KOREA FOCUS
Costs of Korean Unification
By Yang Un-chul

Research Fellow
The Sejong Institute





Ⅰ. ntroduction

North Korea’s polity has been maintained thus far on the basis of its communist Korean Workers’ Party and the military. But its economic system has been rendered unviable, forcing the communist state to rely on outside handouts to feed its 23 million people. North Korea has attempted to change policies to overcome its economic difficulties, but its economy has yet to return to normal. Without any fundamental political and economic changes, the North Korean regime cannot last long and there is growing possibility of unification occurring on the Korean Peninsula.
 
The methods of unification can vary but the possibility of a German-style unification by absorption is considered relatively high. That’s because the basic conditions for Korean unification by mutual agreement are deemed insufficient in light of present inter-Korean military confrontations.
 
The German-style unification through absorption, if realized on the Korean Peninsula, is likely to impose tremendous economic burdens on South Korea. A rise in the expected cost of unification is greatly influencing the South Koreans’ traditional concept of unification. In other words, the public tendency to view unification as the utmost value from the perspective of nationalism is changing.
 
As far as the economic burden of unification is concerned, the German case seems to indicate many things for the South Korean people. Before unification, West Germany had supported East Germany by strengthening cross-border exchanges and cooperation. After unification, West Germany swiftly helped East Germany’s transition to the capitalist system through massive fiscal support. But the fact that the sum of resources and capital disbursed by West Germany for the transformation of East Germany is realistically beyond the reach of South Korea is offering a paradoxical lesson that the German-style support would be impossible in Korea.
 
Germany has been struggling with fiscal difficulties for many years because the country hastily pursued political integration with little regard for the economic expense of national integration following the collapse of East Germany. West Germany’s transfer expenditure was mostly for the purpose of consumption by the East German people.
 
This kind of dissipated expenditure is different from transfer expenditure that can generate incomes. Unlike investment, dissipated expenditure never contributes to improving incomes. Despite the absence of investment value, the West German government enforced an enormous amount of dissipated transfer expenditure, taking into consideration the non-economic purpose of providing a social safety net. Accordingly, it is an unrealistic to calculate the fiscal burden of Korean unification on the basis of the German government’s fiscal transfer payments.
 
If the economic burden of Korean unification means purely dissipated expenditure, like the expansion of the social security system in Germany, the South Korean people will have to choose a comparatively less costly unification. Then, what is the least costly path to unification on the Korean Peninsula? The answer is to reduce the burdens of dissipated fiscal assistance. To that end, North Korea should be led to become economically viable, but it will require a sweeping overhaul of the North’s economic system.
 
Paradoxically, the problem is that the North’s reform and regime transformation would be enormously expensive. Therefore, the key to reducing the unification cost depends on how to effectively transform the North Korean economic system after unification.
 
In most countries that experienced a system transition, a clash between development and transformation was reality. North Korea’s incorporation into the capitalist system would simultaneously have bright and dark sides. As in Germany, the North Korean people would enjoy political freedom and improved quality of life in the process of Korean unification, but may feel comparatively deprived. Thus a smooth unification would be hard to attain without the cooperation of the North Korean people.
 
Of course, benefits from unification cannot be overlooked. Unification is inevitable in terms of national history and has a lot of factors to transform divergence of national power, caused by the national division, to convergence of national power. For example, we can expect considerable transfer effects from reduction in defense budgets and synergy from complementary nature of the two Koreas’ industries.
 
Unification cost should not be viewed as a simple accounting expense. It rather can be defined as an economic expense inclusive of opportunity cost, because it can yield profits in the future, like an investment in social infrastructures. In other words, unification cost is not regarded as a short-term inactive investment, but as an active investment implemented from a long-term perspective.
 
In its preparation for national unification, South Korea has to view unification cost as ``future goods” and devise measures to secure funding resources, with full consideration given to the welfare of the North Korean people. The financial crisis of 1997-98, which is still fresh in our memory, vividly showed South Korea’s fiscal vulnerability and the nation was forced to sustain significant pain and pay social expenses in the process of overcoming the crisis.
 
The Korean economy has since accomplished a great leap forward in terms of quality and quantity, while its liquidity problem has been resolved. But the Korean economy is lacking in a clear vision for its long-term growth locomotive and struggling with the rapidly growing fiscal deficit. When additionally considering the serious youth unemployment and the vulnerability of social security system, a radical unification is expected to give rise to considerable economic hardship.
 
Nevertheless, it is not easy to prepare unification expenses in advance. It is very unreasonable in terms of opportunity cost if the South Korean government faced with fiscal deficit tries to secure financial resources in preparation for unification. At present, the bulk of Seoul’s inter-Korean cooperation fund is being spent to provide humanitarian food assistance and other dissipated resources for Pyongyang, instead of being used to help foster North Korea’s economic transition and viability.
 
The plausible measures for South Korea to secure financial resources to assist North Korea may generally include tax increases, issuance of government and public bonds and foreign currency borrowing. But none of these measures are easy to implement and taxpayer resistance cannot be ruled out in the long term. Therefore, South Korea will be politically and economically burdened in order to smoothly secure financial resources for unification, as it is required to produce a national consensus and accommodate the welfare needs of the South and North Korean peoples alike.


II. Measuring Costs of Unification

 
1.       Concept of Unification Cost
 
The term unification cost was first used to describe the expenditure intended to equalize the two Koreas’ incomes in the event of unification. The meaning of unification cost later changed to refer to expenses in a broad sense, like an investment in social infrastructures and industrial restructuring, which can generate future profits. In this sense, unification cost exceeds the boundary of a simple accounting cost and can be defined as an economic expense inclusive of opportunity cost.
 
With unification expenses regarded as opportunity cost, derivative concepts, such as benefits of unification and division cost, have come to light. Various interpretations of unification cost have been made, as its real concept has been expanded to include visible and invisible value.
 
Generally, unification cost is regarded as a long-term active investment, not as a short-term inactive investment, which has a character of social capital to develop North Korea. Most studies on unification cost reflect the South Korean perspective and are based on the premise of the German-style unification by absorption. The problem is that such studies may negatively lead the South Korean people to believe that unification expenses would put heavy economic burdens on them.
 
There are at least two problems in the concept of unification cost. First, much research is still excessively focused on the expense itself and thus fail to take the potential benefits of unification into consideration. The second problem is the failure to distinguish between the dissipated and loss-making expense and an investment-like expense that can yield potential profits.
 
If unification is realized as a historical incident, the cost-benefit analysis of unification is completed as time goes by. But in the short run, the amount of unification cost is not significantly meaningful. Only the capability of absorbing the impact of unification and relevant preparations are the problems. By contrast, the potentially lucrative expense, or investment, is an optional matter. Unlike unification cost, the amount of investment payments can be chosen.
 
Therefore, the definition of investment needs should be established ahead of the calculation of unification cost, in the event of unification on the Korean Peninsula. But the concept of cost could be more appealing in terms of preparation for the shock of unification. As a matter of accommodation, the term unification cost is used in this article as the same expression as investment needs.
 
2.       Methodology of Unification Cost Estimation
 
Early studies on the estimated cost of Korean unification were carried out mainly on the basis of the German experiences. In particular, various studies were conducted after five years of German unification. The research methodology of unification cost can be classified into six kinds in terms of development stages.
 
In the first stage, South Korea’s income level and fiscal scale were analyzed with the German government’s fiscal expenditure taken into consideration. If the German government paid 5 percent of its gross domestic product for unification expenses, for instance, the ratio was readjusted to the South Korean circumstances.
 
In the next stage, the timing when incomes of the two Koreas are equalized or North Korea reaches a targeted income level is arbitrarily set and the fiscal resources necessary to attain such a goal within a certain period of time were calculated. If unification is realized in 2010 and the two Koreas’ incomes were equalized in 2030, North Korea’s economic growth rate should comparatively far exceed South Korea’s. As this kind of research does not adopt exquisite models, however, it is difficult to determine whether the estimate of unification cost would be precise.
 
Thirdly, a sophisticated specific model was used in the methodology of unification cost estimation. This research generally uses the computable general equilibrium (CGE) model but its calculation method is based on the target approach method as in the preceding studies. The CGE model represents the added value of input and output measured on the basis of the industrial connection analysis and consists of price, quantity, market liquidation and other numerical simulations specifying conditions for general equilibrium.
 
Fourthly, unification costs and benefits were simultaneously taken into consideration in studies. Ways to reduce Korea’s division cost were additionally studied in consideration of the stark reality of territorial division.
 
Recent studies put the emphasis on the benefits of unification. Despite some merits, the quantitative estimate of unification costs could simplify judgment and run into serious problems, such as a wide deviation in cost estimates.
 
3.       Fallacy in Estimation
 
It is a valuable task to try to correctly estimate unification-related expenses, despite some problems in its estimation methodology. But it is difficult to quantify the outbreak of visible and invisible values, such as post-unification mass migration and the North Korean people’s degradation into second-class citizens.
 
Therefore, studies on unification cost should be focused on the government’s fiscal capabilities, rather than on the estimation itself. And with the determination of the subject of unification, the influences from political implications of unification cost cannot be ruled out. For example, the claim that unification cost in Korea would be far bigger than in Germany because the inter-Korean income gap exceeds the gap between East and West Germany is a politically oriented claim.
 
In other words, its logic means that the estimated capital necessary for income growth in North Korea is equal to the amount of fiscal expenditure needed to reduce inter-Korean income gap. Thus it is not reasonable to insist that a wider income gap means a larger unification cost. Most estimates for unification cost are simply experiments of probability, not carefully attempted calculations. For that reason, their policy implications are insignificant. If investment needs calculated by optimum models under reasonable assumptions are too big to bear, unification itself could mean fiscal bankruptcy. Then unification itself would be rendered impossible and the goal of income equalization would be unattainable.
 
Accordingly, if the object of unification is not clarified, the unification cost will inevitably be exaggerated. If the purpose of unification is simply to raise North Korea’s income to a certain target in comparison with South Korea, it is a natural result that the cost estimate would increase as the South’s income is bigger than the North’s. Of course, income equalization is desirable for a unified Korea, but it should not be the ultimate goal of the unification policy. The ideal and feasible goal of the unification policy is to help North Korea maintain a viable growth. In order to attain such a goal, it is necessary to build an appropriate system and environment for North Korea’s moribund economy to function normally.
 
If these conditions are not met, the input of resources will be inefficiently used, as experiences of many developing countries resorting to outside aid showed in modern history. In the case of South Korea, there have been a lot of studies on the locomotive of its economic growth. But practical studies assumed that South Korea’s economic growth was largely attributed to the rising number of the employed, increase in the input of fixed capital, improvement in educational level, expansion of housing supply, technological advancement and economic effects of scale.
 
Therefore, the path North Korea is supposed to follow after unification will be similar to one pursued by South Korea thus far. The problem is that the possibility of the Korean economy slipping back into a serious economic crisis cannot be ruled out, if a unified Korea immoderately enforces its currency and fiscal policies to boost domestic consumption. Likewise, the Seoul government has recently attempted to stimulate the construction industry as a means to overcome unemployment and sluggish domestic consumption, but such pump-priming measures eventually failed to rehabilitate the economy.


III. Securing Financial Resources for Unification

There is no national consensus yet over how to secure financial resources in preparation for unification, due to concern over South Korea’s capability to cope with colossal unification expenses. Such a concern is corroborated by North Korea’s serious economic reality. The fiscal transfers from West Germany to East Germany were mainly related to expenditures for social security allowances, including unemployment benefits and retirement pension.
 
But South Korea has yet to have the first-rate social security system that used to be enjoyed by West Germany. Furthermore, it is difficult to expect South Korea to offer its level of welfare benefits to North Korea, even if the South could afford to do so. South Korea, which had undergone the shocks of a devastating economic crisis just years ago, is now facing very daunting decisions over how it has to prepare for unification and how much it has to spend in the event of unification.
 
If the North Korean nuclear weapon problem is resolved ahead of unification, demand for the Inter-Korean Cooperation Fund will increase due to the stimulation of cross-border economic exchanges and the government can consider taking advantage of deposits of public fund managers, loans from financial institutions and bond issuance.
If unification is realized, unification bond, the German-style Solidarity Surcharge and the Korean Unity Fund would be actively utilized, along with large-scale tax increase, issuance of public bonds and overseas borrowing. In addition, unification benefits, such as reduction in defense spending, would contribute to scaling down unification expenses.
 
1.       Inter-Korean Cooperation Projects
 
Under the current situation, the ongoing inter-Korean economic cooperation projects can be regarded as a unification cost.
 
The stimulation of inter-Korean economic exchanges can, in the long run, contribute to reducing unification expenses by transforming North Korea’s economy in a market-friendly manner. The seven core projects of inter-Korean cooperation are the construction of a South Korean industrial park in the North Korean border town of Kaeseong, expansion of cross-border transportation networks, tourism cooperation, agricultural cooperation, electric power cooperation, forestry and water resources cooperation and information technology cooperation.
 
Table 1 shows the Unification Ministry-compiled estimates of inter-Korean cooperation projects in the period between 2006 and 2010. The total expenditure is estimated to reach at least 9.39 trillion won ($10.2 billion).
 
At present, a major funding source for inter-Korean economic exchange is the Inter-Korean Cooperation Fund. Since the inception of the fund in 1991, a total of 4.782 trillion won had been raised by the end of December 2004, with its spare cash totaling just 470 billion won.
 
The fund can be broadly divided into an inter-Korean cooperation account and a light-water reactor account. The inter-Korean cooperation account is used for economic exchanges, including fertilizer, food and other humanitarian aid, human exchanges, support for social and cultural cooperation, loans for economic cooperation projects and social infrastructure. Since 2000, about 700 billion won to 1 trillion won has been available annually for inter-Korean economic cooperation. But the amount of fund implemented for inter-Korean economic cooperation, excluding food, fertilizer and other humanitarian aid, totaled 100 billion to 200 billion won.
 
The main funding source for the inter-Korean cooperation account is the government. Since 100 billion won was paid in 2000, the government’s contribution has steadily increased. The government increased its donation to 500 billion won in 2005 and 750 billion won in 2006 (Consult Table 2 for reference). But its donation to the inter-Korean cooperation fund should be sharply increased, considering the rapid pace of development in inter-Korean relations and the funding needed for the seven core projects.
 
The government’s 2006 budget for unification and foreign diplomacy increased by about 700 billion won, marking the highest categorical growth rate with 36 percent. But there is a clash between the need for the inter-Korean cooperation fund and the need to support low-income people at home on the basis of the principle of equity. There will be a clear limit to the expansion of the fund unless the North Korea nuclear weapon issue is resolved.
 
2.       Tax Burden
 
Taxes are the biggest funding source for unification projects. The tax increase can be justified if a national consensus is reached. But a reduction in consumption and price increases caused by the tax increase could bring about contrary effects. In light of its experience with inflation policies and overseas borrowing during the days of rapid economic growth, South Korea should carefully consider increasing taxes. South Korea’s tax burden and social security burden have steadily mounted since the economic crisis in the late 1990s.
 
South Koreans’ tax burden ratio, which is the ratio of tax to disposable income, was 20.5 percent as of 2003. It was lower than the 30 Organization for Economic Co-operation and Development member countries’ average of 27.3 percent but higher than Japan’s 2002 ratio of 17 percent. Accordingly, the current level of South Korea’s tax burden is not low. It will not be easy to produce a national consensus over a tax increase, as the tax burden ratio has been on the steady rise.
 
Of South Korea’s 2003 aggregate tax revenue of about 135.49 trillion won, the national tax accounted for 77.6 percent of the total, and the local tax amounted to 22.4 percent. Compared with 1990, the national tax grew more than four-fold and local tax grew more than five-fold. National tax revenue steeply increased between 1998 and 2001, while local tax revenue rose sharply because of the introduction of the auto-fuel tax in 2000 and the local education tax in 2001.
 
South Korea’s national and local tax rates are higher than those of European countries, excluding Germany, but lower than those of the U.S. and Japan, which have similar economic and welfare systems. This reflects the low fiscal independence ratio of South Korea’s provincial governments.
 
North Korea also has to participate in the post-unification tax increase. Tax revenues are expected to further rise if North Korea manages to secure a foothold for growth by modeling itself on the operation of small Chinese enterprises and the success of small-scale privatization in Eastern Europe and Russia. Like China, North Korea will be able to significantly lessen its fiscal burden if its local governments attain fiscal independence from the national government.
 
3.       Issuance of Public Bonds
 
Following the outbreak of the 1997-98 financial crisis, South Korea issued government-guaranteed bonds on a large scale in order to write off bad financial assets. The country had maintained relatively sound finances, but it was forced to sustain a huge fiscal deficit. Increased government expenditures have since resulted in a rise in its fiscal deficit as well as in the issuance of government and public bonds.
 
Under the government of President Roh Moo-hyun, the national debt snowballed. The net debt increase totaled 69.5 trillion won, including 29.4 trillion won in public funds converted into national debts, 30.6 trillion won in a foreign exchange stabilization fund, 5.5 trillion won for supplementation of fiscal deficit in general accounts and 4 trillion won in a housing fund and others. The national debt exceeded 200 trillion won as of June 2005.
 
The issuance of bonds helps the government maintain a balanced budget and raise capital, but it could slow down the economy because of its link to interest rates. At the end of 2004, South Korea’s national debt totaled 203.1 trillion won, or 76.4 percent of the gross domestic. Of the total, financial debt that can be independently repaid through asset sales and retrieval of loans accounted for 61.8 percent. South Korea’s fiscal soundness is considered high, as its national debt ratio is below the OECD average of 76.4 percent.
 
Currently, national bonds of 10-year maturity account for 30 percent of the total. In the future, maturity periods should be extended to stabilize government finances and market capital flow. Most short- and mid-term bonds reflect real interest rates. In the case of Korean unification, long-term bonds should be issued at relatively low interest rates. But unification bonds could be unpopular. With various national bonds already available, demand for unification bonds may not be high.
 
4.       Overseas Borrowing
 
South Korea’s fiscal capability will be restricted in the event of unification. Thus, it should secure assistance from international organizations and neighboring countries and actively attract investments from abroad. It is desirable for North Korea to join international financial organizations before unification and raise capital through borrowing.
 
The foremost task to be considered in preparation for unification is to secure a special trust fund from the World Bank as well as grants or capital from the international community. A debt-for-equity swap for nongovernmental organizations involved in development projects in North Korea should also be considered.
 
5.       Other Funds
 
With regard to unification expenses, some of the 56 government-managed funds, which are linked to assistance for North Korea, can be utilized. Inter-Korean exchange and cooperation projects are reflected in the National Sports Promotion Fund, Culture and Arts Promotion Fund and Broadcasting Development Fund, among others. In the future, the Economic Development Cooperation Fund or the Small Business Structural Improvement Fund can be utilized.
 
If the Inter-Korean Cooperation Fund is expanded through the utilization of such funds and other joint business projects, an estimated 1 trillion won (accounting for 1 percent of the general account) in terms of the 2004 value could be additionally raised. The cooperation fund can be further increased through donations from lottery funds. For instance, if 20 percent of lottery earnings are dedicated to the Inter-Korean Cooperation Fund, about 140 billion won (accounting for 0.14 percent of general account) worth of capital in terms of 2005 value will be raised.
 
6.       Establishment of Northeast Asia Development Bank
 
The concept of unification cost could also be approached from the perspective of the participation cost of the Northeast Asian economic bloc. The South Korean government could donate part of its budget to establish the Northeast Asia Development Bank or Northeast Asia Development Corporation. The problem is that the bank would be required to raise about $16 billion to $140 billion a year to meet anticipated demands for macroeconomic development and the demand for development financing is expected to reach about $5 billion to $15 billion a year.
 
The biggest obstacles to the establishment of the bank include the absence of a vision for the realization of a Northeast Asian bloc, the unresolved North Korea nuclear dispute and China-Japan competition for regional hegemony. A Northeast Asia Development Corporation could be set up at with relatively little capital on the initiative of private sector. Considering most public corporations are mired in the red, however, the proposed bank’s role should be carefully examined.


IV. Reduction of Unification Cost

 
1.       Unification Cost and Public Opinion
 
If the goal of unification is to equalize the incomes of North Koreans and the South Koreans, the relevant expenses cannot in the strictest sense be called unification costs. In other words, most unification cost estimates reflect the income gap between the two Koreas, rather than the potential economic losses. But South Korean people’s willingness to pay for North Korea after unification is important, as the income gap cannot be eliminated at an economically acceptable expense.
 
The results of opinion polls conducted in 1997 and 2005 could provide some insight. In the 1997 survey by the Sejong Institute, 1,500 people were questioned about their opinions on unification and the tax increase after unification. Most respondents preferred gradual unification to radical unification. Regarding the additional tax burden that would likely be imposed to help North Korea’s reconstruction, a third of them opposed it and most respondents expressed concern.
 
A 2005 survey carried out by the National Assembly revealed far more shocking results. Asked about aid for North Korea, 65 percent called for a reduction in aid, and 40 percent said they were unwilling to pay even a penny for unification.
 
Opinion polls conducted by the Korea Institute for National Unification (KINU) in 1994 and 2003 also indicted that it would not be easy to secure funds to pay for unification. In the KINU surveys, the South Korean people turned more open-minded than in the past towards paying unification expenses, but the majority of them preferred a tax increase of less than 5 percent.
 
The opinion polls in 2005 seem to offer more suggestions. Though the Roh government and former President Kim Dae-jung’s government improved inter-Korean relations through their engagement policies, North Korea’s attitude could have had a negative influence on public opinion in the South. Despite continued support for North Korea, the principle of reciprocity was never observed, as seen in the communist state’s failure to repatriate South Korean prisoners of war captured during the 1950-53 Korean War.
 
In addition, serious youth unemployment, worsening income imbalance and other economic hardships in South Korea may have led to a negative public response to the aid bound for North Korea. The negative sentiment could also have been a result of the South Korean people’s reaction to the miserable plight of North Korean defectors, the Pyongyang government’s human rights violations and other cases of infringement of fundamental humanitarian values in the North.
 
The surveys by the Sejong Institute, KINU and the National Assembly showed that the majority of the South Korean people were unwilling to pay for unification and preferred gradual unification. Therefore, the government’s policy goals in preparation for unification should be focused on seeking measures to minimize aid to North Korea and producing a national consensus on North-bound assistance.
 
2.       Smooth Transition of North Korean Economy
 
The best way to reduce unification costs is to make capitalism swiftly take its root in North Korea. The scenario in which North Korea’s economic transition is completed before unification is currently the most desirable way to reduce unification costs, but the possibility of its realization seems very slim because of North Korea’s political structure.
 
Gradual unification could end in failure because the cost of North Korea’s industrial transformation could be enormous because of its economic characteristics. Radical unification could also lead to the collapse of the North Korean government and unification through absorption. The problem is whether South Korea will be able to cope with the tremendous expenses and confusion that will likely be created by gradual or radical unification. The fact that even West Germany, which was economically far more advanced than South Korea and had prepared for unification for many years, had difficulty coping with its unification cost testifies the difficulties of unification through absorption.
 
Having witnessed German unification, we can assume that the most worrisome part of the process of North Korea’s economic transition would be the mass relocation of people from the North to the South because of the wide gap in income and living environment. North Korea has ceaselessly forced its people to sacrifice their material welfare because of the isolated country’s structural economic slump.
 
Because the degree of isolation of North Korean society is serious, unification will accelerate the southward movement of the North Korean people. The society defection effect, which is now spreading, would be inevitable. In this process, it would be a politically burden to restrict population movement by force or law. Likewise, providing incentives to block population movement would be politically and socially burdensome.
South Korea’s aid is necessary to help narrow the South-North gap in living standards. The convergence of the two Koreas’ economic power means extensive investments in North Korea. Before unification, investment in the North can be gradually implemented through inter-Korean economic cooperation. After unification, large-scale investment should be made from the perspective of national land development and balanced regional development. Such an investment would inevitably be accompanied by enormous fiscal burdens. But the success of a regime transition could offer an economic benefit.


Ⅴ. Conclusion: Lesson from German Unification

A unified Korea is presumed to be a capitalist system based on free democracy and market mechanism. North Korea’s extremely inefficient economic system should be swiftly converted into the capitalist system. The key to the transition depends on private property ownership and market mechanism swiftly taking root in North Korea.
 
Thereafter, the foundation for a unified economy will be formed through the complete integration of two economic systems, which includes the use of a unified currency. Thus, the smoother the system transition process is, the lesser economic burden the Korean people will shoulder.
 
As history showed, the German unification was a phenomenon of the East German economy rapidly collapsing and being absorbed into West Germany. But the joy of unification was short-lived and the overall Germany economy began experiencing mounting unemployment, inflation, sluggish growth and other economic burdens that were brought about by radical unification. Witnessing the German unification, the South Korean people became concerned about how to shoulder unification-related fiscal burdens in the future.
 
Notwithstanding many problems, East Germany’s radical transformation of its economic system was successful. The transformation was implemented through changes of key policies and those changes included macroeconomic stabilization, price and trade liberalization, market and corporate reforms, currency exchanges, the formation of a social safety net, legislation of bills on the basics of market economy and establishment of relevant systems.
 
Of course, there were some policy mistakes committed in the process of system transition. Despite stagnant growth in their production capability, the East German people preferred high currency exchange rates out of expectation they could enjoy the same living standards as the West German people by maintaining high incomes.
 
Political determination of currency exchange rates resulted in the overvaluation of the East German assets. The East German people’s excessively high income, particularly in comparison with their productivity, was rather one of the biggest causes for the collapse of the East German economy. As a result, the East German corporations saddled with overvalued assets became nonviable in the global market and eventually went bankrupt as their sales were made nearly impossible.
 
West Germany’s support of East Germany was backed by the former’s strong economic power. On the eve of the German unification, in fact, West Germany’s economic power was at its peak in terms of government fiscal condition and macroeconomic indicators. Nevertheless, extravagant assistance to the East German region imposed tremendous fiscal burdens on the West German government and people, resulting in surge in government debts, tax increases and inflationary pressures.
 
In one positive aspect, however, inflation was avoided in spite of significant wage hikes and excessive government expenditures, because the currencies of West and East Germany were linked. That was entirely made possible by West Germany’s enormous fiscal assistance. Assistance to the East German region is still continuing and West German residents’ individual debts are rising. Despite massive fiscal transfers, the convergence of the East and West German residents’ incomes is expected to take far more time.
 
Unification on the Korean Peninsula is expected to create far heavier burdens than in the German unification, taking into consideration North Korea’s backwardness and South Korea’s economic strength. Considering its economic scale, foreign debts, foreign exchange reserves and government debts, South Korea may find it difficult to independently secure unification-related investment resources due to fears of a German-style surge in national debts.
 
Above all, South Korea which underwent severe financial crisis just years ago should be careful about expanding government debts or securing unification-related financial resources through overseas borrowing. Instead, strengthening the national competitiveness through restructuring and productivity hike will be the best economic policy in preparation of unification.
 
After the German unification, many East German residents complained that there were no incentives despite the appreciation of the East German currency. Even at present, the East German residents still believe that their high unemployment rate is a result of discrimination by West Germany.
 
In the case of South Korea, the “flow method,” rather than the “stock method,” would be a more efficient way of fiscal assistance for North Korea, in order to quell the North Korean people’s complaints and help rehabilitate the North Korean economy. But what is more important than anything else is to improve our economic power in preparation for unification and break the wall of distrust to embrace the North Korean people.
[Sejong Policies Study, Vol. 2, No. 1, 2006]
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