The German dilemma

Within the Eurozone, Germany is coming under increasing pressure to approve and adopt policies designed to stimulate the Eurozone economy. This is because (i) Germany is the largest economy in the Eurozone, (ii) since the global financial crisis, Germany has enjoyed the strongest performance within the Eurozone based mainly on exports, which has led to a very substantial trade surplus, (iii) German public finances are in a very healthy state compared with most in the Eurozone and (iv) they are rich and have the policy flexibility to act.

Many in the rest of Europe are calling on the German government to launch a large debt-financed fiscal boost through public investment spending, creating, it is hoped, jobs and demand throughout the Eurozone. The Germans are resisting this strongly because they have worked very hard in recent years to get their government finances back onto a solid footing, and are expected to get close to a balanced budget in 2014. German politicians are stoutly resisting European calls for them to spend more and move back into deficit.

It is though in monetary policy where the greater controversy is being generated. Through his public utterances over the last six months, Mario Draghi has sought, to maintain market confidence by positioning the ECB as about to introduce a US- or UK-style QE programme in its efforts to boost demand and inflation. However the actual policy steps agreed at ECB meetings have not lived up his words – QE is always just a few months away. It is clear that, behind the scenes, the Bundesbank and several ECB members are fiercely opposed to such a policy, with many in Germany believing it to be illegal. They are angry at the way that Draghi has sought to bounce them into such a policy by his public statements.

To many in Europe (and indeed the world), the Germans are the bad guys, doggedly blocking any moves to boost the moribund Eurozone economy due to their particular economic ideological fixations around sound government finances, conservative monetary policy and a strong currency. Being so out of step with their Western allies is not a position in which post-war German governments have wished to find themselves, and in any other field than economic policy, they would have made adjustments to their position and found a compromise.

It should however be recalled that Germany never asked for the single currency, and when it became inevitable, did their best to restrict membership only to those economies that were happy to embrace German economic orthodoxies, for precisely the reasons that are now being played out within the Eurozone.

In 1990, Mitterand’s price for accepting the re-unification of Germany was monetary union. In permitting Germany to become a much larger, and thus more powerful nation, he sought to maintain France’s significance by sharing the all-powerful Deutschemark. Kohl accepted this provided that all those involved in monetary union were prepared to manage their economies according to German orthodoxy. Thus the ECB’s mandate was constructed along very similar lines to that of the Bundesbank – very independent of politicians, with a mandate of low inflation delivered through conservative monetary policy. Similarly, the Maastricht Treaty constrained the size of government deficits and public debt that individual countries would be permitted. With these in place, the only economic solution for countries finding themselves in economic difficulties is for export-led growth, with the private sector becoming more competitive in global markets through cost control, innovation and structural reform. There would be no room for short-tem fixes generated by lower interest rates, weaker currencies and debt-financed government spending.

The criteria for membership of the euro were deliberately designed to exclude what are now known as the peripheral economies. Only the “core” European economies were expected to qualify, who understood and were prepared to accept German economic thinking. However everyone wanted to qualify and through a combination of the long economic boom of the 1990s and some very creative accounting, the euro began life both with many more members than Germany had ever intended, and with much weaker (though disguised) public finances than Germany would have countenanced.

Since 2008, the Germans have continued to espouse the policies that they believe were written into the monetary union. Thus they expect countries to embrace public sector austerity to reduce budget deficits and bring their giddy debt levels back under control, they expect their Central Bank to adhere to policies of sound money by control of money supply growth and they have a particular fear of Central Banks who buy government debt with newly-printed money. This is the economic and monetary union Germany insisted on, signed up to and has always believed that others had agreed to.

To date they have not relented on these principles, but it is leading to great pain and bad will across Europe, where the peripheral economies which previously resorted to policies of devaluation and government spending to boost their economies in times of trouble, cannot understand why these should not be adopted now. Germany now faces its greatest dilemma – whether to abandon the economic principles which have been the foundation of its economic success since 1945 and remain on good terms with the rest of Europe, or, remain true to its economic ideals and be the cause of the break-up of the monetary union as weaker economies are forced to leave.

In 2012, Angela Merkel opted to bail out Greece rather than risk the break-up of the euro, though by all accounts the decision was close and arrived at only after months of consideration. When the ECB finally votes to adopt QE (almost certainly sometime in early 2015), there will be vigorous opposition within Germany including legal challenges. Once again Mrs Merkel’s leadership will be key in determining the future for Germany and for Europe.

Review of financial markets performance – 2012

As 2012 comes to an end, a review of the performance of financial markets indicates that it has been (at the time of writing) a relatively good year for returns.  The major equity indices have managed very acceptable gains – the UK 6.5%, the US 12.5%, Europe 13.5%, Japan 10%, Hong Kong 22%.  Asian equity markets, except for China, once again delivered the best returns for global investors.  Government bond yields have moved lower adding some capital gains to the ever-lower income yields, while corporate and peripheral Eurozone government bonds made more substantial gains as credit risk perceptions declined and equity markets rose.

Somewhat surprisingly sterling has been the strongest of the world’s major currencies, gaining 2% against the Euro, 4% against the dollar and 13% against the yen.  With the very substantial proportion of UK stock market earnings generated overseas, this currency strength probably accounts for the slightly weaker performance of the UK market in 2012.  The best performing currency was however gold which is 7.5% higher in dollars, and 3.5% higher in sterling.

And yet, throughout the year, economic growth in Europe, Japan and China has consistently been disappointing with Europe and Japan slipping back into double-dip recessions.  Forecasts of company profits globally are about 6% lower than the levels expected at the start of the year, and European profits much worse than this.  Once again this year demonstrated that correctly forecasting economic growth or company earnings can be of little value in determining movements in asset prices.

The most significant factor in this year’s good returns is that last December there was a great deal of fear in markets that the problems in the periphery would be too much for Europe’s politicians to be able to deal with.  Stock markets thus began this year a little depressed, but rallied quickly in the first quarter after the announcement of two Long Term Repurchase Operations (“LTRO”) by Mario Draghi.  These provided about E1bn of liquidity for 3 years at 1%, which was mostly taken up by banks in the periphery, who were able to use this liquidity to buy their own governments’ bonds at much higher yields.  This generated profits for them and much-needed demand for their governments’ bonds.

After this strong first quarter, markets then gave back the gains in the second quarter as the impact of the extra LTRO liquidity faded and the global economic data started to fall short of expectations.  The Greek election (just) managed to deliver a coalition majority in favour of the bailout and austerity programme agreed with the EU and the IMF.  However the economic and fiscal situation in Spain was deteriorating rapidly over the summer, once again calling into question the survival of the euro.

In late July, Mr Draghi announced his willingness to buy up the bonds of the weaker countries in potentially unlimited amounts, and “to do whatever it takes” to ensure the survival of the euro.  This was openly opposed by the Bundesbank but once markets understood that Mrs Merkel was supporting Draghi, equity markets and the peripheral government bond markets rallied strongly to the end of the year.  Then, in September, Ben Bernanke announced a policy of monthly Quantitative Easing to be continued, initially indefinitely, or following December’s Federal Reserve meeting, until there has been sufficient recovery for the rate of unemployment to fall below 6.5%.

Since the late summer, it has been the policy actions of the ECB and the Federal Reserve that drove the markets higher, even as the economic news across Europe, the US, Japan and China continued to disappoint.

Thus the fear in financial markets, and consequent low prices, at the beginning of 2012, has given rise to the healthy returns from many investments over the year.  The transition from that fear to the more current sense of complacency, together with the poorer performance of the global economy and corporate profits, means that markets begin 2013 at more expensive levels, leaving less scope for gains next year.

Eurocalm before the Eurostorm

That the Eurozone ends 2012 in an apparently stable condition is mainly down to the work of two people. The first is Mario Draghi with his promise of potentially unlimited intervention in sovereign bond markets.  The second is Angela Merkel’s with her summer policy decision that forcing Greece from the Eurozone would be more damaging than keeping it in.

Mrs Merkel over-ruled the Bundesbank on both of these issues, and her steady approach to crisis management leaves her as one of the most popular European leaders within her own party and country.  She has now clearly grasped that, for the Eurozone to survive in the long term, it is necessary to have a much deeper integration of Eurozone countries, which extends ultimately to national government finances, common banking supervision and control, and joint liability for debt. In short banking, fiscal and political union is required to complete the economic and monetary union.  These are not particularly popular positions to adopt, either with the German people or with the other European nations, but they are the logical steps required to ensure the long term existence of the single currency.

She understands that for this to happen, Germany will have to dip into its pockets and provide substantial assistance to the poorer countries in the transition. However, she has not been as explicit with the German people that the financial costs of such policies to them will be very great.  The German people are not in favour of lending more money in bailouts to their Southern neighbours, and they are not in favour of accepting losses on previous bailout monies already granted.  Next autumn there is a Federal election in Germany in which Mrs Merkel would like to be re-elected as Chancellor.  So ideally, from her perspective, there would not be any more Eurozone bailouts before the German elections.

The recent agreement on the next tranche of Greek aid was farcical.  Everyone (Greece, the IMF, the EU and the ECB) is pretending that Greece is not insolvent, merely illiquid and that (based on optimistic assumptions) all will be well a decade from now.  Significantly, Germany has agreed that should Greece be doing well by 2015 in delivering on its budget deficit targets, then they would be prepared to forgive some of their debt.  The truth is that if Greece does not achieve its targets the Germans will be forced to forgive the debt because it cannot be repaid.  The point though is that any debt forgiveness happens after the German elections, when European priorities may once again be more important than domestic German ones..

Southern Europe is now very close to the limits of its tolerance for austerity. The Greek, Spanish and Portugese governments have all told their people that they are on the last round of austerity measures.  With youth unemployment close to 50% in these countries, anti-euro, anti-austerity political ideas are beginning to gain ground.  German leaders still consistently state that austerity in these economies will be necessary if further bailout funds are to be provided, and this rhetoric will not be watered down ahead of the elections.

The other major Eurozone election due by April 2013 is in Italy.  Mr Berlusconi’s withdrawal of support for the technocratic Monti government and his announcement that he will fight the elections on an anti-austerity, anti-German platform are not helpful for the euro. However, it is the honest debate to be having.

The Eurozone begins 2013 in recession, and fiscal policy is being tightened further, except in Germany.  A weak European economy will mean larger budget deficits than planned, and more pressure from the southern economies for bailouts.  This will produce more demands for austerity from the northern economies, with the rapidly fading ability to deliver either.

The stability of current financial markets in the Eurozone will not survive very long into 2013 without a dramatic improvement in economic growth, which is very hard to envisage.  Ultimately, the only solution for the weaker economies is inflation. This can come about either through leaving the single currency or through overturning the Germanic culture, which controls Eurozone economic policy. The former is the more likely solution, and the investment conclusion is to remain very wary of all euro-denominated investments until a more sustainable monetary system is in place in Europe.

 

The single currency – making Germany more European or Europe more German?

Following the fall of the Berlin Wall when Kohl wanted to press ahead with the reunification of Germany, the price of Mitterand’s acceptance of this was to demand that Germany share the power of its currency with the rest of Europe (or more particularly France) in a monetary union. Germany agreed provided that the guardian of the currency, the ECB, was made in the image of the Bundesbank, with its rigorous implementation of policies to control inflation. Both were happy because Mitterand believed he was making Germany more European, Kohl believed he was making Europe more German and the Bundesbank believed that it had the right to criticise and have a special influence over the policies of the ECB.

Until last year, the ECB did indeed operate in much the same way as the Bundesbank would have done, tending to be quick to raise interest rates and rather slow to cut them. After a Dutchman and a Frenchman, it was to have been a German, Axel Weber, who was expected to take over the ECB Presidency. However, he resigned following the introduction of the ECB policy of limited buying of the bonds of troubled peripheral governments, which in retrospect was a fairly minor breach of Bundesbank monetary orthodoxy. The man selected to take over the Presidency was Mario Draghi, an Italian and a former investment banker.

By the time Draghi took over as President in November, Europe was in deep crisis, and the ability of the politicians to respond with bailout money funded by the other governments was almost nil. If the Euro were to survive it would require extraordinary monetary policy measures. Draghi understood this and introduced two Long Term Repurchase Operations, lending unlimited money to any Eurozone bank at 1% for 3 years. Much of this was used by the Spanish and Italian banks to buy their own government bonds trading at much higher yields. For the Bundesbank this was pretty close to the direct funding of government deficits, which is illegal – they were unhappy but did not oppose it.

The crisis has worsened during this year and Spain has become close to joining the ranks of those on the bailout list. Doing so would use up most the capacity of the bailout funds (which were designed to be so big that they would never need to be used). Over the summer, Draghi has come out with a new bond-buying plan for which he has garnered substantial support. Under the plan, if the politicians agree to a sovereign bail-out with conditions, and use some of the bail-out funds set up for the purpose, then the ECB will buy bonds of those countries to maintain their deficit financing costs at a reasonable level, in potentially unlimited amounts.

Rather neatly, everyone, except the Bundesbank is happy with this. The German politicians can claim that any bail-out requires German approval and will be subject to strict conditions, thus making Europeans more German, whilst the rest of Europe sees the ECB being publicly prepared to print large quantities of money to support the weaker European economies even though this creates the risk of inflation in Germany, making Germany more European! The Bundesbank reject it because the ECB is now no longer operating in the Bundesbank’s image.

The history of the crisis in Europe is that at each step Germany talks tough and finally gives in and pays up to keep the Euro alive. It has reached the end of contributing to bail-out funds with taxpayer funds and future bail-outs need the money to be printed by the ECB. Draghi’s plan allows this to happen, once the politicians agree to a bail-out. Despite their talk, German politicians always do seem to agree to them, and so, ineluctably, the Germans are giving up on the sound money orthodoxy, which has served them so well over the last 50 years. It is the Germans who are becoming more European rather than the Europeans becoming more German.

The implication for markets is that the pattern of markets is set to continue on a loop: creating crises in the bond markets of weaker countries, followed by those counties requesting assistance from Germany and Germany demanding more austerity from them before acquiescing, leading to a rally in markets before the cycle starts again. Draghi’s plan is a good solution for today but doesn’t solve the fundamental problems. However, if German politicians continue to become more European, the clearest market implication is to sell German government bonds, because Germany will either take on the debts of the rest of Europe in some way or the money printed by the ECB will create inflation in Germany.

Mario Draghi – boiling the German frog!

The anecdotal boiling frog story holds that if you throw a frog into a pot of boiling water it will immediately jump out, but if you place it in a pot of cold water and slowly boil the water, it will not perceive the danger and will be cooked to death. The recent announcement by Mario Draghi, the President of the ECB, of how the ECB believes it can bring the Eurozone crisis under control, smacks of these tactics.

By the end of July, as many of Europe’s leaders had set off for their holidays, Spanish bond yields hit critical levels, which if maintained would shortly leave Spain unable to raise money in the financial markets and requiring a full-scale bailout from the other governments. Spain is however too big for the other Eurozone countries to bail out without considerable help from the ECB in the form of printing money.

Mr Draghi has carefully constructed a plan of action that garners just enough political support to be workable. First, a country must ask for assistance from its fellow Eurozone governments, which must be approved (thus achieving full political buy-in) unanimously. They and the ECB will then set out the conditions for such assistance (achieving the strict conditionality criterion demanded in particular by Germany) and the ECB will then be free to buy short and medium-dated debt in any amount in the secondary market.  That should, in theory bring down yields and enable the country to continue to fund itself in markets. Draghi has promised that he would also deal with the issue of ECB priority in the repayment of debt which bedevilled the Greek bailouts.

As an idea this has the support of the “moderates” within the Eurozone, essentially most of the political leaders and Central Bankers with the sole exception of the Bundesbank, which firmly opposes any Central Bank buying of government debt. The Bundesbank though is a greatly weakened institution today. On the ECB it has only vote out of 17, and only has influence to the extent that the German government agrees. In this case, both Merkel and Schaeuble have come out in favour of the Draghi plan – the Bundesbank is therefore rather isolated. Draghi has successfully driven a wedge between the Bundesbank and the German government

The realpolitik logic of such a plan however is where the boiling frog appears. Once one starts buying up the debt of credit-challenged countries, one begins to incur a large cost should it cease. Since the ECB can create money at will, the cost to it of buying more debt (if conditions do not improve) is zero, but the cost of stopping buying more debt will be considerable if the country defaults on the debt already owned. The German politicians may choose to believe that by imposing conditionality on a country before the ECB starts buying its debt, they are not creating an inflationary problem, but they are the frog being placed into tepid water. Every successive purchase of debt will be the equivalent, in the eyes of the Bundesbank, of raising the water temperature another notch.  

Europe continues to march ever closer to a denouement to its crisis, but the ultimate choice to be made is still the same. Germany has to decide very soon between the lesser of two very large evils.  Should it maintain its foreign policy objective to be a good European and keep the euro together, it will have to accept massive money printing to bail out the sovereign debts of the other countries, and suffer the consequent inflation. Alternatively, should it maintain its key economic policy objective of a sound currency with tight control of the money supply, it will have to accept the break-up of the euro and possibly of Europe as other countries find themselves politically unable to cope with the resultant economic depression..

 

The Super Mario Brothers – changing European politics

Last November saw the two Marios, Draghi and Monti, take on key positions within the Eurozone; Mario Draghi as President of the ECB succeeding Jean-Claude Trichet and Mario Monti succeeding the Silvio Berlusconi as Prime Minister of Italy. Both were appointed rather than being democratically elected but importantly both are hugely experienced within European politics and highly regarded and trusted by their peers. Both have moved fast to create change in their respective areas and together can be seen to be challenging the old power balance within the eurozone away from a Franco-German dominated politics towards a more truly European version.

November was also the period of greatest intensity in the sovereign debt crisis, when Italian 10 year government bond yields exceeded 7%, threatening a global banking and financial markets disaster. Mr Draghi acted decisively in December, cutting the ECB’s key interest rate and then announcing a new policy of Long Term Repurchase Operations, offering unlimited liquidity to Eurozone banks for a 3 year period at only 1%. This new policy has turned out to a marvellous euro-fudge. To German-minded Central Bankers a LTRO is not equivalent to the Anglo-Saxon policy of Quantitative Easing (aka printing money) that they loathe so vehemently, but is a liquidity-management tool which Central Bankers would be expected to deploy at times of crisis. The liquidity is merely lent to the banking system on the basis of collateral, it is not the creation or printing of new money. However (a) the scale of the operation, being unlimited, (b) the long time period involved, prior to this the ECB had never offered such facilities for longer than 1 year and then only in the darkest days of the 2008-09 crisis, and (c) the 1% rate, a zero premium to the official rate and thus creating no stigma for a weak bank being forced to pay higher rates for emergency liquidity, all meant that the short-term effects of this policy are remarkably similar to those of a policy of Quantitative Easing. The financial markets have certainly responded in such a fashion as the dangers of a eurozone banking crisis have receded.

Mr. Monti was effectively installed by Merkel and Sarkozy after they forced the departure of Berlusconi. Despite having enormous wealth and a population and an economy equivalent in size to France, the lack of growth in the Italian economy and its enormous level of national debt meant that it was seen as the weakest of the large European economies. Monti earned his stripes as the EU Competition Commissioner, taking on and defeating both Microsoft and Hewlett Packard in well-publicised battles over their monopoly powers. He has surprised many with the speed and ambition of the fiscal and economic changes he has forced through the Italian parliament, taking on many of the protected special interest groups which benefit from rigidities in the regulatory system. He is clearly aiming at delivering the significant structural reform to the Italian economy which is so badly needed and which Berlusconi failed to deliver.

Having gained credibility with his actions within Italy, Monti has used the fact that Merkel likes and listens to him to argue with Germany about its single-minded focus on austerity as the only tool to restoring the European economy. In recent weeks the tone of German thoughts on the European economy has changed towards the need for greater pro-growth policies. Italy now has a seat at the top table when these matters are discussed.

Sarkozy and France appear to be the losers in this power shift. Sarkozy was very quick to ensure that he maintained a French presence at the top of the IMF by getting Christine Lagarde to replace Dominique Strauss-Khan, but that has cost him a key voice within Europe, where she was well regarded but it has not really helped in terms of getting the IMF to be pro-Europe. It is noticeable how much quieter Sarkozy has been since Monti’s arrival at the top table. This may reflect his domestic political weakness – he faces re-election in May and with current polls suggesting he is set to lose, he has been forced to ask Merkel to campaign for him in France. The Franco-German axis in Europe which has dominated European politics for the last few years is breaking down as Germany is now the clear leader and then below are a newly-weakened France and a newly-strengthened Italy. A greater Southern Europe perspective is just beginning to have an effect on the way in which Europe is now being run.