Open Access

Daniel Fehrle, Vasilij Konysev

• German reunification in 1990 marked the first sudden integration of a socialist and capitalist economy. Despite East Germany’s (EG) economic catch-up with West Ger- many (WG), the integration remains unfinished, as indicated by per capita output in EG still being about one-third lower. To study this unfinished regional convergence, we apply wedge-growth accounting using a human capital-augmented, two-sector, two-region model, incorporating labor supply constraints to capture key qualitative differences between EG and WG. Our findings show that sectoral labor and capital wedges are similar within regions and have significantly converged between regions, with EG initially overusing inputs. While productivity in the nontradable goods sector has fully converged, the tradable sector in EG remains less productive than in WG. Counterfactual analysis suggests that this productivity gap, together with persistent net inflows to EG, explains EG’s lower economic activity. However, reducing the in- flowsGerman reunification in 1990 marked the first sudden integration of a socialist and capitalist economy. Despite East Germany’s (EG) economic catch-up with West Ger- many (WG), the integration remains unfinished, as indicated by per capita output in EG still being about one-third lower. To study this unfinished regional convergence, we apply wedge-growth accounting using a human capital-augmented, two-sector, two-region model, incorporating labor supply constraints to capture key qualitative differences between EG and WG. Our findings show that sectoral labor and capital wedges are similar within regions and have significantly converged between regions, with EG initially overusing inputs. While productivity in the nontradable goods sector has fully converged, the tradable sector in EG remains less productive than in WG. Counterfactual analysis suggests that this productivity gap, together with persistent net inflows to EG, explains EG’s lower economic activity. However, reducing the in- flows would result in significant welfare losses in EG. Furthermore, we account for the reunification event, identifying a substantial productivity catch-up in EG between 1989 and 1991. Our findings offer clear policy insights, highlighting the trade-offs between economic activity and fiscal transfers.…