The Effects of Inter-Korean Integration Type on Economic Performance: The Role of Wage Policy

Abstract

This paper analyses the effects of various possible types of inter-Korean integration on economic performance in the northern part of Korea after reunification, focusing on the role of wage policy. The wage policy of reunified Germany is generally said to have been one of the major reasons for the increase in unification costs there, because it led to East German worker wages in excess of their productivity level. To reduce the costs of unification, Korea therefore needs to apply wage policies different from reunified Germany's and from South Korea's, which requires a new type of integration. Against this backdrop, this paper classifies the integration types into three – a unitary state, a federation, and an SAR (Special Administrative Region) – and analyzes their relative economic effects under the assumption that each type is accompanied by different wage policies. According to this analysis, the federation type shows unemployment and growth patterns similar to those observed in East Germany, the unitary state type higher unemployment and lower growth than in East Germany, and the SAR type lower unemployment and higher growth.

Keywords:

• Korean reunification
• economic integration
• wage policy
• minimum wage

JEL CLASSIFICATIONS :

• H77
• O21
• O24

Acknowledgements

The authors thank Kyuil Chung, Sung Ju Song, Ji Young Choi, Byung-Yeon Kim and seminar participants at the Bank of Korea for helpful comments and suggestions.

Notes

¹In this paper, reunification refers to the formation of one country, and integration to the combining of different regions so that they work together or form a whole, but the degrees of consolidation in various areas may differ. Accordingly, the extents of political, economic, social and cultural integration can differ in Korea after reunification.

²Alexander Fisher, former director of DIW, estimated that it reached €2.1 trillion, Schroeder (2008) €1.6 trillion during 1990–2008, and Müller (2005) €1.56 trillion during 1991–2004.

³Wolf and Akramov (2005) at the Rand Research Institute estimated the cost to have been between 50 and 667 billion dollars over a four- to five-year period, and Peter M. Beck (The Wall Street Journal, January 4, 2010) predicted it to be from 2 to 5 trillion dollars over a 20-year period.

⁴As of 2010, South Korea's GDP was $1014.3 billion and the former West Germany's (including Berlin) €2210.2 billion. Right after reunification, the population in East Germany was one-quarter and the per capita income one-third those of West Germany. As of 2010, North Korea's population and per capita income were one-third and one-nineteenth those of South Korea.

⁵Of course, peaceful reunification based on consensus rather than military force may cost less, but no study on this has yet been undertaken.

⁶Public goods include systems related to monetary finance, taxation and finance, judicature, education and welfare; and basic infrastructures, such as those for transport, communications, and parks.

⁷The sizes of the costs and benefits may also differ in accordance with the extent of insecurity and stability of the international order, the degree of democratic development (Alesina & Spolaore, 2005), ethnicity, race, culture and language. Bolton et al. (1996) argued that having one common language is one of the major factors significantly reducing the probability of political separation.

⁸A FTA (Free Trade Area) that integrates either the goods market only or the capital market only does not pursue labor market integration; the difference in income is therefore unlikely to be a problem.

⁹In the meantime, Haimanko et al. (2005) argued that fiscal transfer policy is not effective in addressing problems arising from the integration of nations. For instance, if competition to attract capital by reducing taxes is severe, benefits will increase for those who succeed in easing such competition when countries integrate (Bolton et al., 1996). Competition among local governments to attract capital may occur even after integration. In this case, countries may favor a federation over a non-federation type of integration.

¹⁰Integration types can be viewed from many aspects, for example political, economic, societal and cultural, but this paper considers the political and economic aspects only. Political integration refers to formation of a political unit accommodating a central organization, and economic integration that of a free market in which goods and services, and capital and labor move freely.

¹¹In most nations of federations, the labor markets become integrated as time passes but usually tend to be relatively separated during the initial periods of federation.

¹²Hong Kong was returned to China by the UK in 1997, and Macao was returned by Portugal in 1999.

¹³Average monthly wages at businesses with more than five full time workers (Ministry of Employment and Labor Survey Report on Labor Force at Establishments).

¹⁴Average monthly wage of South Korean workers (3,047,000 won)× 2.4% or 5.2%.

¹⁵Barro (1990) introduces an assumption that, in an endogenous growth model, separating the public capital arising from government spending from private capital and forming a public fund can be productive, but this paper differs from Barro (1990) in that public and private capital are not separated.

¹⁶A unified Germany mainly provided industrial subsidies, but this model takes wage subsidies into consideration based on the analysis of previous studies that wage subsidies are more effective in increasing employment. Previous studies supporting wage subsidies include Akerlof et al. (1991), Begg & Portes(1993), Sinn (2005) who dealt with German cases; and Hamermesh (1978), Phelps (1994), Katz (1998), Dreze (2002) who explored general cases (reference is made again to Dluhosch & Horgos, 2008, pp. 372–373).

¹⁷According to the Federal Statistical Office of Germany, the average annual wage-productivity gap during 1991–2007 in East Germany was about 9%, meaning that μ is 0.09, different from the average annual wage-productivity gap estimated at 80–90% for seven years (1991–1997) by Conny Wunsch (2006).

¹⁸For more details on this, refer to Section 3.