Learning Capitalism the Hard Way—Evidence from Germany’s Reunification

In a world where the future is uncertain and firms do not know the model, forecast ability matters. We ask whether, as predicted by rational expectations, forecast ability is uniform. And if not, whether firms learn. Firm level forecast ability is measured as forecast error based on the Ifo Institute’s Business Climate Survey. We find that contrary to the prediction of rational expectations, forecast errors are persistent but we do not find any evidence that firms learn with age only. Then, we exploit German reunification, as a natural experiment where firms in the East are treated with ignorance about the state of the market. As predicted by our formal model of learning, firms in the East make larger forecast errors relative to the West. And over time this gap decreases. We argue that the initially higher forecast errors in the East are due to ignorance and not different market conditions. And, convergence is due to learning in the East, rather than convergence in market conditions.