Economic Theory

Ludwig Erhard’s social market economy – a liberal, not a social democratic concept

“Social market economy” is a vague slogan in European political debate. The term originated in Germany. But what does it really mean?

Most people think it means a mixed economy, combining the “efficiency” of the market with “social justice”. The latter requires government intervention to distribute the fruits of the market economy “fairly”. This is the social-democratic version of a social market economy, one that is strongly slanted towards “distributive justice”.

Alfred Müller-Armack, a German economist and sociologist, coined the term (soziale Marktwirtschaft) in 1945. He sought a “new synthesis” of market freedom and social protection. His conception of the market economy owes more to mechanical physics than to biology: the policy-maker “engineers” the “free” market to produce the maximum of wealth, which can then be redistributed in the name of social justice.

This view of social market economy became popular in West Germany from the late 1960s. And from Germany it spread elsewhere in Europe. It is seen as a genuine “third Way” between extreme socialism and extreme capitalism. That is why Tony Blair, backed by his intellectual guru Tony Giddens, talked about the third way so much during New Labour’s heyday.

But, from the 1940s to the 1960s, a different view of Social Market Economy held sway in West Germany. To the public, it was the economic philosophy and programme of Ludwig Erhard, the Federal Republic’s Economics Minister from 1949-63, and Chancellor from 1963-66. Erhard is known as the father of West Germany’s Wirtschaftswunder – its post-war “economic miracle”.

In Erhard’s inner circle were economists and lawyers from Freiburg University. Their central concept is Ordoliberalism. Walter Eucken, the Freiburg School’s founding economist, outlines a free-market order, constituted and regulated by a “policy of order” (Ordnungspolitik). Ordnungspolitik maintains the market economy’s framework of rules, but it does not intervene in the economic process: price-setting and resource allocation are left to market participants. To use a classical-liberal analogy, the state should be the market’s umpire, but not one of its players.

Ordnungspolitik should avoid interventions that impair the free operation of the price system and the market whilst monetary and exchange-rate policies should guarantee price stability. The state should uphold freedom of contract and freedom to trade; and it should avoid discriminatory interventions to favour particular sectors and firms. Economic policy should steer clear of erratic changes that cause private actors to shun risk-taking and investment. Eucken also favoured strong competition rules to prevent public and private restraints on trade.

Wilhelm Röpke and Alexander Rüstow were also in Erhard’s inner circle. They were concerned with the non-economic – or social – foundations of a market economy. To Röpke, this is “what lies beyond supply and demand”.

Röpke and Rüstow regard the social part of the social market as part of an organic whole, along with the rule of law and free markets – not a redistributive device to correct the iniquities of a mechanical market. Social cohesion emerges spontaneously from below, nurtured by the traditions and conventions of institutions such as the family, church, workplace, sports clubs and other voluntary associations. These foster virtues of responsibility, self-help and civic-mindedness – the moral framework that sustains a successful market economy. Social policy is first and foremost Ordnungspolitik, integrating as many people as possible into market society, with a basic safety net for those who fall by the wayside.

This, then, is a conservative-liberal view of social market economy, not a social-democratic one. It has more in common with Edmund Burke and Alexis de Tocqueville, and indeed with Smith, Hume and Hayek, than it does with John Rawls, Tony Blair and Bill Clinton. And it was the social market economy Ludwig Erhard believed in when he was in charge of West German economic policy.

What competitiveness Germany has today is a legacy of Erhard’s Ordnungspolitik. His free-market reforms transformed the western, non-Communist half of Germany from wartime destruction into Europe’s economic powerhouse and a world leader in industrial exports. But Germany carries the burden of half a century of post-Erhard “social” interventions; the result is high taxes, heavy regulation and a large welfare state. Today, Germany’s economy is ill-equipped to tackle big challenges such as an ageing population and the need for a more services-based economy.

Dr Razeen Sally is Director of the European Center for International Political Economy.

Member of the Advisory Council

Dr Razeen Sally is a member of the Advisory Council for the Institute of Economic Affairs as well as an Associate Professor at the Lee Kuan Yew School of Public Policy at the National University of Singapore. He has been Director of the European Centre for International Political Economy, a global-economy think tank in Brussels.