WHY WE SHOULD WORRY THAT MRS MERKEL DOES NOT UNDERSTAND GERMANY’S ECONOMIC HISTORY

Normally my blogs take the form of commentary on what I have been up to and where I have been going in my global quest for value on behalf of investors in the funds we manage at CIM and Santa Lucia.  

Of course the analytic and portfolio management process is not just a function of what we find on the road.  It is an aggregation of many inputs including reading reports on companies and putting all the research, desktop and field, into context.  The contextual part of the process requires us to  detour into a certain amount of economic and political commentary hence providing the pleasure of reading a lot of well written and carefully thought out work from some of the most intelligent people on the planet.  We sieve through that and hopefully synthesize those elements that are most relevant.  I am sure we miss a lot of gems but there is a fair amount of dross to discard on the way and triage is important.  My law degree is probably the most useful part of my education as 99% of the stuff that appears in legal judgements is irrelevant.  The greatest skill is to identify the 1% that matters.  It is a skill that fewer and fewer judges seem to possess with unfortunate consequences as is regularly evidenced by the stupidity of judgements coming out of courts such as the European Court of Human rights, and sadly elsewhere as the rule of law deteriorates in too many countries.

This is a preamble to a blog that will consist primarily of an extract written by the brilliant Michael Pettis, a Beijing based economist who was asked to review a book called The Leaderless Economy by Peter Temin and David Vines.  Pettis has a truly global understanding of the interrelationship of trade flows and capital flows around the world.  I think the insight that follows is supremely important because it explains to a large extent why Europe is in such a mess.  Regardless of the appalling behaviour of some Greeks particularly the political elite including multiple frauds, constant and deep corruption, and dysfunctional institutions that inflict great damage on their own country as well as on others, the sad fact is it is Germany’s failure to behave properly that is at the heart of the problems facing Europe right now and indeed to some extent it is German policy that is adversely affecting the world economy at large.  Over to Mr Pettis.

“If China runs a capital account deficit and the US a capital account surplus, and these are roughly equal to net purchases by the PBoC and other Chinese government entities of US government bonds and US assets, China will run a current account surplus exactly equal to its capital account deficit.  The US will run a current account deficit exactly equal to its capital account surplus.

This may show up in the form of corresponding bilateral trade surpluses and deficits between the two countries, but it is not necessary, and in fact extremely unlikely, that it would. While we cannot say just from looking at the numbers whether low US savings relative to investment forced the Chinese into saving more than they invest, or whether high Chinese savings relative to investment forced the Americans into saving less than they invest, but the savings rate in one of the countries was determined in large part by distortions in the other.

The main point is that if you want to understand the causal relationship between Chinese surpluses and US deficits, or between German surpluses before 2009 and peripheral European deficits, you have to look at the direction of net capital flows, and not at bilateral trade. I will return to this, but to get back to The Leaderless Economy, this book is underpinned by the same deep familiarity with financial history that Peter Temin brings to all his work, and perhaps this is why the book should leave everyone terribly frustrated on two counts. First, the authors show that while the 2007-08 global crisis and its aftermath were unquestionably large and complex affairs, there was nothing about the crisis that was unprecedented – we have experienced similar events before – and we understand far more about what might or might not have worked than subsequent policymaking might suggest.

The authors show for example that anyone who had a reasonable understanding of the current and capital account pressures of the 1920s whose inconsistencies doomed Germany should have been able to understand why downward pressure on German wage growth, in the several years before the global crisis was set off in 2007 by the US subprime crisis, would ultimately force huge internal imbalances onto Europe during that time. More importantly, this understanding should have been enough to convince European policymakers that unless Germany responded to the crisis by reflating domestic demand sufficiently to generate large current account deficits, it would be all but impossible to prevent a decade of anemic growth and extraordinarily high unemployment in peripheral Europe.

It’s not that Germany in the 1920s was anything like Germany in the 2000s, or even that Germany suffered in the 1920s from the kinds of pressures it forced onto peripheral Europe in the 2000s (although this is closer to the truth). The problem was that Germany in the 1920s was required to export large amounts of capital, because of extremely high reparations demands, while its ability to run current account surpluses was constrained by European post-war policies.

No country can run a capital account deficit unless it runs a current account surplus, and these enormous countervailing pressures forced Germany, among other things, into an unsustainable borrowing path. Similarly since 2008-09 peripheral Europe has been under pressure to run capital account deficits (it must repay substantial borrowings and fund flight capital, but it has trouble borrowing without implicit ECB guarantees). Its ability to run countervailing current account surpluses, however, is constrained within Europe by Berlin’s refusal to allow a reflation of domestic demand and it is constrained outside Europe by Germany’s enormous current account surplus, which prevents a currency adjustment. This forces peripheral Europe into both rising debt and high unemployment, and it is only because Europe as a whole has forced the problem of weak German demand onto the rest of the world that conditions in Europe are not even worse.”     

Unhappy together, Happier apart?  Where is Fiona Shackleton when you need her?

In summary unless Germany changes its ways the present EU structure and the Euro in particular are at risk.  Meanwhile what Greece does or does not do is almost irrelevant.  Anything they do, even a default, will not solve the critical contradiction at the heart of Europe.  The peripheral countries cannot consume enough, and Germany will not.  The peripheral countries cannot afford to pay for what they do consume while Germany can but chooses not to consume what it can afford.  Over to you Mrs Merkel.