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Fiscal stimulus and German unification
For all the talk about the Great Depression, we are missing one historical analogy for a program of large fiscal stimulus, namely Germany after the Berlin Wall came down. The two countries united, lots of money was spent and lots of money was borrowed. West Germany had a modern economy with both manufacturing and services. At the time Germany had unemployed resources, especially if you count the labor moving from East Germany to West Germany as grossly underemployed and available for higher-return projects.
The results were less than wonderful. The higher demand boosted measured gdp growth in the short run (bananas and porn, plus reconstruction) but Germany fell into economic stagnation. The new demands took the West German economy only so far. The higher taxes and debt then kept the German economy down for many years. Few Germans were happy with the economic fallout from this "stimulus." And that was with a relatively well-functioning financial system and a reasonable amount of initial optimism.
You can list many dissimilarities between German unification and the current U.S. situation (and in the comments I am sure you will). Still, as historical examples go, I believe this one has some relevance. When European leaders are skeptical about fiscal stimulus, they have some reasons, some of them quite recent.
If you'd like a lengthy account of the economics of that period, along with lots of numbers, try this study. Just read through the first few pages, you'll see statements like:
Economic theory suggests that a fiscal expansion financed by distortionary taxation could potentially generate substantial adverse growth effects after the initial positive demand stimulus dies down.
It is then estimated that the negative economic impact from the German stimulus may explain up to one third of the subsequent growth gap between Germany and comparable European nations.
Addendum: Don't be fooled by the topic-shifting comments on why East Germany didn't do better; this post is about how West Germany fared from so much stimulus. Not so great.
Posted by Tyler Cowen on March 26, 2009 at 07:48 AM in History | Permalink
Comments
Actually, since no one really seems to know what to do about this, I'd be happy to see different regions take different approaches. Then if one region seems to be dealing with it better, others can learn from that example.
Posted by: MichaelG at Mar 26, 2009 7:52:04 AM
"You can list many dissimilarities between German unification and the current U.S. situation (and in the comments I am sure you will)."
Yeah, but one dissimilarity stands out. Germany is more likely a case of classic crowding out (which Chicago school is so fond of these days), while current situation is the case of insufficient capacity utilization, filled by stimulus (which Krugman pushes though)
Posted by: Konstantin at Mar 26, 2009 8:23:22 AM
Hmm, I'm no expert on German unification but I seem to remember that the major sticking point at the time was how to convert the DDR currency to D-mark. If I remember correctly Kohl found it expedient to convert it at a frankly idiotic rate, thus dooming the manufacturing industry in East Germany and pricing out East Germany as a place for German industry, and other investors, to invest (the German car industry, for example, has invested more in Hungary and the Czech Republic, than in former DDR). So if we are thinking of a stimulus that are going to pay ridiculous amounts of money to workers in dying industries, then Unification probably shows that this is a bad idea. If you think that Wall Street is a dying industry, then the bailout would probably qualify as analogous to Unification. Otherwise, I'm hard pressed to see any relevant lessons for today.
Posted by: Dan Kärreman at Mar 26, 2009 8:41:29 AM
Tyler, can you comment or blog on whether these views can ever be falsified? E.g. is there any outcome under which you and Cochrane (say) would admit, "Wow OK, the Obama stimulus worked," or under which Krugman would say, "Whoops I was wrong"?
If there is no recovery in the next 3 years, I am quite sure that Krugman would say, "I told you, the stimulus wasn't big enough." I'm not sure what Cochrane would say if unemployment drops to 2 percent next year; maybe something like, "See, I told you we didn't need a big stimulus--the problem fixed itself quickly."
Posted by: Bob Murphy at Mar 26, 2009 8:45:48 AM
Konstantin,
Isn't it only insufficient capacity utilization in the sense that we aren't producing what we were before? What if people don't want what was produced before? Then, to push old products at the expense of new would be crowding out, no?
As political evidence, any lesson from other countries is going to be a hard sell. But, as a case study, that is an awesome example. Imagine trying to do such as a controlled experiment. Why would anyone waste time looking for dissimilarities?!?
I wonder how much the Germans thought that Easterners deserved economic equality from the get-go because they were denied it through no fault of their own. It seems any major upheaval is an opportunity for asinine policy. As Rahm Emanuel says "a crisis is a terrible thing to waste."
Posted by: Andrew at Mar 26, 2009 8:56:53 AM
Germany in the 1990s. Japan in the 1990s. America in the 1930s. The failure of government spending to stimulate the economy seems like pretty much the historical rule in peacetime.
What I find interesting is that the only examples of Keynesian stimulus that seem to work involve an increase in *military* spending. Germany in the 1930s. America in the 1960s, 1980s, and maybe the Bush, Jr. years. It's not hard to explain why peacetime fiscal stimulus consistently fails. Government spending is wasteful, and if your unemployment rate is lower than 30% or so you're mostly going to crowd out private spending. There's actually no reason to think fiscal stimulus would work, since Keynesian theory has been taken to the cleaners for thirty years running.
But why does military spending seem to work?
Posted by: Nathan Smith at Mar 26, 2009 9:08:25 AM
I have travelled extensively throughout Germany, including the eastern part (former DDR) in the decade following reunification. The German government in Bonn (and later Berlin) poured money into the East. The results? A stunningly beautiful infrastructure, but little real economic growth. I rode sleek, high-speed trains over smooth new track through decrepit villages full of abandoned houses and factories. I drove on the autobahns past abandoned farms and decaying towns. Many of the residents of eastern germany have moved to the west, where the jobs are.
Posted by: ned at Mar 26, 2009 9:19:19 AM
Both the current US monetary/fiscal stimulus and the German reunification fiscal stimulus are and were addressed to stimulating demand. In the US, shortage of demand seems to be a large part of the problem. In the German case the problem was clearly not shortage of demand. It was shortage of effective productive capacity. If you address the wrong problem, the likelihood of getting satisafctory results tends to be between low and negligible.
That is not to say that the chances of the US moves solving everything are are all that good. There is a law (which has escaped Google) which says "If answering the wrong problem delivers the right result, your faith in miracles is not misplaced. If answereing the right problem gives the right result, you are just lucky."
Posted by: Diversity at Mar 26, 2009 9:25:12 AM
A brief quotation from The European Economy Since 1945 by Barry Eichengreen (pp. 320-1).
"From 1992 though 1994, the eastern Lander grew at an average annual rate of 9 percent, encouraging comparisons with the post-WW II Wirtschaftwunder. The reorganization of production, backed by new investment, raised gross value added per employee from barely 40% of the W. German levels at the beginning of the transition to nearly 70% by mid-decade. But growth declined to 5% in 1995, 4% in 1996, and 2% in 1997. Growth in the eastern Lander then average just 1.4% between 1996 and 2003, below the 2.3% of Germany's West. ... the key factor in the disappointing recovery was the evolution of labor costs...In effect, W. German unions and employers were allowed to set East German wages. Seeking to defend western jobs against low-wage competition from foreign firms interested in setting up in the ruins of the East, they advocated a policy of rapid wage adjustment toward western levels."
You know, I’m a great fan of Tyler’s but it bugs me when economists outside the academic setting feel at liberty to engage in this kind of superficial argument. You can’t just say, “they did fiscal stimulus, see what happened” without controlling for all the relevant factors. Imagine if they did physics experiments of medical studies that way!
Posted by: Phil P at Mar 26, 2009 9:28:58 AM
I agree with Phil P.'s post that the manipulation of East German wages to be significantly higher than their marginal productivity was the huge mistake of that merger of economies.
Posted by: liberalarts at Mar 26, 2009 9:42:42 AM
Phil P and Dan Karreman nail it. East German workers were subject to West German wage bargaining (therefore minimum wages out of all proportion to their productivity), at the same time as premature currency union caused real appreciation in the East German currency. Taken together, these policies prevented East German workers from competing with their (more productive) West German counterparts in the way normal economic theory would suggest (price). Fiscal stimulus was bound to be ineffective when East German labour was so utterly mispriced. See e.g. http://www.ifw-members.ifw-kiel.de/publications/minimum-wages-and-employment-the-case-of-german-unification/kap1045.pdf
Helmut Kohl saw a political/moral imperative (East German workers must have the same rights as West German ones), and ignored the economic consequences. The result was stagnation.
As with Phil P, I'm a big fan of Tyler - but pretty sure he's off base here...
Posted by: Ali at Mar 26, 2009 9:52:34 AM
Oh so the pro Keynsian side is saying that unions and labor laws that artificially keep wage levels above marginal productivity are bad for low skilled laborers? Interesting..........
Posted by: John Pertz at Mar 26, 2009 10:06:04 AM
Rather than poke at the analogy, I would say we're more like East Germany than most people realize. I've been to East Germany, and I happen to live in a Rust Belt town (Syracuse, NY) and the problems that afflict both areas are remarkably similar. The biggest issue is that economists often assume that structural adjustments occur relatively quickly, and that individuals that are displaced through structural unemployment rationally adjust to the circumstances and either move to another area where jobs are more plentiful, or accept another job at a lower wage (or both). In reality, unemployment and the attendant social problems linger for a painfully long time, making the city less attractive to alternative industries that might find the existing industrial infrastructure attractive.
Since our current unemployment figures appear to reflect an ongoing structural adjustment away from manufacturing and construction, we need to recognize that we're on the cusp of another generational decline in real income for America's lower middle class. Germany managed to weather the storm fairly well by propping up East Germany industry, despite heavy losses. Will we make the same decision? If not, what will we look like when individuals with a high school diploma are only able to find employment in low-paying service sector jobs? My guess is that we'll look a lot less affluent than Germany is today.
Posted by: Braden at Mar 26, 2009 10:36:24 AM
You claim fiscal stimulous did not work in Germany in the 1930s because labor got too small a piece of the pie. Now you are claiming that fiscal stimulous did not work in Germany of the 1990s because labor got too big a piece of the pie.
Your reasons for claiming fiscal policy do not work sound like someone claiming a car does not work even though it gets you from place a to place b smoothly, comfortably and safely because it used energy to do it. If you find something about it you do not like you use that as a rational to claim that fiscal policy failed.
You are great at finding rationals for proving your ideological conclusions, but weak at using rational arguments to convince anyone that you're arguments are valid.
Posted by: spencer at Mar 26, 2009 10:49:53 AM
Entertaining 'gotcha' from John Pertz :-)
That said, there's nothing inconsistent about believing:
(i) wages should (and ultimately will) reflect marginal productivity (whether unions like it or not)
(ii) government spending can be an important source of demand when productive factors are underemployed
(iii) fiscal stimulus will have a dramatically smaller impact if the labour market is forced out of equilibrium by artificial wage floors - which is exactly what happened in East Germany after unification.
Picture two scenarios for (say) China, during the current crisis.
Scenario 1 - the Chinese government introduces a massive fiscal stimulus
Scenario 2 - the Chinese government introduces a massive fiscal stimulus and simultaneously introduces a $20/hour real minimum wage.
Now is Scenario 2 a fair template for evaluating the effectiveness of fiscal stimulus? Hardly. We'd expect the wildly unrealistic minimum wage (which would destroy millions of jobs) to swamp any stimulus effect. Pointing to the resulting unemployment and saying 'aha, fiscal stimulus was tried, and failed' doesn't make for a compelling economic case. Ceteris just ain't paribus, which is why I'm not at all convinced by Tyler's analogy...
Posted by: Ali at Mar 26, 2009 11:07:16 AM
"Your reasons for claiming fiscal policy do not work sound like someone claiming a car does not work even though it gets you from place a to place b smoothly, comfortably and safely because it used energy to do it. If you find something about it you do not like you use that as a rational to claim that fiscal policy failed."
The burden of proof is on the proponents of fiscal stimulus not Tyler. Besides how is Tyler any different than "WWII proves stimulus works" Krugman.
I don't understand where this belief in fiscal stimulus comes from. Exactly what are the reason you think fiscal stimulus will work? I don't understand why I am required to believe in things for no reason whatsoever. It seems like madness to me.
Posted by: assman at Mar 26, 2009 11:17:32 AM
There definitely some interesting parallels here. Spending on infrastructure to promote growth? Check. Promotion of clean energy investments as the economy of the future? Check. (http://www.nytimes.com/2008/05/16/business/worldbusiness/16solar.html?ref=business) Increase in taxes to pay for it? Check. (Germany had a 7.5 reunification tax)
And yes, the analogy does suffer to a large extent because of the labor issue -- East German workers priced themselves out of the market. Well, we're headed in that direction too with the Employee Free Choice Act that will boost our own labor costs.
For further reading on the reunification topic I would recommend this article from Der Spiegel:
http://www.spiegel.de/international/spiegel/0,1518,373639-2,00.html
And check out this graph:
http://www.spiegel.de/international/spiegel/0,1518,grossbild-515451-373639,00.html
Posted by: Colin at Mar 26, 2009 11:30:12 AM
People, you can blame slow growth in East Germany all you want on legally-mandated excess wages. The question at stake in this post is growth in West Germany, and it did not benefit so much from fiscal stimulus. You are not reading the post carefully.
Posted by: Tyler Cowen at Mar 26, 2009 11:34:03 AM
Tyler,
And the spending was not in West Germany; it was in East Germany. There is
the answer to your question.
Posted by: Barkley Rosser at Mar 26, 2009 12:09:18 PM
"You can list many dissimilarities between German unification and the current U.S. situation (and in the comments I am sure you will)."
How about the fact that the labor unions demanded that the prevailing wage of West Germany applied to all of Germany (even though the productivity of East Germany was obviously lower), and that they used an almost 1-1 conversion for the two currencies, which to this day baffles most European economists.
Let's see, your example to show that stimulus doesn't work is to compare:
1) a situation where a country already in recession essentially annexed a gigantic slum and for political reasons tried to treat that slum like it was just like the rest of the country, and so they spent a lot of funds on fiscal stimulus on East Germany by taxing West Germans (who were currently suffering a massive inflow of labor from the East, causing wage stagnation).
2) a situation where an already integrated economy built up an asset bubble which lead to over-leverging which in turn caused a financial collapse which in turn caused a real economic collapse and under-utilization of resources, and we're now trying to use fiscal stimulus to pick up the slack.
Oh yeah, they're so similiar it's spooky.
Posted by: Tim at Mar 26, 2009 12:11:50 PM
Tyler, I re-read the post carefully. In the second paragraph, dealing with the results of reunification, you mention "Germany", "West Germany", "German", and "Germans".
So which is it? Are you talking about the costs and benefits of the reunification/stimulus to Germany as a whole? Or only to West Germany?
You could say the Apollo Program was a stimulus failure, if you look at the economy of Iowa during the 1960s. Or a huge success, if you look at the economy of central Florida during the same time.
Posted by: Bob Knaus at Mar 26, 2009 12:28:17 PM
Keynesians always have a way of dodging any apparent empirical refutation of their theory. Ultimately Keynesianism is unscientific in the Popperian sense: it is too vague ever to be falsified. To the extent that it could be falsified, it was falsified by the 1970s stagflation. But no natural experiment can ever really exhaust the Keynesian dodges.
assman is right. The burden of proof is on the Keynesians, and they can't discharge that burden.
Posted by: Nathan Smith at Mar 26, 2009 2:31:17 PM
Keynesians always have a way of dodging any apparent empirical refutation of their theory. Ultimately Keynesianism is unscientific in the Popperian sense: it is too vague ever to be falsified. To the extent that it could be falsified, it was falsified by the 1970s stagflation. But no natural experiment can ever really exhaust the Keynesian dodges.
assman is right. The burden of proof is on the Keynesians, and they can't discharge that burden.
Posted by: Nathan Smith at Mar 26, 2009 2:31:40 PM
I think your "analogy" makes no sense because:
1. At the time, West Germany may have had some slack capacity, but it wasn't in a severe recession / near-depression sort of scenario, i.e. the output gap wasn't particularly huge compared to what we are looking at right now. It was widely argued that unemployment was to a large extent structural.
2. While initially, pouring additional money into the East was clearly a fiscal stimulus for the West (because demand flowed back to the West), the longer-term expansionary effect is not really clear: If you keep sending money to the East that is not exclusively additional spending, but also partly financed by cutbacks in the West, then you may actually be looking at a negative stimulus, because much of the eastbound money did not flow back. It stayed in the East or flowed abroad. So to the extent that the money going East was not additional spending, but cut in the West, the longer-term stimulus for the West wasn't particularly large.
3. Nobody disputes that one of the reasons why West Germany underperformed in subsequent years is precisely because of the burden of integrating the East: If you pour money into the East and this money is then missing in the West (it may flow back as demand, but it is not invested in the West: so infrastructure deteriorates, schools and universities get less funding, taxes are higher, etc.), then of course this drags down growth. It's a no-brainer. This is not the case with stimulus spending right now: The money would not go elsewhere, it would (presumably) be used to do something useful right where it's being spent.
Posted by: Thomas at Mar 26, 2009 2:55:48 PM
Or to say it in much simpler words:
German unification involved giving money to somebody else without getting anything in return (apart from a "demand stimulus" and feeling good about helping your fellow countrymen).
A stimulus in the current situation involves spending money on yourself. Maybe not money perfectly well spent, but it's still spent on the same people that are paying for it, and it either increases their utility (via consumption) or there future production capabilities (via infrastructure, human capital, production subsidies,etc).
You cannot compare the two.
Posted by: Thomas at Mar 26, 2009 3:02:48 PM
