European Economy. Economic Papers. Germany's growth performance in the 1990's

… although construction also took a plunge in the West.
At least one third of the total difference in the growth performance between Germany and its
European partners since the mid-1990s can be attributed exclusively to the shrinking German
construction sector. However, this huge impact did not stem solely from developments in the
East, but coincided with the cyclical evolution of the building sector in the West. Specifically,
strong immigration in the late 1980 and early 1990s boosted residential construction in West
Germany. By the mid-1990s, when the inflow of immigrants tailed off, demand for residential
construction stalled. At the same time, the public sector reduced drastically its subsidies for
low-cost housing, while public investment was cut substantially, reflecting mainly budgetary
consolidation efforts. Moreover, the demand for business premises declined in a general
environment of low growth expectations. Therefore, while the boom-bust cycle of the
construction sector in the New Länder was much more eye-catching, the parallel decline in
the West was just as important in pulling down overall output growth.
Sharp tax increases to finance huge transfers to the East …
Economic growth has also been affected by the large financial burden re-unification imposed
on the country. These transfers have been used to finance the reconstruction of the eastern
economy and, even more importantly, to pay for the large deficits in the social security
systems of the New Länder which resulted mainly, but not exclusively, from very high
unemployment levels. These transfers have amounted to some 4% of GDP per year in net
terms ever since re-unification. Initially, they were mostly financed by allowing budget
deficits to increase, but when the budgetary situation risked to become unsustainable taxes
and social security contributions were raised sharply. Although most other European
countries also witnessed a rise in the tax burden in the early 1990s, in Germany this increase
was particularly strong.
… impacted adversely on growth throughout the second half of the 1990s.
Economic theory suggests that a fiscal expansion financed by distortionary taxation could
potentially generate substantial adverse growth effects after the initial positive demand
stimulus dies down. Two transmission channels of this second-round negative impact can be
identified: crowding out of private investment as higher taxes reduce expected net profits, and
adverse labour market developments arising from higher wage and non-wage costs.
According to simulations undertaken with the Commission services’ QUEST II model, this
could have led to a negative growth impact of around 0.3% per year from the mid-1990s
onwards. This negative impact may, therefore, explain up to one third of the growth gap
between Germany and its European partners.
Cost-competitiveness suffered in the first half of the 1990s …
Re-unification also contributed to the deterioration of Germany’s external competitiveness in
the first half of the 1990s. Although the overall competitiveness of a country is a complex
notion, which is difficult to measure, it is evident that the cost competitiveness of Germany as
measured by relative unit labour costs declined strongly in the first half of the 1990s. This
was due to wage increases much above productivity increases, especially but not exclusively
in the East, coupled with a strong appreciation of the D-Mark. The decline in Germany’s
competitiveness can be detected, for instance, in the relative loss of export market shares
witnessed since re-unification. In particular, East German firms are virtually absent from
world markets, causing the New Länder to run a de facto trade deficit of enormous

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proportions. Other indicators, such as a relatively low inflow of foreign direct investment also
point to a comparatively low attractiveness of Germany as a business location.