East Germany, West Germany, and their Mezzogiorno Problem: An Empirical Investigation

Economic and monetary reunification in Germany has proved to be more expensive than previously thought - and not just for the Germans. If a `Mezzogiorno' problem of continuing fiscal transfers to the East and possible migration flows westwards are to be avoided, there must be convergence in productivity levels. This paper analyses possible convergence paths and the policy regimes which accelerate convergence. The intention is to illustrate the (albeit less extreme) problems facing a European monetary union of asymmetric and incompletely converged economies. Working from first principles, or with the aid of an econometric model, shows that convergence sufficient to avoid a `Mezzogiorno' problem is likely to be slow: perhaps 30-40 years in the German case despite very fast growth in the East. Second, it is not clear that the process is incentive compatible: a substantial part of the servicing and subsidizing costs must be paid by other (non-German) economies in the union without any obvious compensating benefits. Third, to reduce the need for continuing transfers actually requires a policy which promotes price and wage flexibility in the depressed region. This appears to run counter to current market integration in Europe. Such `unpleasant arithmetic' is an important contribution to the monetary union debate, because without it the smooth running of a union of incompletely converged economies will certainly be compromised.