Labor Reallocation and Wage Growth: Evidence from East Germany
In 1992, East Germans' nominal wages were about half of West Germans'. This gap reduced to a third by 1996, and is about a quarter today. We use matched employer-employee data for the universe of (male) Germans with social security records to study the determinants of this steep convergence. Empirically, at least half of the total convergence can be attributed to an improvement in the allocation of East German labor across firms. The bulk of this is driven by improvements in within-region reallocation in earlier years, while migration of East Germans to Western firms steadily grows to explain more in recent years. Before 1991, both East German firms and workers were exposed to a distorted labor market under the planned economy of the German Democratic Republic. After reunification, the labor market was liberalized as in the West, while workers were also allowed to freely move across the (former) border. The evidence suggests that the competitive labor market succeeded in quickly unraveling most of the misallocation generated by the planned economy. Consistent with this hypothesis, older birth-cohorts, who were exposed to distorted labor markets for a longer period, were the ones to gain the most immediately following reunification. Interestingly, these wage gains were generated by high-growth firms reducing their number of employees. We propose a one-to-many firm-worker search model with size and match-quality distortions to explain i) why high-growth firms downsize when labor market conditions improve, even though ii) high-wage firms remain larger in the cross-section. Both distortions are important for jointly understanding firm and worker dynamics in East Germany post-reunification.