Eastern Germany, and also the Bavarian regions close to the eastern border, face considerable adaptation pressure because of the eastern enlargement of the European Union. Labour costs in the Czech Republic and Poland are a quarter to a fifth of the costs in eastern Germany and a fifth to a sixth of the costs in Bavaria. German industrial firms have seized this opportunity to shift labourintensive manufacturing to eastern Europe. For German workers, however, a problem of major proportion has arisen. Their competitiveness will gradually erode if their costs remain so high.

The problem effects German industry as a whole but especially the Bavarian regions along the eastern border and eastern Germany, which is still suffering from the rapid increase in wages after German unification. To be sure, the hourly wages for industrial workers are still only 72% of the western level in eastern Germany (with gross monthly wages standing at 77%, net monthly wages at 83% and real net monthly wages at 90%). Nevertheless, total productivity has stagnated since 1997 at just 60%.

Unfortunately there is no convincing economic scenario in which this wage situation can be maintained after the opening of the border to eastern Europe without resulting in further increases of unemployment, which already has had catastrophic effects in many places. Especially border regions like the east German Lausitz will continue to lose population if wages remain inflexible.

This is why wage structures must change. In particular wages in border regions as well as wages for unskilled labour will have to fall in relation to average wages, because German unemployment and the low-wage competition from eastern Europe is concentrated in these segments of the labour market. Wages need not fall to Polish levels. They are supported by a better infrastructure and a better legal system that still temporarily safeguard the productivity advantages. But wage declines are necessary to restore the competitiveness of the people in the effected regions.

Falling wages for people who already earn low wages is indeed a major social problem for Germany. For the lowering of wages not to become a lowering of earnings, the welfare state should compensate the loss with wage supplements. The Ifo welfare-to-work model, which was the basis of the Hessian Model introduced at the German Bundesrat, is a carefully designed, revenue-neutral model for such supplementary payments. It is compatible with the necessary wage flexibility – unlike the current welfare system – and it cushions the losses in income for low-wage workers. For the typical low wages in eastern Germany it will even lead to a clear improvement in earnings for those with small incomes.

The other instrument for compensating wage reductions, at least in eastern Germany, is worker participation in the productive capital of their companies. Investment wage agreements that run over a longer period of time and that compensate only the already employed workers through a company participation scheme lower the wage costs of new employees. They offer an incentive for the creation of new jobs without placing current employees at a disadvantage.

The market does not guarantee social justice. But justice can also not be achieved by measures that run counter to the market by clinging to wage structures that do not reflect the competitive situation. It is only possible to implement social justice by measures that do not hinder the effectiveness of the market. Welfare-to-work and investment wages are such measures. They are urgently needed in eastern Germany to prepare for Polish and Czech membership in the European Union.

Hans-Werner Sinn
Professor of Economics and Public Finance
President of the Ifo Institute

Published as "Die Löhne müssen sinken", Die Welt, March 1, 2004, p. 12.