01 November 2015

Vox EU: Do not perpetuate the Dutch Disease in Europe - Lessons from German reunification for a European Fiscal Union

With a European transfer union on the cards, we can learn a lot from Germany’s reunification – a transfer union of sorts. This column takes us through various lessons, concluding that transfers would cement southern Europe’s lack of competitiveness and drive Europe into permanent stagnation.

Europe is debating further moves towards a transfer union, following the implicit and explicit transfers in the form of fiscal rescue programmes and monetary bail-out operations by the ECB. French President François Hollande and his young Minister of Economy Emmanuel Macron are now proposing a fiscal union complete with a common budget, a pooling of old debts, a common deposit insurance, a common unemployment insurance, a common finance minister and a common parliament (Hollande 2015 and Macron 2015).

As their proposal happens to coincide with the twenty-fifth anniversary of German reunification, which has led to the establishment of an intra-German transfer union, it might be useful to review the German experience in detail before further, and irrevocable, steps are taken to transform the Eurozone. In fact, it turns out that the German example should actually serve a warning for those who want to move ahead as quickly as possible, since it has been far less successful than outsiders seem to assume. While East German cities have all been beautifully renovated and reunification succeeded politically, East German productivity has seen very little progress in the last twenty years. Indeed, the convergence between East and West Germany petered out as early as 1995, with East German GDP not only ceasing to grow faster than West Germany’s, but actually falling behind. While GDP rose by 30% between 1995 and 2015 in the West German federal states, it did so only by 23% in the eastern states. [...]

The rapid wage increases, supported by generous welfare benefits, had the effect of inflicting the so-called Dutch disease onto East Germany. When the Netherlands found gas deposits in the 1960s, the income from gas exports pushed up wages in the public sector and the energy industry, stimulating the domestic sector and causing imports to rise, but also undermining the competitiveness of the Dutch export industries, because competition in the labour markets forced these industries to also pay higher wages. It was not until the Wassenaar Agreement of 1982, coupled with a subsequent fall in world energy prices, that wages became more moderate and the economy started to gradually improve. While the eastern German states have exported no gas, the financial transfers from the West played—and still play—the same role, making possible wage growth beyond productivity growth and thus reducing competitiveness.

The Dutch Disease is also in evidence throughout Southern Europe today, with the low-interest loans made possible by the public rescue funds and the ECB guarantees taking the role of Dutch gas or inter-German transfers. Whether an economy receives money from abroad in the form of transfers or proceeds from gas exports or loans makes no difference. In each case the foreign funds make it possible to uphold non-competitive wage structures – in other words, to maintain a living standard that exceeds the level compatible with local productivity. The result is excessive prices and a loss of competitiveness.

The fiscal union demanded by Hollande now is an understandable attempt to compensate for the lack of competitiveness of the southern EU countries by resorting to international transfers, but these transfers would cement their lack of competitiveness and drive Europe into permanent stagnation. The travails of German reunification should be a warning against pursuing this course.

Full article in VoxEU

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