Germany's Slump Explaining the Unemployment Crisis of the 1990s

According to a widespread view, Germany's unemployment crisis is caused by rigid labour markets, low profitability and increasing international competition. We argue that this view does not provide a convincing explanation for the dramatic rise in Germany's unemployment rate since 1989, first because no distinction is drawn between the situation in the Eastern part of Germany and that in the Western part of Germany, and second because supply-side conditions in the Western part of Germany have not generally deteriorated. We argue that Germany's slump is the result of a series of adverse supply and demand shocks since unification. Supply shocks dominated in the East, demand shocks in the West. These shocks were mainly policy-induced. The adoption of an extremely overvalued exchange rate and rapid wage increases in East Germany magnified the general problems of transition, resulting in a loss of employment of more than a third and a sustained structural weakness of its economy. The wage explosion was made possible by the government's failure to create a proper institutional framework for wage negotiations. The unification shock to the East added at least 2.5 percentage points to Germany's overall unemployment rate, as measured by the OECD definition. We attribute some 1.5 to 2.5 percentage points of the present unemployment rate to the weak economic growth of the last several years and the impact of the increasing tax wedge on the wage level. Weak growth has been largely the consequence of uncoordinated, contradictory and procyclical macroeconomic policies that have been adopted since unification, while the increasing tax wedge has been mostly driven by the decision of the government to finance unification partly through the social security system. Econometric evidence suggests a structural break in aggregate wage-setting in West Germany, with increased nominal flexibility in recent years and insignificant persistent effects since the 1980s. Hence, aggregate wage setting in the Western part of Germany is highly responsive to unemployment, while in the Eastern part, it is not.