An Access Advertising EconBrief:
Do You Believe in Miracles? Economists Do
When the U.S. men’s hockey team defeated the Soviet Union in the 1980 Winter Olympic Games – and later went on to win the gold medal – announcer Al Michaels spoke for millions of incredulous fans when he jubilantly exclaimed, “Do you believe in miracles? Yes!” American sports fans were experiencing the power exerted by faith in the face of seemingly insurmountable adversity or physical impossibility – the kind of faith displayed by Joan of Arc, Bernadette of Lourdes and the children of Fatima.
The economic way of thinking is the epitome of rational evaluation, the opposite of mysticism and blind faith. Yet economists, too, believe in miracles. They have their revered figures, their shrines, their analogues to divine revelation.
A case in point is the memorable German Economic Miracle. Like many miracles, it occurred in a time of deepest crisis, at a place of unrelenting conflict – in the divided city of Berlin during the summer of 1948. (We can thank David R. Henderson’s lively account in the Fortune Encyclopedia of Economics for most of the detailed information that follows.)
The Debacle of Post-War Germany
The defeat of Nazi Germany and the other Axis powers by the Allies in World War II left Germany in a ghastly state. Its cities were bombed-out skeletons, devastated by the Allies’ precision-bombing raids. When Axis leaders rejected Allied peace overtures, British and American commanders resorted to firebombing major cities, killing civilians by the thousands. This, coupled with wartime casualties, had reduced Germany’s population and labor force drastically. An estimated 20% of all housing was completely destroyed. In 1947, food production was estimated at roughly half of its 1938 (pre-war) level. Allied occupation leaders set food rations at between 1,000 and 1,500 calories per day, per person. Industrial output was about one-third its pre-war level.
Few now remember that most people then expected Germany to subsist on the charity of its conquerors for decades. Since the economies of France and Great Britain were also badly damaged by the war, this was tantamount to making Germany a ward of the United States. The famous Marshall Plan may have been a friendly gesture to most of Europe, but to Germany it was intended as a lifeline. The Germans not only had to cope with their own destitution, but also with approximately $1 billion in reparation and restitution payments dictated by the terms of the peace treaty signed with the Allies. Germany also had to pay the Allies about $2.4 billion annually to pay for the Allied occupation of the country, especially in the divided city of Berlin. The $2 billion in cumulative payments to Germany under the Marshall Plan only offset some of this burden.
The Allies were not satisfied to extract financial reparations. They also dismantled what had been Europe’s most productive coal and steel factories in western Germany. It would be another decade before Germany acquired full use of these input production facilities. The Allies also confiscated all German patents and licensed them for Allied use, mostly by U.S. and British companies. The contemporaneous value of the intellectual property confiscated has been estimated at $10 billion.
As if all this weren’t bad enough, Germans had to live with the economic regime of price controls and inflation begun under the Nazis in 1936. Ironically, the Allies had adamantly insisted on a political policy of de-Nazification – that is, removing from office all officials who has served under the Nazi regime – but seemingly were indifferent to changing the economic policies of the Nazis.
Perhaps the Allied nonchalance toward price controls and inflation was explained by their omnipresence throughout the Allied countries. The U.S. and Great Britain had followed Hitler’s example by enacting wartime price controls and financing the war by printing money (as well as borrowing). This produced the same shortages of goods and services and upward pressure on prices that Germany experienced. In any case, one of the first actions taken by the Allied Control Authority (the unified commands of the U.S., Great Britain, France and the Soviet Union) upon assuming control in November, 1945 was to retain existing German price controls.
Economists estimated that the German money supply, consisting largely of currency and demand deposits, was about five times larger than its size in 1936. This testifies to Germany’s policy of financing wartime expenditures by printing money. Ordinarily, this results in hyperinflation, or rapid and continuous rises in prices. The face that one so-called cost-of-living index in May, 1948 was only 31% above its value in 1938 testifies to the effects of price controls in keeping prices down. But holding prices artificially low had the same effect it always does – it created gaping shortages of virtually everything. These dramatically reduced living standards of German citizens, much the same as higher prices would have had the price controls not been in effect.
After the war, a tiresome day-to-day routine developed for the average German. It was described by Henry Wallich, an American economist of German ancestry who later became a noted monetary theorist and Federal Reserve Board Governor.
“Each day, and particularly on weekends, vast hordes of people trekked out to the country to barter food from the farmers… Hungry people traveled sometimes hundreds of miles at snail’s pace to where they hoped to find something to eat. They took their wares – personal effects, old clothes, sticks of furniture, whatever bombed-out remnants they had – and came back with grain or potatoes for a week or two.”
According to David Henderson, the job title of “compensator” became important in German business, for it denoted “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 U.S. and British zones of Berlin] were in the form of ‘compensation trade’ (i.e., barter).”
The reduction of the German economy to a primitive state of barter is perhaps the clearest indicator of its desperate condition. Barter, or direct exchange, is a grossly inefficient form of economic trade. Money, or indirect exchange, allows us to easily trade our labor services or personal assets for anything we want without having to waste our time and effort traveling the land finding people who want to trade their specific production specialty or asset for ours. This explains why early 1948 economic output in Berlin was estimated to be roughly half that of its 1936 level.
The madness of Adolf Hitler and his followers had led Germany down the road to serfdom and totalitarianism. The war had reduced the cities to rubble, devastated its industry and left its people destitute. Military defeat had made Germany an occupied nation. The country needed a miracle.
How the Miracle Happened
During wartime, we are taught to regard our enemies as evil and their cause as unjust. In particular, we regard them as a collective, a social whole consisting entirely of individuals each single-mindedly devoted to our destruction. This philosophy makes it easier for us to justify killing them in large numbers and continuing to exact retribution even after military conflict has ceased.
Yet the premise underlying the philosophy never holds true completely. Dissenters exist even in the most rigorous totalitarian state. In Nazi Germany, these people were found largely in the “Soziate Marktwirtschaft,” or “socially conscious free-market school” of economic thought. Appropriately enough, the intellectual home of this school was the University of Freiburg. (“Frei” means “free” in German.) As the name implies, adherents were strong believers in free-market economics. Social consciousness then implied a willingness for government to redistribute income to benefit poor people and, in this case, to limit monopoly power exerted by business.
The Soziate Marktwirtschaft not only held these views, but expressed them openly throughout the Third Reich’s years in power. This made them the public face of dissent in Nazi Germany. As F.A. Hayek demonstrated in his classic book The Road to Serfdom, the roots of Nazism were nurtured in the 19th-century socialist opposition to Bismarck. The Nazis recognized just enough of their past in the phrase “social consciousness” to refrain from liquidating the Soziate Marktwirtschaft; complete purity of free-market thought would probably have punched their ticket to the gas chamber.
After the war, the Freiburg School vied with the Social Democratic Party (SPD) for the measure of political control ceded by the Allied Control Authority. The SPD had the backing of labor unions, large manufacturers, British authorities – in short, of the establishment. The SPD favored continuation of price controls and Nazi monetary policies.
American military authorities, prodded by politicians back home, were determined to eradicate all stain of Nazism from the new regime. They remembered that the Soziate Marktwirtschaft had been virtually the only open opposition to the Nazis. They weren’t particularly keen on free-market ideas, but they recalled a memorandum written by Freiburg’s leading spokesman, Ludwig Erhard, and published during the war. The memo was hostile to Nazi economic policies – a highly risky stance at that time. That memo was primarily responsible for Erhard’s appointment as Bavarian Minister of Finance in 1945. Two years later, he moved up to Director of the Office of Economic Opportunity in Berlin. He brought with him the two leading economic theorists of the Freiburg School, Wilhelm Roepke and Walter Eucken.
In 1948, the political crisis that led to the division of Berlin into Eastern (e.g., Soviet) and Western sectors coalesced. The Soviet Union withdrew from the Allied Control Authority and organized a blockade of the city. As Shakespeare might have put, the moment in the affairs of man had come that, taken at the flood, would lead on to fortune.
Berlin was nominally governed by U.S. General Lucius D. Clay, its Military Governor. But he relied heavily on Erhard for advice. After all, Clay knew next to nothing about economics while Erhard was an acknowledged expert and had access to the even more powerful minds of Roepke and Eucken. On the red-letter day of Sunday, June 20, 1948 – a date that will live in economic glory – Erhard dropped a triple economic-policy bombshell. Clay, acting on Erhard’s advice, replaced the Nazi currency, the Reichsmark, with a new German currency, dubbed the Deutschmark. And each Deutschmark was declared to be worth only about one-tenth the face value of the former Reichsmark. The effect of this was to instantaneously downsize the German money supply. This was disinflation, cold-turkey style.
Meanwhile, just across town, the German Bizonal Economic Council voted to accept Erhard’s recommendation (and reject the opposition of the SDP) that all requirements for price, quantity and rationing controls be dropped. Federal Reserve economist Fred Klopstock’s narrative of the succeeding months of June-August, 1948 told how “directive followed directive removing price, allocation and rationing regulations.” Price controls and regulations were either removed, ignored or raised to the point of nullity. The era of shortages was about to end.
The third bombshell is the least remembered today. Prior to June 20, 1948, the top marginal income tax rate (expressed in Deutschmarks) was 95% on income above roughly 6,000 Deutschmarks per year. On the median 1950 German income of approximately 2,400 Deutschmarks, the top rate was 85%. Military Government Law no. 64, another Erhard, brainchild, retained the top rate of 95% but applied it only when income reached 250,000 Deutschmarks, over 100 times greater than the median income. (This would be comparable to a U.S. income over $3 million dollars today.) The corporate tax rate, formerly variable between 35% and 65%, was changed to a flat rate of 50%. This measure caught the attention of a young economist serving in the military government in Germany. His name was Walter Heller and he would later become Chairman of the Council of Economic Advisors under President John F. Kennedy and spearhead the famous Kennedy tax cut of the early 1960s.
Erhard deliberately chose a Sunday to unleash his policy offensive because government offices were closed. It would be impossible to mobilize official opposition to his actions until the next day – too late to head them off. For the rest of his life, he told the story of Gen. Clay’s reaction to his ideas. “Herr Erhard, “the General told him grimly, “my advisors tell me that what you have done is a terrible mistake.” “Pay no attention to them, General,” Erhard replied cheerfully, “my advisors tell me exactly the same thing.” Later, when an Army colonel demanded to know how Erhard could relax rationing in the face of a food shortage, Erhard replied that he had abolished rationing, not relaxed it. The only “rationing tickets” Germans needed now were Deutschmarks, and Germans would work hard to get them. Seldom in human history has a man been so triumphantly vindicated.
The Miracle Unfolds
The miracle was not gradual. There was no lag of time or slow recognition. The effect of Erhard’s actions was instant, immediate and electrifying. Henry Wallich put it perfectly: “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.”
On Monday, June 21, 1948, German shops began to fill with goods. Now it was worthwhile to exchange goods for money, since the money received would purchase other goods. Price signals once more motivated the actions of buyers and sellers.
Workers returned to work full-time. Previously, they had spent a substantial part of the workweek spending their wages before they depreciated, or bartering their possessions or skills for food. Now absenteeism fell by over 50%. This drove up industrial production by over 50%, to 78% of its 1936 level, by December, 1948.
Within ten years, the annual rate of industrial production increased fourfold over its 1948 lows. Even allowing for population growth as Germany began to reproduce itself, per-capita growth still tripled. Eventually, Germany became far and away the leading industrial power in Europe. Real wages of workers rose by 73% from 1950 to 1960. Predictably, “socially conscious” policies began to mushroom, particularly once the SDP took political control in the 1970s. Germany suffered the usual spate of recessions and its welfare state soon grew to unwieldy size. But deeply ingrained in its political culture and memory was the story of the “Wirtschaftswunder;” Germany’s downfall into utter poverty and miraculous restoration to freedom and plenty. That memory has sustained it as the rest of Europe fell under the sway of statism and stagnation. Where its neighbors have stampeded over the fiscal cliff, Germany has always stopped short of the brink. And to this day, Germany has remained a bulwark against inflation.
Ludwig Erhard remained first economic minister for over 15 years under Germany’s legendary Chancellor, Konrad Adenauer. In 1963, Ludwig Erhard became Chancellor of the Federal Republic of Germany. He remained in office until his resignation in 1966 and remained in Parliament until his death in 1977. In 2007, it was revealed that Erhard had never actually been a member of any political party, which made his political representation on behalf of Germany’s Christian Democratic Union technically illegal. This was an altogether fitting coda to the career of a free-market economist turned politician.
In 1969, the Freiburg School gained its greatest honor when eventual Nobel Laureate F.A. Hayek retired to Freiburg, where he presided as the world’s reigning libertarian economist. His influence was such that a New Yorker profile in the late 1990s dubbed the 20th century “the Hayek century” because it vindicated Hayek’s faith in capitalism and free markets. Hayek, who had risen to fame in neighboring Austria in the late 1920s, was an inspiration and friend to Freiburg-School economists like Roepke and Eucken.
The Miracle That Wasn’t
Economists view the German Miracle as a miracle of human reason, not of blind faith. It reaffirms the economist’s view of a free market as a mutually beneficial instrument of voluntary exchange. Prices coordinate the activities of buyers and sellers by giving them just enough information to transact to mutual benefit. Indeed, without markets it would be impossible to conceive the collection and collation of the information dispersed in billions of individual minds spanning the globe. The impersonality of markets contrasts with the vastly more limited and personal quality of government action, in which a few people control and command the efforts of nations and coercion, rather than voluntary exchange, is the organizing principle.
Inflation and taxes both distort the signals sent by prices, ruining the coordination and killing the incentives that make the system work. Although the general public sees higher prices as the drawback of inflation, the economist also sees that the higher incomes generated thereby may neutralize those price increases for many people. It is the distortion of relative prices and the consequent bad decisions made by consumers and business investors that really argue decisively against inflation.
It is the opponents of free markets who act on the basis of blind faith, not economists. Across time and distance, it is the anti-market forces who consistently oppose scientific logic, technological progress, productive philosophy and individualism. Thus, economists do not pray for markets to work miracles; they expect it. David Henderson’s verdict is that “what looked like a miracle to may observers was really not a miracle. It was expected by Ludwig Erhard and by others of the Freiburg School….”
Do Miracles Still Happen?
Today, there is a sense that events like the German Miracle are part of some distant, unreal past. The “New Normal” promises a different, darker ending, with less economic growth, more unemployment and a lot less happiness all around. Yet it is not clear why this should be so. The U.S. today is nowhere nearly as bad off as Germany was in 1948.
President Obama sorrowfully reminds us of the dismal legacy handed him by his predecessor. But President Bush did not lead America to military defeat. The U.S. was not physically devastated by war, its manhood annihilated and its industrial might crippled. 2008 brought us financial crisis and recession, not a halving of our national output. Forty million Americans receive food stamps, but this is a sign that we produce too much food, not far too little as did Germany in 1948. The Federal Reserve has stuffed banks’ excess reserves full of digital deposits, but this is not the tenfold inflation of currency engineered by the Third Reich. The U.S. birth rate has fallen below the reproduction point, but this is hardly the ghastly slaughter suffered by Germany’s manhood in World War II. The U.S. suffered an epochal housing crisis, but a surplus of housing is not the 20% loss of housing stock felt by Germany.
We have an obesity crisis; we are not rationed to only 1,500 calories per day like postwar Germans.
True, the U.S. cringes under the horrible specter posed by massive government debt at all levels. But this looming financial threat to our future is not the immediate real shortage of nearly every life- sustaining good and service that stared Germany in the face like a grinning death’s-head skull. Yet Germany did not merely survive – it thrived on its fundamentalist free-market regimen. Its gains were immediate, not postponed. If Germany had its Miracle, why can’t it happen here?
The immediate, knee-jerk, reflex answer is that “they” wouldn’t let it happen. And in this case, “they” can be interpreted as almost everybody in, and outside, both political parties.
But why not? As we showed above, the answer cannot be that we are too far gone; the truth is just the opposite. Is it that we’re not yet bad enough off, not yet close enough to complete collapse and total starvation to submit, from sheer exhaustion, to the icy-cold free-market treatment?