I came across this article written by Michael Collins, Investment Commentator at Fidelity and I thought that it would be good to share this with our followers.
I thank Michael’s for his contribution:
Germany’s abhorrence of inflation is easy to explain. The Weimar Republic (1919 to 1933) hosted hyperinflation between 1921 and 1923 when authorities printed money to overcome the disruption caused by political instability and war reparations. Savings evaporated as prices rose 130 times over in 1922 before the papiermark became valueless in 1923.
Inflation wrecked savings again around the end of World War II. While inflation’s scourge was first suppressed by rationing and price controls, its devastation was wrought when the Reichsmark was exchanged for the Deutsche mark at a rate of 10 to one in 1948. Over the past decade, inflation fears were revived when, after joining the euro at too high a rate in 1999, Germany undertook austerity-like reforms to become more competitive and wages and public benefits stagnated. As these inflation fears were stirring in today’s Germans (even though inflation only peaked at 3% in 2007), they were footing the cost of reunification. Deutsche Bank calculates that by the middle of this decade the merging of West and East Germany since 1990 will have cost the equivalent of Germany’s annual GDP
This history explains Berlin’s stances during the eurozone crisis against inflation and its reluctance to salvage another economy, even if past rescues have, in effect, bailed out German banks while shifting risks to eurozone taxpayers.
Citing the moral hazard of saving cheating Greece and other troubled eurozone members, the centre-right government of Chancellor Angela Merkel has pushed the self-defeating policy of austerity over the past two years. She is undeterred, even though this policy has caused record eurozone unemployment (11%), heavier government debt burdens and steeper economic slumps. Her tough approach led to the eurozone fiscal compact that makes Keynesian stimulus illegal.
Germany’s other stances during the crisis are more about what it opposes. Berlin is resisting financial-stability powers for the European Central Bank, such as an ability to meet bond payments. It is against more cheap liquidity from the ECB, which gave banks one trillion euros (A$1.3 trillion) via three-year repos around New Year. Berlin rejects eurobonds or similar collective efforts to underwrite eurozone sovereign debt, which would boost yields for German businesses and mean that Germany would help foot the bill for any default. It has baulked at a banking union, which would involve a recapitalisation fund and deposit guarantees. It cringes at higher inflation in Germany of, say, 4% to 6% that would help erode the real debt burdens of its neighbours.
Oh that upheaval!
What’s Berlin in favour of apart from budget discipline? It calls for “future-oriented” investment such as infrastructure spending, supply-side reforms such as flexible labour markets, greater business access to capital, privatisation programs and freer intra-Europe trade. Merkel is in favour of “more Europe” with moves “step by step” towards a fiscal and political union of eurozone countries.3 And Berlin is prepared to do “everything necessary” to keep Greece in the euro.4
The contradiction within this last intention is that it implies a joint approach to tackling Europe’s woes while Germany’s stance is shattering such unity. The other inconsistency about Germany’s position is that its policymakers have failed to learn fully from their own history; namely, how policies similar to theirs today crushed Germany in the 1930s.
In 1930, Heinrich Brüning began his two-year rule as chancellor of a centre-right coalition, at a time when Germany’s shrivelling economy was battling capital flight and war reparations. Brüning’s strategy for a shrinking economy, rising unemployment and deflation of 7% was to balance a budget in structural deficit. He slashed official salaries by up to 20% and raised income taxes, among other steps, and when revenue fell he lopped spending even more.5
The result was the German’s economy collapsed. Industrial production plunged 40% by 1932 from four years earlier, unemployment soared to about one-third of the workforce and Brüning won the nickname “the hunger chancellor” to encapsulate the misery in society.6The political centre evaporated – as it has in Greece now – and the rise of far-right and far-left parties heralded the end of the Weimar Republic and the ascension to power of Adolf Hitler in 1933.
What could prompt Germany to learn fully from its history and ditch its austerity push and take grand steps to solve the eurozone crisis? Lots of things, of course, including pressure from other governments concerned about the social costs of austerity to political calculations by Berlin at what the collapse of Greece will mean for Europe. And there’s the cost that Target-2 will inflict on Germany.
Involuntary lending
Target-2 is the loose acronym for the Trans-European Automated Real-time Gross Settlement Express Transfer system. In plainer speak, it stands for the eurozone’s interbank system – how a commercial bank in one eurozone country pays a bank from another. The “2” is because the system was expanded in 2007 to capture small transactions that until then were cleared through private systems.
The issues with Target-2 arise because a country’s balance of payments must, well, balance. This means that the current and capital accounts must add up to zero. (These accounts are the widest measures of a country’s trade and capital flows.) Countries with current-account deficits must attract capital to offset this gap, and vice versa. There were no Target issues before the US sub-prime crisis erupted in 2007 because private capital flowed from Germany to southern Europe as Germany enjoyed current-account surpluses while its neighbours had current-account deficits.
But since 2007 private capital no longer funds the current-account deficits of southern Europe – in fact, private capital has gushed back to Germany. It has unwittingly fallen on national central banks within the eurozone to ensure balances of payments balance. They are doing this via pseudo euro transfers, which are a routine part of central banking. In the absence of private capital flows, these transfers create liabilities to the Eurosystem for current-account debtors and claims for those running current-account surpluses – namely Germany.7 The Eurosystem comprises the ECB plus national central banks in the eurozone.
In essence, when, say, Spain or Greece import goods from Germany, national central banks manipulate the money supply in their jurisdictions to facilitate the payment and adjust their balance sheets to show a liability for the importing country and a claim for Germany. As well as showing up on national central-bank balance sheets, the Target transactions appear on countries’ balances of payments. But nothing shows up on the ECB’s books because these payments net out to nothing for the whole system. That’s why they went unnoticed for so long after 2007.
Trapped
Thanks to Germany’s export prowess, the Bundesbank’s claims on the Eurosystem have exploded from five billion euros in 2006 to well in excess of 850 billion euros now, more than 30% of Germany’s GDP. They could easily, according to some forecasts, exceed one trillion euros by year end. Interestingly, bank runs in Greece, Spain and other troubled economies that sent money to Germany boost Germany’s Target claims in a similar way to that of its exports. The Netherlands has some Target claims, too, while Greece, Ireland, Italy, Portugal and Spain have sizeable Target liabilities.
Hans-Werner Sinn, the president of Munich’s Ifo Institute think tank who first warned about the Target menace, claims that since 2008 these transfers have financed the current-account deficits of Portugal and Greece, a quarter of Spain’s gap and all of Ireland’s shortfall plus its capital flight.8 Sinn is among the most important players in the eurozone debt crisis you’ve never heard of as he first used the Target issue to push austerity and block eurobonds.
The functioning of the Eurosystem depends on each country meeting its obligations and is underpinned by the collateral held by central banks. But there is no system whereby national central banks hand over tangible assets to redeem debts as occurs between the 12 regional Federal Reserve Banks in the US over similar liabilities. The lack of such a system led to the collapse of the Bretton Woods fixed-exchange-rate system that governed international finance from 1944 to 1971 though creditor nations could redeem claims for gold. Even if the Eurosystem brought in such a system, central banks from struggling eurozone countries lack the marketable assets to give the Bundesbank anyway. So Germany is poised to pile up no end of these intangible credits.
The crunch for Germany is what happens to these claims in case of default. If a eurozone government goes bust, the ECB would have to write off a defaulting country’s Target liabilities and the cost would be shared among the eurozone’s central banks in proportion to their ownership of capital in the ECB. For Germany, that’s 28%, though this share would marginally increase as the defaulting country’s central bank wouldn’t pay. Thus a Greek default could be managed. But a collapse of the euro would wipe out Germany’s claims because there are no laws determining how they would be paid if the eurozone splintered. “This may be the largest threat keeping Germany within the eurozone and prompting it to accept generous rescue operations,” Sinn said in a co-authored paper.
What he’s saying is that Germany stands to lose so much from foregone Target claims alone if the eurozone shatters that it might as well spend the money needed to save the euro. On top of the wealth that would vanish with lost Target claims, the money Berlin has given to the European Financial Stability Fund and placed in IMF rescue packages would be at risk. Then add on the political and financial costs of an economic seizure if the euro were to collapse. The only downside to Germany’s conundrum is that if the eurozone is to crack up, the sooner the better for Germany because those Target claims climb every day. While events may overtake authorities, it’s easier to believe that German policymakers will act to keep the euro in its most extended form as possible rather than opt to put their country and the rest of Europe through Weimar Republic-like economic torment.
The Three Wise men 