the GDR was essentially as developedas those regions which now constitute the FRG.Data for 1936, for example, show that percapita income was 993 Reichsmark in the Eastand 996 Reichsmark in the West.

Today, of course, it is not as easy to assessthe relative per capita incomes of the two Ger-manys. The GDR’s administratively-set domesticprices and exchange rates do not accuratelyreflect its economic conditions; consequently,“official” data, when available, must be treatedwith skepticism. For example, the East GermanStatistical Office recently published the first of-ficial income estimate for East Germany; itreported that GDP was M 353 billion for 1989.~Most West German estimates of the GDR’s 1989GNP range from M 230 billion to M 300 billion.”If a 1M:IDM conversion rate is used with theseestimates, the GDR’s 1989 per capita incomewas somewhere between DM 15,000 and DM21,000,6 only about half of that estimated for

Table IBasic Data for East and West Germany (1988)

Unit East Germany West Germany

Area thousands of sq. miles 41,768 96,094

Population thousands 1667$ 61,715

Employment thousands 8,594 27 306Agriculture’ % of total 11 5Manufacturing1 % of total 47 40Services’ % of total 25 36Trade and transport’ % of total 18 19

GNP Mark/D-Mark billion (1989) 280-350 2,260

GNP per capita MarklD-Mark (1989) 17 000-21,000 38,600

Gross monthly salary Mark/D-Mark 1 250 3 192

Net monthly salary MarklD-Mark 1,050 2,153

Monthly social securityretirement benefits MarklD-Mark 450 1,597

Labor productivity as a percent ofWest German labor product*vity 49 100

‘Data are for 1987.SOURCES Official statistics of the GDR compiled by the Deutsche Bundesbanic and Deutsches lnstitut fuer Wirtschaftsforschung

the FRG (DM 36,600) in 1989 (table 1). Thus, of the disparity between the two Germanvs isdespite East Germany’s good educational system, shown by the relatively high proportion of totalits per capita income and, by proxy, its labor employment devoted to agriculture andproductivity, is estimated to be, at best, only manufacturing in the GDR (58 percent) com-half that of West Germany.7 Of course, these pared to that in the FRG (45 percent); indeed,comparative productivity figures are likely to the GDR’s cuirent proportion of employment inprove misleading if used to predict what might agriculture and manufacturing is roughly iden-occur after unification takes place; for example, tical to that which prevailed in the FederalGDR products previously produced and sold Republic over 20 years ago.”under a central plan designed to achieve autarkv - - - -

- - - In the past, the large difference in living stan-may not be able to compete effectively with

- dards between the two German states could begoods that can now be imported from the West. - - -maintained only by the GDR’s actions to close

The economic disparity between the FRG and its borders with the West and prohibit virtuallythe GDR is further demonstrated by the cx- all unauthorized movement of labor, capital,tremely high environmental pollution in East goods and services between East and West Ger-Germany, its obsolete infrastructure, outdated many. Since the border became permeable inmanufacturing planis and the generally poor autumn 1989, more than 2000 East Germanquality of its housing stock. Another indication citizens have moved into West Germany daily;

‘The 50 percent estimate for the GDR’s relative labor pro- Kirner (1990)). However, the Kiel Institute for Worldductivity was made by the Deutsches Institut fuer Wirt- Economics estimates that GDR labor productivity is onlyschaftsforschung, Berlin, in 1987 for the year 1983. It is about 35 percent of West German levels.nearly identical to Collier’s (1985) estimate of 54 percent “See Gerstenberger (1990).and to cross-country comparisons (see Cornelsen and

as a result, between then and the first severalmonths of 1990, the GDR’s population decreasedby about 500,000 persons.

This massive exodus was possible onlybecause the West German constitution grantscitizenship status to all East Germans. Amongother things, this allowed East Germans whomoved to West Germany to obtain immediatesocial benefits (unemployment benefits, retire-ment insurance and aid to the disadvantaged)that are tied to West German income levels.FRG unemployment payments, for example, areabout 68 percent of West German net incomes;in comparison, net incomes in the GDR are onlyabout one-third of that in the FRG.°Thesubstantial difference between West Germanunemployment benefits and East German in-come levels explains, in part, the massive migra-tion of East German workers. However, thesespecific incentives were eliminated on July 1,1990, when the social community between bothstates was established. From that date, all socialbenefit payments to East Germans will be basedon East German income levels, not on those inWest Germany.

The migration of many skilled workers to theFRG caused the economic situation in the GDRto substantially deteriorate. Since November1989, GDR industrial production and employ-ment has decreased and most East Germanenterprises have been unable to fulfill their pro-duction plans. By the end of April 1990, in-dustrial production was 4.5 percent below itslevel one year before, and the number ofemployed persons had fallen by 4.6 percent.Shortages of goods and services produced grow-ing social unrest in East Germany.

Given the circumstances described above, thegoals of the GDR population are quite evident:They want to improve their relatively low stan-dard of living as quickly as possible. Given thedisappointing economic results associated withsocialism, they were generally unwilling to ex-periment with a system part-way betweensocialism and capitalism. They chose, instead,

immediate and complete integration with theFederal Republic of Germany even though theyknew that it would require total restructuringof the East German economic and politicalsystems.

The extreme political uncertainty in the GDRafter the Wall fell, the obvious desire of theEast German population to unify both countriesand the massive outflow of East Germans intoWest Germany, which aggravated housing pro-blems in the FRG, left little room for politicalmaneuvering in West Germany and little time tofind a solution that would satisfy both East andWest Germans. Legally, of course, West Ger-many could not oppose rapid unification; theWest German constitution (Article 23 of the“Basic Law”) explicitly permits the East Germanstates to join the Federal Repubhc without re-quiring the consent of either the West GermanGovernment or its Parliament. This excluded avariety of possible partial solutions and gradualapproaches.b0

Therefore, the main task facing West Ger-many was to design a unification strategy thatwould restore the confidence of East Germansin the future prospects of East Germany and, atthe same time, be compatible with the chief in-terests of West Germans. Consequently, thedebate in West Germany focused on the possi-ble costs of the unification process. Among thecosts mentioned were:

1. The possible increase in the West Germaninflation rate,

2. The prospects of either higher taxes orhigher interest rates (due to increased FRGborrowing) resulting from increased FRGexpenditures for East Germany, and

3. The wealth transfer from West Germans toEast Germans associated with the replace-ment of Mark-denominated savings and cur-rency in the GDR by DM-denominated mon-etary assets.

Once the actual conversion rates are chosen,it is possible, albeit tentatively, to assess the im-pact of monetary unification on matters thatconcern the East and West Germans. The ten-

“Pensioners moving to West Germany received an averagepension of DM 1,121 (1988), more than twice the averageEast German pension in Marks.

either flexible or fixed exchange rates between the twocurrencies as an intermediate stage during the period ofeconomic transformation in the GDR.

101n fact, almost all West German economists as well as theBundesbank preferred a more gradual approach involving

tative nature of the assessment is chiefly due tothe absence of reliable data on the East Germaneconomy and to the simultaneity of themonetary and political integration with thetransformation of the East German economy.The short-term focus of the analysis should notlead to the impression that the risks and pro-blems associated with unification of the twoGermanys are either substantial or pervasive.The strong overall consensus in both Germanstates is that the long-term prospects of unifica-tion are positive and that East Germany has thepotential to repeat the “economic miracle”achieved by West Germany from the 1950s tothe present.”

Although this paper focuses primarily onmonetary unification, a brief discussion of theeconomic reforms necessary in the real sectorof the GDR economy is needed. The Gmu itselfwill not improve the economic situation in EastGermany substantially; it can provide, however,a sound monetary framework for an overallrestructuring of the GDR’s economic and legalsystem.

A cornerstone of real sector reform in theGDR will be the introduction of free-marketpricing and production. Previously, most pro-duction and prices had been set by governmentagencies in accordance with their central plans.One consequence of this system—as in manyother socialist countries—was that these priceshad been held essentially unchanged for yearsdespite changes in demand and cost condi-tions.’~For example, the GDR’s official index forconsumer prices has shown virtually no move-ment over the entire post-World War II era.

Moving to a market-based economy will re-quire a number of changes. First, the currentpricing structure is distorted by large subsidiesfor some industries, especially food and energy(their subsidies totaled M 50 billion in 1988,about one-third of total private expenditures inthe GDR) and heavy taxes on other industries,primarily consumer durable goods (the tax total-ed M 43 billion in 1988). These distorting in-fluences on prices will have to be reduced.

Second, the central planning approach to pric-ing and production must be replaced by theusual market mechanisms that determine thesedecisions in free-market economies. Not onlymust prices be set by market conditions ratherthan by government bureaucrats, but also theextensive system of state-owned enterprisesmust be privatized as well. In order for marketprices and wages to successfully provide thesignals for reallocating resources, the traditional“soft budget constraint” of state-owned enter-prises has to be replaced by the “hard budgetconstraint” of profits, losses and, if necessary,strict bankruptcy laws.”’

Third, the “Kombinate,” which are con-glomerates of GDR firms that produce similarproducts, have created an extremely highdegree of horizontal concentration in the GDReconomy; this has contributed to the GDR priceinflexibility discussed previously. Consequently,price reform requires that these “Kombinate” bedismantled as soon as possible. However, even ifthis is not immediately forthcoming, the in-troduction of the freely convertible D-Mark willcreate a more competitive environment becauseit will significantly open up the GDR’s economicrelations with West Germany and the rest ofthe world.

Thus, while there are many open questionsconcerning specific details of how the divergentlegal systems will be reconciled and howprivatization will be achieved, there is wide ac-ceptance that these are the central elements ofreal sector reform and that they will takeplace.14

As noted previously, the major controversyover unification focused on monetaryunification—that is, how to determine the ratesat which GDR financial stocks and flowsdenominated in Marks would be converted intotheir appropriate D-Mark values. The mainreason for the intensive debate was that none

11See lnstitut der deutschen Wirtschaft (1990).

“’See the survey conducted by Commander and Coricelli(1990).

“See Sokil and King (1989).“See e.g. “Reform’ (1990).

of the existing exchange rates between theMark and the D-Mark seemed relevant fordetermining the n-Mark value of GDR financialstocks and flows after unification. In thisrespect, the Gmu is quite different from the for-mation of a monetary union between two ormore market economies. For instance, the ap-propriate conversion rate was easily determinedwhen Saarland, which had become independentfrom Germany after the World War II, wasunified with the FRG in 1959. In this instance,Saarland’s financial flows and stocks, which hadbeen denominated in French Francs prior tounification, were simply converted to their DMvalues at the prevailing market exchange ratebetween the Franc and the n-Mark.

In the case of Gmu, however, all existing ex-change rates were either highly distorted oressentially devoid of economic significance. Thesame criticism applies to the macroeconomicdata that might otherwise have been used tocalculate an “equilibrium exchange rate” on thebasis of the traditional exchange rate models.”

After the fall of the Wall, the one market ex-change rate between Mark and n-Mark was theDM price for Mark bank notes that had been il-legally “exported” from the GDR to West Ger-many. However, this rate, which is shown infigure 1, is not representative of the underlyingfundamental relative price of Marks in terms ofnMs for several reasons. First, it was subject tospeculative influences which made it veryvolatile,” Second, it reflected demands by EastGermans for certain goods (e.g., consumer elec-tronics and coffee) that were highly taxed in theGnR; table 2 shows that the Mark prices of theseproducts in the GDR were about five timeshigher than their n-Mark prices in West Ger-

many. Third, the arbitrage (flow) of subsidizedEast German products to the West has remainedrelatively weak due to transaction costs andtrade restrictions.

Another possible candidate for the “true ex-change rate” to use for conversion purposesmight have been the so-called “nevisenren-tabilitaet” (foreign exchange profitability) of GDRexports in terms of their nM equivalent. Thisrate is calculated by dividing the Mark value ofthe aggregate GDR exports by their nM revenuewhen they are sold to West Germany. In 1989,this ratio, which was used by the GDR govern-ment for all internal conversion calculations,was 4.4 Marks per UM, Again, however, thisratio does not indicate what the market ex-change rate would be. First, the domestic pricesof many G]JR export products were artificiallyhigh due to taxes imposed by the GIJR; conse-quently, the numerator of the ratio is heavilyinfluenced by tax policy, not economic values.Second, export decisions were made by the GDRgovernment primarily to obtain foreign ex-change to finance its imports. It is evident thatthis non-market allocation process, which istypical of centrally planned economies,” is notrepresentative of market-based trade; amongother consequences, it can lead to exports withvery low profitability.”

A third alternative is the official 1M:1DM ex-change rate set in the past by the East GermanGovernment.’9 Like all such official exchangerates established in socialist countries, this wasan arbitrary rate used primarily as an accoun-ting unit which embodies no useful economicinformation relevant to determining the rate touse for Gmu conversion purposes.’° All foreignexchange transactions were conducted at flexi-ble (implicit) exchange rates which were theratios of the internal Mark price to the worldmarket nM price of each product.”

“’See Frenkel and Goldstein (1986), Williamson and Miller(1987).

“’II varied from 16:1 (November 17, 1989) to 3:1 after thedefinitive conversion rate for non-GDR residents hadbecome public.

“See Wolf (1985b, pp. 215).“’See Cornelsen and Kirner (1990).“’Until 1989, this rate was also used for the “forced ex-

change” (“Zwangsumtausch”) of DM 25 for West Ger-mans who wanted to visit East Germany. From the begin-ning of 1990, West German travelers could exchange D-Marks at a 1:3 rate against Marks.

2cThe same criticism applies to the exchange rates agreedto by the East and West German governments inDecember 1989 when they established a fund to exchangebank notes for travel: Each East German citizen was entitl-ed to purchase up to 100 DM at a 1DM:1M rate and anadditional 50DM at a 1DM:5M rate.

“1See Wolf (1985b).

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Table 2Consumer Prices of Selected Goods and Services in the GDRand the Federal Republic of Germany (1985)

Price in Price in M price as a percent

Goad/Service (M) GDR (DM) FRG of the DM price

Potatoes (5 kg) M4.05 DM5 32 76Tomatoes (1 kg) 4.40 2.10 210Rye Bread (1.5 kg) 0.93 4.54 21Beef (1kg) 980 19.45 50Chocolate (100 g) 385 0.89 433Coffee (250 g) 25.00 5.25 476Jeans (men’s) 135.00 59.90 225Brown Coal (50 kg) 3.51 19.40 18Radio/Cassette Recorder 1.16000 199.95 550Color TV 5,650.00 119900 471Rent (1 bedroom) 75.00 390.00 19Electricity (75 kwh) 7 50 29.30 26Haircut (man) 1.90 1125 17Railway Ticket (50 km) 4.00 9 20 43

SOURCE: Materialien zum Bericht zur Lage der Nation, 1987, pp. 513. 516. 732-735

for example, rely on the “law of one price”holding in integrated and competitive markets.””The relative version of PH’, developed byGustav Cassel to determine equilibrium ex-change rates after World War 1,24 relates the re-quired exchange rate adjustment between thecurrencies of two countries with different infla-tion rates. However, this procedure requires theexistence of an unbiased base period in thepast, a condition which clearly is not met in theGDR setting.

The absolute version of PPP avoids the baseperiod problem by defining an equilibrium ex-change rate as the ratio of the price of a stan-dard market basket of goods in one currency tothe price of the same basket in another curren-cy. Thus, the consumption basket of an averageGDR household could provide one basis for ab-solute PPP calculations of an appropriateMark/n-Mark exchange rate. In 1985, for exam-ple, the goods and services which made up thisbasket (excluding rents) had a DM equivalentvalue which was 10 percent higher than their

Mark price.”” If we assume that the GDR pricelevel has remained unchanged while the marketbasket’s nM equivalent value has risen at the in-flation rate in West Germany since 1985, theprice differential would be about 15 percent in1989. Thus, an absolute PPP exchange rate basedon consumer prices (for a given market basketof goods and services) would be 1.1SDM:1M ora lnM:O.9M conversion rate. However, due tohigh subsidies and the existence of a “monetaryoverhang” (explained later in the paper), in-dicative of an excess demand for goods in theGnR, the economic relevance of such calcula-tions is severely limited.””

Because most structural exchange rate models(e.g., those based either on the monetary ap-proach with fixed or flexible prices or on theportfolio balance approach) require either short-term or long-term PH’ to hold, they are besetwith the same conceptual drawbacks as the sim-ple PPP calculations already discussed. In addi-tion, they presume that people are able toengage in unlimited arbitrage between financial

““See Cassel (1918, p. 413): “As long as anything like freemovement of merchandise and a somewhat comprehen-sive trade between the two countries takes piace, the ac-tual rate of exchange cannot deviate very much from thispurchasing power parity.”

“4See Dornbusch (1987).

“Including rents the difference was 25 percent.““An alternative PPP measure, the ‘Devisenrentabilitaet,”

yields an equilibrium exchange rate of 1 DM:4.4M.However, the problems of this specific measure havealready been discussed.

markets in the respective countries; this condi-tion did not exist in the GDR prior to the Gmu.”7

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In order to clarify the issues associated withthe Gmu, this section presents a brief discussionof the main items whose values were convertedfrom Marks to DMs in the process of monetaryunification. Throughout the paper, a distinctionwill be made between financial stocks andfinancial flows.

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The stock of financial assets in the GDR isrepresented by the consolidated balance sheetof its banking system presented in table 3. Incontrast to how these accounts would be drawnup in the United States, the loans and liabilitiesof the central bank (“Staatsbank”) must be add-ed to the state-owned commercial banks on aconsolidated basis. As is typical in most central-ly planned economies, the GDR did not permitdirect financial transactions between enterprisesand households e’dichotomized money sup-ply”)-”8 Therefore, this consolidated balancesheet presents a comprehensive picture of thestock of all financial assets and liabilities in EastGermany.

The principal items on the asset side of thebanking system were loans to state-ownedenterprises, housing (chiefly state-owned), directcredits to the government, and claims on for-eigners. Loans to households were negligible,making up less than 1 percent of all bank assets.In contrast, such loans represent about 23 per-cent of bank assets in the Federal Republic.

Savings of private households are the mostimportant liability of the GUR’s banking system.The consolidated balance sheet prioo to theGmu also shows a considerable amount of

foreign liabilities. However, the bulk of theseforeign liabilities (M 96 billion) was simply anaccounting item e’Bichtungskoeffhdent’i arisingfrom the GDIVs practice of valuing its foreignassets and liabilities at a 1DM:4.4M exchangerate rather than at its “official” IDM:1M ex-change rate. After Gmu, of course, the DMdenominated foreign debt of the Grill will bevalued at its face value. The revaluation offoreign assets and liabilities also reduced theamount of external claims (from M 45 billion toDM 36 billion) and the debt of the government(from M 61 billion to DM 12 billion).

After revaluation of foreign assets and liabili-ties and the overall 1DM:2M conversion of alldomestic items, except for the limited 1DM:1Mconversion of savings, the liabilities of the GDRbanking system (1DM 246 billion) exceeded itsassets (1DM 220 billion) by DM 26 billion. Thisdifference was created by the asymmetric con-version of the left and the right side of the con-solidated balance sheet produced by an effective1DM:t4M conversion rate of total savings. Toequilibrate their balance sheets, East Germanbanks were given interest-bearing governmentassets from an equalization fund established bythe GIJR for this purpose. Except for this fund,the post-Gmu balance sheet shows that the netbank debt of the actual GDR government sectoris relatively small (DM 7 billion).

The 1DM:1M conversion rate for financialflows determined the n-Mark equivalent forMark-denominated wage and rent contracts inexistence prior to July 2, 1990. Although thesecontracts can (and undoubtedly, will) be renego-tiated after this date, a legal transformation ofexisting contractual obligations from their pre-vious Mark payments into 1DM payments (“re-kurrenter Anschluss”) was required”” For allnew contracts and those old contracts for whichpayments could be adjusted immediately or onshort notice, the conversion rate was irrelevant.GUR pensions were treated somewhat differ-

2OThis also excludes the application of the “underlyingbalance approach to exchange rate assessment,” whichwas developed by the lnternationai Monetary Fund. Accor-ding to Williamson and Mifler (1987, p. iO~,who haveelaborated this method, the “fundamental equilibrium ex-change rate” is defined as the rate “which is expected togenerate a current account surplus or deficit equal to theunderlying capital flow over the cycle, given that the coun-

try is pursuing ‘internal balance’ as best as it can and notrestricting trade fcr balance of payments reasons.”

““See Wolf (1985a).“Poole (1990) emphasizes, on purely economic grounds.

that “any attempt to convert prices of goods and servicesfrom CM (Ostmarit to DM through central direction canonly cause great difficulty.”

Table 3consoudated Ba~anceSheet of the Banking System Gf the GOR as of May 31, 1990

M Conver- DM Wi ~enver- DM

Assets blilien sion rate billion Liabilities billion sion rate biii~on1. Lending to domestic 1. Oepc~~ts1rom domestic

borrowers non-bankslotal 3.974 -- 18D 7 rota: 249.9 ..~

Go’,errrnent 603 2’ 123 Government 108 21 4o wh’cn

Lenc.~g:n oar nestonwi9-:hc- ‘e’,’aiLat on o’e~teri’.alliah~tios 3! 2 -— —

clams on tr,e governmartfrom ihe in’t1al proisionof notes ano coins ii 1948 4.9 — —

Enterprises 231 7 21 115 8 Enterprises 57.0 2.051 27.8Hous’ng sector 102.6 21 51.3lid viduats excludinghousobuild ng loans) 25 2:1 1.3 lndviduals 182.1 --- 123.4

Giro anc savingsbalances ofindv:duals

Res,oents 165.6 1 44:1’ 115.2Non-’esidents 23 2 05-1’ 1 1

Life :nswance 142 2:1 7.12. External claims 450 —- 363 2. External liabilities 152.5 — 556

~a)cMEA countries 174 -— 87 (a) ~MEA countries 1.1 -—- 0.6lo) Western ;ndustrial and ~ Western indust’ial and

deveiopir.g countries 275 - 27.6 developing countries 55.0 550~clProvisons for external

liabilities ç’Ricntungskoef.fizenten”j 96.4 ‘ —

3. Participations I 1 1.1 1.1 3. Currency in circLilation~excIudingthe banks’ casnholdings~ 13.6 2:1 6.8

4. Accumulated profits/reserve funds/guaranteefunds 234 1.1 23.4

4. Other assets 31 2’1 15 5. Other liabilities 7.2 21 3.6Total 4466 — 219.6 Tcta 4466 -- 2460Balancing item — — 26.4 Balancing item - -- -—

Tctai 4466 1.81:1 246.0 Total 4466 1 81 1 2460

hose at actually l.ab,l~Iiesor ‘he ban-cing sector to tne governrr-enl. whch migrt cisc be snown in ‘.ao.iitres .tem 1. Inthis taoio hey are shown .1 con,-oct.on w’tn the external ltab~Iiriesof the GOP. because the tem ‘may also be regardedas a k’nd of value aojusment” for the c-xte-na, l,ab:itttcs, wntcn arc otne’w’se put at too b,. a value in GDR \Iark

convers.on of a balance of M 245 h~Uon which results after offsetting ‘he lencir’g ‘rom the re\.aiuatior. o exte’nairabilities (M 31.2 b,:lio’i) and c!arns arsir-.g from tne ‘nitial p.ovision o~nc-tea and co:ns ri 1943 (M 4.; ‘oiU’oni aga rstprov-sions f

0r exte’ra l’ab,ities “ R’chtungskceff~z.an’sn) to the sane amount

‘External c~aims(assets tern 2 ib~lano external ‘,abir,.es t.,aoirnes item 2cofl are here st’l: ,aiuoc a:the accountingrates of the end of 1989. The market rates c! June 30. 1990 Gre tO be used ‘or the ~‘r-aiconversion Trio arrourilssnown ~s’iiltr.en presumably be somewhat bower ti.abh:ties item 2(o) a’so incluocs fore’gn cur’eroy cePosits fromres’dems).

tonversion ra:~for ba’ances0c ron ‘es’donts arsing on and after January t. 1990 3:1. otherwise 2.’.

conversion rate ci 1 1 ‘or M 2.0cm x 32 rni’ron = OM 54 bilion. M 4 000 x ‘0 1 mtii on = OM 40’ bi’1.on arid M6000 x 30 rr’iiiion =OM 18 S or- yi&cs a tota1 of DM 5~8b lion: to roma’,r-oer f-’v. 100.8 brlb’onl was con~.ertedata rate cf 2 1Baiances as at mr. end o’ ~959arrc’~rt’nnmc. V 21 oif.ori were convo-tec at 2:1. i~crar~crear a’ 31Paitty oflse’ agQins~ londing i-, ~or’r’cctton~v:1,1Inc re~aiuat:or.c.’ externa: ahi.cies ~M3~.2 o ldon~an’: cla:ms ar.singfrom tne ist:al o’o’jis.rjn of no:es an~coinsn 1948 M ~ g :~ton).:~‘.eartnrtez cal tr.’.a,r.de: (M 8c.i h’ lc.n) ,vasLsec:0 r~u~q :i.;’ bait rc’r~-

ently. As already mentioned, the social unionadjusted the GDR pension system to make itconsistent with West German standards; amongother things, this meant that the DM value ofGDR pensions was not less than their previousMark value.

For West Germans, who traditionally haveplaced a very high social value on price stabili-ty, concern over the imphcations of the Gmu onthe inflation rate played a predominant role inthe choice of the conversion rate. The existenceof an excess supply of money, which, byWalras’ Law, reflects rationing on goods andlabor markets,~°is a widely acknowledged oc-currence for centrally planned economies, in-cluding the GDR.33 Many observers expectedthat a flat IM:1DM conversion of the East Ger-man money stock would produce a rise in theprice level and, hence, a transitory increase inthe measured rate of inflation for the integratedGerman currency area after the Gmu.

The expected impact of monetary unificationon the German inflation rate can be determinedas follows: First, estimate a hypothetical G]JRmoney stock that would be compatible withstable IJM prices in the Gflfl; second, comparethis hypothetical money stock with the actualDM money stock of the GDR after conversion.If the actual money stock exceeds the hypotheti-cal one, the conversion could produce a tem-porary increase in inflation in both Germanys;otherwise, the conversion does not have infla-tionary implications.

To accomplish the first step requirescalculating the East German money demandafter the Gmu. To do this, of course, one has toestimate the velocity of money and potentialnominal production of the GDH economy. Thefollowing estimates are based on the assumptionthat both relative and absolute DM prices in theGDR as well as the GDR’s velocity of money willbe identical to their West German counterpartsafter unification. GULl potential production canbe estimated either by using its GNP, which is

about 13 percent of West Germany’s GNP, orsome measure of potential output determinedby relative labor productivity estimates. This lat-ter method32 uses the proportion of the EastGermany population to West German population(about 26 percent) and the estimated averageGULl labor productivity relative to that in WestGermany (about 50 percent) to obtain a relativeGULl potential production of about 13 percent,which is identical to the relative GNP differential noted above. Use of a lower estimate of theGUR productivity differential, for instance, the30 percent estimate of the Kid Institute forWorld Economics, reduces the GDR’s potentialproduction to only about 10 percent of that inthe FRG.

This approach can be used to determine the“non-inflationary” conversion rates for differentmonetary aggregates; various estimates areshown in table 4. Applying the West Germanratio between potential output to the stock ofcurrency yields a conversion rate of about1M:IDM for East German currency holdings. Tocalculate a non-inflationary Mi money measurefor the GULl requires determining the ‘mo-neyness” of the various GUR deposit categories.If the “Spargiro” (M 69.0 billion) and deposits ofenterprises are essentially demand deposits andthe “Buchsparen” (M 90.7 billion) are essentiallythe same as traditional savings deposits includedin M3, the pre-Gmu GUR Mi money stock wasabout one-third of that in West Germany. Thus,the non-inflationary conversion rate for theGUll’s Ml money stock would lie in the1UM:2.4M to 1UM:3.3M range. Using the M3money stock, the non-inflationary conversionrate would he within 1UM:1.5M and 1DM:2M.33

Comparing East and West German moneystock measures is always problematical becausethere is a much wider spectrum of financial op-portunities available to West German investors.Their savings in long-term time and savingsdeposits, bank savings bonds and other financialinstruments issued by banks, which are called“monetary capital” and not included in M3, arelarger than the NI3 money stock. Adding thesefinancial assets to the West German M3 moneystock yields a liquidity stock measure (L).

30See Commander and Coricelti (1990), p. 3.31See Sokil and King (1989).

33ln West Germany, the money stock MS includes currencyin circulation (excluding banks’ cash balances), sightdeposits, time deposits with a maturity of less than fouryears and savings deposits at statutory notice.

~lt which was suggested by the President of the Kiel In-stitute for World Economics, Horst Siebert.

Table 4Conversion Rates on the Basis of a Non-Inflationary Money Stockfor the GDR (1989)

Non-inflationary

Actual values values for the GDR Conversion rates

GDR’ FRG A2 A B

(M billion) (OM billion) (DM billion)

Currency 17.0 1469 19.1 14.7 1 09 11.2Ml’ 146.6 450.6 599 45.1 1:2.4 4,33

M3~ 252.0 1255.5 1670 125.6 1 1.5 1’2.0LB 2520 2738.3 3642 273.8 1:0.7 1 07

Vaiues for the GDA include deposits of enterprises and housenolds with the banking system.2Ass-urnng that GDR potential output is 133 percent of FAG potential output.3Assuming that GOP pot~ntiatoutput is 10 percent of FAG potential output.

~currencyin circulation and domestic non-banks’ sight deposits5M1 plus domestic non-banks’ t:me depostts and funds borrowed for less than 4 years pUssavings deposts at statutory notice

~M3 olus savrng deposits at agreed notice, long-tern, time deposits, bank savings bonds andother financial instruments held by private nouseholds and enterprises with banks.

SOURCE: Oeutsche Bundesbank. Monatsberichte. Jahresbericht l989 der Staatsbank der OOR.

In contrast, savings deposits and currency arethe only financial stores of value available inEast Germany.34 Thus, for East Germany, L andM3 are identical. Using the L measure, the non-inflationary conversion rate would be about1UM:1M. However, in order to make the con-verted East German L measure truly com-parable to the West German L, about 50 per-cent of East German savings would have to be“frozen” for about four years.

As table 4 shows, an assessment of the infla-tionary impact associated with the Gmu dependson which monetary aggregate is regarded as theone linked most closely to inflation. Mosteconometric estimates for the Federal Republicshow a very stable relationship between themoney stock, M3, and inflation (and nominalGNP); this is the reason why the Bundesbankuses M3 as its main inflation indicator and as itscentral intermediate monetary policy target.35

Taking M3 as the benchmark money stock fornon-inflationary purposes suggests that the con-version rate for the GULl money stock shou.ld lie

in a range between 1UM:i.5M to 1UM:2M.While the latter value was recommended by theBundesbank, the political compromise reachedbetween the two governments led to an averageconversion rate of about 1UM:l.7M. While theestimated non-inflationary conversion ratesshown in table 4 are subject to considerableuncertainty, the final conversion programchosen for the Gmu seems unlikely to produceany substantial inflationary impact on prices inthe new DM currency area.

rry~ ~ VIfl(’jtr 4yrtvrz~

—,

The non-inflationary conversion calculationsdescribed above assumed that the velocity ofthe appropriate money stock in the GULl is iden-tical to that in the FRG. Some observers in theFederal Republic have argued that countrieswith higher per capita income levels have dif-ferent monetary velocities from those in less-developed countries. Figures 2 and 3 show theresults of a cross-country analysis comparing

~4Thisaspect was emphasized by the East German CentralBank (“Staatsbank”) in an official statement of April 3,1990

355ee Deutsche Bundesbank (WS9a), Schlesinger andJahnke (1987).

Figure 2Velocity of Ml and GNP per Capita for OECDCountriesVelocity

8

7

6

5

4

3

2

‘1

per capita nominal incomes and velocities forthe Ml and M3 money stocks in OECU coun-tries in 1987. The figures indicate that per capi-ta income has no significant influence on thevelocity of money. However, the marked inter-country differences in the velocity of moneyserves as yet another reminder that the non-inflationary GULl money stock calculations aresubject to considerable uncertainty.

.ImvlinTtttknt& of me &trt.o

orope.ntivertesw~ .tast t.:er~ ~t..:.oft

The potential impacts of the Gmu on theunemployment rate in the GUR and itseconomic growth prospects were another im-

portant determinant of the conversion rate.While West Germans were concerned about thepossible fiscal costs of unemployment paymentsto East Germans, the East Germans, as notedearlier, were primarily interested in the pro-spects for employment and for raising theirstandard of ilving as quickly as possible. Theseprospects depend fundamentally on how com-petitive the GUll firms will be after the centralplanning process is dismantled and the economyof the GUll is opened up to world markets.While it is evident that the conversion of enter-prise debt has a direct impact on the financialstructure and capital costs of firms in East Ger-many, the implications of the conversion ratefor wages in the GUR are more difficult toevaluate.

Velocity8

7

6

5

4

3

2

1250000 5000 10000 15000 20000

GNP per capita

ii fcv

Figure 3V&ocity of M3 and GNP per Capita for OECDCountriesVelocity

25

20

1.5

1.0

0-5

0.0

The 1UM:ZM conversion rate for financialstocks determines the debt burden and interestpayments of enterprises after the unificationprocess.38 It has important consequences for thecosts of capital and for the projected privatiza-tion of East German firms. The latter, an essen-tial element of the process of economictransformation, requires that the firms to beprivatized must have a positive net worth. Forenterprises that will remain under state owner-ship, the ratio of their UM equity to their total

UM assets after conversion will play a key rolein determining whether they can survive with a“hard budget constraint,” i.e. without subsidiesfrom the government.

Because there is no data on the debt-equityratios of East German enterprises, it is difficultto assess the implications of the llJM:2M con-version rate on their financial situation and ontheir interest payments. To get a rough estimateof the sustainability of alternative debt burdens,however, the proportion of GUR potential out-put to ERG potential output can be used; asalready mentioned, estimates vary between 10

38Again, the conversion rates which were put forward in thedebate varied widely, ranging from a 100 percent debt

economic research institutes in their report of April 12,1990, over the 1:2 rate, which was proposed by the

Velocity

2.5

2.0

L5

1.0

0.5

no250000 5000 10000 15000 20000

GNP per capita

relief which was recommended by the five leading German Bundesbank, to a full 1:1 conversion.

and 13 percent. According to Bundesbank (1989)statistics, the net financial debt of West Germanenterprises (excluding housing and the financialsector) was UM 681.5 billion and the book valueof their non-financial assets totaled UM 10965billion in 1988. The ERG figures indicate that a1UM:IM conversion for the debt of GULl enter-prises would have produced a relatively largeUM 175 bfflion net debt (see table 3), about 26percent of the West German leveL” If East Ger-man firms’ nonfinancial assets are worth about10 to 13 percent38 of that for West Germanfirms, the right side of their balance sheetswould have exceeded the left side (UM 110-140biffion) by huge amounts, even if West Germanfirms’ balance sheets contain extensive hiddenreserves. Without further debt reduction,privatization of virtually all East German firmswould have been impossible. According to WestGerman bankruptcy law, which requiresbankruptcy proceedings if a firm has negativenet worth, most East German firms would havehad to be declared bankrupt.

Of course, an outright cancellation of all GUllenterprise debt would have avoided these pro-blems. However, this “solution” was dismissedfor two reasons: First, firms with permanentnet debt levels are common in all industrializedcountries; second, it would have led to a hugeincrease in the government debt as describedlater in this paper. The debt reduction~°achiev-ed by the 1UM:2M conversion rate places theaverage ratio of equity to assets for GUR enter-prises in a range between 20 and 37 percent,which should allow the privatization of at leastsome firms. By comparison, the average equityto asset ratio is about 20 percent in West Ger-many and 50 percent in the United States.’°

Because the results are quite sensitive to theestimate of the value of real assets in the GULl,it is difficult to assess whether the interestburden of East German firms will be similar tothe West German enterprise sector or whetherit will be significantly higher. In addition, it isnot yet clear whether East German firms willhave to pay market-determined interest rates ontheir debt after monetary unification.

The second determinant of East Germanfirms’ post-conversion competitiveness are theUM wages they will have to pay. While neitherthe GULl nor the FRG government should deter-mine wages after the transition to a marketeconomy, their treaty established a wage con-version rate to define the financial obligationsof existing contracts for the time immediatelyafter July 2, 1990. However, the actual conver-sion rate chosen has implications for wagelevels and competitiveness only if nominal UMwages in the GULl after conversion are inflexibledownward and if initial UM wages are set “toohigh” compared with labor productivity.

These considerations would have called for aconversion rate that reduced average wagesbelow the level indicated by the GDR’s averageproductivity. The advantage of this low startinglevel for wages is that it would have allowedworkers and firms in East Germany torenegotiate their contracts more easily afterGmu. This would have enabled them toestablish a wage structure more closely mat-ching sectoral productivity differentials than theprior GUR wage structure, in which wageswere relatively uniform regardless of productivi-ty differences.

To evaluate the competitiveness of East Ger-man firms after a 1UM:1M wage conversion,their labor productivity relative to that in com-parable West German firms must be comparedwith their relative UM wages. These com-parisons would require information on the pro-ductivity of individual firms or, at least, in-dividual sectors in the GULl after July 2, 1990.Unfortunately, such sectoral data are notavailable at all; moreover, estimates of laborproductivity in the GUR aftef- the transition to amarket economy are very difficult to determineex ante. However, the experience following theWest German currency reform in June 1948shows that large productivity gains can beachieved rather quickly; these gains arise frombetter incentives associated with the marketprocess and increased availability of inputs. In

37A high debt burden is regarded as a typical concomitant ofthe central planning mechanism, which gives enterprisesautomatic bank credits inducing large hoardings of inven-tories or camouflaging cost overruns, waste and sales inthe black market (Grossman 1989, p. 31).

capital as in West Germany, Alexander and Gagnon (1990)estimate the level of the East German capital stock to be10,4 percent of the West German capital stock.~ strategy of recapitalization is now also suggested for

other Eastern European countries, See Hinds (1990, p. 44).45See Bank for lnternational Settlements (1989, p. 86).~On the basis of a Cobb-Douglas production function and

assuming an identical elasticity of output with respect to

the GULl, where such incentives are lacking,shortages of specific inputs are often reportedto have led to significant decreases in outputand productivity.’

On the other hand, the far-reaching restruc-turing of production processes will not be possi-ble without some temporary output disrup-tions.~~If these positive and negative effectsroughly cancel each other in the first fewmonths after conversion, the GUll’s productivityshould reach about 50 percent of that in WestGermany, which is consistent with pastestimates made by the Ueutsches lnstitut fuerWirtschaftsforschung.

Before the conversion took place, the averagemonthly salary of a worker was M 1250 in theGUR and UM 3192 in West Germany. With the1UM:1M conversion of the initial nominalwages, monthly wage costs (includingemployers’ contributions to social security) forEast German firms would be about 37 percentof West German wages.43 Thus, the average DMwage level in the GUR after the conversion isnot so high relative to the average productivitydifferential between GUll and ERG workers thatit would preclude future wage negotiations.

However, the initial wage differential cannotbe held constant by the government after theGmu. Therefore, the medium-term outlook foremployment as well as for foreign and WestGerman investment in the GUR will dependmainly on the rate of subsequent wage in-creases in the GUll. If these exceed the growthof productivity in the GUll, employment and in-vestment in GUll firms will fall.

Because the unification process has beendriven primarily by the desire of East Germansto improve their standard of living, the effectsof monetary unification on the FRG-GDR real in-come differential were intensively discussed inboth East and West Germany. However, sincewages will be renegotiated after the Gmu,monetary unification will have only a short-termimpact after July 2, 1990.

An estimate of the change in East Germanreal incomes resulting from the Gmu can becalculated by assuming that nominal wages inthe GUll will remain constant after conversionand after the various subsidies are abolished.The basis for comparing pre- and post-Gmu realincomes in the GUll is the consumption basketof an average GUR household that was discuss-ed earlier.

The abolition of trade restrictions andproduct-specific taxes and subsidies will produceprice structures and a price level in East Ger-many similar to that in West Germany. Thus,the Gmu will cause a “one-shot” consumer priceincrease of about 15 percent for the unchangedGUll consumer goods basket.” In addition, theincrease in social security contributions, due tothe introduction of the West German socialsecurity system into East Germany, will reducethe average net monthly income of an East Ger-man worker from M 1050 to UM 983 afterunification. Together with the one-shot price ad-justment in consumer goods, real incomes inthe GUR will be reduced by about 21 percent.45

41According to a survey of the lnstitut der deutschen Wirt-schaft, about one lhird of all GDR employees had to sus-pend their work for two or more hours per day because ofshortages and defective machines.

~ln the past, all decisions on investment, production andsales were made by the central planning bureaucrats;managers of firms were mainly responsible for technicaloperationt

43The 1DM:2M conversion rate proposed by the DeutscheBundesbank differs less from the 1DM:IM rate chosenthan one might assume at first glance. In its calculations,the Bundesbank assumed that all subsidies would beremoved before conversion, requiring an increase in Markwages of about 25 to 30 percent to compensate for this ef-fect. If these new Mark wages were then converted at a1 DM:2M rate, the effective conversion rate between initialEast German Markwages and DM wages after the Gmu

would have been about 1DM:1.2M. Including theemployer’s contribution to social security, the initial laborcosts in the GOP would have been about one third of theWest German level if the 1DM:2M conversion rate hadbeen used.

UThis change from Mark prices to 0-Mark prices has no ef-fect on the overall German inflation rate which is measuredon the basis of the DM equivalent of goods and services.

~These orders of magnitude show that conversion rates forGOP incomes considerably above 1DM:1M, for instance,IDM:2M or IDM:3M, would have strongly increased themovement of workers from East to West Germany. Assum-ing constant consumption patterns, a 1DM:2M (1DM:3M)rate would have reduced GDR real incomes by 57 percent(70 percent) compared to their pre-Gmu levels.

The above calculations overstate somewhatthe negative welfare implications of unification.Households will adjust to the price changes bypurchasing more of the goods with relativelycheaper UM prices and less of those whoseprices rose more because they had been heavilysubsidized in the past. The prospective adjust-ment of the previous Mark price structure tothe UM price structure is indicated in table 2.As no detailed data on consumption patterns ofEast Germans are available, the quantitativerelevance of this substitution effect is difficultto evaluate.” The same comment applies to thepositive welfare effects attributed to prospectivequality improvements in available consumergoods; after the Gmu, East Germans will be ableto buy West German products which, onaverage, are of better quality than their EastGerman counterparts.

On balance, the real income of East Germansand the real income differential between Eastand West Germany will remain essentially un-changed immediately after the Gmu, with realnet incomes in the East about 50 percent lowerthan in the West. This result reflects the factthat monetary unification by itself can onlycreate a framework for real sector reform.Significant improvements in East German livingstandards will only be generated by betterallocation of their resources and increased in-vestment. Thus, the incentive for East Germanworkers, especially skilled workers, to move tothe Federal Republic of Germany remains atleast as strong as it was before the Gmu.However, the prospect of a rapid and wide-ranging restructuring of the GUR economy hasalready improved the motivation of East Ger-mans to remain in the GUll and contribute toits economic recovery. The number of GURcitizens moving to the FRG, which reached amonthly peak of 133,000 in November 1989, fellto only 19,000 by May 1990.

)~n.t .~VjtflThfl ~ ~at Vatt tn.trina.nv

The Gmu will result in a wealth transfer fromWest Germany to East Germany.~~Themechanisms and the quantitative effects of thiswealth transfer, however, remain uncertain.

To examine this issue, even if a definitiveanswer is not forthcoming, it is useful to startwith an example of a hypothetical currencyunification between two market economies, e.g.,between France and West Germany. Supposethat the UM is to be replaced by the Franc andthat the current market exchange rate(1UM = 3FF) will be used to convert all UMfinancial and real stocks and flows in theirFranc equivalent. In this case, there is notransfer of real wealth; simply multiplying all U-Mark prices by three does not reallocate wealthwithin Germany nor between France and theFederal Republic.48 Redistribution of wealth bet-ween creditors and debtors in both countriescould occur only if that currency unificationleads to unexpected changes in inflation and ifsome debtors or creditors had been expecting aparity adjustment. In this case, the net transferbetween the two countries would then be deter-mined by creditor/debtor relations betweenFrance and Germany and by the direction ofthe change in expectations.

In the Gmu case, there is no wealth transferbetween GUR residents and West Germans dueto unexpected exchange rate variations becausethere were virtually no financial linkages bet-ween individuals or enterprises in both coun-tries prior to the Gmu. The asymmetric conver-sion of assets and liabilities, however, transfersGUll debt to the FRG (see shaded insert). Beforethe Gmu, the aggregate wealth of the East Ger-man economy consisted of its aggregate realassets and its aggregate net foreign claims(debts); domestic financial claims and liabilitiessimply cancel out in the aggregation process.Because monetary unification has no implica-tions for the GUll’s foreign claims and liabilities,it can increase the wealth of the GUR only if itsdomestic financial assets, which are mainly sav-ings, are converted at a higher rate than itsdomestic liabilities.

In a closed economy, even this asymmetricconversion would have no aggregate effect onthe economy’s wealth; the gap between assetsand liabilities in the consolidated bankingsystem would have to be filled by government

“An analysis of the Deutsches Institut fuer Wirtschaft-sforschung comes to the result that private householdscan compensate the price effect by reducing their con-sumption of foods by 10 percent.

47See, for instance, Poole (1990).“It is assumed that a procedure for an equitable distribution

of seignorage can be devised.

Mechanics of the Wealth Transfer Effectedby (Imu

1 lie total wealth I\\’} ol each economic Canceling all ititra-CI )l-l financial claims andagent in the CDII is the suni of its real liabilities (H(.~’’~’= HI.,’ ~m

1yields total wealth

en) t h I l1\ ~ I plus it S Tiet 11101 ieta ry ;vea It h be fore Grnt(\\tj:

(4ffl fl\\,~ RIit\’ -,- uHF’ - 1St(1) Vt: -- I~V + NM.

The asvnimr’t nc con~-eisicniof ml ra-Gtill~ nIoIIelarV u o,ilth i~,the si.:m 01 claims on financial liabilities and clainis flU C~:)R> HI .,‘‘‘~~lother (1)R residents (( ~ and on foreigners iitqiiire the creation of an eqiializatioii Ut’m

K:?) minus liabilities against GliB residents lEA ~vlik-li leads to:(] ,,~‘9diul It )reigllcrs (I.?I:

(5) HG’’°’ = HI ~ ~- E(21 .V\-1, -~ ~ -r C.T — I, -- i,

Substituting (2) in (1) vield~: là. this equalization tern is regarded as afinancial liability of \Vest Gt’rnianv. (5) can be

fat — 11W — (C: C.IYR — I ‘nh1

± u’~ — substituted in (I):

In) RU- -- RR\V + H (( -- i.’t + i:.

total u-calft of thc ( l )B is the ‘,u m of in -

iIi~idutl total wealth: (:ornpai-iTg 13 and G shows that the wealtht!’ansle’ t~Jiit’lii,, clirectlt- as~ociated ~viIh

I_i: RU ~. flRt\ + R((’”” — i. ‘‘~ Cmi’, cIepei~d~~0!i the amount of this11K:? — it equalization item.

1’ (Ti (11n11 the 4np i. ~i hi’ PhliHtt’TTt. m’,sI C!Th tim’’ Ifl’ O’\ !-eO In

I: ic:h -:I( i—.~.’ I Ir’. ci” ,liI/.ci: 1)’) ,t’ ‘.lt’’’ I Ii ~li’iiiEi;it ti,’’se iis’-ct —

I ,i:Ii)i:,Iil—r~11:. !.,sT P mninl-\ “‘ ~ uI,1.i.!i’m~’~1TO a rwnwcmn !.eT U,~fl

La.,i_,i,,ti. “i:~1’ :‘ :b-i;t ot H- i ,e-t1

.:’r’uan he !v’t ~~i~,’th tri-nsic’ :~j,,i’p’ ‘‘~‘p We

I (i~I•~‘i”!’.)lT ~ 1! he -~-cli,c-’’i. jji_I’

‘ill: 1:,. ~-t:i:— . ‘—al. ‘.‘ raId (‘T~L’” if lb’’, n’-m.,c~’_ —-

ml.,:. ‘: •-.i~--,’ -.,. -j~i’•~ .• Ii~IEi.’’, ~m:m’ IT’I’ tic’ ~irOmrec- ::fl:flI-r.

‘,t,)flhlTt hi;it \\ ‘s. ‘~ . .~i.,.,: ~ II:’- J’~J’ ~ P’’!. ,fl,;~,Iljp’~’)!’ qj. I’t’r’: ‘‘‘I.

- .. —f’P! -::.1 ~.:‘ j-,.,— :_.a- ;,:1.i,:_i__,, ‘.:.. I.

- .~~r’ .h”-’N. ‘.1 ‘.m’m:’- l~’ ~ kit -. . .~l~’

tji .~ 1 ‘‘‘ ‘‘r~—,1,.e_,:,_r’ :

: -

- -- - :, ‘. - ~., :.:.. ~ - -.- -

tor’s net debt and the limited 1LJM:1M conver-sion of savings (including currency) implies aUM 26 billion (5.3 percent) increase in the Ger-man central government debt. The impact ofthis asymmetric conversion would have beeneven higher if it were not for the “Richtungs-koeffizient” discussed previously.

Using an assumed 8 percent interest, this ad-ditional debt will increase the German govern-ment’s interest payments by UM 2.1 billion,about 0.7 percent of its total expenditure. Auniform 1UM:1M conversion of enterprise debt,savings and currency would have produced aUM 76 billion increase in government debt. Ifthis debt were borne mainly by West Germantax payers, this would have been identical to awealth transfer of UM 1230 from each WestGerman—in the form of an interest-bearing andnon-repayable IOU—and would have provided eachEast German with an additional UM 4560. Thisexample illustrates why the 1UM:IM conversionrate for savings was controversial in West Ger-many after it had become evident that a iDM:IMrate for enterprise debt was impracticable.

The set of conversion rates chosen for the Gmuhas important implications for the debt burden ofEast Germany’s enterprise sector, for the wealthtransfer between both German states and for thelevel of West German government debt. TheIUM:2M conversion rate for enterprise debt maycause some financial difficulties for many GUllfirms, but it will also lay the groundwork for theprivatization of the more profitable enterprises.This result is a necessary precondition for theGDR’s transition to a market economy. The ceil-ings for the 1UM:IM conversion of savings limitthe wealth transfer from West Germany to EastGermany to a relatively small amount. The sameapplies to the required increase in Germangovernment debt and its interest payments.

A (transitory) rise in the inflation rate of thecommon German currency area is unlikely afterthe Gmu. The post-conversion money stock in theGUll seems to be roughly compatible with theGUR money demand at the new UM prices.

The medium- and long-term impacts ofmonetary unification on the competitiveness ofGUR firms, on unemployment and relative livingstandards in East Germany, and on the wealth

transfer from the West Germans to East Germanshas been widely overestimated. The ultimate out-come of unification will be determined by theproductivity of East German firms, the real in-come necessary to encourage East Germanworkers to remain in the GUR and the actualwage and income levels that will be achieved inEast Germany.

Monetary unification has only have a short-termimpact on the initial wages and incomes in theGUR. Because the conversion rates are compatiblewith the more pessimistic estimates of the pro-ductivity differential between East and West Ger-many, they do not appear to have produced theproblem of too-high initial GUll wage levels andpossible downward-stickiness of wages in the faceof some initial unemployment pressures. Whetherthe prospects provided by the economic andsocial community of the two states and the far-reaching financial assistance offered to East Ger-many by the West German government will suf-fice to keep skilled workers in the GUR remainsopen to question.

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