Abstract: The paper analyzes the political economy of capitalist transformation in nineteenth century Germany. The emergence of capitalism after 1806 gives an example that economic freedom can precede political freedom, leaving the political power of the “dominant coalition” intact. The paper argues that the German capitalist transformation was instigated by competition among the European states. Primarily it was conducive to the monopolization of the coercive power of the state. As a result competition among the states drove a wedge between the interests of the monarch and his supporting dominant coalition (landed gentry). The increasingly independent public administration in Prussia which was influenced by Adam Smith’s liberal ideas organized a political bargain which established economic freedom in various sectors but took the economic interests of the landed gentry into account. In various aspects the sweeping institutional change was Pareto-superior for groups, which made capitalism also acceptable for the elite group.