How free markets saved West Germany after WWII

See German Economic Miracle by David R. Henderson. Excerpts:

"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.
 

"Price controls on food made the shortages so severe that some people started growing their own food, and others made weekend treks to the countryside to barter for food."

"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."

"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”"

 

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."

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."

"Ludwig Erhard agreed with Röpke. Erhard himself had written a memorandum during the war laying out his vision of a market economy."

"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"

"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.”"

"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.

 

"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 money. 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."

"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."