Stop Throwing Good Marks After Bad

The good news is that eastern Germany is now growing at 9% a year and unemployment has leveled off at 14%. The bad news is that growth is still primed by state subsidies, tax breaks, and social transfers from the west amounting to more than $100 billion annually.

The command economy of the former German Democratic Republic has undergone vast change in the past five years. A service sector--from banking to pizza parlors--has sprung up, while manufacturing has shrunk dramatically. During that wrenching process, it made sense to support easterners' incomes because it avoided a social explosion and also generated purchasing power for local goods and services.

But that time has ended. The costly "help" that Bonn offers today comes from a poisoned chalice. Tax breaks and accelerated write-offs on commercial real estate, for instance, have resulted only in empty offices in Dresden and Leipzig, not real jobs in industry.

Bonn is mulling over a scheme that would further distort the marketplace by creating a fund that government agencies could use to invest in companies. It would offer tax breaks and above-market rates of return to attract private funds that the government would then plow back into select eastern German companies. The only problem with the plan is that picking winners--as this would certainly do--has proved to be difficult at best for governments around the world. They tend to be uniformly bad at it. Markets are much better.

Moreover, Bonn has burdened the east with all the petty regulations and rigidities of the west German system. It had one chance of boldly creating a deregulated economy from scratch, but refused. Western labor unions let their eastern brethren believe that equalizing wages between the two parts of Germany quickly was doing the east a favor. Instead, it made industry less competitive by driving eastern unit-labor costs higher than west German levels, which are the highest in the industrialized world.

That has resulted in U.S., Japanese, and other foreign investors bypassing eastern Germany for Poland, Hungary, and the Czech Republic, where lower labor costs make them extremely competitive. Even west German companies are rushing to what was once communist east Europe because they are finding relatively high levels of manufacturing skills at much lower costs, compared with their own brethren in the east. Today, east Germany lives off the fat of taxpayers, not the inherent competitive strength of its people.

It is time to unleash market forces in Germany, in both parts of the country. Bonn must reduce its role in the entire nation's economy. Just for openers, it can start hacking away at the $50 billion in subsidies that the nation's taxpayers still dish out to the west German economy. The money goes for all kinds of things: supporting uncompetitive farmers; subsidizing corporate research into advanced chips; helping to defray costs for the European Airbus. After those cuts have been made, then the government can do the same thing in the east.

Before it's here, it's on the Bloomberg Terminal.