Unit 1 Prosperity, inequality, and planetary limits

How economists learn from facts Do institutions matter for growth in income?

In a conventional experiment, the experimenter changes the variable thought to be a cause (X), keeping all the other variables the same as before, and observes the change in Y that is associated with the change in X. In an agricultural experiment, X might be the dosage of fertiliser applied, the things kept the same (or ‘held constant’) might be the amounts of water and light, and Y would be the amount of the crop produced.

By contrast, in what is called a natural experiment, we rely on accidents of history, geography or other differences to ‘perform the experiment’ and to present us with different values of X that can then be associated with differing values of Y, when not much else that could cause changes in Y differs.

A natural experiment is a situation where we use an external event, such as a change in institutions or a natural disaster, to compare the outcomes for economic actors who were affected by this event and those who were not.

The division of Germany at the end of the Second World War into two separate economic systems—centrally planned in the east, capitalist in the west—provided a natural experiment. During this time a political ‘Iron Curtain’, as the British prime minister Winston Churchill described it, divided the country. It separated two populations that until then had shared the same language, culture, and capitalist economy. But for half a century they differed in the institutions governing the economy. This allows us to study the effect of different institutions on the economy.

Using the language of experiments, central planning under Communist Party rule in East Germany is the ‘treatment’ and capitalism in West Germany is the ‘control’ that provides an indication of how the East would have developed had Germany not been divided. The control is also termed the ‘counterfactual’ event: what would have happened if, contrary to the facts of history, East Germany had not been organized as a planned economy between 1948 and 1991.

The validity of this as a natural experiment relies on the comparability of the two parts of Germany before the introduction of different economic systems. In 1936, before the Second World War, living standards in both parts of Germany were the same. Firms in Saxony and Thuringia were world leaders in automobile and aircraft production, chemicals, optical equipment, and precision engineering. During the war, the entire German economy was organized as a war economy: for example, wages and prices and the allocation of labour and resources were under central control.

After the war, Communist central planning replaced the war economy in East Germany, where the Soviet Union was the occupying power. Decisions about how and what to produce did not revert to private individuals, but were taken by government officials. The officials managing plants, offices, mines, and farms did not need to follow the principle of capitalism and produce goods and services that customers would buy at a price above their cost of manufacture. Pre-war private property, markets, and firms virtually disappeared.

But a capitalist economy re-emerged in West Germany as a result of decisions by the occupying powers (the UK, US, and France). Following currency reform in 1948, which abolished wartime price controls and introduced a new currency, rapid growth occurred.

The East German Communist Party forecast in 1958 that material wellbeing there would exceed that of West Germany by 1961. The failure of this prediction was one of the reasons the Berlin Wall separating East from West Germany was built in 1961. By the time the Wall fell in 1989, and East Germany abandoned central planning, its GDP per capita was less than half of that of capitalist West Germany. Figure 1.16 shows the different paths taken by these and two other economies from 1950.

Figure 1.16 shows that West Germany started from a more favourable position in 1950 than East Germany. In 1936, before the war began, the two parts of Germany had virtually identical living standards; both had achieved successful industrialization. East Germany’s relative weakness in 1950 was not mainly because of differences in capital equipment or skills, but because its industrial structure was more disrupted by splitting the country than was the case in West Germany.¹

But other capitalist economies that had even lower per capita incomes in 1950, grew much faster. By 1989, the Japanese economy, which had also suffered war damage, had—with its own combination of private property, markets, and firms, along with strong government coordination—caught up to West Germany. By 1989, Spain, which until 1975 like East Germany was ruled by a dictatorship, had closed part of the gap. Growth accelerated after the market reforms introduced in 1959.²

We cannot conclude from the German natural experiment that capitalism always promotes rapid economic growth, while central planning is a recipe for relative stagnation. What we can infer is more limited: during the second half of the twentieth century, the divergence of economic institutions mattered for the material living standards of the German people. For a longer run view of comparative performance under central planning (the Soviet Union and Latin American countries), see Figure 1.19 in Section 1.12.