March 2, 1990
"A Prenuptial Agreement for German Currencies"
San Jose Mercury News
By Timothy Taylor
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EAST and West Germany are proposing a sort of shotgun marriage between their
respective currencies, the ost mark and the deutsche mark. They are likely to
discover that while they can force the wedding to occur, no one can dictate living
happily ever after.
The impetus behind this sudden union is that a million East Germans have already
emigrated to West Germany in the last year or so, and they are still heading west
at a rate of about 2,500 every day. East Germany is only as large as the state
of Ohio, so it's not hard to pack up and head for the border. At this pace, one-tenth
of East Germany's population will have left by the end of this year!
East Germans are heading west largely because West German wages are about four
times higher. Social security payments in the West are higher than many wages
in the East, according to the Economist magazine. Even better, you can buy things
with your money in West Germany, rather than looking at empty shelves in East
So how are you going to keep the East Germans back in Leipzig and Karl-Marx-Stadt
when they've seen the living standards of Frankfurt and Stuttgart and Berlin?
Led by Chancellor Helmut Kohl, the West German government appears to have decided
that the first step toward encouraging East Germans to stay home is to start their
economy running on deutsche marks instead of their current communist funny money.
Somehow, marrying the two German marks has become a symbol of unifying the two
Germanies. The issue is no longer whether a common currency is a good idea, but
how it should be done.
The problem is that an ost mark has a market value of perhaps an eighth or
a tenth of a deutsche mark. If East Germans are forced to convert their money
and savings to D- marks at the market exchange rate, they will feel impoverished
and continue to head west.
So West Germany is contemplating a subsidized exchange rate, a sort of bribe
to stay home. Five-to-one? Three-to-one? Last week, world financial markets shuddered
at rumors of a one-to- one exchange rate.
The cause for concern is straightforward. A one-to-one rate would mean that
the buying power of East Germans increases by a factor of eight to 10. Adding
to the money supply in this way is a textbook example of how to create inflation.
There is a tremendous irony here. West Germany has been hypersensitive about inflation
ever since the hyperinflation of 1922-23, when the price level increased by a
factor of 20 billion in two years. (Really!) The social instability of that hyperinflation
helped make Nazism attractive, and thus helped cause World War II and the division
of Germany. But now, reunifying Germany appears to call for risking a bout of
Germany may try to minimize the inflation by limiting the number of ost marks
that can be exchanged per household each year, or by having several different
exchange rates, but those half measures are like saying that if you eat the ice
cream slowly, the calories won't count. As long as the ost mark receives a subsidized
exchange rate, it will stimulate inflation. West German interest rates are already
moving on up, as investors anticipate that money loaned out today will be repaid
in inflation-depreciated marks in the future.
But for all the difficulties of converting East German bank accounts to D-marks,
that step should be easier than integrating the economies themselves. For example,
East Germany still subsidizes food, rent and transportation, and West Germans
are now driving across the border to buy cheap meals and groceries. A common currency
and a unified economy must mean the end of such price subsidies.
Wage levels pose another problem. If the currency unification leaves wages
in the East at one-quarter of those in the West, the migration will continue.
But if the reform tries to provide East German workers with more than their productivity
is worth -- given the decaying infrastructure, outdated capital, and inefficient
production and management of their country -- then businesses will avoid hiring
workers or investing in East Germany.
So East German wages need to straddle the sharp edge between being high enough
to keep East German workers at home and being low enough to encourage West German
(and other European) businesses to invest.
East and West Germany have established a joint commission to hammer out the
details of a common German currency. I believe the commission will eventually
settle on some exchange rate and then release lengthy statements explaining how
both Germanies and all the world will benefit from their Solomonic decision.
The unvarnished truth is less cheery. West Germany is the third largest player
in the world economy, after the United States and Japan. It is about to sink tens
or hundreds of billions of dollars into East Germany in subsidies for the ost
mark, welfare and social security payments, economic development incentives and
It's a gamble, and the interconnected global economy will transmit the effects
of the gamble to inflation and interest rates throughout the world.
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