Working Paper: CEPR ID: DP1155
Authors: Hanswerner Sinn
Abstract: Economic development in East Germany is not uniform. The building and construction industry is booming but manufacturing industry is stagnating. The paper argues that severe distortions in relative factor prices are the cause of the dichotomous development. These distortions result from excessive wage increases and investment support large enough to make the cost of capital negative for East German industry. The negative cost of capital implies that this factor in fact mutates into an economic good whose `production' the firm tries to increase by using more of other factors. It is suggested that the support for investment be abandoned and that a political compromise be sought, whose aim is to reduce the planned wage rises. The compromise could include an investment wage agreement for insider workers and a distribution of the stock of public housing to prevent workers from suffering wealth losses. It would be a Pareto improvement avoiding the large welfare loss incurred by the policies currently pursued.
Keywords: factor prices; transformation; subsidies; East Germany
JEL Codes: D24; H2; P21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| excessive wage increases (J38) | severe distortions in relative factor prices (F16) |
| public subsidies (H20) | severe distortions in relative factor prices (F16) |
| severe distortions in relative factor prices (F16) | dichotomous economic development (O29) |
| negative cost of capital (G31) | increase production of labor (J89) |
| increase production of labor (J89) | construction boom (L74) |
| high wages (J31) | stimulate demand for non-traded goods (H49) |
| capital subsidies (H29) | positively affect demand for non-traded goods in construction sector (L74) |
| high wages (J31) | upward pressure on costs in industrial sector (L16) |
| upward pressure on costs in industrial sector (L16) | capital subsidies cannot offset high wage costs (J38) |
| combination of high wages and low capital costs (J39) | significant welfare losses (D69) |
| unilateral subsidy of labor (J68) | better align market prices with shadow prices (F16) |
| new wage contract allowing for income differentiation (J31) | Pareto improvement (D61) |