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Economic policy in a social market economy has two distinct roles which are crucially different: to establish and preserve the economic order (Ordnungspolitik) and to influence economic processes (Prozeppolitik). Prozefipolitik attempts to modify the business cycle, growth and allocation in day-to-day or year-to-year or even longer-term operations, for instance in providing social overhead capital. Ordnungspolitik refers to the establishment of property rights, of the incentive system, of the institutional arrangements and of the rules including the constitutional conditions. The Ordoliberals who laid down the intellectual foundations of West Germany's economic order also argue that the main policy task is Ordnungspolitik, i.e. to establish the institutional arrangements for a market economy.

Proze/Jpolitik should be limited to special cases.

Eucken (1952) had developed the constituting principles of the competitive order. Open markets, nowadays the most important ingredient of the concept of contestable markets (Baumol et al.

1982), are a prerequisite for competition. Private ownership is both a guarantee of individual liberty and an incentive to minimize costs and to reveal truly economic information. Freedom of contract is conducive to competition. Liability ensures that social costs are internalized. The constancy of economic policy helps to prevent the intertemporal misallocation of resources, and price level stability (see below) is a sine qua non for the price mechanism to operate.

An economic order for the economy as a whole may be interpreted as consisting of separate partial orders for specific functional areas (order for the competitive process, monetary system, social order and labor market) or for specific policy areas (trade policy, business-cycle policy, agricultural policy). A basic issue is how these partial orders can be made consistent with each other (Eucken 1952, p. 304; Kloten 1989, p. 11). A related problem is how macro policies can be integrated into the order of a social market economy.

The Social Market Economy as an institutional framework has a set of important requirements that have to be satisfied for the institutional framework to function. These conditions are the system (market) conformity of policy measures, the defense of competition, price-level stability and the social order. These elements can only be understood with the historical experience of Germany prior to 1945.

Interventionlsm, Market Conformity and the Role of State The German population in general and the intellectual fathers of the social market economy in particular had experienced an interventionist state, especially in the thirties and during the war. It was clear to the majority that a controlled economy

- "une 6conomie dirig6e"

–  –  –

Therefore, decentralization and a competitive order was called for. 4 The interventionist experience of the twenties and the thirties had shown that one intervention would quickly lead to the next.

This is especially true for price regulation, for "example regulating the price of a standard loaf of bread would quickly spread like a cancer to all types of bread, including bagels and croissants, to the labor costs of the baker, to flour, to the milling process, to wheat, and all other inputs as well as substitutes for the product. As we know from the present European agricultural policy, intervention cannot be partially confined to one specific product, but tends to have side effects which are seldom recognized prima vista.

A specific intervention may not only affect other markets (via the interdependence of markets by the potential for substitution and by complementarity), but intervention may also have an impact on the market system itself, changing the basic properties of the allocation mechanism. Therefore, the intellectual founding fathers of the Soziale Marktwirtschaft (Eucken, 1952; MiillerArmack, 1944, 1946; Ropke, 1942) demanded that policy actions should be compatible with the market economy ("marktkonform"): in a narrow interpretation, a policy decision should not induce such a change or disequilibrium in another market that a new intervention becomes necessary. In a broader sense, a policy measure should not change the property of the overall system.

It has proven extremely difficult to pinpoint the concept of market conformity. In a static view, one can quickly see how the regulation of one market shifts demand or supply to another market; but in intertemporal decisions such as the choice of a location, capital accumulation and the depletion of resources it takes a long time to see impacts. Moreover, the concept of market conformity is extremely difficult to define with respect to the impact on the system as a whole (system conformity). Finally, the concept "does not provide a conclusive answer to the question as to what activities the state should fulfill in a free society and what decisions are reserved to the market" (Watrin 1979 p. 421).

A specific aspect of intervention!sm is the issue of the nationalization of basic industries. This was a prominent topic in the early days of West Germany, and although it occasionally flares up, it is not an issue any longer, partly due to the severe inefficiencies of those German firms which are supposed to have been oriented towards the common weal (Gemeinwirtschaft) in the last twenty years, and partly due to the experience in Eastern Europe.

Apart from the issue of interventionism, the state as a "Rechtsstaat" is restrained in its activities by a set of rules and procedures. It has been assigned the role of protecting individual liberty and of guaranteeing the institutional arrangement of the competitive order, for instance by competition policy (see below). Eucken (1952) and Miksch (1937) required a strong government that could defend the competitive order and suppress specific interests. The state "is assigned a crucial role in monitoring the proper functioning of the competitive process, which, if left alone, is believed to degenerate due to monopolistic tendencies and growing disproportions of private power" (Vanberg 1988, p. 19).

The state has the producing role according to Buchanan (1975, p. 68) of providing public goods (or rules for public goods as in environmental quality management). Moreover, the West German state has taken over a dominant role with respect to the equity targets, i.e. in the attempt to produce fairness.

With respect to the proper productive role of the state such as with public goods, the aggregation of individual preferences by the market is not possible (free rider), and a political aggregation mechanism has to substitute for the market process through voting. Voting is also applied when merit goods, for instance policy targets, are involved. In deciding on public and merit goods, a federal structure being based on the subsidiary principle allows the expression of regional preferences. Thus, economic decentralization is to some extent accompanied by political decentralization.

Endogenous Tendencies to Monopolies and a Framework for Competition Competition is a necessary condition for an effective decentralization, but the spontaneity of the market may be endangered endogenously by the behavior of firms. Profitmaximizing firms can improve their position by reducing competition. They can form cartels and engage in other forms of cooperation in order to reduce competition; they can strive for a monopoly position by internal growth or can attain a monopolistic position by mergers. This was the experience in Germany in the three decades preceding World War I and at the time of the Weimar republic, reflected in the debate in the late 1920s and early 1930s (Mises 1926; Riistow 1932; Hayek 1944). These potential endogenous tendencies would severely affect the institutional setting of a market economy; at the same time, firms could engage in rent seeking and attempts to influence the institutional arrangements under which they operated. Historically, the result was an industrial complex interlinked with the state ("Vermachtung" der Wirtschaft, Kloten 1989, p. I I ). 7 An important framework of the institutional arrangement of a social market economy is therefore competition policy. Its role is to guarantee that competition is not eroded endogenously by principally ruling out cartels, by controling mergers and by surveilling the abuse of a monopolistic position. But other important aspects include free market entry to keep markets contestable and an open economy to allow competition from abroad.

Inflationary Experience and the Independence of the Bundesbank

Germany has gone through two big inflations: the hyperinflation of 1923 and the repressed inflation from 1936-1948. Inflation generates severe repercussions from distorting allocation and especially from hurting those individuals with a fixed nominal income, for instance wage earners. Inflation can therefore be a danger to an economic system, it can lead to a political destabilization of society, and it violates the condition of constancy of economic policy. For these reasons, price-level stability is an important target of economic policy; the Bundesbank was institutionalized as an independent central bank.

The government cannot monetize its budget deficit by taking recourse to the central bank.

These provisions are not part of the constitution, but of the Bundesbankgesetz. It is interesting to note that the actual position of the Bundesbank is not only defined by the legal rules but by a consensus in the population. This more or less holds for other aspects of the institutional system as well. If the consensus changes, the institutional setting may vary.

The "Social Question" and the Social Order

The late 19 th and the early 20th centuries in Europe were dominated by the social question. Industrialization, new forms of production, the ^migration from the countryside to the industrial locations gave rise to social problems. Socialist movements claimed to have found an answer to how economic efficiency and progress and personal freedom could be obtained by the public ownership of means of production and central planning. The social ethics of the Catholic church centered on improving the conditions of human life. From this historical perspective, any economic system has to provide an answer to the social question, both from an ethical point of view and from a practical one.

There must be some consensus on the economic system.

The experience with a central collectivist planning system in Europe was that such a system did not deliver the promises made;

it did not protect the worker as an individual but rather it required an Orwellian-type control of the individual worker, for instance in limiting his choice of work place or controlling what type of work he did in order to allocate food stamps in a rationing system. Thus, introducing the market economy in 1948 was in itself a social reform. The system provided economic opportunities and choices.

Besides stressing this positive property of the market economy, the attribute "social" market economy refers to the basic position of at least some of the Ordoliberals that the allocation process by markets may lead to an income and wealth distribution that warrants correction (Vanberg 1988, p. 20). An important aspect of this can be found in the social insurance schemes which were started in the 1880s and have been further developed in the 40 years of the Federal Republic. The "productive state" (Buchanan 1975, p. 68) has gained a more important role;

moreover, the worker participated in economic growth - to wit the wage drift in the fifties and sixties - and he was integrated in economic terms by acquiring real (houses) and financial wealth.

Finally, the issue of the position of the workman of the last century had changed. With 54.9 percent of the work force in service activities (including 20.1 percent in government) and only 40.1 in industry (Statistisches Bundesamt 1989), the social question of the 19th century has disappeared from the center of the stage.

Bibliothek des Instituts fur Welfwirtschaft

3. Trends and Challenges: How do the Principles Work?

How has the social market economy performed in its 40 years? Can we recognize trends? Is there a slow erosion of the "social market order" (Bernholz 1979; Klump 1985; Tuchtfeldt 1973;

Vanberg 1988?; Willgerodt 1988). Is the German economy still a social market economy (Kloten 1989, p. 14)? And what will be the challenges of the future?

Policy Targets

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