Czech Republic to overtake East Germany in seven years

What could explain why East Germany, with all the rule of law and administrative integrity in place, plus 1 trillion euro of subsidy, is soon going to be overtaken by Czech Repbulic (in gdp per captia) which is plagued by rampant "looting" and "no law and no finance"? Labor market inflexiblity is the key.

The economic transition in the East Bloc is always said to be a failure. Rapid convergence didn’t happen, income level stagnates, reforms and polices are wrong... Nevertheless, to give a fair judgment, we need to find a proper benchmark, because otherwise we don’t know how things otherwise would have evoled.

For Czech Republic, the perfect benchmark is East Germany. Before taken over by the communists, The Czech lands (Bohemia and Moravia) were at similar level of economic development as what later became Democratic Republic of Germany. Four decades later, at the time of communism’s collapse, Czech was poorer than East Germany. East Germany is bigger than Czech (population: 16 million vs. 10 million at the time of transition), but not much bigger. They are not only neighbors, share a lot of historic background, but also similar in industrial structure (as a result of Soviet planning) at the time of transition.

What did East Germany get afterward?  East Germany got pretty good institutions (legal system, political system, business environment) in place in short period of time, , rapid transfer of knowledge and know-how from fellow Germans from the West through training and transfer programs, efficient banking sector as a result of the direct takeover of East German Bank by more efficient Frankfurt banks, and on top of all these, one trillion Euro of fiscal transfer to finance massive public investment in equipment and infrastructure.

With all of these perfect advantage, East Germany was supposed to be converge to living standard in the West pretty soon and further widened the gap with its Easter neighbor the Czech Republic.

In the Czech Republic, in contrast, legal system is not functioning, “looting” was rampant among corporate managers in the midst of mass privatizations, business environment is plagued by corruption and bureaucracy red-tape, inflation was high and fiscal policy was not working for most of the 1990s, financial system was in bankruptcy until foreigners start to take over some of them......and not to forget, there is no "West Czech Republic" that can inject one trillion Euros.

All of these contracts will forecast East Germany’s rapid and certain dominance of Czech Republic in terms of economic growth and rising GDP per capita.

The results in hindsight however contract such predictions made back then. Yes, Now East Germany is still some 15% richer than Czech Republic (note that East Germany started richer), but the trend in the past seven years or so will project that with another seven years, the Czech Republic is going to take over East Germany in terms of GDP per capita, if Czech Republic continues to growth at 3.3% /year while East Germany at 1.0%/year.

The reason, as Professor Jennifer Hunt (McGill University) suspects is rooted in the labor market in East Germany.  East Germans are half as productive as their Western counterparts, but with the slogan “The same pay for the same work” they are demanding the same level of salary.  In 2003, although Eastern GDP per capita was only 67% of the western level, disposable income per capita was already 82% of the western level.  Western firms thus would rather expand their facilities in the West to serve the new consumer market in the East, instead of employ workers in the East.

It is certainly a good and attractive slogan that everyone gets the same pay, but when you are not as good as others (at least at this moment before you go through some skill training), demanding the same level of wage as the smarter people are getting can only give you two results: (1) unemployment; why would employers (except the public sector) want to pay more to get less. (2)  lower paid and dirty jobs that people in the West don’t want to do; so you are segregating yourself by your own decision. As an old communist-era axiom in the Czech Repubic goes: "We pretend to work, and they pretend to pay us". True in East Germany now.

The whole plot was conspired by the labor unions in the West, which got higher wage pact for their comrades in the East. The true intention was to price out East German workers from the market, not to show solidarity!

Reference:

Jennifer Hunt: Is the transition in East  Germany as success?  (pdf file)