Bilal Hafeez of Deutsche Bank AG recently spoke at a conference in Germany. He spoke about the Euro and said that he believes one person can save it. The problem is that the person died long ago. Deutsche Bank recently transcripted the speech given at the annual Deutsche Bank Mittelstand (small and medium-sized enterprises) FX conference in Hamburg, Germany on 7 March, 2013. Now some German ‘Brains Turn To Jelly Guten Tag. Ich spreche ein bisschen Deutsch. Zum Beispiel, wie komme ich am besten zum Bahnhof. Heute, werde ich über Währungen sprechen,’ The full speech about the Euro and its savior can be found below:
1. I’ll have to switch to English before I further insult the language of Goethe. As a parent, I’m always on the look-out for parenting tips. So it came as a nice surprise to watch a riveting British documentary called “The Child of Our Time”
2. The documentary has been regularly broadcasting the development of a varied group of children since their births in 1999 (and 2000). The latest showed them entering their teenage years. What I found particularly worrying were the boys. They wore their jeans low revealing their underwear, they seemed addicted to violent computer games and seemed to grunt rather than talk to adults. My son is five, so I have some time before he reaches his teens.
Nevertheless it prompted me to look into how I could raise my son such that he ended up being well-rounded. Research shows that one of the key factors for teenage development is having a positive male role model other than the father. The reason for this is that teenagers are rebelling against authority, which sidelines the father. Boys also go through significant physical changes, not least their pre-frontal cortex in their brain essentially turning into jelly just like their baby years. They therefore need structure to transition into manhood, and a male role model can provide that
3. Europe’s Saviour Who else has entered the terrible teens? The Euro-Area! It was born in 1999, and so is currently fourteen years old. It has all the hallmarks of teenage angst. It is ridden with internal conflicts, it is groping around for structure, and it is suspicious of authority. So who can be a positive role model for the Euro-Area? Well it cannot be the “fathers”: Germany or France. It has to be an external figure that all Europeans respect, and whose motives and character are beyond dispute. That rules out anyone living as even the most competent person will make missteps or have something from their past dredged up to undermine them. That leaves us with historical figures whose lives have been laid bare by history. I can only think of one figure that is respected by most Europeans and has never sinned, Jesus!
Who’s to blame, and who is blameless
If everyone in the Euro-area would adopt the principle of not casting stones unless they were without sin then the constant accusations would stop. And remember, everyone has breached agreements in one way or another, even the stronger countries like Germany and France. How so? Well, all Euro-area countries were supposed to follow the Stability and Growth Pact (SGP), which amongst other things imposed a limit on of fiscal deficits of 3% and of government debt to GDP of 60%. Both Germany and France breached the SGP in the early 2000s and suffered no penalties. I should add that both Ireland and Spain met the SGP rules before 2008. So blaming “weaker” countries for not following agreements rings
hollow.
If everyone held back their accusatory stones and instead focused on the future, then we may have a clearer vision of things to come. The two pressing issues for the Euro-area are the impact of austerity and the survival of the Euro-area in its
current form.
If Everyone Is Saving, Who Is Spending?
This problem was later explored by Adam Smith and popularised by John Maynard Keynes as the “paradox of thrift”
4. Simply put, this suggests that even if it makes sense for an individual to save in bad times, if everyone does that, then the overall savings in an economy may actually fall as overall income falls (and so there is less to save). This is particularly the case when unemployment is high and interest rates have hit the lower bound of zero. Another way of looking at this is that if individuals save, they spend less, which in turn means there is less demand to consume the output of companies. Companies then cut back on employment and stop investing. This further reduces demand in the economy and the vicious cycle continues.
Since 2008, this is precisely what has been happening in the Euro-area. Households, companies and governments have entered austerity mode, unemployment is at record highs and interest rates are close to zero. Growth has fallen to zero. Meanwhile, government debt has actually gone up since 2008 by 25%. This is the paradox of thrift in action. If we compare this to the US, we find a stark difference. There the heavily indebted household sector began to save and deleverage soon after the 2008 crisis, but the government held back from austerity and instead initiated a stimulus.
Now with household deleveraging having run much of its course, the focus has shifted to deleveraging the government’s balance sheet. By staggering the austerity across sectors in a way that would support overall demand, the US has been able to see unemployment rates decline, growth settle around 2% and overall debt levels fall
5. For this reason, we are bullish on the dollar. The US has dealt with its debt problems in a way that promotes growth. This will attract capital inflows and we expect the euro to head to 1.20 by the end of this year.
Neither Lender, Nor Borrower Be
Even though the
growth and employment numbers look bad for the Euro-area, Germany has escaped the worst thanks to its exports to the rest of the world. Since 1999, Germany’s exports to the rest of the Euro-area doubled, but since 2008, they have fallen by 4%. But the slack has been picked up by exports to Asia, notably China, where exports have doubled. This suggests that Germany continues to have excess savings, which are simply a reflection of its current account surplus. That is, Germany’s produces more than it consumes domestically, so it exports and has excess savings. China then has started to increase its imports from Germany, which means its current account balance is deteriorating. This implies that it is saving less and borrowing more. This reveals another paradox: savers, like Germany, can only operate if there are borrowers (dissavers), like the US (or China). We cannot have a world where all countries are savers/exporters. If one country saves/exports, it necessarily means another borrows/imports.
I mention this because one gets the impression that the German savings/export model is held up as a template for all Euro-area countries to follow, particularly as a way to reduce global borrowing and debt. But all that would happen is that Euroarea net exports go up, while the rest of the world’s net imports match it, which means the rest of the world is now borrowing more. So borrowing doesn’t disappear, it just shifts to another part of the world. And remember, by being a savings country, it also means you are the lending country, since savings equals lending. So exporters, like Germany, are in effect the lenders to the bilateral importers, like China. It is like vendor/customer finance. A debt problem in an importing country would therefore have an impact on an exporting county.
Everyone is connected
When one looks at cross-border bank lending to China, or domestic credit growth, it is clear there has been a surge of borrowing in China to help finance the imports from the rest of the world. The record high levels of investment, and China’s attempt to rebalance away from that to consumption suggests that biggest macro risk in coming years for Germany and others will come from China, rather than from the Euro-area
6. Be Careful What You Wish For
What about Euro integrity. Some say eject the weak countries. But we need to understand the risks associated with that. Take the extreme case of a complete break-up. Then we have to contend with over EUR 10 trillion of cross-border loans between Euro-area banks. On break-up, there would be a dispute as to which currency the loans should be redenominated to. Each country would want their currency to be used. But either way, one bank will lose, and another will gain. Estimating the losses would be extremely difficult especially if one was not sure of the re-denomination currency.
The uncertainty of this would likely lead to the Euro-area financial system seizing up, which would spread globally. Remember, the Euro-area financial system is the largest in the world. In many ways, this would likely lead to crisis similar if not worse than the 2008 financial crisis’
7. Even if only one country was to leave, the possibility of others leaving would now exist. Markets would then start to price worse-case outcomes, which would be extremely destabilising. With that risk, it becomes clear how well the ECB has done in its actions last year. It was able to provide enough of an assurance to the market that the Euro-area will remain intact. This willingness makes us more confident that this year could well see no major Euro-area crisis unlike the last 3 years.
Inflation Trauma
As I am in Germany I have to talk about inflation. Germany seems particularly concerned about ECB actions leading to inflation or even hyperinflation. Why this focus? We need to turn to Freud to help us understand. He modelled the psyche by three constructs, the id, ego and super-ego. The id contains the basic instinctual drives of a person: seeking pleasure and avoiding pain. The ego is the rational faculty that attempts to be more realistic about actions. Finally, the super- ego acts like the conscience; initially influenced by parents, but later by society. The ego tries to mediate between the id and super-ego.
At times though the id dominates, this is particularly the case when there has been a childhood trauma. Applying this to Germany, we find that in Germany’s “youth” it was traumatised by hyperinflation (1923). Since then, it has tried to avoid any sign of inflation no matter how remote. Japan is similar in that it suffered from hyperinflation in 1946. The US, on the other hand, was traumatised by the Great Depression in the 1930s. Ever since, the US has obsessed about growth, and avoiding recessions.
Using the Ego, Not the Id
Now if we were to go back to 2008 and say that over the following years, the ECB would more than double its balance sheet, and Euro-area government debt would increase by 25%, what would the typical German expect to happen to inflation? Many would have expected inflation to surge. Instead, inflation has averaged 1.8%. This is below the ECB’s target, and lower than the average before 2008. Except for the late 1980s and a brief period in the very late 1990s, it is lower than anything the Bundesbank ever achieved for Germany
8. How could that be? The answer is simple, demand is weak. There is no pricing power for corporates or workers. Credit is no longer as readily available as before the 2008 crisis. Consequently, money supply growth has averaged 2% since 2008, while it was 8% before
9. As for historical episodes of high inflation, a surge in oil prices is associated with high inflation, but that surge happened before 2008, not since. History has also shown that hyperinflation has tended to be associated with printing money to pay off large debts
accrued to fund wars. That is not a scenario we think is likely! So there we have it; the reality suggests that inflation risks are more contained than many fear. Japan after more than 20 years in weak growth and deflation has finally overcome its aversion to inflation and is enacting a radical policy of reflation. The yen will be the biggest casualty of its new policy, but Japan also provides the example of a country traumatised by an earlier experience of hyperinflation can implement the wrong policies for a sustained period of time.
Pact With the Devil
What about the long-term outcome for the global economy? Will good times ever return? For that, we have to return to Goethe. Ralph Emerson, the eminent 19th century philosopher and champion of individualism, described six of the greatest men in history in his work “Representative Men”
10 . The six men included Plato (the Philosopher), Shakespeare (the Poet), Napoleon (the Man of the World) and of course Goethe (the Writer)
11. I think Goethe’s play “Faust” could provide the answer to my questions
12. In Part One of the play, Mephistopheles, the devil, makes a bet with God that he can divert God’s favourite subject, Faust, from pursuing the highest truth. Up until this point, Faust has exhausted his studies, pursued magic and even contemplated suicide in his pursuit of truth. Enter Mephistopheles who makes a bargain with Faust that he will do whatever Faust asks of him, but in return Faust will serve him in hell. Faust’ side of the bargain is that if he (Faust) experiences a moment that he wishes to remain in forever, he will die at that instant.
After this bargain, Faust pursues love with the help of Mephistopheles. Faust seduces Gretchen13, but things turn awry as she becomes pregnant and drowns her illegitimate child. She ends up being sentenced to death. In Part Two, Faust and Mephistopheles are in the imperial court. There Mephistopheles persuades the Emperor to introduce paper money to replace gold and enrich the empire. Faust then pursues and marries the beautiful Helen of Troy, only for the death of their son to result in her disappearing.
It’s the Intention In the End
At the end of Part Two, an elderly Faust, who controls land reclaimed from the sea, complains to Mephistopheles that an old couple’s hut is ruining his view. Mephistopheles is ordered to remove them, but kills them instead. Upon hearing this, Faust becomes despondent and is blinded by an angel. He sees within himself that he has will. With that, he wishes to drain the marshes of his land to provide a place for people to be free and happy. With that thought, he is in his moment of bliss and dies.
Mephistopheles thinks he has won his bargain, but angels come down to takes Faust’s soul to heaven. It would appear his deeds were enough to reach eternal truth. Reducing the play to simple terms, it would appear that if the intention is to do good for others, then the reward is heaven. That is even the case if one has made a pact with the devil! So with the US’s intention to reduce unemployment, the Euro-area’s to build a stronger union and China’s to rebalance, the ending should be a happy one, even if the journey is bumpy!
H/T Matthew Boesler
