A Report On

Rebuilding of the German Economy After World War II

Submitted in partial fulfilment of: ECON C321 Macroeconomics

Prepared by:

Prankur Sharma

2009B3A4622P

18 October, 2011 Birla Institute of Technology and Sciences, Pilani

1. Introduction Following World War II, the German economy, was in ruins. Millions of people were displaced in the aftermath of the war, becoming homeless refugees with few possessions. Once again, inflation played a devastating role in the collapse of the German economy. Luxury items, such as pens, nylons, and cigarettes, became just as accepted as the paper money in economic exchanges. The Allied powers that controlled Germany saw this as an opportunity to start fresh and create a new society that could enjoy economic prosperity. One of the first steps to creating a free German economy was abolishing many of the rules that the Nazi party imposed on economic functioning, as well as to create a new legal tender that Germans could use as money. These measures proved to be enormously successful, and provided a solid foundation for the establishment of a new economy in West Germany. The German economy has often been referred to as a Soziale Marktwirtschaft, or a Social Market Economy, a name that reflects its dualistic devotion to the materialistic aspect of economics, as well as the human aspect. As a reaction to the extreme role that the Nazis assigned their government in the old economy, the new German economy is mostly free from government regulation, except to protect the competitive environment from being dominated by monopolies. The economy now made provisions for those who could not keep up with its demands, caring for its poor as well as its wealthy participants. Today, Germany has the most expensive social welfare system in the world. Although Germans have tried to keep state influence out of the German economy, several events have prompted the state to take greater and greater control of the nations economic policies. One of the most significant of these was perhaps the Reunification that took place in the early 1990s. The economy of East Germany, which had been a socialist state, suddenly merged with that of West Germany, which had run on the Social Market system, and the government of West Germany set about privatizing the East German economy. One of the biggest issues was the fact that many people often had legitimate claims to the same property, since many expropriations had taken place since the end of the war. The conversion rates between East German and West German Marks also presented a problem, as well as the lack of infrastructure driving away investors. Despite these problems, as the divided nation moved toward unity, the German economy also began to flourish. By the time the Treuhand, the organization created to help privatize East German enterprises, was disbanded, over 10,000 different firms had been privatized. Although the merger put the new German economy on shaky footing, costing the German people much of the prosperity they had won following World War II, these newly imposed government regulations eventually turned the tide. Today, Germany has one of the most powerful economies in Europe and the world.

2. Economic Situation of Germany Just After World War II At the end of World War II, much of Germany was in ruins. Large parts of its infrastructure was attacked or bombed by the Allied Forces. The housing stock was reduced by 20%. Food production was half the level it was before the start of the war; industrial output was down by a third. Many of its men between the ages of 18 and 35, the demographic which could do the heavy lifting to literally rebuild the country had been either killed or crippled. During the war, Hitler had instituted food rations, limiting its civilian population to eat no more than 2,000 calories per day. After the war, the Allies continued this food rationing policy and limited the population to eat between 1,000-1,500 calories. Price controls on other goods and services led to shortages and a massive black market. Germany's currency, the Reichsmark, had become completely worthless, requiring its populace to resort to bartering for goods and services. 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 Hitlers top Nazi deputies, Hermann Goering, imposed rationing. During the war, the Nazis made flagrant violations of the price controls subject to the death penalty. In November 1945 the Allied Control Authority, formed by the governments of the United States, Britain, France, and the Soviet Union, agreed to keep Hitlers and Goerings price controls and rationing in place. They also continued the Nazi conscription of resources, including labour. 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. 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. 3. Walter Eucken Perhaps the most important person in Germany's stunning rebirth was Walter Eucken. He was the person on whose principles the rebuilding of the German economy took place. The son of a Noble Prize winner in literature, Eucken studied economics at the University of Bonn. After a stint in World War I, Eucken started teaching at his alma mater. He eventually moved on to the University of Freiburg, which he would make internationally known. Eucken gained followers at the school, which became one of the few places in Germany where those opposed to Hitler could express their views. But, more importantly, it's also where he began to develop his economic theories, which became known as the Freiburg School, ordo-liberalism or the "social free market."
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Eucken's ideas were firmly rooted in the camp of free-market capitalism while also allowing a role for government involvement to ensure that this system worked for as many people as possible. For instance, strong regulations would be put in place to prevent cartels or monopolies from forming. In addition, a large social welfare system would serve as a safety net for those who found themselves struggling. He also supported having a strong central bank independent from the government which focused on using monetary policies to keep prices stable, in many ways mirroring the same thoughts brought to fame by Milton Friedman. This type of system may sound completely normal today but at the time it was seen as pretty radical. One must consider Eucken's philosophy in the era in which he generated it. The Great Depression which consumed the entire globe hit Germany particularly hard; hyperinflation essentially ruined the economy and led to Hitler's rise. Many people felt that socialism was the economic theory that would sweep the world. And soon, the Western half of Germany controlled by American and Allied forces would have to make a decision in which way to go. 4. Policy Changes in the German Economy As West Germany was in its infancy, there became a heavy debate over the direction of the new state's fiscal policy. Many, including labour leaders and members of the Social Democratic Party, wanted to have a system that still maintained government control. But a protg of Eucken, a man by the name of Ludwig Erhard, had begun to gain prominence with the American forces which were still in de facto control of Germany. Erhard, a World War I veteran who attended business school, was a largely under-the-radar figure who worked as a researcher for an organization which focused on the economics of the restaurant industry. But in 1944, with the Nazi Party still in firm control of Germany, Erhard daringly wrote an essay discussing Germany's financial position which assumed that the Nazis lost the war. His work eventually reached U.S. intelligence forces who soon sought him out. And once Germany did surrender, he was appointed to the position of the finance minister of Bavaria and then worked his way up the ladder to become the director of the economic council of the still occupied western half of Germany. Once he gained political influence, Erhard began to formulate a multi-pronged effort to bring West Germany's economy back to life. First, he played a large role in formulating a new currency issued by the Allies to replace the worthless remnant of the past. This plan would reduce the amount of currency available to the public by a staggering 93%, a decision that would reduce the little wealth that German individuals and companies held. In addition, large tax cuts were also instituted in an attempt to spur spending and investment. The currency was scheduled to be introduced on June 21, 1948. In an extremely controversial move, Erhard also decided to remove price controls on the same day. Erhard was almost universally criticized for his decision. Erhard was brought into the office of U.S. General Lucius Clay, who was the commanding officer overseeing the occupied western
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half of Germany. Clay told Erhard that his advisors informed him that the German's drastic new policy would be a terrible mistake. Famously, Erhard responded: "Don't listen to them, General. My advisers tell me the same thing." But, remarkably, Erhard proved everyone wrong. 5. Imposition of the Currency Reform of June, 1948 The long anticipated currency reform came in June of 1948. The old Reichsmark was replaced with the new Deutschemark. The conversion was as follows: Type Of Account Individuals Individuals Companies Public Authorities All others Notes:

Amount 600 Reichsmarks exceeding 600 Reichsmark 60 Reichsmarks per employee One month's revenue

Conversion Rate 1 Reichsmark: 1 Deutsche Mark 10 Reichsmark: 1 Deutsche Mark 1 Reichsmark: 1 Deutsche Mark 1 Reichsmark: 1 Deutsche Mark 10 Reichsmark: 1 Deutsche Mark

Balances exceeding 600 Reichsmarks: Supposedly converted at 10 Reichsmarks: 1 Deutsche Mark but the method of payment resulted in the conversion being actually 10 Reichsmarks: 0.65 Deutsche Mark or 15.4 Reichsmarks: 1 Deutsche Mark.

Debts were converted at the 10:1 ratio. Official prices and pension payments were converted at a 1:1 ratio. The Reichsmark balances and Reichsmark bond holdings of commercial banks were wiped out but these banks received "equalization claims" equal to 4% of debt (25:1 conversion ratio) and deposits with the central bank of West Germany equal to 15% of demand deposits and 7.5% of time and savings deposits. The required reserve ratios were 7.5% for demand deposits and 3.75% for time and savings deposits so the banks had excess reserves to support lending.

The central bank of West Germany was called the Bank Deutscher Lander until 1957 when its name was changed to Bundesbank (Buba). 6. Results of the Currency Reforms Almost overnight, West Germany came to life. Shops immediately became stocked with goods as people realized that the new currency had value. Bartering ceased quickly; the black market ended. As the commercial marketplace took hold, and as people once again had an incentive to work, West Germany's famed sense of industriousness also returned. In May of 1948, Germans missed approximately 9.5 hours of work a week, spending their time desperately looking for food and other necessities. But in October, just weeks after the new currency was introduced and price controls were lifted, that number was down to 4.2
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hours per week. In June, the nation's industrial production was about half of its level in 1936. By the end of the year, it was close to 80%. 7. Spontaneous Growth from 1948 to 1960(The Miracle Economy) The monetary, economic and institutional reforms of June 1948 were followed by about 18 months of consolidation with stable to slightly falling prices. Industrial production increased by 24% in 1949 and 12% in the first half of 1950. Over the period the average annual growth rate was 15% per year. The employment growth picture was mixed. Labour requirements reflect not only the level of production but also the level of labour productivity. Labour productivity was increasing dramatically in the recovery period. In 1948 there were 600,000 new jobs but a loss of 370,000 old jobs for a new gain of 230,000. But in 1949 there were only 260,000 new jobs and a loss of 410,000 old jobs for a net loss of 150,000 jobs. On top of this mixed picture on job creation there was an influx of 9 million refugees (expellees and immigrants). The major problem was the capital shortage. Not only was there the problem of the war destruction of capital but the reparation confiscations of capital equipment depleted the capital stock and made entrepreneurs afraid to invest because of the possibility that their investments might be confiscated in the future. Profitability was increasing because wage rates were not increasing as fast as prices and productivity. In other words, unit labour costs were declining. The prescription for dealing with the capital shortage problem by the Keynesian economic advisers to the government was three-fold: 1. expansionary monetary policy 2. tax incentives for saving 3. investment planning by the government William Ropke, an economist whom Americans would call conservative but in European terminology is called liberal, recommended increasing the interest rate to encourage savings. The Tax Law Adjustment Acts of June 1948 and April 1949 created tax breaks for capital creation. West Germany had a high, graduated income tax imposed by the Allied Occupation Force after World War II modeled upon the New Deal income tax of the U.S. There were income tax reforms over the period 1948 to 1955 to reduce the severity of the income tax program. The West German government was directed involved in investment planning in the "bottleneck sectors" of mining, steel and energy. West Germany retained the rent control program created during the days of the Weimar Republic, continued by the Nazis and later by the Occupation. There was thus a chronic
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shortage of housing which the government tried to alleviate with construction subsidies and public housing. German foreign trade recovered dramatically despite the loss of Eastern European markets. Foreign trade increased 84.4% per year over the two year period 1948-1950. Throughout the 1950s it increased 16% per year in real terms. Thus West Germany very quickly wiped out its trade deficit and commenced running a trade surplus. Initial exports were raw materials such as coke from coal and scrap metal but by the end of the 1950s exports were mainly manufactured goods. Also by the end of the 1950s Western Europe had become the major customer and major supplier for West Germany. West Germany's growth continued over the years. By 1958, its industrial production was four times higher than it was just one decade earlier. The 1960s and 1970s saw Germany moving towards managed growth characterized by full or overutilization of capital, labour force being fully utilized with an unemployment rate of approximately 1 percent and an undervalued currency. 8. The Marshall Plan Between 1948 and 1951, the United States poured financial aiding totalling $13 billion (about $100 billion at 2003 prices) into the economies of Western Europe. Officially termed the European Recovery Program (ERP), the Marshall Plan was approved by Congress in the Economic Cooperation Act of April 1948. After a transitory 90-Days Recovery Program, the Marshall Plan spanned three ERP years from July 1948 to June 1951. The Marshall Plan was by no means the first U.S. aid program for post-war Europe. Already during 1945-1947, the U.S. paid out substantial financial assistance to Europe under various different schemes. In total annual amount, these payments were actually larger than the Marshall Plan itself. The Marshall Plan also did not bring about the immediate integration of Europe into international markets. Large external debts presented a serious obstacle to liberalization of Europes foreign exchange markets. So the question is that can West Germanys revival be attributed mainly to the Marshall Plan? 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. Moreover, Belgium recovered the fastest from the war and placed a greater reliance on free markets than the other war-torn European countries did, and Belgiums recovery predated the Marshall Plan.
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9. Conclusion From the early 1950s, after the western occupied territory became the Federal Republic of Germany (F.R.G.) in 1949, until the late 1960s the economy boomed due to rebuilding and reconstruction activities. This was supported by the monetary reform in 1948, the establishment of a competition-orientated system, capital and to a certain extent, currency aid for investments and imports with the help of the Marshall Plan. The economic boom was, however, primarily due to domestic investments, a growth in private demand, a dismantling of monopolies and the focus on exports. The eastern part of the country became the German Democratic Republic (G.D.R.). The recovery of the German economy was accompanied by a continuous growth in income and employment, as well as the establishment of a stable social network. High volume production of consumer goods was prevalent. The focus of the industry switched to cars, machines, electrical equipment, furniture and, due to steady technological progress, to new products and markets. The economic reforms and the new West German system received powerful support from a number of sources: investment funds under the European Recovery Program, more commonly known as the Marshall Plan; the stimulus to German industry provided by the diversion of other Western resources for Korean War production; and the German readiness to work hard for low wages until productivity had risen. But the essential component of success was the revival of confidence brought on by Erhard's reforms and by the new currency. The West German boom that began in 1950 was truly memorable. The growth rate of industrial production was 25.0 percent in 1950 and 18.1 percent in 1951. Growth continued at a high rate for most of the 1950s, despite occasional slowdowns. By 1960 industrial production had risen to two-and-one-half times the level of 1950 and far beyond any that the Nazis had reached during the 1930s in all of Germany. GDP rose by two-thirds during the same decade. The number of persons employed rose from 13.8 million in 1950 to 19.8 million in 1960, and the unemployment rate fell from 10.3 percent to 1.2 percent. Labour also benefited in due course from the boom. Although wage demands and pay increases had been modest at first, wages and salaries rose over 80 percent between 1949 and 1955, catching up with growth. West German social programs were given a considerable boost in 1957, just before a national election, when the government decided to initiate a number of social programs and to expand others. However later Germany was caught in the middle of the Cold War. West Germany was a strong ally of America and was largely capitalist, albeit with a large role for the government to keep a check on the free market; East Germany was closely aligned with the Soviet Union and was communist. Side by side, these two nations offered a perfect way to compare the two major economic systems in the world. Surprisingly, there wasn't much to compare. While West Germany blossomed, East Germany lagged. Due to a struggling economy and a lack of political freedoms, East
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Germany's residents soon protested and, despite laws restricting travel, tried to leave the country in droves. On November 11, 1989, the East German regime allowed members of its country to travel directly to the west for the first time in decades. This led to the nearimmediate collapse of East Germany. And soon, the two nations would be united again. But it would be a long time before the two sides would be equal. When reunification began, the eastern parts of the country had only 30% of the gross domestic product of the western half. And today, over twenty years later, the east still has only about 70% of the GDP of its counterparts. But in 1948, none of this was even conceivable. And, if it were not for Walter Eucken and Ludwig Erhard, none of this might have happened. Today, Germanys economy is the largest in Europe and the fourth largest in the world trailing only USA, China and Japan which is nothing short of a miracle if look at its dismal condition just after World War II.