German Reunification and its Economic Status in the European Union

Table of Contents

I. Introduction

II. Macroeconomics of the German Reunification

- Government Expenditures

III. The Maastricht Treaty
3.1 The Convergence Criteria
3.1.1 Inflation/Price Stability
3.1.2 Long-term interest rates
3.1.3 Exchange rate stability
3.1.4 Fiscal positions
3.1.4.1 Budget deficit
3.1.4.2 Total Government debt

IV. Euro - The New European Currency
4.1 Benefits of the Euro - Cost Effectiveness and Rapid Financial Transactions

V. Economic and Monetary Union: Objectives and Risks

VI. The Development of the European Union and Germany's Role in the European Union after the German Reunification

VII. Review and Conclusions

VIII. Endnotes

IX. Bibliography

I. Introduction

The German unification took place on July 1, 1990 and politically a few months later on October 3. It created a new Germany in the center of Europe. The economic unification of Germany raises many issues because it not only represented the breakdown of the period after World War II, a division in Europe, but also addresses the problems concerning the income and wealth disparities. The most important question is: will Germany - with its internal economic problems since the unification - have the same dominant status in Europe as it used to have before the reunification? Germany has established itself as one of the strongest nations within the European Union, which makes an analysis of the possible relations between Germany and other strong economies in Europe very interesting.

A couple years after the fall of the Wall in Berlin, i.e. after the reunification of the parts of Germany, the integration of the two German countries became already perceptible. The change from the "Planwirtschaft" (planned economy) in the former German Democratic Republic (GDR) to the "S oziale Marktwirtschaft" (social market economy)¹ internally raised many problems. The former German Democratic Republic population used to live in its system, which provided them a regular life. Since the reunification, they were confronted with a new system - a market economy within a social system. The economy of the German Democratic Republic had to be completely modernized to raise the living standard to the former Federal Republic of Germany (FRG) in order to increase the economic growth and to raise the individual income. This change led to a "culture and consume shock" for many people. Facing this fact, people tried to keep their GDR identity. This was reflected in the tremendous gain in the 1994 election results for the PDS party (Party of the German Socialists). The government of the former Federal German Republic invested approximately one trillion German Mark (approximately $390 billion), into the new states of the former German Democratic Republic since the reunification, which is "40 times the amount in real terms of the US Marshall Fund aid sent to West Germany after World War II".² These huge investments gave East Germany the highest growth in Europe.

The importance of unification for Germany's economic power is a matter of major concern among its neighbors and competitors in international markets. Having Germany as a member of European Union is a major advantage for these countries, which rises the status of the European Union in the international system.

The research is concentrated on forecasting possible interaction between the countries within the European Union and the reunified Germany, both in the aspect of financial markets and the economic activities. Potential problems concerning policy coordination are addressed within the discussion. Particularly, the focus is on the role Germany will play within the Union including an outlook on what impact the new European currency, the Euro, will have. Analyzing Germany's status in Europe, the German economic situation, since the reunification in 1990, has to be examined.

II. Macroeconomics of the German Reunification

Government Expenditures:

Since the German reunification, the western and the eastern part of Germany had to deal with the two different systems; the Soziale Marketwirtschaft in the Federal Republic of Germany and the Planwirtschaft in the German Democratic Republic. Furthermore, the reunified country had to take into consideration that the former FRD had to invest a tremendous amount of money to jump-start the devastated East German economy. These investments also helped to increase the living standard in the eastern part to those of the western part of Germany.

Major government investments have been used to improve the infrastructure in the German Democratic Republic. Nowadays, the GDR has the best and most advanced technological telecommunication network in the world. The former state-owned business enterprises have been returned to private ownership by the `Treuhand Gesellschaft', the holding company that took these firms over after the unification, enabled equal living conditions in the eastern and western part of Germany.³ These huge expenditures caused much deeper holes in the federal budget than the government expected.

Analyzing the public debt in the last couple years one can see that the debts increased enormously form 929 billion German Mark in 1989 to 1,996 billion German Mark in 1995 (form 41.3% to 58% of the Gross Domestic Product).⁴ Not only many layoffs caused by the shutdown of many formerly state-owned eastern companies but also unemployment significantly increased since 1992, and temporally reached pre-World War II levels in 1997. However, the unemployment problem is still a current issue, which many countries have to deal with.

III. The Maastricht Treaty

Having signed the Maastricht treaty, the European countries have made a commitment to search for a path towards integration, stability, and growth by creating an economic and political monetary union. Since there are significant differences in the levels of prosperity between the member countries, it will therefore be of great importance to implement the emphasized economic and social cohesion within Europe.

Obviously, an integrated Europe is an advantage because it makes business easier to take place with a single entity.

More than fifty years after the last World War, the European unification is supposed to be a guarantee for stability, both in terms of long-term economic and monetary aspects. This is the basis for further development in maintaining economic growth throughout the European continent and permanent high level of employment, a major problem that faces many European countries. The success of the Euro and the European Union itself is heavily dependent on the proper conduct of internal policies, both by the European Central Bank (ECB) as well as the national central banks.

On January 1, 1999, eleven European nations, accounting twenty percent of the world economic output, replaced their national currencies with the single European currency, the Euro. These eleven nations constitute the European Union. Europe's current economic and monetary union (EMU) is the result of 25 years of political battles among and within the nations of the continent. The European Union, both in the 1980's and early 1990's nearly tore itself apart as it made the attempt to stabilize the currency fluctuations of the European countries and move towards a single currency. In the end, supporters of a common currency succeeded.

The Maastricht treaty stipulated five criteria (Article 109 j) that countries had to meet in order to become eligible for the single European currency. These criteria were to have been met in the early 1998.

3.1. The Convergence Criteria:

3.1.1 Inflation / Price stability:

⁵ Every of the eleven countries joining the European Union have to fulfill the criteria of inflation/price stability a year before the examination. A high degree of price stability is expected, which means that the rate of inflation of the particular country should not exceed by more than 1.5 average percentage points that of the three highest ranked countries.

3.1.2 Long-term interest rates:

According to this criteria the member countries are not "allowed" to exceed their average nominal rates by more than 2 percentage points of the three highest ranked states.

3.1.3 Exchange rate stability:

To fulfill this aspect, the joining countries have to respect the nominal fluctuation margins, which are provided for the Exchange Rate Mechanism (ERM) of the European Monetary System. This aspect has also to be fulfilled two years before the examination.

3.1.4 Fiscal positions:

According to this point there are two important criteria:

3.1.4.1 Budget deficit:

The member countries should not exceed three percent of the Gross Domestic Product.

3.1.4.2 Total government debt:

The member states should not exceed the sixty percent of the Gross Domestic Product. The convergence criteria for the European Union countries have been examined by the Europaeische Waehrungsinstitute (EWI) - European Monetary Institute (EMI) as well as by the European Union Commission. Based on the convergence reports the decision for the European Monetary Union was made. Eleven European nations decided to join the EMU, however, there are still several nations that either opted to join or not to join or did not meet the qualifications mentioned above.

The reunification raised several problems for the German Bundesbank. Firstly, they had to deal with exchange of the currency in West Germany (DM) and the less valuable currency in East Germany (Ost Mark), which brought inflationary pressure. Secondly, political issues concerning the economic growth increased fears to keep the rate of inflation low.

"In the European Union, following the signing of the Maastricht Treaty, the European System of Central Banks, consisting of the European Central Bank and the national central banks of all member countries of the European Union, commenced operation in January 1999. Modeled on the law governing the German Bundesbank, the primary objective of the European System of Central Banks is to maintain price stability.

As a second objective, the European System of Central Banks also has to support the general economic policies in the European Union."⁶

IV. Euro - the New European Currency

The single currency has been a goal of European politicians since the 1950's and became the official EU policy in 1991. In addition, while it might open to debate, political factors have been the driving force in the drive for the formation of the monetary union. In these terms, three principle factors made the Euro attractive and feasible.

First was the quest for anti-inflationary credibility. Under a single currency, countries with relatively high inflation, such as Ireland and Finland, could tie their currencies to that of the low-inflation country such as Germany, to help reinforce perceptions about their commitment to bringing inflation down.

Secondly, boarder links to European integration suggesting that those states that were not currently participating would not have second-class citizenship within the European Union in the quest for monetary stability.

Probably the most important factor is that they would be able to draw support from powerful businesses. The prospect of exchange rate stability and a single currency won the solid backing of most large corporations and banks in Europe. Huge businesses believed that removing the uncertainties of currency fluctuations would help them realize the full potential of a single European marketplace as well as give them a larger home base with which to confront outside competitors. These forces may help the eleven member nations of the European Union and draw in a few more countries through the full implementation of the single currency in 2002.

4.1. Benefits of the Euro - Cost Effectiveness and Rapid Financial Transactions

Rapid financial transactions can take place based on same payment systems throughout the Euroland. In addition, the cost and time of buying and selling currencies will be eliminated. The European Central bank made its first move in 1999 lowering the rates from 3% to 2.5% in April and then raising back to 3% in November.⁷ It is significant that in neither case there was much political opposition from the states, which most likely to have opposed these moves. The rate cut in April was probably the last thing the rapidly growing economies on the fringe of the Euro area (Ireland, Spain, Finland, and Portugal) needed. Likewise, when it came time to raise rates in November, the sluggish German economy probably could have benefited from a longer period of lower interest rates. However, the European Central Bank's mandate is to maintain price stability in the Euro area as a whole. Thus, it has explained its decisions to rise or lower interest rates based on development at the Euro area level rather than in terms what has happened in individual member states.

V. Economic and Monetary Union: Objectives and Risks

As Germany has one of the strongest economies in the world, it is obvious that the interest of the European Union member countries appreciate to have Germany in the Union, in order to strengthen the economic links. Many of the joining states, such as Spain, Portugal or Greece do not have strong economies and political strength compared with Germany or France. However, even if the appreciation, having Germany as a member of the new Euroland, is of interest, still many of Germany's smaller neighbor countries dislike having their monetary policy effectively decided by the German "Bundesbank". As these `smaller' countries are included in Germany's trade relations, and the German Mark dominates these trade conditions, they have no other options than to follow those conditions. In other words, they have to adjust to each movement of the German Mark interest rates.⁸

On the other hand, Germany dislikes the idea of the new European currency, too, because it will lose its powerful currency, which is widely seen, as Europe's most successful since the World War II. In many debates in Germany and other countries, such as France, Great Britain and some of the Scandinavian countries, the issue of the monetary union has been discussed whether to join or not. Regarding the aspect of the competitiveness of the industry in Germany, however, increased agreements to respect, that Germany will set the standard for the new currency. Nevertheless, Great Britain as well as Denmark, recently, rejected to join the European Union, because they are `afraid' of losing their `independence'. On September 28, 2000 the results of the Danish towards the Euro was announced; 53,1% rejected to adopt the Euro. However, Danish politicians think that it is only a matter of time until their country will also introduce the new currency in their state.⁹

Obviously, the "Euro question" is not solved up to this point. Even if every aspect seems to be thoroughly examined, there are still many uncertainties what will happen in the year 2002, when the Euro will be introduced as the single currency. Further, huge differences between the European Union member states concerning the level of production costs and productivity growth trends should be taken into consideration. In his speech, Professor Otmar Issing (Member of the Executive Board of the European Central Bank), pointed out this interesting and important fact, which addresses the consumer and the companies. "Both consumers and companies are becoming increasingly aware of any price differences between similar or identical products. These differences will therefore be harder to maintain - even if markets are segmented for reasons such as the particular tax system or different product specifications."¹⁰

Concerning the stability and growth of the monetary issue, one aspect will be the avoidance of short-term fluctuations in exchange rates between the European Union member countries. Hedging becomes less of importance, and corporate financial officers won't have to deal with exchange rate risks within the European union. Therefore, the monetary union will avoid the risk that other modern types of exchange rate systems might have. On the other hand, in the long run, exchange rates will be more difficult to determine, because aspects such as inflation and real income of the European Union have an impact on the exchange rates.

Moreover, politicians fear that a merging monetary policy could cause unemployment rates to increase in several countries, which would reflect in decreasing productivity performance - below the economic and monetary union.

VI. The Development of the European Union and Germany's role in the European Union after the German Reunification

As the third powerful economy in the world, Germany has played a significant role in the early 1990's. It seems that Germany will remain the most influential in the European Union. The beginning skepticism in other European countries towards Germany since the reunification caused a depreciation in the German public support for the European Union. Huge investments to finance the reunification and several internal economical problems, such as appreciation in unemployment rates and budget deficit the former chancellor Dr. Helmut Kohl as well as the present chancellor Gerhard Schroeder still follow the Euro politics. The German nation did not support the idea of being unified with other European countries in a European Union, because Germany itself used to have the strongest economic and political power within Europe. Ever since the end of the last World War, Germany was supported by the Marshall Plan, of which it benefited the most, to be one of the strongest nations in the world. In both aspects, economically as well as politically, Germany took charge of leadership sought well conducted foreign politics with its Western neighbor countries and was able to be reunified after it was separated after the Second World War into the Federal Republic of Germany and German Democratic Republic. Another major concern is the united European currency, the Euro, since the "Deutsche Mark" - the German currency - has become one of the strongest currencies in the world besides the U.S. dollar and the strongest currency in Europe.

Currently, the European Community (EC) has to deal with several differences between the member countries concerning the monetary stability as well as in terms of economic performance. Even though substantial progress has been made since the 1980's, "there are still partially deep divergence that are especially reflected in price and cost movements, in massive external disequilibria and large national budget deficits".¹¹

According to these economic facts and policy approaches by the member states, an early fixing of monetary powers to European Union authorities would cause further internal threats to monetary stability. This threat would hurt especially stronger countries such as Germany, France or Italy. This point illustrates the uncertainty of the German population towards the monetary union. Comparing the other member of European Union with Germany major differences in productivity and income differences as well as the strength of the currency is visible. "However, Germany and its Central Bank have taken the lead in the further process of Europe's unification. Standards that were accomplished on a domestic basis now do have to be achieved on a Community basis, in order to ensure long-run economic growth and stability."¹²

Being the strongest nation in Europe, Germany set high standard for the European Union and the joining countries. These standards were set to avoid the fear of inflation and thereby ensuring economic growth and stability in the long run. The issue of a long-term monetary stability was seen from a critical point of view. The current president of the "Deutsche Bundesbank", Ernst Welteke, follows the statement of the former president, Dr. Hans Tietmeyer, by favoring a strict interpretation of the Maastricht Treaty. This statement addresses the issue of the stability for each of the European Union member countries concerning the budgetary discipline. Even Christian Noyer, the vice-president of the European Central Bank, recently mentioned this point in his speech at the Oxford University on November 22nd, 2000 by saying: "An emerging `stability consensus' among policy-makers in Europe on the desirability of a stable currency and sound public finances provided the crucial backing for a, sometimes painful, process of budgetary consolidation and disinflation, in which domestic policy objectives needed to be brought in line with the need to fulfill the Maastricht convergence criteria."¹³

As there are a lot of differences in the economic performance and different political point of view, the strongest nation in Europe, Germany, tries to keep and set high standards for current members of the European Union as well as for potential candidates, which might join the new unified Europe. Analyzing the European Union's development it is obvious, that Germany plays a significant part concerning the economic and monetary aspects. With Germany as a leader in the European Union, further opportunities regarding an economic stability and growth are guaranteed.

VII. Review and Conclusions

The relationship between Germany and the other member countries of the European Union raises many issues concerning the economic and political performances. In the year 2002 the new currency, the Euro, will be finally in circulation. Even if still many states have major concerns about Germany's dominant position, Germany's strong performance will cause an increase in the overall productivity and growth in the European Union.

As mentioned earlier in the paper, there are advantages as well as disadvantages aspects for the European Union / Monetary union. It is obvious, that in a monetary union only one currency is possible. However, it could be that for some regions different policies would be more favorable.

If a country has a deficit in the balance of current transactions, it is very difficult to compensate this balance and to be competitive. The effect of such a scenario in the short term is that government spending stimulates inflationary pressures. This in turn depreciates the domestic currency, driving the export prices down. Therefore, the foreign demand for domestic goods and services increases. The major dilemma rises. On one hand, the exports increase, but on the other hand, the domestic currency declines.

An advantage, of which people think in the first place, is the decrease in transaction costs between the countries. Prices for same products often differ in each country. The creation of the monetary union (EMU) will most likely eliminates the issues of price discrimination. The target groups, which will profit, are the consumers. Having different currencies, it is hard to recognize these price changes across the countries.

In the past, Germany dominated the monetary policy. However, in the European Union a European committee will decide these kinds of problems. This means that Germany will not have the same status as it used to have before entering the European Union. Besides, the reunification caused many problems in Germany concerning enormous government investments and the unemployment rates. Furthermore, Germany's reunification also caused problems in other nations dealing with this event. France is one of the countries where speculations have been circulating regarding Germany's possible affects on the future of the European Union and on Europe itself. These concerns were based on Germany's history before the last World War. Nevertheless, the last couple of years have shown that the relationship between the strong nations in Europe has increased confidence regarding the reunification and European integration. Germany's former Finance Minister, Theo Waigel, pointed out the necessity of good relationships with other member states. A Union without other strong countries would lead the European Union into a weak position compared with other dominating economies in the world. "A currency Union without France is unthinkable".¹⁴

Despite a democratic structure in the administration of the currency, Germany, France and Italy still dominate Europe. These three nations are hardly of one mind and purpose. The biggest challenge is the divergence between core European states such as France and Germany. As Europe moves to specialization, there will be greater tendency towards divergence because of the growth rates in various industries.

Analysts predict that a unified Europe with the new currency, which most likely will become a reserve currency, will be able to compete better with the United States.

The political and economic standards European Union will change significantly in the near future.

After years of slow growth, high unemployment and worsening social problems, many European hopes, that the EMU will point the way towards more prosperity. The new central bank is likely to argue that it cannot solve structural problems throughout decades, and that attempts to use looser monetary policy to stimulate the economy will only lead to a new round of inflation. With the positioning of the EMU and the Euro over time, the European Union will have to deal with social and political demands that it cannot meet without calling into question one or another of its central commitments, such as free trade, economic growth, unemployment creation as well as price stability. None of this necessarily suggests that the Euro along with the EMU is expected to fail. In fact, it is likely to have many positive effects and continues to have deep political support that will help to ensure that the Euro will have the capability to endure the many possible difficulties.

Throughout the paper the problems and benefits concerning economic performance and political relationships are illustrated, focusing primarily on Germany, since it will be the driven force in a unified Europe. Future developments in Europe will show in which direction things will further go. Since Germany's government collides in its policy with European Central Bank, as well as with the German Bundesbank, development of relations will be of special interest. As Germany will remain one of the strongest nations in the European Union, it will have further responsibilities to strengthen European Unions performance.

VIII. Endnotes:

1 Comment: this kind of market economy is different than that in the United States

2 Internet Source: "Die Deutsche Wiedervereinigung und dessen Folgen" - 1998

3 DIW - Wochenbericht 17/99 "Die Wirtschaftliche Lage in Deutschland"

4 "Inflation and Wage Behavior in Europe", Paul DeGrauve, Stefano Micossi and Giuseppe Tullio, Clarendon Press-Oxfort, 1996

5 Internet Source:

1) "Der Maastrichter Vertrag - Wege in die Gegenwart" - 1999

2) EWI - Stand der Konvergenz, "Der Konvergenzbericht des EWI, 07/99

6 "Money, the Financial System, and the Economy", 3rd edition, R. Glenn Hubbard, Columbia University, 1999

7 Deutsche Bundesbank, "Statistischer Teil", Monatsbericht, 05/2000

8 "Cooperating with Europe's Monetary Union", C. Randall Henning, Institute for International Economics, Washington DC, 1997

9 Spiegel, Politik: "Daenen sagen Nein zum Euro", Ausgabe 39/2000, September 28, 2000

10 "The New Economy - a European view", Speech by Professor Otmar Issing, Member of the Executive Board of the Central Bank, National Conference CBI 2000, Birmingham, November 7, 2000

11 European Central Bank, "Statement of the Deutsche Bundesbank on the establishment of an economic and monetary union in Europe", September 1999

12 Source form Dresdner Bank/Kleinwort Benson "Statement of the Deutsche Bundesbank on the establishment of an economic and monetary union in Europe", December 1999

13 Speech by Christian Noyer, Vice President of the European Central Bank, at Oxfort University European Affairs Society, November 22, 2000

14 Theo Waigel, former German Finance Minister, October 1995

IX. Bibliography

1) "Cooperating with Europe's Monetary Union", C. Randall Henning, Institution for International Economics Washington, DC ; May 1997

2) "Banking in Transition", `East Germany after Unification', Gregg S. Robins, London 1999

3) "Inflation and Wage Behavior in Europe", Paul DeGrauwe, Stefano Micossi, Giuseppe Tullio, Clareudon Press-Oxford, 1996

4) "Building The New Europe", vol.1, Mario Baldassarri-Prof. of Economics; University of Rome `La Sapienza', Robert Mandell-Prof. of Economics; Columbia University, NY, St. Martin's Press SIPI, Rome 1991, 1993

5) "Zur Finanzierung der deutschen Einigung - eine optimal control-Analyse mit dem RWI- Konjunkturmodel", Ullrich Heilemann, Zeitschrift fuer Wirtschafts- und Sozialwissenschaften 1999

6) "Money, the Financial System, and the Economy", 3rd edition, R. Glenn Hubbard, Columbia University, 1999

7) Heinz-Dieter Kunz, "Deutsche Vereinigung und europaeische Integration," in Europa - wohin?, edited by Max Haller and Peter Schachner-Blazizek, Graz, 1994

8) Sources from banks: European Central Bank, Dresdner Bank, Deutsche Bank
- "Statement of the Deutsche Bundesbank on the establishment of an economic and monetary union in Europe", September 1999, December 1999
- "Statistischer Teil", Monatsbericht 5/00

9) Geoffrey Pugh, "Die oekonomische Konsequenzen der deutschen Wiedervereinigung fuer die Europaeische Gemeinschaft," Berichte des Forschungsinstitutes der Internationalen Wissenschaftlichen Vereinigung Weltwirtschaft und Weltpolitik e.V., September 1994

Internet resources:

>> "Der Vertrag von Maastricht - Wege in die Gegenwart", December 1999)

>> DIW-Wochenbericht 17/99: "Die Wirtschaftliche Lage in Deutschland"

>> EWI-Stand der Konvergenz, "Der Konvergenzbericht des EWI", July 1999

>> Spiegel, Politik: "Daenen sagen Nein zum Euro", Ausgabe 39/2000, 09/28/00

>> "The New Economy - a European view", Speech by Prof. Otmar Issing, Birmingham, November 7, 2000

>> Speech by Christian Noyer, Vice President of the European Central Bank, Oxfort University European Affairs Society, November 22, 2000

>> Polen, Deutschland und Europa - Gemeinsame Perspektive fuer das 21. Jahrhundert, Dr. Wolfgang Schaeuble (Former German Finance Minister), June 4, 1998