German lesson for euro launch

Berlin will be fine in time. Politicians spend money; so do senior executives in new HQs

BERLIN - A few years ago there was a European currency union. No not the European currency union. It was the currency union between the East and West German marks, which took place in 1990 at a rate of one to one.

Of course, the parallels between that particular currency union and the one which starts in Europe next year are not that close.

In Germany in 1990 the two currencies were being linked, ahead of the two being joined politically. West Germany was clearly going to be the dominant partner, though quite how dominant was not clear then. The decision over the rate of conversion was determined on political grounds rather than economic.

Nevertheless, this does happen to be the only recent experience Europe has had of linking currencies. Since this happens to be my first visit to Berlin since the dying days of the old East German regime in the spring of 1990, it seems sensible to try to draw some lessons from this experience. What has Germany learnt over the last eight years that might be relevant to EMU?

From the outside Berlin, at least in terms of the amount of new buildings being constructed, is a boom town. It is the world's largest construction site; go to Potsdamer Platz, the old "Piccadilly Circus" of Berlin and never in your life will you see so many cranes. They stretch into the middle distance, as German banks and companies rush to put up new headquarter buildings in what many believe will become continental Europe's most important commercial site.

Nearby, the old Reichstag building and other government offices are being restored in preparation for the move of the capital from Bonn next year.

So was the currency union a success? No, it was a disaster, the scale of which is still impossible to judge. In spite of the construction boom, the annual subsidies of approximately pounds 50 billion a year from the former West Germany, and the evident rise in the standard of living of ordinary East Germans, unemployment in the East remains in the mid-teens, nearly double that of the West.

At the time of unification Chancellor Helmut Kohl declared that in 10 years the standard if living in East Germany would have caught up with the West. Now it is clear that this will take 20 years or more. If, as seems likely, Mr Kohl is thrown out in the elections next month, it will be partly because he is being rejected by East German voters. He is even more unpopular here than he is in the West.

What's up? It is partly a currency problem. When the two currencies were merged, East German wages were about two-thirds of those of the West. Productivity, it was thought, was about half the level. So if you allowed for an injection of both capital and management, it seemed plausible that East German labour costs could be brought down to West German levels quite quickly.

There was a risk. Most people were aware that the one-to-one rate was wrong in economic terms, as the Bundesbank warned at the time, but the politics required it. In economic terms it looked difficult but do-able, if the adjustment was spread over several years.

That turned out to be wrong for two reasons. The first was productivity, which was even lower than anyone had thought; not half the level of the West, but a quarter or less. The adjustment needed was vastly greater than expected.

The second was the former Soviet satellites. No-one had factored into their thinking the possibility that East Germany would face competition from the other former communist countries, in particular Poland, Hungary and the Czech Republic.

Poland is a mere 50 miles from Berlin. Unencumbered by an overvalued currency, Poland has now become the fastest-growing economy in continental Europe.

Instead of flooding East Germany with their capital and know-how, West German companies were forced by competitive pressures to place their main expansion programmes further east. Eight years ago, people in Poland and Hungary were envious of East Germany; it would be helped by its rich sibling whereas they would have to make the transition on their own. Now they can see that the flexibility they enjoyed helped create a more durable form of economic growth than the subsidies that went to East Germany.

True, living standards are still lower, but if you allow for different price levels, the gap is not as large as at official exchange rates. Knock off the subsidies and the gap narrows further. And at least they have jobs.

Eventually, provided you are prepared to project forward far enough, I suppose East Germany will recover. Berlin itself ought to be fine, for though the construction boom will fall back and overall growth will decline as a result of that, the move of the capital from Bonn will bring economic activity. Politicians and civil servants spend money. So, too, do senior executives; that string of new headquarters' buildings will be populated with well-paid employees.

You can add to that three other "bull" points. One is the scope for growth in the region around Berlin. The city has never grown suburbs like most western cities. The old West Berlin was physically constrained by a wall, and the old East Berlin did not have the resource to sprout a ring of suburbs. As a result you go from a dense city to open fields in about 10 minutes.

Second, Berlin is centrally located for a wider Europe. It is perched on one side of Germany, but is physically close to the fast-growing countries to the east. As Europe rebalances eastwards, Berlin becomes the new hub.

Finally there are the powerful cultural attractions of the place - the museums, the theatre and opera, the clubs and the food, and of course, the (tarnished) history. But it is hard to feel comfortable about the rest of East Germany which must face another decade of grave difficulty.

So what are the lessons for EMU? The first lesson is to get the conversion rates right. If you don't, the adjustment process will be painful and prolonged.

The second is that subsidies have to be enormous if they are going to counter the effects of a wrong exchange rate and much lower productivity

A third is that a single currency makes differences in performance much more explicit; there is nowhere to hide if your prices or wages are wrong. New investment will tend to go where it will get the best return and that is much clearer under a single currency.

And finally, I suppose, there is a political lesson. Politics can achieve an enormous amount. The joining of the two currencies was an act of political will which led to a much faster political integration than has previously been thought possible. But the euphoria of that period has evaporated in the long, cold grind of adjustment.

Voters who are promised something and then find the reality is different are liable to be bad-tempered. We will see how the hero who merged the two German currencies - and then the two Germanies - will be treated in the polls next month.