Catching-up of East German productivity to West German levels has halted completely since the mid l990s. The remaining productivity gap cannot be attributed to an inferior capital endowment. Instead, it appears to be the result of inappropriately designed industrial policy that promoted the specialisation of East German industry in capital intensive smoke-stack industries. These industries absorb a large share of factor inputs, although their contribution to aggregate output is rather limited. East Germany will therefore have to face another wave of painful structural adjustment when public subsidies are further reduced.