The economic threat of Korean unification

What are the real reasons behind South Koreans’ apparent mansuetude toward North Korean government and their 'softly-softly' approach to the reunification? It is now abundantly clear that, behind the ritual bow to the broad goal of one Korea, the South Korean political establishment prefers the persistence of the two Koreas for the foreseeable future. Explanation for this attitude is simple although rarely made explicit or publicly: the prohibitive costs of unification which may threaten the very foundation of Korean economy. A highly visible benchmark exists in this area, that of German unification. It is very instructive. Not only were the direct costs exorbitant: It is estimated that the German government spent well over 1500 billion euros to facilitate the integration of East Germany into the European economy. To put this figure in perspective, the annual lending volume of the World Bank is about 20 billion dollars. Looking at it differently: funding of the German unification exceeded 2.8 times the cumulative total lending of the World Bank since its inception in 1946 until 2004. More importantly, the results of such massive inflows were disappointing. Since the reunification, German economy has been badly underperforming. OECD data tell the sorry story: from a growth rate well above the European average in 1991 and 1992 (5% and 5.2% respectively), the German economy plunged to 1.8% rate in 1993 and to -1.8% in 1994. More ominously, the burden of unification does not appear to diminish over time. For the last ten years, the unified German GDP grew at an average annual rate of 1.2% and its persisting weakness is largely attributed to the dire economic situation of East Germany.
Deleterious impact of reunification does not stop inside German borders. Massive funds transfer is largely responsible for the tightening of the monetary policy of the Bundesbank during the 1990s, which resulted in higher interest rates across Europe. This led to slump in growth across EU economy in the 1990s.
How relevant is the German example to Korea? Most observers agree that the then German Chancellor, Helmut Kohl, made a crucial mistake by fixing ostmark-deutschmark exchange rate at unrealistic high level of 1:1. But this was a political decision to assert the equality of all Germans. Can Korean politicians take a different position in what is fundamentally a political process? The won-won exchange rate may not be at parity but it would very likely to be higher than warranted by a cold-headed economic analysis.
Even allowing for learning from past mistakes, there is no escape from the fact that the economic and demographic challenge in Korea is more daunting than in Germany. North Korea represents a larges share of total population and the income disparity is considerably greater. West German population was about three times larger than the East German one (60 million to 20 million), while the population of the two Korea is roughly comparable (24 million for the South, 22 million for the North). The per capita GDP gap between the two Germany was estimated at about 4:1 in favor of the West. This proved to be an underestimate, reflecting the well-known “viability” of the planned economy statistics. The current estimate of per capita GDP gap in Korea is to 10:1 in favor of South. This is most certainly an underestimate. Not only, the poverty of North Korean has been abundantly reported but the structure of North Korean economy is likely to be considerably closer to the old Stalinist heavy industry model than East Germany ever was.
Clearly, even if the absolute amount that the South Korea will need to spend in the North may be lower than those spent by Germany, the relative economic burden is likely to be markedly higher and the corresponding risks of slowdown or ever recessions are very serious indeed.
One approach to lower the burden is to share it. I am certain that Korea is exploring ways and means of underwriting the costs of unification. Potential candidates are not legion, given the amounts involved. Standard international aid will be a drop in a bucket and the non-regional allies such as the US cannot be relied upon, given their fiscal situation. There are potential very large sources of liquidity in Asia: China, Taiwan or Japan but they will need to be convinced not only of the political right of unification but also of the economic advantages to them. In Europe, Germany was the pre-eminent economic power and therefore it was able to spread the costs of unification through higher interest rates across Europe. It is doubtful whether Korea enjoys a similar regional leverage, particularly as its economic impact may as well be quite negative. Furthermore, any significant diversion of funds from global funding of the dollar is likely to have worrisome consequences on macro-economic stability.
It may well be that an optimal economic strategy to achieve political reunification of Korea without hampering Korean and regional economies exists (Jeffrey Sachs, Paul Krugman, McKinsey Global Institute – are you there?) but unless it is well-understood and shared not by Koreans but also by its neighbors and by its allies, particularly the United States, the unification will remain a distant, and not necessarily benign, dream.