German Economic Miracle - Econlib (2024)

What caused the so-called miracle? The two main factors were currency reform and the elimination of price controls, both of which happened over a period of weeks in 1948. A further factor was the reduction of marginal tax rates later in 1948 and in 1949.

Before

By 1948 the German people had lived under price controls for twelve years and rationing for nine years. Adolf Hitler had imposed price controls on the German people in 1936 so that his government could buy war materials at artificially low prices. Later, in 1939, one of Hitler’s top Nazi deputies, Hermann Goering, imposed rationing. (Roosevelt and Churchill also imposed price controls and rationing, as governments tend to do during all-out wars.) During the war, the Nazis made flagrant violations of the price controls subject to the death penalty.1 In November 1945 the Allied Control Authority, formed by the governments of the United States, Britain, France, and the Soviet Union, agreed to keep Hitler’s and Goering’s price controls and rationing in place. They also continued the Nazi conscription of resources, including labor.

Each of the Allied governments controlled a “zone” of German territory. In the U.S. zone, a cost-of-living index in May 1948, computed at the controlled prices, was only 31 percent above its level in 1938. Yet in 1947, the amount of money in the German economy—currency plus demand deposits—was five times its 1936 level. With money a multiple of its previous level but prices only a fraction higher, there were bound to be shortages. And there were.

Barter also was so widespread in business-to-business transactions that many firms hired a “compensator,” a specialist who bartered his firm’s output for needed inputs and often had to engage in multiple transactions to do so. In September 1947 U.S. military experts estimated that one-third to one-half of all business transactions in the bizonal area (the U.S. and British zones) were in the form of “compensation trade” (i.e., barter).

Barter was very inefficient compared with straight purchase of goods and services for money. German economist Walter Eucken wrote that barter and self-sufficiency were incompatible with an extensive division of labor and that the economic system had been “reduced to a primitive condition” (Hazlett 1978, p. 34). The numbers bear him out. In March 1948 bizonal production was only 51 percent of its level in 1936.

The Debate

Eucken was the leader of a school of economic thought, called the Soziale Marktwirtschaft, or “social free market,” based at Germany’s University of Freiburg. Members of this school hated totalitarianism and had propounded their views at some risk during Hitler’s regime. “During the Nazi period,” wrote Henry Wallich, “the school represented a kind of intellectual resistance movement, requiring great personal courage as well as independence of mind” (p. 114). The school’s members believed in free markets, along with some slight degree of progression in the income tax system and government action to limit monopoly. (Cartels in Germany had been explicitly legal before the war.) The Soziale Marktwirtschaft was very much like the Chicago school, whose budding members Milton Friedman and George Stigler also believed in a heavy dose of free markets, slight government redistribution through the tax system, and antitrust laws to prevent monopoly.

Among the members of the German school were Wilhelm Röpke and Ludwig Erhard. To clean up the postwar mess, Röpke advocated currency reform, so that the amount of currency could be in line with the amount of goods, and the abolition of price controls. Both were necessary, he thought, to end repressed inflation. The currency reform would end inflation; price decontrol would end repression.

Ludwig Erhard agreed with Röpke. Erhard himself had written a memorandum during the war laying out his vision of a market economy. His memorandum made clear that he wanted the Nazis to be defeated.

The Social Democratic Party (SPD), on the other hand, wanted to keep government control. The SPD’s main economic ideologue, Dr. Kreyssig, argued in June 1948 that decontrol of prices and currency reform would be ineffective and instead supported central government direction. Agreeing with the SPD were labor union leaders, the British authorities, most West German manufacturing interests, and some of the American authorities.

The Change

Ludwig Erhard won the debate. Because the Allies wanted non-Nazis in the new German government, Erhard, whose anti-Nazi views were clear (he had refused to join the Nazi Association of University Teachers), was appointed Bavarian minister of finance in 1945. In 1947 he became the director of the bizonal Office of Economic Opportunity and, in that capacity, advised U.S. General Lucius D. Clay, military governor of the U.S. zone. After the Soviets withdrew from the Allied Control Authority, Clay, along with his French and British counterparts, undertook a currency reform on Sunday, June 20, 1948. The basic idea was to substitute a much smaller number of deutsche marks (DM), the new legal currency, for reichsmarks. The money supply would thus contract substantially so that even at the controlled prices, now stated in deutsche marks, there would be fewer shortages. The currency reform was highly complex, with many people taking a substantial reduction in their net wealth. The net result was about a 93 percent contraction in the money supply.

On that same Sunday the German Bizonal Economic Council adopted, at the urging of Ludwig Erhard and against the opposition of its Social Democratic members, a price decontrol ordinance that allowed and encouraged Erhard to eliminate price controls.

Erhard spent the summer de-Nazifying the West German economy. From June through August 1948, wrote Fred Klopstock, an economist at the Federal Reserve Bank of New York, “directive followed directive removing price, allocation, and rationing regulations” (p. 283). Vegetables, fruit, eggs, and almost all manufactured goods were freed of controls. Ceiling prices on many other goods were raised substantially, and many remaining controls were no longer enforced. Erhard’s motto could have been: “Don’t just sit there; undo something.”

Journalist Edwin Hartrich tells the following story about Erhard and Clay. In July 1948, after Erhard, on his own initiative, abolished rationing of food and ended all price controls, Clay confronted him:

Hartrich also tells of Erhard’s confrontation with a U.S. Army colonel the same month:

Of course, Erhard’s prediction was on target. Decontrol of prices allowed buyers to transmit their demands to sellers, without a rationing system getting in the way, and the higher prices gave sellers an incentive to supply more.

Along with currency reform and decontrol of prices, the government also cut tax rates. A young economist named Walter Heller, who was then with the U.S. Office of Military Government in Germany and was later to be the chairman of President John F. Kennedy’s Council of Economic Advisers, described the reforms in a 1949 article. To “remove the repressive effect of extremely high rates,” wrote Heller, “Military Government Law No. 64 cut a wide swath across the [West] German tax system at the time of the currency reform” (p. 218). The corporate income tax rate, which had ranged from 35 percent to 65 percent, was made a flat 50 percent. Although the top rate on individual income remained at 95 percent, it applied only to income above the level of DM250,000 annually. In 1946, by contrast, the Allies had taxed all income above 60,000 reichsmarks (which translated into about DM6,000) at 95 percent. For the median-income German in 1950, with an annual income of a little less than DM2,400, the marginal tax rate was 18 percent. That same person, had he earned the reichsmark equivalent in 1948, would have been in an 85 percent tax bracket.

After

The effect on the West German economy was electric. Wallich wrote: “The spirit of the country changed overnight. The gray, hungry, dead-looking figures wandering about the streets in their everlasting search for food came to life” (p. 71).

Shops on Monday, June 21, were filled with goods as people realized that the money they sold them for would be worth much more than the old money. Walter Heller wrote that the reforms “quickly reestablished money as the preferred medium of exchange and monetary incentives as the prime mover of economic activity” (p. 215).

Absenteeism also plummeted. In May 1948 workers had stayed away from their jobs for an average of 9.5 hours per week, partly because the money they worked for was not worth much and partly because they were out foraging or bartering for food. By October average absenteeism was down to 4.2 hours per week. In June 1948 the bizonal index of industrial production was at only 51 percent of its 1936 level; by December the index had risen to 78 percent. In other words, industrial production had increased by more than 50 percent.

Output continued to grow by leaps and bounds after 1948. By 1958 industrial production was more than four times its annual rate for the six months in 1948 preceding currency reform. Industrial production per capita was more than three times as high. East Germany’s communist economy, by contrast, stagnated.

Because Erhard’s ideas had worked, the first chancellor of the new Federal Republic of Germany, Konrad Adenauer, appointed him Germany’s first minister of economic affairs. He held that post until 1963 when he became chancellor himself, a post he held until 1966.

The Marshall Plan

This account has not mentioned the Marshall Plan. Can’t West Germany’s revival be attributed mainly to that? The answer is no. The reason is simple: Marshall Plan aid to West Germany was not that large. Cumulative aid from the Marshall Plan and other aid programs totaled only $2 billion through October 1954. Even in 1948 and 1949, when aid was at its peak, Marshall Plan aid was less than 5 percent of German national income. Other countries that received substantial Marshall Plan aid exhibited lower growth than Germany.

Moreover, while West Germany was receiving aid, it was also making reparations and restitution payments well in excess of $1 billion. Finally, and most important, the Allies charged the Germans DM7.2 billion annually ($2.4 billion) for their costs of occupying Germany. (Of course, these occupation costs also meant that Germany did not need to pay for its own defense.) Moreover, as economist Tyler Cowen notes, Belgium recovered the fastest from the war and placed a greater reliance on free markets than the other war-torn European countries did, and Belgium’s recovery predated the Marshall Plan.

Conclusion

What looked like a miracle to many observers was really no such thing. It was expected by Ludwig Erhard and by others of the Freiburg school who understood the damage that can be done by inflation coupled with price controls and high tax rates, and the large productivity gains that can be unleashed by ending inflation, removing controls, and cutting high marginal tax rates.

Footnotes