This month marks the 25th anniversary of the reunification of Germany. Integrating two vastly different economies was a hugely risky venture. West Germany was a global powerhouse while East Germany was an economic weakling, wracked by poor productivity and unprepared for the introduction of a market system.
One of the main decisions facing West German politicians was the choice of official exchange rate between the West German Deutschmark (DM) and the East German Ost-Mark.
On the face of it the decision was straightforward. The DM was one of the world's strongest currencies, an anchor of stability and a symbol of West Germany's post-war economic miracle. The Ost-Mark was the currency of a failed state and an enfeebled economy. The market reached its own verdict and in the winter of 1989-90 the Ost-Mark was trading at seven to one DM.
This exchange rate destroyed East Germans' spending power in Western shops and set up huge incentives for the citizens of East Germany to seek work in the West. With the opening of the border, tens of thousands migrated westwards. The shift in population undermined East Germany's economy and placed huge pressure on West Germany's welfare system.
This set the scene for an epic battle between politicians and policymakers over the choice of an official exchange rate for the Ost-Mark.
The policymakers, in the form of West Germany's Bundesbank, wanted the Ost-Mark to trade close to a market exchange rate. It argued that a weak Ost-Mark was would help offset the effects of poor productivity and would help East German industry cope with reunification. The Bundesbank warned that an artificially high exchange rate would force up costs in the East and inflict more damage on its economy.
West Germany's Chancellor, Helmut Kohl, disagreed. He wanted a one to one exchange rate believing it would provide stability, preserve the spending power of East Germans and stem the flow of migrants. With elections looming in the East, a one to one exchange rate would also go down well with the new citizens of the Federal Republic.
Chancellor Kohl brushed aside the warnings of the Bundesbank and in the summer of 1990 the DM was introduced in East Germany with wages and savings converted on a one to one basis. East Germans' deployed their new spending power to go on a massive spending spree in the West.
On the economics, the Bundesbank was proved right. A one to one exchange rate added to the woes of a chronically weak economy struggling with foreign competition and the introduction of markets. Many East German businesses went bankrupt, unable to afford a dramatic rise in wage and pension costs. By the mid-90s East German industrial output had fallen by almost 30% from 1988 levels.
The choice of exchange rate made it harder for East Germany's economy to catch up with the West. 25 years later, unemployment in the East is twice as high as elsewhere. And the eastern states are considerably poorer – a West German is twice as likely to drive a BMW while an East German is twice as likely to drive a Skoda.
Yet the decision on the exchange rate was about politics, not economics, and in these terms it was a success. Reunification has worked. Today the two Germanys are a single nation and the dominant economic and political power in Europe. A generous exchange rate avoided the destruction of the spending power and savings of East Germans and made them feel equal citizens in the newly united Germany.
Sound economics is not always good politics. In a democracy, it is politicians and people, not policymakers and officials, who make the decisions. Major policy decisions cannot be reduced to an economic calculation; countries are not like businesses, seeking to make optimal financial decisions. Politics trumps economics.
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