The German Non-Miracle

How a handful of economists defied orthodoxy and produced the economic success story of the past quarter century.

THE SETTING

Some years ago the award-winning sports columnist Jim Murray wrote an amusing article detailing the hapless antics of the San Francisco Giants. Always good, but never champs, the Giants were the perennial bridesmaids of baseball. "Once upon a time there was a baseball team called the San Francisco Giants, and they finished second more often than Germany," quipped Murray.

In the intervening years, the Giants have solved their second-place blues by growing even more hapless. Yet their once-frustrated counterpart, the Deutschland, solved its dilemma in a rather successful fashion. Today there is little question that the number-one economic success story of the past 25 years is the remarkable tale of the Federal Republic of Germany.

In 1945 Germany lay in ruins, the vanquished victim of mankind's most grotesque holocaust. The war had shaken the German economy by its very roots: it destroyed one-fifth of all housing, decimated the transit lines between regions, reduced industrial output to but a third of its 1936 level, erased a huge percentage of the working-age male population, and swamped the countryside with a tidal wave of immigrants that would reach the 8.5 million mark by 1948. While the defeat belonged to the Nazis, the immense destruction belonged to the entire German nation.

Yet the shocking reality was that war-scorched Germany was to face its greatest economic crisis in the years after 1945. The postwar devastation was the combined effect of two principal factors.

First, a tremendous inflation broke loose—the predictable result of prior history. Under the Third Reich, the German government had financed a colossal industrial build-up to accommodate the designs of the Nazi war machine. The tremendous industrial expansion was paid for with rampant monetary expansion. All the screws of the Nazi State had to be tightened to their breaking point to suppress the resultant inflation; the guns of the Gestapo turned on black marketeers and others who sought to evade the officially posted prices of goods and services. The result of the effective price controls under Fascism was the explosion of liquidity after Fascism.

Enter crisis-source number two: Allied control policies. In an effort to forestall the inevitable realignment of money and prices, the Allied commanders of France, Britain, and the United States slapped on an extensive control network that fixed wages and prices at preinflation (1936) levels. The economically obvious occurred: goods disappeared from legal markets and were sold illegally at prices far above the official prices. Severe misallocation of resources took place; cigarette lighters, for instance, which were unregulated by price controls, zoomed in value and were much sought after by people desperately in need of food and shelter.

The stupendous gap between the legal and illegal prices grew to such proportions that a general collapse of the currency ensued. People resorted to barter, and German cities typically saw a mass exodus on weekends as city-dwellers flocked to the countryside to trade with the farmers in kind. As the German economist Walter Eucken summed up: "The failure of money and the central administration of the economy has led to increasing self-sufficiency of economic units and to the emergence of a system of barter, two things incompatible with an extensive division of labor. The economic system is reduced to a primitive condition."

In the eastern zone, the Russian formula was basic: loot everything of value. In the west, however, there was a different problem: total indecisiveness. As Wilhelm Roepke relates: "Among the victors only Russia could be said to have had a German policy at all." The western zones were afflicted by an acute case of disarray, and government policy fluctuated among the vengeance of the French, the reformist zeal of the British (Laborites), and the bewilderment of the Americans. About the only consensus to be found anywhere was to rely on economic controls.

The Allies were thorough in their regulation of Germany. Censorship was so tight, for example, that James T. Farrell's popular novel Studs Lonigan was declared contraband. The victors attempted to administer the economy through a patchwork assortment of price regulations, allocation details, and rationing. In the fall of 1946 the mechanism had reached bankruptcy, the officially rationed food allotment being under 1,500 calories per person per day. Ludwig Erhard was to report: "All attempts at mending matters were frustrated, not only by the prevailing conditions of devastation, exhaustion and disruption, but also by the supposed experts, in and outside Germany, clinging tenaciously to their reliance on controls. The people worked on doggedly, tormented by hunger and exasperated by zonal restrictions, corruption and the black market."

THE IDEAS

Meanwhile, an exciting intellectual debate roared in the academic institutions and councils of government, exploding from its previously suppressed condition in an inflationary blast mirroring the flare-up of prices. Out of the haze of viewpoints emerged two predominant schools of thought: the Social Democrats and the "Freiburg School."

The Social Democratic Party (SPD) can be thought of as a moderate version of the British Labor Party. While socialists neither in name nor in doctrine, the SPD favored a revitalized economy run from the top. In the great moment of crisis for the German nation, SPD leaders argued that the anarchic vagaries of market allocation are both unjust and inefficient.

The major SPD economic ideologue was Dr. Kreyssig, who in June 1948 told the 18th Bizonal Economic Council that, since the society had been under control for such a long period, any decontrol or currency reform would be ineffectual. To Dr. Kreyssig's mind, not only would recovery not follow, but collapse was inevitable if prices were set free; the only course for the German economy was one of strong central direction. Another SPD spokesman was Herr Schoettle, who joined the argument against free markets by claiming that the task of reconstruction was too big for individual enterprise alone—massive State involvement was imperative if Germany was to recover.

Not surprisingly, the Social Democrats favored an aggressive fiscal and monetary expansion policy and the "full employment" policies that had gained political popularity elsewhere. The SPD was joined in this expansionary position by the labor unions, the British authorities, most German manufacturing interests, and, in a slightly more moderate tone, by the Americans.

There wasn't much in the program of the Social Democrats that the Freiburg School found to agree with. During the dark days of the Hitler epoch, a liberal resistance movement had developed at the University of Freiburg. Under the leadership of Walter Euken, it included Alfred Muller-Armack, Wilhelm Roepke and Ludwig Erhard. These men constructed one of the most comprehensive political-economic doctrines of this century: the Soziate Marktwirtschaft. The idea of a "socially conscious free market," as the translation goes, was that totalitarianism is the evil to be most guarded against and that the only way to prevent tyranny is to promote freedom. The theory spread freedom across political and economic lines and espoused a policy of noncontrol—by either the State or individuals—of individual choice. The conclusion was that free markets, and only free markets, can provide human society with the incentives, efficiencies, and freedoms that can lead to a vital and progressive society.

The Soziate Marktwirtschaft, while a liberal movement, did not emerge from the doctrines of the liberal economists. The Freiburg approach was not laissez-faire: government was to be active in promoting competition and protecting free markets from monopoly, public or private. It also allowed for a small degree of wealth redistribution through graduated income taxation and social welfare programs, but it was insistent on keeping tax rates low enough to prevent economic disincentives to productive effort.

In 1946 Wilhelm Roepke, probably the most eloquent and vociferous of the school, set down a precise format for the German reconstruction. The plan was to create a new currency, to decontrol the economy, and to let the German people produce. In Roepke's words: "The prerequisite of a return to economic sanity in Germany is the radical reform of the German money system. This reform must restore the Mark as the true measure of values, as the trusted means of exchange, and therefore as the agent that harmonizes and integrates the economic process. To this end, the 'repressed' inflation must be stopped by two measures at the same time, the one hitting at repression, the other at inflation.…There would be little sense in making an end of the 'repressed' inflation if we were to retain the strangling devices of economic repression and to go on 'directing,' 'licensing,' 'prohibiting,' and what not."

Roepke proposed a central monetary authority and, as was the Freiburg belief, held to a monetarist perspective. He went on to advocate the rebuilding of Germany, not through charity—which he claimed was absurd and unnecessary if the Allies would only let Germany go to work—but through "credits and investments," that would accrue to Germany as soon as a stable political and economic climate prevailed. Roepke also advanced the radical concept of free trade—unilaterally, if need be—to put German exports back into the world market. It was economically obvious that Germany, to recover, was going to have to rely greatly on its exporting success, and reduction of tariff barriers was a logical step to improve foreign trade. Finally, Roepke called for an end to the Allied bureaucratization and, in a pronunciamento not taken as particularly friendly to the French, British, and American overseers, he propounded "a deflation of Allied administration which ought to be as drastic as that of the German currency." Roepke had proposed a currency deflation of 100 to 1!

THE EVENTS

The debate was won, much to the surprise of economists, politicians, and anyone capable of adding numbers, by the liberals from Freiburg. Gaining influence through tireless effort and sheer force of intellect, the liberal school was led into political prominence by Ludwig Erhard, who was to become Economics Minister in the Adenauer administration (194957) and then Chancellor (1963-66). The first move was the currency reform in late June 1948. While the complete formula was somewhat complicated, the effective devaluation amounted to an exchange of 100 old Deutschmarks for 6½ new ones. It was quite a deflation.

Yet as Roepke had enunciated, and as Erhard had not forgotten, the currency reform had to entail much more than just new money—it had to launch a new system. On July 7, 1948, the German government approved a law giving the economic authorities the right to "take all necessary measures in the field of control and to determine in detail which goods and production should be freed from price controls."

The ensuing deregulation was dramatic and shocking to occupation forces. As Erhard notes, "It was strictly laid down by the British and American control authorities that permission had to be obtained before any definite price changes could be made. The Allies never seemed to have thought it possible that someone could have the idea, not to alter price controls, but simply to remove them." With determined action and the strong support of one American, a Gen. Lucius Clay, the German free market exponents were able to blast through the inertia of Allied supervision.

The sweeping success of the currency reform is of little doubt. As Prof. Henry Wallich put it, "The spirit of the country changed overnight." Two observers not native to Germany, Jacques Rueff and Andre Piettre, had the following report: "Only an eye-witness can give an account of the sudden effect which currency reform had on the size of stocks and the wealth of goods on display. Shops filled up with goods from one day to the next; the factories began to work. On the eve of currency reform the Germans were aimlessly wandering about their towns in search of a few additional items of food. A day later they thought of nothing but producing them. One day apathy was mirrored on their faces while on the next a whole nation looked hopefully into the future."

The individual decontrol policies were rather delicate, and Erhard, in his political position, freed everything from price controls that his personal strength in the government would allow. Almost all consumer goods were immediately deregulated (excepting agricultural commodities); wages were set free three months after the currency reform; and industrial commodities (steel, iron, coal, oil, etc.) were gradually deregulated over the next few years; while foreign trade, which was under technical restrictions in law, was turned to free competition in practice in a very short time. The one area where price control would remain in effect throughout the 1950's was the special case of rents.

The result of this substantial deregulation was to let the Germans take full advantage of the powerful incentives set before them. The gravity of the German postwar condition provided strong motivation for productive effort, yet economic restriction had prohibited the enterprise and imagination of the populace. In a system where supply and demand cannot coincide, the result is economic chaos. In the German instance, the price regulation had legislated massive shortages, for the surest way to curtail supply is to make it impossible to reap the rewards of production. Additionally, the heavy reliance on black markets created vast senseless gyrations and economic waste. Commenting bn the explosion of effort in the post-reform era, Gordon Hallet has noted how "the startling change between the period before and after July 1948 indicates the extent to which an economic system can either frustrate individual efforts or give them the opportunity to be effective."

Contemporary analysts might paint the German policy as harsh in that it left few rewards for those who did not seek to take care of themselves. While government expenditures on social welfare through transfer payments were comparable with those of other European nations, the State abstained from further economic intrusions via "full employment" policies, subsidies, and income redistribution. In fact the tax policy was shifted to reduce the burden on upper-income brackets. The tight money policies pursued by Erhard created buyers'—rather than sellers'—markets.

If the harshness of the policy was great, so was the positive record of accomplishment. Industrial production and national income skyrocketed. Industrial output increased 50 percent within the year, and national income (in constant prices) was restored to the 1936 level in just over a year (it had fallen 20 percent below this figure). Economic recovery was complete except for one plaguing phenomenon—the emergence of unemployment, which steadily rose to a peak of 10.2 percent in 1950. The instantaneous response of the British and Americans was to explain the dilemma in Keynesian terms and diagnose the problem as "insufficient effective demand." The prescription; immediate government and monetary expansion, along with reintroduction of economic controls.

The German response, in the light of the Keynesian revolution, was terribly naive. The Germans theorized that an increased money supply would simply cause inflation and that the employment problem was frictional, fueled basically by the stream (still flowing) of millions of refugees. The resultant policy was a strict balanced-budget fiscal framework and a conservative monetary course by the Deutsche Bundesbank. Unemployment dropped steadily—to six percent in 1952, three percent in 1956, and one percent by 1960. By that year the Germans could boast of an inflation rate of 20 percent—not for the previous year—but for the previous decade. The Soziate Marktwirtschaft had produced the economist's Garden of Eden: full employment without inflation.

THE RESULTS

Today, it is superfluous to ask whether or not the German post-1948 economic policies were successful. As the industrial giant of Western Europe, the Deutschland has surpassed countries that were far ahead when the race began, revealing some striking substantiations of free market liberalism.

In the realm of macroeconomics, the German recovery strongly suggests that the Freiburg ideologues were factually correct in claiming the possibility of sustained economic growth without government stimulants. The whole goal of the Erhard policy was to provide a sound, noninflationary currency, and all fiscal and monetary policies were geared to this. The consistent growth of German industrial output demonstrates the feasibility of noncyclical expansion. Indeed, when interventionist political forces prevailed and activist fiscal policies were instituted (as in the expansions of 1950-51 and, more recently, 1965-66), the fiscal tools were in both instances badly mismanaged. The "booms" that were created turned inflationary and had to be extinguished with deflationary monetary manipulations. The German experience has been to leave well enough alone and provides powerful evidence for Milton Friedman's conclusion—that with the high costs and impossible delays of information gathering, "fine-tuning" is mythical.

The German experience flies in the face of Keynesianism, which concentrates on the inherent disequilibrium of a market economy. It has been remarked that the German economists who administered the Erhard reforms were pitifully ignorant of Keynesian economics and that the performance of these "neophytes" should serve as a painful slap at the doctrines of the Keynesian school. The respective conditions of West Germany and Great Britain in the last 25 years, if a comparison can be made, do not speak well for the real-world results of Keynesianism (albeit bastard Keynesianism).

In rejecting the Keynesian formulas, Erhard consistently balanced budgets in the reform period. The German constitution had even been endowed with a clause prohibiting deficit spending as a tool of the State in "normal" circumstances. While this proviso might be an insignificant obstacle to most government bodies, the German nation had witnessed two crippling inflations in the previous three decades, and popular sentiment was heavily anti-inflationary. With budgets balanced—foreclosing on the possibility of aggressive fiscal action—the central bank made conservative policy decisions regarding reserve requirements, rediscounts, and open-market operations. The money became so "hard" that the interest rate, without inflationary, easy-money credits, dropped to three percent in the early 1950's.

It will be wondered, in our golden epoch, just how the massive rebuilding and subsequent growth of Germany took place without the stimulus of government spending or loose credit. Miraculously, it was financed by the simplest and most direct sources: saving, investment, and overtime. Under Soziate Marktwirtschaft, tax credits were liberally granted to savers. Investment tax credits provided incentives for corporations to plow profits right back into capital—almost tax-free. And laborers working over-time were allowed to retain almost 100 percent of all extra pay. The war and subsequent social and economic ruin provided strong motives for the German nation to gain a better way of life, and when a "liberalistic" tax policy favored individual initiative, the system exploded with enthusiasm. After the 1948 reforms, saving and investment leveled off at 20-25 percent, with the growth rate, after soaring to 20 percent, settling between 5 and 8 percent per annum.

Although the central planners of the German state believed they could have outstripped the achievements of the market economy, the record—in their own bravados—shows differently. Opposition elements in the German government concocted quite extensive predictions for the recovery under a centrally planned framework. Their scenario was the Long Term Plan, submitted to the Economic Co-operation Agency in 1948.

As Wallich details: "It was developed by German experts but reportedly revised upward under the persuasion of the American occupation authorities. Thus it was estimated in 1948 that after the end of the European Recovery, Program in 1952-53 the index of production would have reached 110 percent of 1936 (the original German estimate reportedly had been below 100). Agriculture according to the program would have returned to pre-war levels. Foreign trade would be in approximate balance, but only on the assumption the East-West trade could be resumed on a large scale and that Germany could somehow earn 300 million dollars a year from other dollar-short countries to meet a Western hemisphere deficit.…Reality has not dealt kindly with these estimates.…Industrial production in 1952-53 averaged about 150 instead of 110. Net agricultural output was 111 percent of pre-war instead of 100. The overall balance of payments was highly favorable and even the dollar sector was approaching balance."

Another study was compiled by four German research institutes and was issued in 1950—after the currency reform and when industrial output had regained its pre-war levels. These estimates claimed that five years would be needed by government planners (in addition to $1.5 billion in US aid) to achieve a balance of trade and various agricultural and industrial goals. That these targets were met in 1952-53 (without the aid) is now a matter of historical fact.

Nor can it be objected that the authors of these forecasts could not possibly have known of certain economic conditions external to Germany—the Korean War, for instance. For the whole claim for central planning is that the foresight of planners will outperform the anarchic functions of the market. Planning, by its very name, is the art of extrapolating into tomorrow.

Outside stimuli like the Korean boom are no guarantee of prosperity—that can only come about through the economy quickly adjusting to new demands and successfully competing in world markets. On the basis of the relatively pessimistic plans submitted at the time, it appears that reconstruction would have been considerably slower under centralized planning. If the authorities could only foresee X level of output in a given year, that would only necessitate Y level of investment the year before. To surpass this level of investment and hence of output, due to "new developments," is next to impossible given planning. So it is that the plan of a nonmarket economy becomes its most optimistic estimate: if everything goes as "planned," this will be the result.

The legitimacy of the Soziate Marktwirtschaft lay in its basic assumption that economics is to be theorized from an individualistic perspective. The theory implied a social structure that would provide individual economic units with the maximum possible incentives to do what Germans had to do: to produce, to work long hours, to be economically imaginative, to be financially sound, to save, and to invest. These were the precise operations that all economists—socialists, capitalists, and those not so well defined—realized were imperative for success. The debate was whether a planning bureau—centrally—or private citizens—severally—could most effectively perform these actions. The Soziate Marktwirtschaft serves as a forceful argument for the latter.

The individualistic methodology has much to provide in its aggregate results. The "German Miracle" (as it is mistakenly called) is a valuable addition to economic history and the science of economics itself. Its message is challenging to all those who would look past the importance of individual action and disregard the spirited nature of private enterprise. When the aspirations of a productive people are fully set free, a tidal wave of entrepreneurial zest and laborious drive can put the horoscopes of the central planners to shame, if not to silence.

EPILOGUE

It is perhaps of little interest to the social scientist, but of great importance to the ideals of man, that the story of the "German Miracle" contains much more than economic data. It is a compelling human drama involving courageous men and a powerful idea. The men were heroes of the Nazi resistance—certainly medal-wining credentials for any political vanguard. Out of the desolation of Hitler and the war arose a philosophy so profound in its appeal against authoritarianism, and so vigorous in its enunciation, that a few men and an idea were able to break the chains of State control and grant a nation a truly new lease on life. It is a refreshing tale of history that shows us intelligent men, a committed ideal, incredible odds, and then a victory. It is a tale that deserves to remain in our thoughts.

A frequent contributor to REASON, Tom Hazlett works in Los Angeles and provides a regular political commentary on KPOL radio.