16th December 2011: Is Germany Maneuvering For A European Depression?

Red Pill / Blue Pill Conundrum For Policy-makers

Quote of the Day:

This is your last chance, after this there is no turning back.

• You take the blue pill, the story ends, you wake up in your bed and believe whatever you want to believe.
• You take the red pill, you stay in Wonderland and I show you how deep the rabbit hole goes.

Remember… all I’m offering is the truth… nothing more.

Morpheus – visionary leader in the film The Matrix

Macro Overview

Presenting A Backdrop To The Motion 

• I like this devil’s advocate game, let’s put forward a motion we are ambivalent about and then try and argue its case:

• Is Germany positioning itself for a European deflationary depression?

• Firstly, let’s make one thing clear, I have no definitive opinion on this, it is not a statement – it is just a question. But let’s take a step back and examine the backdrop to this. For years and years I had been writing about the then impending Western debt bubble, indeed, I started writing about it long before the bubble actually burst. Of course, we know what happened and, since then, much of this bad consumer debt has settled on the balance sheets of the financial sector and much of this debt as been subsequently transferred to sovereign balances. Debt is not magicked away – it can only be shuffled around until it is either paid or defaulted upon.
• More recently, in January 2008 (before the crisis hit) I wrote that the only real option for Bernanke and that was what I called “Hair of The Dog Monetary Policy” – to force feed us more of the very same poison which had made us sick in the first place. Inflation was the “lesser of two every evil, evils”, I wrote. He’d have to cut rates and ease monetary policy so drastically to keep the credit lines open and then to try to inflate his way out of the problem. Using a variety of ingenious methods (aka Quantitative Easing), that’s basically what he did.
• In any normal environment this would be extremely risky, if not foolhardy, monetary strategy – never mind social consequences of letting the inflationary predator off the leash, what about the moral hazard? So why was I so convinced that Bernanke would fly his helicopter  right in the face of moral hazard and print like a mad man? There are many reasons to be honest: the relative politicization of the Fed and its lack of “Monetary Dominance”, the unknown quantity of the Zero bound of interest rates (the Fed has the tools to fight inflation but not deflation). But the most fundamental reason is not always the easiest to explain – it arises from the cultural consequences of restructuring (defaulting on) this mountain of debt which was crippling the economy.
• Debt doesn’t go away, the debtor must either pay or default – it’s that simple. To cut a long story short, just like Japan in the 1980’s, Western societies had racked up too much debt. Unlike Japan, where much of the initial debt leverage emanated from the corporate sector (and then the banking and public debt), The West, after the Enron disaster, had raised corporate balance sheets to much higher standards under the Sarbanes-Oxley act of 2002. So corporations were actually in good shape (thank goodness for Enron), heading into the crisis. Instead a debt bubble in The West originated on consumer balance sheets. With direct encouragement from central bankers (the original sinners – see my comment: Greenspan prostituted economic HIV), consumer debt in Anglo-American economies was exploding to a size that would dwarf even the Japanese debt bubble of the 1980’s.

Racing Cars and Fiscal Policy

• I remember a track day with in a two-seater Formula Jaguar (see photo above – a truly terrifying car!) where I would repeatedly spin off-track on the chicane. The instructor (in the other seat) told me I had two options: either brake harder and slow right down or (his way) put your foot on the gas and get enough speed so that the down-force from the aerodynamics stick you harder to the tarmac. On the next lap, he took the controls and showed me his way … I don’t remember much but I remember I closed my eyes and screamed like a little girl. But, to my amazement, not only did we stay on the track we cut a massive chunk out of my personal best lap time.
• When debt rises in an uncontrolled manner, there is an political inflexion point, an economic chicane, if you like, which it must be dealt with. Status quo is simply not an option – otherwise we’d continue to spin off track. But there is a “choice” for policy makers, and my opinion is that this choice is determined more by cultural aspects of a society than by the apparent logic of economic mathematics. Indeed this cultural divergence is part of the reason why a, fiscally harmonized, EU is such an ambitious project. Let’s look at the two options at the economic chicane (excuse my over-simplification):

1. Option 1 is to simply stop spending when we approach the economic chicane, cut the debts, slash the deficits and take the pain up front. In motor racing terms, this is the “braking option” – in terms of economic “acceleration” it’s a U-turn in policy velocity – towards deceleration. Philosophically it’s bluntly Darwinian, constructive destruction, some would argue: the strong will survive, the weak will die, then we move on. This solution tends to be favored by a school of economists who think the best way for debt to be “worked out” is primarily through clean, hard default – not by relying on the flawed models of monetarists. This tends to induce, initially, a deflationary outcome as capital is sucked from the system violently. This school of economics is actually a Germanic cultural trait – in fact the school originated from the old Austrian Empire – the “Austrian School of Economics”.
2. Option 2 is to spend more to increase growth and let growth and inflation work its magic on the economy by implicitly reducing the relative value of the debt by increasing the value of everything else (aka “soft default”). This, like my instructor, is the “foot on the gas” option to attacking the chicane and this solution tends to be favoured by Modern Monetary Theorists and Keynesians. This tends to induce, initially, an inflationary outcome as capital is typically forcefully infected into the system and, as Keynes himself said; “inflation is always and everywhere a monetary phenomenon”.  While the Austrian school emanated from “core Europe” (popularized by French, German and Austrian economists), John Maynard Keynes was very much an Anglo Saxon and his political approach to economic management is the framework for much of the Anglo-American (whether Democrat or Republican) economic model and thus monetary response to the crisis.

• Am I reading too much into the origins of these two schools of thought? Perhaps … but I really do think that history and cultural issues play a strong part in understanding why different societies are more comfortable enduring one option over the other when they hit the economic chicane of debt-led insolvency.
• How does all this play into Europe’s debt crisis? Is Germany really positioning itself for a European deflationary depression?
• This is an absurd, if not alien concept to many – who on Earth would want deflation in this environment? Well that’s an interesting question which we’ll try to answer. It’s not an easy question as I think the answers lie in the cultural and historical aspects of each society – as “The Union” that is the new, incredibly culturally diverse, 26-member cast of Europe, is finding this out the hard way.
• Well… lets continue…

Cultural Attitudes To Debt Play A Huge Role In Differentiating Between Remedial Policies 

• Right, so when debt levels reach a certain point there is a pretty horrific economic inflexion point – it’s a bit of a “red pill / blue bill moment” that the lead character, Neo, faced in the movie “the Matrix”.
• In terms of fiscal options, I likened it to a chicane on a race track where the driver either has the option of braking and slowing right down or accelerating and hoping the aerodynamics of the car keep him on the road. Kyle Bass puts it slightly differently, he uses the “fork in the road” concept – hey, pick your favourite analogy. But listen carefully to what Bass says in this video after about 5min 30 seconds [emphasis mine].

So this is a belief commonly held by most central bankers and academians who, as you know, unfortunately run many of these countries. They believe that when you get to this proverbial “fork in the road” (and this fork in the road means that there are two options that you believe that you have: one is default and one of them is inflation… and you believe that these options are mutually exclusive of one another).

When you sail into the zone of insolvency, when your debts get to become many multiples of your revenue. This is something we spend a lot of our time thinking about. When you attempt to inflate yourself out of this problem and your debts are already more than 5, 6, 7 times your revenue, you put yourself into this position where inflation causes the default.

So, in many of these nations, inflation is not an option (and I know your show isn’t long enough) but when you talk about the ECB monetizing all of these debts I think that doesn’t change any of the spending, number one. And what you’ve seen coming out of the Bundesbank and many places in Germany is: that doesn’t change the behaviour of the participants whatsoever – in fact it might encourage their continuing behaviour of the profligacy that’s riddled throughout Southern Europe.

I believe the ECB knows one thing: they have to print money. Whether it’s the ECB or the 17 various central banks at the periphery… they don’t have the money to recap their banks.

So your question should be: do they print before they default or after they default (or both) … and in my opinion they have to just print afterwards, because the number they are going to have to print is so large and that they know this going in…

• I know I’ve commented on this video before, you have to watch it – I have watched the second part many times and Kyle Bass’s comments are just intellectual gold dust, in my opinion. It was this interview and a couple of others (which I will show you below) which initially sparked my train of thought on the subject of Germany and the inflation vs deflation pill-choice.
• Let’s look at a couple of other poignant comments which were made in the last few days. The first comes from legendary hedge fund manager, Michael Platt – it speaks to the simple arithmetic of the European sovereign debt crisis. In his view, an inflexion point is coming and, as Kyle Bass inferred, there is actually very little authorities can do to prevent it, they can only prepare for the for the type of carnage they wish to endure first. Listen up…

• Platt manages one of the biggest hedge funds in the World ($30 billion) and he doesn’t hold any punches. Diving in with both feet he says:

We sort of distill it down to one essential fact that we continue to focus on at BlueCrest Capital Management. That is that, if you look at the debt of, say, Italy, with a debt of 120% of GDP which is increasing at a real rate of 5% (where they have to fund these days) and you look at the GDP, which is now is forecast declining at 0.5% of GDP… arithmetically their debt is going to blow up.

Absolutely it’s about the cultural and political divide. The reality is, there is no willingness within the Eurozone to share wealth. In the United States, money flows between different areas: if California is having a very difficult time the rest of the States will transfer money to California. This is not the case in Europe; there is no willingness to transfer money across the boundaries in a long term and sustainable way.

• Lastly I’d like to introduce you to one more interview which continued along the same thought trail this week, it’s a Bloomberg interview with Niall Ferguson, here. And this is the quote I was particularly intrigues by:

The problem here is in Berlin, it’s not a European problem it’s a German problem and the fact of the matter is, the Germans remain more worried about 1923 (i.e. inflation) than about 1931 (i.e. depression) – which is remarkable when you consider what the consequences were for Germany.

• You see where I’m going with this don’t you, dear reader? There is a subtle, common theme in all these comments which, I feel, is worth expanding on. Bass, Platt and Ferguson all agree that there is a huge economic inflexion point coming (or, indeed is happening as we speak) and that there is very little policy-makers can do, but make the preparations in ways they feel are most protective to their (highly divergent) societies. The choices they make are largely dependent on cultural issues – Platt remarked directly on this – but Ferguson and Kyle also implied this by drawing attention to the “choice” between invoking inflation (first) or deflation (first).

Red Pill Deflation Or Blue Pill Inflation? That Is Question

• To those (e.g. Americans) brought up in a society built almost exclusively upon Modern Monetary Theory, where ubiquitous and extremely “efficient” credit extension is responsible for much higher levels of consumer debt, it is obvious what needs to be done at this inflexion point: INFLATE FIRST, ASK QUESTIONS LATER! Indeed, perhaps Bernanke’s most famous speech was: Deflation Making Sure “It” Doesn’t Happen Here.
• Indeed, while Japan has tried to inflate its way out of deflation, it’s quite telling that they were not nearly as pre-emptive or aggressive at the beginning of the deflationary slump. Many (Western Economists) believe this to be a blatant mistake, a “school-boy error” of Monetary Policy. Perhaps it was… or perhaps, collectively Japanese society actually objectively “chose” deflation first and then later tried to inflate their way out of the deflationary debt spiral. Some would say this was a complete disaster, but I’d offer a little more respect for what I believe was actually a cultural choice. It is worth noting that while the economic numbers look horrific to an Anglo-American, Japanese society did not disintegrate into chaos, Japanese unemployment barely rose above 5%, Japanese standards of living and life expectancies continued to rise during this “lost decade”. Deflation did not wreck Japanese society, it only certified it. Could you imagine such a response from American society, faced with a generation of recession and deflation? I think not. This is very much a cultural issue.
• There are many reasons why Anglo-Americans were always going to chose to inflate their way out of this crisis.
• First, there is a financial argument for this. Due to the massive levels of debt from a (so-called) efficient and extremely loose financial policy, deflation would almost certainly plunge Anglo-American economies straight into deep recession and probably depression. Remember the gargantuan levels of consumer debt in Modern Monetary Theorist economies – the principal value of these debts grow in real terms if inflation is negative. So deflation only exacerbates high levels of this massive mountain of consumer debt – that’s a disaster.
• Secondly, a political argument. Because debt is largely held at the consumer level, politicians will always do what is in the interests of the consumer (i.e. their electorate) if they wish to remain in power. Moral hazard plays second fiddle to ensuring that voter debt-burden is softened and votes are protected.
• Thirdly, a cultural argument. Democratically diverse and heterogeneous societies with extremely open and liberal media and civil rights culture, like American and the UK are, by design, less stable. In fact, some would say the instability in a political sense, ensures greater long term stability, as societal flaws are exposed very quickly ensuring a faster politically-led evolution. This notion sounds a little flimsy because it is, it’s a psychological equilibrium based heavily on confidence. In a deflationary downturn, confidence evaporates and, the inherent exposed instabilities, which are normally encouraged and embraced by these societies,  turn on the economy and obliterate business sentiment, crippling the country into a depression.
• But Germany is not an Anglo-American society with a Anglo-American values and an Anglo-American economic model. As I’ve written about before (see my comment: Why The Germans Understandably Hate Inflation) and as Ferguson alluded to in his quote above, the Germans appear to be more petrified of inflation than they are of deflation. Yet for Americans and Brits (who dominate the financial media, let’s face it) to opposite is true.
• In many respects Germany is very much more like Japan than it is like America. In fact the cultural similarities between two very different countries are quite striking: socialist democracies, with a general consumer propensity to save rather than borrow, changes the political dynamic considerably and sets the tone for their societal traits. Also relatively cohesive, homogeneous societies with wealth uniformity (a huge middle class) and a ultimate respect and pride for, what I will call, “personal honour, structure and discipline” plays a significant part in their cultural identity. It is no surprise that they both possess the two best education systems in the G7 for Science and Maths and consequently home to the two most sophisticated manufacturing, engineering and export industries.
• In this cultural dynamic, deflation is not the monster it is portrayed as in the Anglo-American media. To start with, it is politically less destabilizing in a society which embraces a culture of consumer saving over consumer credit. Indeed the personal wealth of a, saving-rich, populous increases with deflation and, in a more culturally cohesive society with more uniform wealth distribution (both have by far the lowest GINI coefficient of the G7), the prospect of societal disintegration is more applicable to inflation than deflation. Also note that, there is a structural industrial cushion for nations whose economy is absolutely dominated by sophisticated manufacturing exports as wage deflation provides a significant boost to domestic industry via reduction of labour cost on a relative basis.

What Choice Does This Leave Germany With Today?

• The bottom line is, if you ask an American or a Brit what the single worst economic period was for their country in the last 100 years, almost unilaterally, the response would be: The (Deflationary) Great Depression of the 1930’s. If you ask a German I’m not sure you get the same answer. I think a German would say: The Hyperinflation of the 1920’s. That’s the psychological difference between Britain and Germany, between David Cameron and “Merkozy”, between the BoE and the ECB, between the US and Japan. Of course, I’m simplifying everything greatly (and I apologize for this) and the economic idiosyncrasies are very different, but their economic positioning and their collective divergent abilities to endure different economic hardships are almost entirely cultural.
• Where does this leave us today? Well, it’s not entirely obvious that Germany wants to do everything its power to avoid a Deflationary Depression (that’s an understatement) – this has come to the distress of many highly vocal American and British pundits who think that Germany and the ECB are, quite simply, idiotic not to print the heck out of the Euro. That’s a culturally and politically naïve simplification, I think.
• So let’s look at the historic facts: the last time Germany tried to aggressively inflate its way out of a debt trap, disastrous Hyper-inflation ensued, soon followed by a huge Deflationary Depression anyway (oh yeah… and don’t forget the most far-reaching World War in the history of mankind). That’s not a great benchmark. The current facts are that Germany has made it clear that:
• The ECB will have a German design – its mandate will be to control inflation and inflation only.
• There will be absolutely no participation on the part of the ECB to print money or directly monetize.
• It is no secret that the Germans have long been making significant preparations for Euro-wide defaults.
• Kyle Bass may be right. The choice is less a case of simply, “do you want inflation or deflation” but rather:

1. do you want inflation first (and then run the risk of trying to deal with a potential deflationary reaction to default later), or,
2. do want deflation and default up front (and then try to inflate and grow out of this, potentially chronic, depression later)?
• The answer in the UK and the US is, without hesitation: “#1 please” – it’s just how we deal wit this, it’s part of our culture. I know this is a controversial thing to say, but, given both the actions and rhetoric I am observing from Germany, given the cultural and historic backdrop of Central Europe… I’m not sure they would give the same answer.. and, to be honest, in their cultural and historical context, I’m not sure they are wrong to do so. After all, from a cultural perspective, who are we to tell the Germans what is best for their country?

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