After running high current account surpluses in the second half of the 1980s, Germany ran sizable deficits in the early 1990s

Question

The most important reason for the current account deficit was the surge in demand from eastern Germany after reunification, causing imports to rise sharply. At the same time, Germany went from being a net creditor country to being a net debtor. Explain why this is a logical implication of the current account deficits. Interest rates in Germany were historically high during this period. Why might that have been the case? Could East Germany have been developed without running a current account deficit? How?

Answer 1

The reunification of Germany caused a surge in demand because the public and private capital stock of East Germany was well below western standards. To equip the whole country with better capital required massive investment spending. The country could have cut its consumption and shifted its purchases to investment goods, but this would not have been logical. Instead, the country maintained its consumption level and borrowed from abroad to finance the increased investment spending. The high interest rates attract foreign capital and serve to ration the investment projects. The current account deficits also implied that Germany increased its debts to the rest of the world, eventually moving from a net creditor position to a net debtor position. (Recall that the change in net foreign assets equals the current account balance.)