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 city of Dresden was completely destroyed. The population of Cologne had dropped from 750,000 to 32,000. 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.
In short, Germany was a ruined state facing an incredibly bleak future. The country was occupied by four nations, and soon it would be divided into halves. The Eastern half became a socialist state, part of the Iron Curtain that was heavily influenced by Soviet policy. The Western half became a democracy. And caught in the middle was the former capital of Berlin, which was divided in two, eventually separated by what became known as the Berlin Wall.
But by 1989, when the Berlin Wall fell and Germany was once again reunited, it was the envy of most of the world. Germany had the third-biggest economy in the world, trailing only Japan and the United States in GDP.
Germany's ascent became known throughout the world as the German Economic Miracle. In Germany, it was dubbed the Wirtscaftswunder. But how did this come to be?
Perhaps the most important person in Germany's stunning rebirth was Walter Eucken. 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."
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. (To learn more, see Free Market Maven: 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.
As West Germany was in its infancy, there became a heavy debate over the direction of the new state's fiscal policy. Many, including labor leaders and members of the Social Democratic Party, wanted to have a system that still maintained government control. But a protégé 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 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.
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. (For more, read Bartering Through A Cash Crisis.)
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 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%.
Also adding to Germany's rebirth was the European Recovery Program, better known as the Marshall Plan. Crafted by U.S. Secretary of State George Marshall, this act saw the United States giving $13 billion (around $115 billion in 2008 prices) to European nations affected by World War II, with a large chunk of this money going to Germany. However, the success of the Marshall Plan has been debated by economic historians. Some have estimated that aid from the Marshall Plan contributed less than 5% to Germany's national income during this time period.
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 Bottom Line
During this time period, 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. (For more, read Free Markets: What's The Cost?.)
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 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 near-immediate 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, 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. (For more, see War's Influence On Wall Street.)