April 17, 1997

Analysis: Will Gamble on Eastern Germany Pay Off?

In This Article

• High Cost of Labor: Wages Are Up; Productivity Isn't
  
• Costly Rebuilding: $3.2 Million a Job at a Plant
  
• Empty Towers: Plenty of Space, but No Tenants
  
• Seeds of Growth: Just Add Money for 20 Years
  

By EDMUND L. ANDREWS

LEIPZIG, Germany -- For a rough idea of what has happened in the former East Germany, imagine someone wrote a check worth $1 trillion to a state with an economy the size of North Carolina's.

Since the Berlin wall fell in late 1989, half the homes in eastern Germany have been renovated. Schools and museums, parks and playgrounds, factories and power plants have been showered with money. The Trabant, the cramped, smoke-belching car that came to symbolize everything people hated about the old communist regime, is all but extinct, replaced by millions of shiny Volkswagens, BMW's and Mercedes-Benzes.

Eastern Germany -- with an economic output last year of $230 billion -- now has twice the number of malls per resident as western Germany. It has 5,000 miles of new highways, 2,800 miles of new railroad track and one of the world's best telephone systems.

And nowhere has the adrenaline of all that money had more impact than in this historic city 80 miles southwest of Berlin. Smartly dressed men and women eat and shop in the exquisitely renovated Art Deco downtown district. Gold-painted sculptures adorn the renovated Baroque facade of Commerzbank's branch.

The once-crumbling skyline now blazes with office towers and luxury hotels. And just out of town are a gleaming new international airport, a $1 billion convention center and a $1.5 billion cargo-handling facility.

Since 1990, the German government in Bonn has given more than $600 billion to its former eastern rival through business subsidies, special tax breaks and support payments for individuals. Enticed by the tax breaks and subsidies, companies have invested $500 billion more.

But for all the cash thrown at eastern Germany, the economy remains fundamentally bankrupt. Even as wages have skyrocketed in a rush to catch up with those in the west, there are not nearly enough real jobs to go around. Unemployment is at 25 percent, growth has almost ground to a halt, output per worker is still half the rate of western Germany's, and exports are minuscule.

"Never before in history has one country spent so much money building pyramids," said Norbert Walter, chief economist at Deutsche Bank in Frankfurt. "There has been a tremendous waste of economic resources."

In Leipzig, a third of the work force is unemployed after accounting for government-financed make-work jobs and early retirement programs. A third of the office space is vacant, including several of the fanciest new buildings. Local tax revenue accounts for just one-tenth of the city's $2 billion annual budget.

The only thing that keeps eastern Germany afloat are billions upon billions of marks handed out by Chancellor Helmut Kohl's government every year.

All this is causing big problems not just for Germany but for Europe, too. Loaded with $300 billion in debt related to eastern Germany, the country is in danger of not being able to meet the fiscal requirements to qualify for the Euro, the single European currency planned for 1999. And without Germany, there can be no Euro soon, wrecking the timetable on which Europe's political leaders have pinned much of their hopes for long-term economic recovery.

The domestic repercussions are just as bad. Even as the 60 million western Germans become angrier about paying a 7.5 percent "solidarity" surtax for reconstructing the eastern section, which has fewer than 20 million people, Kohl is trying to cut health and retirement benefits to reduce the deficit.

For all the excess, some experts argue that in the end Germans will witness a huge payoff from the eastern spending spree if they wait for a decade or more.

But others contend that eastern Germany combines the worst of two worlds: the bankrupt legacy from 45 years of communist mismanagement and the gold-plated rigidity that has jeopardized western Germany's own ability to compete on the world market.

And to the government's chagrin, former Eastern bloc countries like Poland, Hungary and the Czech Republic, which received a fraction of eastern Germany's external aid, are growing faster and attracting a lot of unsubsidized investment from Germany's biggest companies. Those countries, by contrast, have kept wages competitive and relied mostly on free-market forces since the collapse of the Soviet system.

"We blew it in east Germany," said Herbert A. Henzler, chairman of the German office of McKinsey & Co., the consulting firm. "In terms of economic policy, we did almost everything wrong."


High Cost of Labor: Wages Are Up; Productivity Isn't

Where did all the money go?

What many German economists say is not so much that the money was simply poured down a rat hole as that eastern Germany's problems boil down to one almost unbelievable statistic: The average hourly wage in eastern Germany has soared to more than $16 an hour, actually slightly higher than in the United States.

In a well-intentioned but damaging series of decisions in the early 1990s, the German government essentially imposed West Germany's entire structure of high wages and mandatory social benefits onto an economy that had collapsed.

West Germany's powerful labor unions added to the pressure, pushing hard to extend the terms for all western contracts into the eastern states in part to avoid hearing an immediate Ross Perot-style sucking sound of jobs moving from west to east.

High labor costs are now making it hard even for western Germany to compete in the global economy. But for eastern Germany, where the output per worker is only half as much, the wage situation is catastrophic.

"The economy here is comparable to that of a Third World country, or perhaps Spain or Portugal," said Joachim Ragnitz, an economist at the Halle Institute for Economics, not far from Leipzig. But "labor costs are much lower in Spain or Portugal."

The only business that has truly generated a lot of jobs in the last few years is the construction industry, which, thanks to the lavish subsidies, employs about 17 percent of all workers in eastern Germany, a share of the work force that is about three times that of most countries. But even that segment is now losing ground because of tremendous overbuilding.

With too many high-priced workers chasing too few real jobs, the government has persuaded as many as 800,000 people a year to leave the work force through generous early retirement programs. Several hundred thousand people are in training programs and 200,000 more are in what officials candidly call make-work jobs.

Germany was warned ahead of time about the potential for disaster. "It was probably the single biggest mistake," said Gunter Thumann, an economist with Salomon Brothers who was with Germany's ministry of economics and the International Monetary Fund. Thumann helped write an IMF paper in 1990 that pleaded for Germany not to raise wages too quickly in the east.

"It was as if they read only the things we said they shouldn't do," Thumann said, "and then did them."

To be sure, many experts say the German government had little choice politically. Unlike other former Soviet bloc countries, East Germany was absorbed into the West virtually overnight. Its residents had been promised the full benefits of German citizenship, a promise crucial to their vote for reunification in 1990. If eastern German wages and benefits had remained far below those in western Germany, the most skilled residents would have simply flooded westward.

"We are suffering today from decisions that were economically wrong but politically correct," said Werner J. Patzelt, a professor of political science at Dresden Technical University. "If you had told East Germans that they should get reunited with West Germany but that they should only have one-third or one-half of their wages, reunification would never have happened."

But while most of the problems flow from the fact that wage gains have been so much more rapid than productivity improvements, other mistakes contributed to the conundrum now facing eastern Germany. For one, the flood of money from Bonn produced by the tax subsidies was so indiscriminate that billions have been spent on projects that so far have yielded little economic value.

"A lot of the tax-driven projects were unprofessional, dilettantish and simply dumb," said Sascha Hettrich, head of the Berlin office of Jones Lang Wootton, the real estate consulting firm. "It happened a lot."


Costly Rebuilding: $3.2 Million a Job at a Plant

Nowhere is the eastern German jobs problem more vividly on display than at the monstrous and toxic chemical complex that Dow Chemical Corp. is taking over near the city of Schkopau.

The complex looms over the surrounding farmland like a film noir vision of life after the apocalypse, with 500 crumbling buildings ensnarled by hundreds of miles of rusting, leaky pipes. Thousands of windows have been smashed. Many walls are so soaked with poisonous mercury that the job of grinding them up has become a hazard.

Today, this site is the German government's biggest single project aimed at rebuilding eastern Germany's industrial base. It is also one of the most expensive job-preservation programs in history.

The government has committed $7 billion to tear down 90 percent of the works, rebuild it with the latest technology and subsidize losses for several years. But while 18,000 people worked there before the Berlin wall fell, and 4,000 are working now, Dow plans to employ no more than 2,200 when the plant is restored. The cost per job: $3.2 million.

"From Dow's perspective, it would have been much easier, less expensive and less risky to build an entirely new plant," said Bart Groot, the general manager of the site. But Kohl pledged to rebuild eastern Germany's devastated chemical region, whatever the cost. With wages so high, the only choice was to build costly, capital-intensive factories employing only a comparative handful of workers.

By 2000, if all goes according to plan, this plant will be equipped with everything from computer systems to a 280-mile pipeline to the Baltic Sea. It will get a new highway, new rail connections and a terminal at the Baltic port of Rostock.

For Dow, which has pledged to invest up to $700 million in return for 80 percent of the company, the project is relatively safe.

But does it make sense for Germany to spend so much money for so few jobs? Beyond the Dow project, the government plans to invest more than $20 billion to rebuild scores of other insolvent chemical complexes nearby.

Supporters argue that the plan is the least bad of the alternatives. Simply demolishing the old plants would cost billions and leave nothing for the region's future. By rebuilding with the latest technology, they argue, the Dow complex will ultimately generate 10,000 jobs and jump-start the local economy.

Even with all the subsidies, the project could still go sour if demand from Eastern Europe is below expectations. To turn a profit, the plant's sales need to double to at least $1.2 billion. "That's where the risk comes in," Groot said. "If that market does not materialize, then the investment becomes much less attractive."


Empty Towers: Plenty of Space, but No Tenants

Handsome and knowledgeable, Nico Preindl radiates the confidence and charm of a supremely effective real estate agent. But these days he spends much of his time in the echoing emptiness of Leipzig's new List Bogen office complex.

"It is a catastrophe," said Preindl, an agent for a unit of Hypo Bank of Germany, one of the developers. "There are four big office projects right in this neighborhood, and we all have the same problem -- no tenants."

Preindl is one of many witnesses to the financial disaster from Bonn's promotion of eastern German real estate. Thanks to a 50 percent tax write-off, wealthy western Germans have poured more than $100 billion into tax-oriented real estate funds.

The result is a region that is wildly overbuilt with luxury hotels, office towers, shopping malls and apartment complexes. The problem is particularly acute in Leipzig, which was a center of trading and publishing for centuries before World War II.

During the last five years, Leipzig officials estimate they have attracted $20 billion in investment. The city has a forest of new office buildings, 40 new hotels, scores of shopping malls and at least a dozen new industrial parks within a 30-mile radius.

The only thing missing is the business to support all this. "This city is under terrible pressure," said Heinrich Rohrs, general manager for Commerzbank's Leipzig branch. "The whole city is so overbuilt. There just isn't any demand. There isn't any life."

The $100 million List Bogen hardly looks like a disaster. The facade is sheathed with pink marble, accented by blue steel frames and dark-tinted windows. The building has 217,000 square feet of space, advanced energy systems and a fiber optic network.

But so far, the only tenant is a small bakery on the ground floor. Preindl says he has contracts to lease 10 percent of the space. But he must fend off hungry competition on all sides. A few blocks away is the Atrium, which has rented only one-third of its space. Next door is the even bigger Frederich List Haus, which will be finished in June and has yet to sign up any tenants.

"Our company has the staying power," Preindl said. "But how long should we have to wait? The next two years? The next five years? The next 10? No one knows."

In eastern Germany, local officials have labored mightily to blend tax breaks with direct subsidies from Bonn. Want a $200 million Formula One speedway to spruce up a desolate coal-mining area? The state of Brandenburg does, so it is planning one for Lausitz, 40 miles west of Dresden, where the land is pocked by old strip-mining craters and laced with toxic chemicals.

Some officials have already nicknamed their project, which would be the biggest raceway in Europe, the German Indianapolis. The state has agreed to pick up 80 percent of the construction cost.

There are a few problems, though. The Formula One racing organization has said it will not use the new track. Nor are German automobile makers interested in using it as a test center. And the entrepreneurs who dreamed up the project are balking at a required 15-year commitment.

Brandenburg officials say they are not perturbed. "The decision has already been made," said Cord Schwartau, a spokesman for the state economics ministry. "We are just debating the details."


Seeds of Growth: Just Add Money for 20 Years

For all the problems, many experts agree that western German money is slowly creating the basis for what ultimately could be a spectacularly modern economy.

Eastern Germany's telephone network, built from scratch by Deutsche Telekom, is more advanced than that of the United States. Siemens AG, the giant electronics conglomerate, and Advanced Micro Devices, the American computer chip manufacturer, are building semiconductor plants near Dresden. The Opel unit of General Motors has one of the most advanced automobile assembly plants in the world, in Eisenach.

"I feel optimistic," Patzelt of Dresden Technical University said. "You can see the flourishing landscapes that are developing -- the infrastructure, the shops, the factories. We are in the spring now, not the fall."

Outside Magdeburg, an irrepressible eastern German entrepreneur named Eberhard Pohl has tapped several hundred million dollars in government help to build the Technologiepark, home to more than a dozen high-technology start-ups.

"You see how beautiful the land is?" Pohl asked, as he drove down newly paved streets in the middle of what was recently farmland. He pointed out a wildlife sanctuary on one side of the road and on the other, the gleaming modern glass Innovation Center, hooked up to 5,000 digital phone lines.

But all this is cold comfort to most unemployed workers. The new factories are usually so highly automated that they make little dent in the jobless situation.

At the $200 million prescription drug factory built by Salutas Pharma GmbH, robots mix ingredients, pound out pills and pack boxes. The factory will employ no more than 320 workers. "If we designed the plant any other way, we simply would not be competitive," said Ludwig Grasmueller, its manager.

None of this investment is self-sustaining yet. With costs far lower in the Czech Republic, Hungary and Poland, most companies are reluctant to invest in eastern Germany without generous subsidies.

That is even true for Germany's high-profile corporations. Volkswagen wants a factory in eastern Germany, but it almost canceled the project because the European Commission in Brussels, which must rule on subsidies that might give an unfair advantage to a business within the European Union, objected that $90 million in subsidies was improper.

Meanwhile, Volkswagen's Audi subsidiary, without much outside help, has built an advanced factory in Hungary, which the company can use as a lever to pry concessions from German labor.

"The unions always assumed we were pushovers and that we would never build a plant in Eastern Europe," Norbert Essing, Audi's spokesman, said. "Now they take us much more seriously."

Analysts say the problem of high labor costs cannot be fixed quickly. "Do you keep pouring in more subsidies, or do you cut wages?" Thumann of Salomon Brothers asked. "You'd really have to cut wages, but politically that's impossible."

But pouring in subsidies is becoming more difficult, too. The German government is running shorter of money, and voters now despise the 7.5 percent "solidarity" tax.

Some subsidies are being cut back. The tax break that ignited rampant overbuilding in Leipzig and elsewhere was trimmed in January, choking off some projects.

Meanwhile, many companies, quietly encouraged by Bonn, are breaking ranks with the national union contracts and reaching cheaper local agreements.

For the foreseeable future, however, Germany plans to keep pumping money eastward, whether or not western German residents like it. Critics say that may be money down the drain. Optimists say the investment will pay off -- eventually.

"In 15 or 20 years, east Germany will have the most modern infrastructure and the most modern economy in Europe," Patzelt said. "All you need to do is finance the transition. What we really need is another 20 years."


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