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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 Germany.

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 double-digit inflation.

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 so on.

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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