SECTION of DOCUMENT:
Lagging Productivity in the East German Economy: Obstacles to Fast Convergence
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Joachim Ragnitz *
** [This paper summarizes a comprehensive study on East German productivity. Cf. J. Ragnitz, G. Müller, A. Wölfl et.al.: Produktivitätsunterschiede und Konvergenz von Wirt schafts räumen. Das Beispiel der neuen Bundesländer. Halle 2001.]
The record: Persistent divergence after initial convergence
Before World War II, the East German region was highly industrialized, and productivity reached more than 90 per cent of the level achieved in the West German industrial sector. After the war, the two states, the German Democratic Republic (GDR) and the Federal Republic, diverged, mainly due to the emigration of human capital from the East, its missing participation in western technological developments and the inefficient economic system. Though the GDR appeared to be the wealthiest country of Eastern Europe in 1990, it was far behind Western levels with respect to per capita income, technological knowledge, infrastructure and private capital stock. It was estimated that productivity was only about one third of West German levels in 1989. Since then, real productivity (as well as per capita income) has risen dramatically. However, most of the increase in productivity occurred during the first half of the 1990ies when existing firms were reconstructed and new enterprises were founded. In the second half of the 1990s, however, GDP growth was only about 1½ per cent per year, lower even than in West Germany. Convergence to West Germany nearly stopped: after a rapid increase of productivity from 33% to 64% of West German levels in 1995, productivity remained at only 68,5% of the Western level in 2000. The breach in GDP per capita is still higher, reflecting higher unemployment (about 17%) in Eastern Germany.
Compared to other European countries, the record is actually quite positive, as East Germany reaches a per capita GDP (in PPP) of about 76% of EU-15 levels in 1999. This is slightly more than in Portugal, about 10 percentage points higher than in Greece, and significantly higher than in Eastern Europe. But as people in East Germany compare their situation to West Germany and not to Eastern Europe, this does not mean much in terms of citizens´ satisfaction with the new circumstances.
Therefore, it is important to identify the reasons for the significant lag in productivity and to draw conclusions for further convergence of the East German economy. Before we debate the causes of the productivity gap, it should be pointed out that its magnitude has been overstated in the national accounts. For companies operating in more than one federal state, the origin of the value added cannot be satisfactorily differentiated at the regional level. This can result in major errors, especially when individual sectors are
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being analysed. Another aspect that should be taken into account is a high level of heterogeneity, where East German enterprises with a productivity corresponding to (or even exceeding) the West German level coexist with those whose productivity is far below these rates.
Table 1: Labour Productivity in the East German Economy (Western Germany = 100)*
* In this table, labour productivity is defined as nominal GDP per employed person. The data for Berlin are included as part of West Germany, not of East Germany.
The reasons for the productivity gap of the East German economy
Among the reasons for the observed productivity gap between East and West Germany, we must differentiate between, on the one hand, aspects related to the supply of important factors of production (physical capital, human capital and infrastructure capital) and, on the other, aspects that are related to enterprise management and general economic conditions.
Factors of Production: Lack of Infrastructure, Capital and Knowledge
As far as factors of production are concerned, the most important reasons for the productivity gap between East and West Germany are a deficient infrastructure, low capital intensity and a certain lack of knowledge capital.
Although massive infrastructure investments have been carried through in East Germany recently, and the main deficits have been overcome, significant differences remain between the old and new Länder with regard to certain types of infrastructure. This is true in particular for transport infrastructure, especially road transport. This deficit is demonstrated not only by capital stock data but also by the time needed to go from one agglomeration to another or from production plants to agglomeration centres. Lengthy travel times from the regions of the new Länder to important agglomerations and to major national transport intersections in the West are due to insufficient feeder roads, frequently unfavourable traffic routing and a generally lower network density. According to our simulations, productivity in the manufacturing sector alone could be about 10 percentage points higher if the infrastructure in East and West Germany were the same.
A second important reason for lagging labour productivity in East Germany is lower capital intensity. There was general consensus at the beginning of the 1990s that in the years prior to unification, due to a lack of investment, the capital stock was small and at the same time of poor quality. Since then, capital intensity has increased significantly. Estimates based on figures from the ifo (Institute for Economic Research) indicate that since the end of 1990 the level of gross fixed capital formation has risen by almost 90%. However, in 1998, capital intensity in the new Länder was still only around 75% of the West German level (see figure 1). In the manufacturing sector, the gap is somewhat smaller, eastern capital intensity reaching almost 90% of the West German level.
The main reasons for the comparatively low capital intensity are the relatively small size of enterprises in the new Länder (see below) and factor price relations different to those of West Germany (favourable relationship between wages and the interest rate). Therefore, low capital intensity is not a transitory phenomenon and will probably continue to exist for some time to come.
It is somewhat difficult to establish the impact of low capital intensity on labour productivity, due to a lack of statistical data. If one assumes the same macroeconomic production function for East and West Germany, East German productivity would be about 6 percentage points closer to the West German level if East Germany could achieve the same capital intensity as West Germany.
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A third element that could explain the East German economys lagging productivity is insufficient knowledge capital. Technological knowledge and business innovation are generally seen as a fundamental determinant of differences in productivity between regions. However, the stock of knowledge capital in the new Länder - measured per employed person is quite similar to the Western level, probably due to the accumulation of knowledge capital in East Germany and the technology transfer from the West. The main problem with regard to knowledge capital, then, is not a lack of availability, but the fact that East German enterprises are still finding it hard to convert product and process innovation into increased productivity and to come up with innovative products that can successfully compete on the market. With better capacity for implementing internally produced knowledge (innovation efficiency) and complete absorption of the knowledge provided by the West, the East German productivity gap could have been about 9 percentage points less in 1997.
Nonetheless, there are considerable sector-specific differences. The R&D intensive sectors in the Eastern Länder such as the chemical industry, vehicle production, appliances for automatic data processing and electrical engineering are characterized by a low level of knowledge capital when compared to those of West Germany. As the innovative potential of a sector is largely determined by its initial stock of human capital and further investments in it, these sectors later on might be forced to produce traditional goods which have little potential for a further boost in productivity.
Another factor that one might think of is the supply of human capital, generated during the formative years in the formal education system and at the workplace. With regard to
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the formal education system, the quality of East German education was comparable to West Germany at the time of unification. Indeed, the new Länder enjoyed considerable advantages with regard to the number of persons with complete vocational training or with academic qualifications.
The situation is different when we take into account the firm level. Before 1990, enterprises were operating on a technologically backward level, and their administration was organized according to the principles of a centrally planned economy. The human capital specific to the workplace therefore almost completely lost its value during the transition to a market economy.
After ten years of transition to a market economy, the situation has changed. The new Länder are far less disadvantaged than they were initially with regard to the job-specific human capital and they still maintain certain advantages with regard to the formal education system or the formal training of the working population. Yet it is also clear that the high level of formal education attained by East Germans is not being utilized adequately, in part due to the specific sector structure of the East German economy (see below). The good supply of human capital is therefore not matched by a corresponding demand.
In view of the now fairly minimal disadvantages of the East, human capital in general does not contribute to the productivity gap. However, it should be noted that certain types of human capital are indeed in short supply. This often concerns very specific skills, especially in the areas of research and development and in marketing, but also applies to general management skills and the willingness and competence to become an entrepreneur.
Structural Factors: Sectoral distribution, enterprise size, market power
In the preceding section, it was shown how differences in the supply of the various production factors contribute to the productivity gap of the East German economy. However, these differences alone do not explain the productivity gap. Other factors are also relevant, which are either associated with the specific economic structure in East Germany or the way that companies are run.
First, the differing sectoral (or functional) economic structures in East and West Germany (see figure 2), biased towards sectors with a lower productivity, contribute to the productivity gap. Our calculations for recent years, based upon the (still unedited) National System of Accounts, indicate that the effect amounts to about five percentage points. This is considerably higher than in the mid-1990s.
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Figure 2 reflects the fact that industries that are typically characterized by high productivity are under-represented in the new Länder. As mentioned above, the current industrial structure in the new Länder is not very intensive in R&D, and technologically advanced industries are poorly represented. Moreover, productivity at the sectoral level also depends on competition, since enterprises in highly competitive markets are forced to increase productivity. Large sections of the East German economy, due to their initial lack of competitiveness, have concentrated on markets with a relatively low level of competition. While this can be seen as positive in terms of employment, it has a negative effect on (potential and actual) productivity.
Finally, it should be taken into account that investments of West German and foreign enterprises in East Germany are mostly limited to production facilities while strategically important and more productive activities such as R&D remain at their original headquarters. Jobs for highly qualified workers are, therefore, under-represented in the new Länder. This has a particular impact on technology-intensive industries, where productivity is low in the East.
A second (structural) factor to explain low aggregate productivity in East Germany is enterprise size. For the manufacturing sector in the new Länder we see an abundance of small and medium-sized enterprises, while there are hardly any large enterprises (i.e. those with 1,000 or more employees; see figure 3).
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Smaller enterprises are generally less productive than larger ones. They are unable to make use of economies of scale, they face difficulties on the markets and they encounter obstacles in financing. For enterprises that resemble each other closely in terms of size and other features, the productivity gap of East German enterprises is considerably lower: Without taking into account large enterprises, East German industrial productivity would reach 83% of the West German level. This result shows that the specific scale structure of enterprises has an important effect on productivity, at least in manufacturing.
With reference to the data just presented, it should however be noted that other causes of the productivity gap already considered may also be closely related to enterprise size. For example, capital intensity in small enterprises is often lower than in larger ones, some sectors are typically made up of small enterprises and so on. Therefore this explanation for the productivity gap should not be looked at in isolation.
A third structural aspect that has to be mentioned is the limited market power of East German enterprises, in part due to insufficient or ineffective marketing. The prices paid for East German products are significantly lower than average, and the gap to West German levels has not narrowed since the mid-1990s (see figure 4). This is a decisive factor in the productivity differences between East and West: According to our calculations, differences in product prices explain nearly half of the productivity gap. Only a small part of this difference is explained by a specific marketing strategy, most of it only reflects limited market power and a lack of reputation.
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In addition to the three structural aspects mentioned, there are several additional factors that are often brought into the discussion, but whose explanatory power has not been proven by our research.
It is usually assumed that inefficient production and organization contribute to the productivity gap, but according to the results of our study, this aspect is not important. Personnel problems are not more widespread in East German enterprises than in West Germany, and East German businesses are not at a disadvantage with regard to their efficiency in using intermediate goods either. The only significant explanation for the productivity gap related to enterprise organization would be a somewhat technically oriented attitude of management, leading to a neglect of market orientation. Although many enterprises have recognized this problem, there is still a lack of promising solutions.
We also tried to assess whether insufficient integration in enterprise networks has been a major factor. It is true that stable, regionally concentrated value-added-networks have not yet taken root, a fact that is reflected, for example, in the relatively low degree of specialization of East German regions. Likewise, the establishment of major West German companies in the eastern Länder has not led to widespread integration of East German firms into national networks. Reasons for a lack of commitment on the part of East German enterprises to such networks could be continued uncertainty in selecting and dealing with different partners, which in turn suggests weaknesses in initiating and implementing cooperation.
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In general, those East German companies that have become part of networks are more productive than those that have not. The efficiency of participants in these networks is not only reflected in the figures relating to turnover and productivity as a whole. The integration of East German enterprises in networks rather goes hand in hand with investment in modern plants, successful innovation activities and a stronger outward orientation of sales. Although cursory evidence indicates that network integration goes hand in hand with higher productivity, the effect of insufficient network integration on overall productivity has not yet been calculable.
Finally, we have to take a look at the role of economic policy. Macroeconomic conditions are virtually the same in the East and the West, and there is a variety of assistance programs for East German firms. In other words, economic policy should have contributed to convergence. However, it is possible that the abundance of assistance programs has led to an inefficient capital allocation, thereby holding down East German productivity. Some kinds of highly subsidized industrial centres, in particular, might be inefficient in this way. High (social) transfer payments to the East may also have a negative impact as they might give negative incentives to work. Indeed, net transfers are totalling more than 140 billion DM a year, and about 90 billion DM of transfers has social objectives (see figure 8). The value of total transfers is equivalent to about one third of the East German GDP, and about one fourth of total demand is financed by transfer payments from West Germany.
In order to explain the lagging productivity of the East German economy, a whole range of factors have to be taken into consideration, especially a lack of (transport) infrastructure, inefficient utilization of the existing knowledge capital, low capital intensity, a sectoral specialization in low-tech industries, small enterprise sizes and limited market power. These factors are interrelated in many ways, for instance, the small scale of enterprises are related to low capital intensity and to limited market power. It should also be taken into account that the significance of the different reasons mentioned has shifted over time. While, for example, lack of capital and a deficient infrastructure were more important at the beginning of the transformation than they are now, structural factors such as the lack of high-tech firms and of larger enterprises over time have become more important in explaining the differences in productivity.
Prospects for future convergence
Comparative international studies tell us that even when general framework conditions in two regions are identical and there is high mobility of production factors, convergence will probably be a slow process. Even permanent differences in productivity remain a relevant possibility, above all when there are path dependencies. The particular sectoral profile as well as the size structure of the East German economy indicates that such path dependencies could be significant. They are not only an important reason for the current productivity gap but may also reduce productivity growth in the future, if, for example, the small scale of the enterprise hinders research and development activity or
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if an industrial structure with low technological intensity makes it more difficult to attract additional enterprises.
However, for East Germany, there is a range of arguments against a low rate of convergence:
The structural problems of the East German economy (enterprise size, sector structures) present a fairly large obstacle to a rapid convergence of productivity. Existing enterprises will not grow fast enough to transform the size structure significantly in the short run, it will remain far from the West German level. The establishment of new large enterprises that could rapidly eliminate this shortfall is not likely to happen in significant numbers either. Similar considerations hold for sectoral specialization. Even though East German industry is at present experiencing robust growth, characterized by a dynamic development of potentially highly productive sectors, these industries are still too small to have a tangible influence on productivity growth at an aggregate level. Again, the establishment of new businesses from such dynamic sectors could change the situation dramatically. However, the chances of this happening are pretty slim due to the weak distinct locational advantages of the new Länder.
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To the extent that the productivity gap is related to these structural deficits, the prospects for further convergence must be seen with a certain level of scepticism. However, there is ample evidence that these factors provide less of an explanation than is often assumed in public debate. Considering all the above-mentioned arguments, we assume that the convergence process will not come to a complete standstill. However, the rate of convergence will not pick up speed quickly enough for equal productivity to be achieved in the near future.
A few simple observations serve to illustrate the point: In order to reach the West German level of productivity within the next 10 years, annual productivity growth in the new Länder would have to be 4.2% higher than in West Germany. This is unlikely to occur. It would even be ambitious to anticipate productivity growth of 2 percentage points above the West German level, which would be sufficient to reach equal levels of productivity within 20 years. In conclusion, the idea that it will be possible to close the productivity gap at the aggregate level in the foreseeable future should be rejected.
However, slow convergence at the aggregate level does not rule out higher productivity convergence at the regional level. This may lead to increased regional differences, with regard to the level of productivity achieved, a fact that is common in West Germany too. Among the Bundesländer, productivity levels range from 96% of the German average (Saarland) to 117% (Hessen). Even higher (136%) is the productivity level in the city-state of Hamburg. This shows that a general comparison between East and West is becoming less and less appropriate. Comparisons should rather be made between Länder and regions that resemble each other closely in terms of economic structure, population density and location. Admittedly, such a consideration will do nothing to alter the fact that productivity in the individual East German Länder is still lagging behind considerably, but the benchmarks for convergence should be similar West German Länder rather than the West German average.
Of course, convergence should be reached without sacrificing employment. One possible and by no means improbable scenario is that market forces make it necessary to eliminate all jobs where a certain minimum level of productivity is not achieved. In this case, the average productivity of the remaining jobs would increase to a level comparable to West Germany. This could occur if wages, with the aim of quickly achieving wage convergence with the West, were allowed to rise above the level that allows East German enterprises to stay or to become competitive. In this case high productivity would not be matched by high per capita income and productivity convergence would not be accompanied by convergence of income.
Economic policy: Limited options
Finally, the question arises as to the necessary economic policy. Further promotion of capital investment would seem to achieve only limited productivity convergence, as the productivity gap is caused only to a small extent by low capital intensity. However, it would make sense to subsidize capital investments that simultaneously help to overcome structural deficits, especially the lack of outward-oriented enterprises and of large enterprises in sectors with typically high productivity. Investment subsidies such as those granted by the joint program Verbesserung der regionalen Wirtschafts
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struktur" (Improving the regional economic structure) are a suitable instrument to achieve this goal, as they can be limited to the establishment of new, outward-oriented businesses in structurally disadvantaged regions. The credit programs of the KfW [Kreditanstalt für Wiederaufbau, German Bank for Reconstruction], one of the aims of which is to promote the growth of small and medium-sized enterprises, are also positive in this regard. However, there would not appear to be a need for any additional assistance measures.
A further priority of the reconstruction policy for the new Länder is to subsidize research and development in East German enterprises. It is, however, hard to judge how useful this is in overcoming low productivity. On the one hand, it was shown that East German enterprises do not generally lag behind in terms of knowledge capital and innovation. On the other hand, East German enterprises have major difficulties in turning successful innovation into market success, compared to their competitors in West Germany. This shortcoming is difficult to eliminate through grants for R&D and, moreover, it is virtually impossible to imagine a policy that increasingly focuses on promoting sales because of the large number of factors related to demand.
This does not mean that there is no further need for economic policy intervention in East Germany. The development of infrastructure, the creation of favourable conditions for schools and higher education, regional policy measures to assist structurally weak regions and the establishment of favourable conditions for business start-ups all continue to require urgent measures. However, the expectations regarding economic policy being able to eliminate the differences in productivity between East and West Germany should remain realistic.
© Friedrich Ebert Stiftung | technical support | net edition fes-library | März 2002