Germany faced some stark choices at the second world war’s end. The country was in moral and physical ruin, with every building in the cities destroyed, housing and food shortages and chaos all around. The allies who won the war were occupying what later became West Germany and the Russians occupied East Germany.
In the debate, on how to address the issues many argued for central control of resources, to be then distributed to everybody that needed them. But, some politicians proposed free markets and free price mechanisms to restart the economy. The free marketers prevailed and the German economy entered an unprecedented era of economic growth. The term Social Market Economy is used to describe the economic policies behind Germany’s post-WWII success.
Justus Lenz is an expert on the German economic transformation. Lenz heads the Liberal Institute of the Friedrich Naumann Foundation for Freedom, a German political think tank. He was interviewed by Echelon’s Shamindra Kulamannage.
Following the end of WWII Germany’s economy recovered from the devastation within a couple of decades. It adopted a policy framework known as a Social Market Economy, which is credited with the economic revival. Can you explain to us what this is?
People consider it a miracle, but it wasn’t a miracle that came out of nowhere. The economic growth we experienced was the result of sound policy decisions.
The country was in moral and physical ruin after the Second World War, with cities with virtually every building in its inner city ring destroyed. There was chaos, supply and food shortages, and housing crises; it was a bad situation.
In the debate at the time on how to address this, many argued we had to control resources, distribute them and continue using old systems used during the war to get everybody what they needed. But, some politicians preferred using the power of free markets and free price mechanisms to restart growth, based on theoretical work done before. The first step for it all was the 1948 reforms that introduced a new currency – the Deutsche Mark – and abolished all price controls, along with making the policy decision to keep it stable.
Although people accepted these decisions after growth kicked in some years later, they were very controversial at the time of introduction, with many wanting to go in another direction.
When the Bundesrepublik Deutschland – the German state – was formally founded in 1949, competition laws and antitrust legislation were introduced to keep the markets open and prevent companies from capturing the market. But what kickstarted economic growth was monetary reform, letting prices go free and letting entrepreneurs compete in a free market. The result was spectacular, and in 1950, after two and a half difficult years, growth started to kick in and people began accumulating wealth again.
The principles of a free market economy are more difficult for people to understand. In the contest of ideas about the future of the economy, how did free market principles prevail over those of a government-controlled economy?
Coining it as a ‘social market economy’ was a brilliant stroke of marketing for this purpose. It explicitly mentions the combination of both the free market and social policy elements and also helps stress the point that when free markets create goods and services at low prices with high quality it is a part of social policy in itself, allowing people to spend less money to get what they need.
The theoretical work for this was done during the 1930s as a result of the Great Depression experience, the First World War, and the rise of fascism, nationalism and socialism. Some thinkers tried to develop the idea behind the concept of the social market economy, and some political leaders fought for its adaptation.
It was a struggle then, and it still is today. Freedom and free markets do matter, as does freedom in the marketplace and you constantly have to argue and fight for it. I would say that if you ask people in Germany, maybe there would be a large crowd supportive of state intervention sometimes, but the greater overall consensus is that this is the correct economic system, and we still fight every day to keep it running.
Why do you suggest that monetary reforms were crucial as an early step for Germany’s revival?
At the time, there was rampant inflation and it just wasn’t possible for business owners to trade and earn money. The monetary reforms came with a promise that people believed in. It was only a promise at the time but people believed that the currency would be stable. Empty stores suddenly had things to buy the next day, which left a strong impression.
Looking at the theory, the currency’s stability creates a condition where the price mechanism can work and effectively drive competition. The Deutsche Mark, Germany’s currency, has always been the most stable in Europe, together with some other ones. As a result, when other currencies decreased in value, prices for German goods went up.
Although this appears to make German exports less competitive, in truth this is only in the short term because this environment creates a constant competitive pressure to improve goods and a company’s processes. It makes companies and entrepreneurs stronger and more competitive. A weak currency can be good for business in the short term, but it can hurt you in the long term, affecting sales.
The monetary reforms came with a promise that people believed in. It was only a promise at the time but people believed that the currency would be stable
Did Germany have a central bank when they introduced the Deutsche Mark in 1948? If it didn’t, how did the currency exist without a central bank?
Going into all the details would be a little complicated because the Federal Republic wasn’t even founded then, and the territory was occupied. Without going into too much detail, Ludwig Erhard who implemented this also had to convince the allied powers, including France and Britain that this was the correct approach. It took a bit of time to build up all these institutions, but they did this reform which worked well.
It’s interesting to contrast West Germany, which followed a free market approach with the social market economy, and East Germany which under the Soviet Union’s occupation had a planned economy?
You could even say it was a real-world experiment, something economists normally cannot do. You can’t force countries to implement policies and see what happens decades later.
Two parts of the country, the same culture, same language, same devastation and circumstances, the same level of education and the same experiences, mindset, geography and climate. There were minor similarities, but overall, the most important difference was the institutional setting that was put in place.
While West Germany had a free market economy with democracy, East Germany had a planned economy with a communist dictatorial government. Decades later, the result is absolutely clear. West Germany thrived, albeit with a few problems in the 1980s, while East Germany went bankrupt in the end. It didn’t have competitive companies and didn’t have products that anybody would want to buy. It makes a powerful case for a free society with free markets and democracies.
I was still young when the Berlin wall fell, but some years later, I went with my parents to visit what was East Germany, and the inner cities were in ruins. It takes time to renovate cities and change everything. Even though I was young, the depressing sights remain ingrained in my mind. If I had the choice, I wouldn’t have wanted to live in East Germany, and a lot of people didn’t want to either. There was a huge movement to flee the country, which is why they had to build the wall to keep people in. They were against being in this planned economy and dictatorial Soviet system.
German companies are now globally competitive, with brands catering to premium segments. How did Germany achieve this?
The German central bank, the Deutsche Bundesbank, had one goal in its mission statement, to keep the currency stable. They were also independent of political meddling in their mission.
Central banks of other states also aim to foster economic growth, but the theory behind Germany’s central bank and its mission statement is to avoid short term fixes and keep the currency stable, allowing the price mechanism to work best.
I believe that this is deeply ingrained in our culture because, after both World Wars, we experienced periods of hyperinflation where people lost all of their savings. There was a lot of popular support for a stable currency. The culture of the people who work at the central bank also has an effect. They are proud, they supported their mission, and always had the intention to resolve any crisis that arose to help the economy by keeping inflation low.
In this environment, our entrepreneurs were successful because they were growthoriented, innovative and competitive. A lot of them were established after WWII and many are family businesses that continue a long tradition. When prices are stable but goods become more expensive as other currencies devalue, you have to find solutions or risk being pushed out of the market.
These entrepreneurs are fierce promoters of free markets and stable prices today. For example, four years ago, the German Minister of Economics at the time proposed an industrial policy that offered subsidies and help to develop a certain sector. It resulted in a huge public outcry and a real political battle in which these family entrepreneurs argued and fought against the proposal. Their message was, we don’t want your help and your guidance, we know how to do it. We want you to take other measures that help everybody, prevent tax rises and stuff like that.
These companies didn’t become what they are today because someone’s industrial strategy determined it, they arose with their entrepreneurial spirit because of the level playing field that allowed them to compete, grow and develop
Are these family-owned businesses what are referred to as Mittelstand?
Mittelstand, you could call them that, but family-owned businesses would be the better term. There’s a debate about that because some of these companies are owned and run by the family, but others are now operated by private management. Mittelstand is for medium-sized companies, but many of these companies serve global markets and employ thousands of people.
Calling them Mittelstand wouldn’t be accurate, but they are family businesses. Some of these companies believe in the free market and the social market economy, but that’s not all that they believe in. The responsibility they have to the local community, their workers, and their customers is important to them as well, with most of them combining their economic and entrepreneurial knowledge for this purpose; and while some of them are engineers, all of them are very deeply interwoven with their companies.
Most of these companies aren’t in the big cities either. When driving around, you’ll often find a big factory and maybe 500,000 people in the middle of nowhere, producing some small component of a machine, and they’ll be one of the best of a few companies that can do it.
These companies didn’t become what they are today because someone’s industrial strategy determined it, they arose with their entrepreneurial spirit because of the level playing field that allowed them to compete, grow and develop. They’re very impressive stories.
One could suppose that the social market economy is a fixed idea that can be bolted onto an economy and it will function. Is that true?
Absolutely not. Society is constantly changing, meaning that I can talk about theoretical concepts, but in practical implementation, some things don’t comply with the general idea. You can’t just take something like that and put it into play somewhere else because this specific implementation of a free market economy is interwoven with culture and history, with long decision-making trees.
What can be done instead is to look at the principles, see where they were successful, even in this difficult starting period, and learn from it. A good example I can give is by using football, also known as soccer, the most popular sport in Germany.
Imagine a large playing field and the players as entrepreneurs who compete against each other. The playing field and the rules that apply to the game are the market framework which is set by parliament, the legislative power of the state. At the same time, the executive power of the state acts as a referee and ensures fair competition.
Is that the definition, what does Ordoliberal mean? It’s a term that appears often in discussions of social market economies?
You could say that ordoliberals developed the theoretical concepts that were put into practice, were put into practice with this concept of the social market economy. So their work is more theoretical and also has normative foundations, they laid the basis. I think this picture works very well because it has a framework of rules of regulation. The goal isn’t to force people to do something, but rather to create a fair space for competition.
When competing, if you’re successful, success is yours and the same applies to failure. You have responsibility for your actions within the framework as well. To ensure responsibility, you then need someone who ensures the rules are followed and none are engaging in foul play. This requires the rule of law, a good justice system, and anti-trust legislation to keep competition fair. It gets complicated and the central bank is also part of this framework.
Often people want government intervention because they are unwilling to take responsibility for improving their circumstances. Did Germany’s postwar experience create people more receptive to individual responsibility and hard work?
These ideas developed much earlier and are deeply ingrained in ordoliberalism’s theoretical groundwork as well as the teachings of the Catholic church that roots in philosophy. I think this principle applies everywhere because we are individuals. As far as liberals, that’s the starting point of everything. But we are political animals, parts of groups, or families of countries, and everybody has responsibilities.
The concept of freedom as the ability to do whatever you want isn’t true, and most people don’t want to do things that hurt other people. This idea is deeply ingrained in the whole framework. Most entrepreneurs want to make a profit, they want to have money to invest and continue to save, but their idea of success involves the long term, and this includes treating employees and customers well, along with people in the supply chain.
Interestingly, most of these companies – especially the smaller ones that don’t have international factories – are still integrated with the local community, and they want to stay there. They want to continue the tradition while developing the business.
Concerning the general idea of personal responsibility, there are problems that you can’t solve alone, where everybody has to be responsible like environmental policy and climate change. The general idea would be to avoid piecemeal engineering, forcing decisions on people. For example, we will forbid you to heat your house, very important in the winter in Germany.
Instead, it’s about putting the costs of the activities imposed on society as a whole into a regulatory framework. Don’t tell people to use electric cars or alternatives, but try to see the external costs of using a combustion engine and put that into the framework and let the marketplace find the best idea on how to replace that.
So it’s not a matter of providing incentives to shift consumer habits, but setting a framework instead and allowing the market to figure out how to allocate resources?
That is the ideal picture, but in reality, you always have to fight for these principles and ideas. The urge to do something quickly and directly is very high for a lot of people, including policymakers but the long-term solution is better and more efficient. We have to argue for them, and when it comes to climate, through natural and environmental policy, the challenges are so big that we, as one country or as the whole world simply can’t afford to not use the most efficient mechanism that we have.
It’s still a very difficult argument to make. There is a constant fight against single policy decisions although this idea in Germany is still popular. For example, we had large subsidies for battery cars and electric cars, which didn’t make much of a difference in my opinion. The urge to do something or anything was just too much, and that’s part of the discussion.
But I am still confident that when the market price mechanism works, it’s the best way to solve a problem. I am saying that because I think that is a very efficient mechanism, and we must organize activities to get people to develop ideas to drive forward. Although Elon Musk is having some trouble now, he is one entrepreneur who changed an entire industry with his ideas. And that’s the power of markets.
At the same time, you can’t use markets for everything. With soccer as an example, there’s an important role for the state to play. And markets are not everything. If, when we manage to use them where they are good, then that’s a win for everybody.
The social market economy is a combination of two concepts: social and market. We’ve discussed the market element. What is the social concept?
Our Founding Fathers would say that the most crucial social policy is creating a free market. They promote high-quality goods and services at reasonable prices. German discounters and stores that sell quality food at low prices are great examples of this.
There is no fixed rule on social expenditure. I don’t know if 30% of social expenditure measured as GDP is good or bad. For Germany, when the country started to develop, it was lower, but it grew as wealth grew. Our focus now is spending on social expenditure more efficiently rather than spending more. There are basic implementations, including universal healthcare, a pension system and unemployment benefits, but the important thing is you don’t have to implement the entire package.
Comparing how other countries have implemented a free market economy, the US has different policy decisions in many areas. There is no absolute right or wrong, but it’s an example of how a country has a lot of options to organize around a functioning free market.
Germany has a federal government very similar to the U.S., with some power vested in its states. How does this form of government operate in a social market economy, particularly concerning taxes and the social aspect of it?
The short answer is that states can only do certain things for social expenditure at a federal level. For example, police, education and policies. There are taxes, but they make up a small percentage. Most are just federal taxes, and there’s a distribution mechanism. The system is not perfect, but which system is?
I sometimes wonder if people in wealthier states would realise they would have to pay less in Taxes and Social Security payments if they didn’t have to finance the poorer states. I’m not sure how that would play out. But as a whole, anyway, it works.
There’s no direct connection between the principles of the social market economy and the tax system.
In principle, it is better to take taxes or social security payments out of profits and income and then do redistribution rather than trying to intervene directly in the market to give rules that try to correct the outcomes.
But talking about the tax system is a whole different story. I would say -and research also suggests that – taxes should be considered in correlation to the quality and level of government services. So in Sweden, taxes are very high, but many people are willing to pay, which is good. In Germany, maybe the overall level is a bit lesser, and in the US, it’s even lesser. There is no perfect answer. But I would say if you charge high taxes, proper justification is needed.
Any concluding thoughts?
In the last few days, I have learned a lot more about Sri Lanka. First, you can’t simply replicate policies and institutions from other countries and implement them, but you can learn from their experiences.
I would stress the power of free markets; there’s overwhelming empirical evidence that having a free market is a good decision in the long term. The example in Germany shows that if parts of a country are sceptical towards free markets, having explicitly said we have the social element, that’s what proponents of the free market want. They consider it because they are efficient tools we should use. So there’s no easy way, but still, free markets follow something in that direction, which is a good idea.