When the Berlin Wall came down, the lack of competitiveness of East Germany’s economy became obvious overnight. This lack found its expression in the form of a considerable gap in terms of productivity when compared to the western part of Germany. In the first half of the 1990s, productivity increased rapidly. But the speed of convergence has decreased considerably since 1995. Economists have tried to explain East Germany’s slowdown in terms of productivity by highlighting macroeconomic reasons, in particular the extraordinary wage increases of the 1990s, the disincentives stemming from large fiscal transfers from West to East, and the lack of infrastructure (e.g. Sinn and Westermann, 2000: especially 12-22). In Sinn and Westermann’s view, these fiscal transfers led to a kind of ‘Dutch disease’ in East Germany which prevented the export-oriented industries from becoming competitive (Sinn and Westermann, 2000: 21-24). However, in the meantime, the shortcomings mentioned above disappeared, or lost some of their former importance. The unit labour cost of the East German manufacturing sector fell, and is now lower than those in West Germany (Blum et al., 2010: 13, 77). Infrastructure has been modernised through public investment (IWH et al., 2011: 6ff., 89). Transfers still occur, but large-scale job creation schemes (German abbreviation: ABM) and schemes for sending employees into early retirement and for retraining workers have been considerably reduced or stopped altogether. Because the earlier limitations have become less important, it is to be assumed that there must be other shortcomings of a primarily structural nature which have exacerbated the stagnation in productivity. Against this background, this chapter will focus on the structural shortcomings of East Germany’s economy, since an understanding of these may contribute to a better idea of what is behind East Germany’s decelerated catch-up in productivity. The chapter presents research findings elaborated on at the Halle Institute for Economic Research (IWH), which has analysed economic development in East Germany empirically since the early 1990s. Before identifying these structural shortcomings a brief look at recent theoretical concepts of new growth theory and new

economic geography is necessary because these go some way towards explaining why regions do not necessarily converge.