Is German reunification a model for Europe?

at 05:36 PM ET, 12/01/2011

American commentary on the euro zone crisis often insinuates that German leaders are being wildly unreasonable in holding up many of the proposed solutions favored by economists. Why won’t Angela Merkel just let the European Central Bank backstop Spanish and Italian debt? And what’s wrong with eurobonds? Sure, they could entail a German-financed bailout of irresponsible neighbors, but a bailout would still be cheaper than the consequences of having Greece — or even Germany — leave the euro. So why are they being so stubborn?


At the Berlin wall. (MAURIZIO GAMBARINI/AFP)
Tyler Cowen has a thoughtful post at Marginal Revolution trying to see things from the German perspective. Among other points, he notes that Germany has some experience in standing firm in the face of expert carping after the fall of the Berlin Wall. “We” — meaning the Germans — “did a deal with East Germany, and the terms of that deal violated a lot of precepts of economic theory,” Cowen writes. “It even included an overvalued currency for the poorer region and a long period of adjustment. Yet we insisted up front that all dealings be done on the terms of the more successful region and culture, with very little compromise. This transition, for all of its short-term flaws, will go down in the history books as a great long-run success.”

Fair enough. But it’s worth thinking through whether German reunification is really such a good model for European integration.

When East Germany rejoined the West in 1990, it was indeed linked to an “overvalued” deutschemark. As a result, unemployment in East Germany exploded (the region lost 4 million jobs in the first five years alone, and the jobless rate peaked at 20 percent), as less-productive workers in the East suddenly found themselves being paid inflated wages. This is much like the situation that Greece and Ireland find themselves in now. Greece would benefit from being able to devalue its currency to improve its economic competitiveness, but it can’t, because it’s yoked to the euro.

So what eventually happened in Germany? The answer involved lots of subsidies and wrenching transfers of wealth. West Germans paid about $1.9 trillion over 20 years, partly via a “solidarity surcharge” on their income taxes, to help modernize the East. That’s roughly two-thirds of Germany’s GDP last year. The subsidies helped cover East Germany’s budget shortfalls and poured money into its pension and social security systems. At the same time, nearly 2 million East Germans — a full one-eighth of the population — moved west to seek work.

Now, as former White House economic adviser Austan Goolsbee pointed out this week, neither of those developments is likely to happen with further euro zone unification. It’s not nearly as easy for a Greek or Portuguese worker to pick up and move to more productive countries like Germany or the Netherlands—the language and cultural barriers are quite severe (See this IZA paper for more.) What’s more, none of the plans for fiscal integration in the euro zone envision the same sweeping transfers and subsidies that Germany saw after reunification.

We could also compare Europe to the United States. As Jacob Funk Kierkegaard of the Peterson Institute shows in this chart, the central authority in Europe, the European Commission, has a much, much tinier budget, as a percentage of Europe’s GDP, than America’s federal government. That explains how more-productive workers in places like New York City and San Francisco are able to prop up less-productive workers in states like, say, Mississippi — via Medicaid, Medicare, Social Security and other domestic spending. (Plus, it’s a lot easier for Americans to pack up and move.) As a result, it’s much harder for a state like Nevada, which found itself depressed by the housing bust, to find itself in a situation like, say, Italy’s.

That doesn’t mean euro zone integration is necessarily doomed to fail without trillions in subsidies from wealthy countries such as Germany and the Netherlands. But it helps explains why, as Goolsbee argues, Europe is so much more dependent on healthy growth to haul itself out of its debt crisis than the United States or post-reunification Germany.

 
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