Europe continues to take the centre stage in terms of determining the outlook for global financial markets and economies – and it is therefore critical to try and keep abreast of the constantly evolving events in the Eurozone and incorporate them into your decision making framework. Germany continues to insist on harsh fiscal austerity in the periphery, without a "lender-of-last-resort" role for the ECB and issuance of jointly guaranteed Eurobonds. The horrors of the Weimar hyperinflation of the early 1920s remain firmly entrenched in the national psyche and influence its deep aversion to "monetary financing" (i.e. monetizing government deficits via the printing press). However, Germany should perhaps be even more concerned about the horrors which could be unleashed by a prolonged and deep recession which was actually the real cause for the rise of Hitler in the 1930s as detailed by Dylan Grice of Societe Generale in a fascinating note. To summarise:
-In the aftermath of the collapse of the gold standard in the early 1930s , most countries selected the easier option of devaluation of currencies to inflate themselves out of a painful recession with the main exception being Germany which chose to cling to the gold standard (and resulting deflation), haunted by the horrors of the 1923 hyperinflation (see attached chart).
-The US clung onto the gold standard longer than countries like the UK and Japan and therefore suffered a deeper depression, while Germany experienced an even more devastating depression than the US as it suffered a comparable loss in industrial output but significantly worse (and more prolonged) unemployment levels (33% at its peak - see attached chart).
-It is generally believed that the rise of the third Reich was caused by the 1923 hyperinflation, and while it is true that Hitler made his first attempt to grab power in 1923 with the "Beerhall Putsch", by the late 20s the Nazis were just another large fringe group.
-The depression in Germany which began in the late 1920s (associated with rising unemployment levels) was tightly correlated with the rising share of the Nazis electoral vote (from less than 5% in the mid 20s to late 20s to 45% by 1933-see attached chart).
-What would the course of history have been if Germany had inflated like the UK, which left the gold standard in 1931 and experienced a significant drop in unemployment and a recovery in output. With unemployment levels of 17% rather than 33% would the Nazis have won the March 1933 elections?
-By insisting on imposing harsh fiscal austerity on the periphery, Germany runs the risk of ever-more misery in the affected countries, and a severe political backlash blaming Germany for their misery.
-It is time for Germany to make-up its mind –the Euro or its hard money principles. It is likely that Germany will eventually make the decision in favour of the Euro, and allow the ECB to act as a lender of last resort. A continued economic slowdown in Germany would make this choice even more probable.
-This could be implemented by giving the EFSF a banking license, allowing it to borrow from the ECB and act like a euro IMF – bailing out countries in return for certain conditions to be met (e.g. labour market, welfare and tax reforms). There would be no breach of existing treaties. The treaties could also be changed (in due course) allowing countries to opt out of the Euro.
Absolutely fascinating and yet another example of how easily misconceptions get imbedded in the popular psyche and lead to erroneous actions and unnecessary and widespread misery! Anyway, I agree that Germany will eventually have to make a choice between the Euro and allowing the ECB to act as a lender-of-last-resort – the question is when? Germany is adamant in following a step-by-step process of eventually more European political and fiscal integration via change of treaties (which will take several years to effect), coupled with some level of support for government bond markets via limited purchases by the ECB in the secondary markets, and support from a leveraged EFSF (and possibly a Euro Redemption fund as recently suggested by the German Council of Economic Advisers). This approach may well work but would the markets be patient enough and not force Merkel's hand prematurely? Time will tell, but meanwhile expect continued volatility in markets – though not a meltdown or a significant upward trend until this issue is resolved.
On Asian Credit Growth:
The above note also has relevance to Asia, as it drives home the point that eventually (when push comes to shove), governments when faced a choice between growth and inflation will choose growth as the social consequences of no growth are more severe – yes, inflation is not a pleasant experience as you lose the real value of your income – but the alternative of having no income at all is far worse!. The attached graph highlights this choice by depicting credit growth in Asia over the past decade and highlights China's very timely response to the 2008 financial crisis by embarking on an unprecedented credit growth rate of 35% per year! With the global economy in a slowdown mode yet again, expect China (and the rest of Asia) to embark on another credit growth cycle leading to buoyant stock (but perhaps not property which was the main beneficiary of the credit spurge) markets.
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