Monday, 28 March 2011

A Japanese reactor meltdown will not undermine the euro

Regional elections in Germany gave negative results for Chancellor Merkel’s Christian Democrat Union. The disaster at the Fukushima nuclear power plant has apparently given the Green party a boost, and so much so that all other parties also lost ground. In the financial press, Merkel’s weakening domestic stance is likely to be used in attempts to discredit the new European Stability Mechanism.

The arguments will be something like: Merkel is losing support. Younger generations of Germans are unlikely to accept the sacrifices imposed by the German financing of the bail-out of Southern Europe. Merkel will be less firm in her support and will try to impose further draconian measures on the countries in need of a bailout. If she does not have her will, Germany may simply withdraw from the euro. 

Given the German-bashing that in particular the London-based financial press thrives on, there is nothing new in that view. However, there are two things that need to be said in return. On 12 March 2010, German Finance Minister Schäuble published an article in Financial Times laying out the principles that Germany wanted to form the basis for any new agreements.

German policy towards the Euro crisis has been in line with Schäuble's statements. Nonetheless, there has been a lot of talk that Germany has in fact only saved her own banks and that Southern Europe/Ireland are “sacrificed” in order to avert significant losses in German banks.

Yes, German banks have certainly been exactly as greedy and silly as any other banks. And yes, there may well be an important element of self-help in the German bankrolling of the ESM.

But let us not forget that Greece had falsified public accounts to fool the world while the government tax collection was in shambles. Ireland let herself go in an orgy of cheap credit while using corporate tax rates as a means of stealing jobs from other EU-countries. Portugal studiously avoided economic reform and it it shows now, as the rest of the world is on the mend.

Still, the German policy is built on the rather healthy observation that you cannot have a monetary union unless there is some kind of cohesion in the economic policy.

As Germany is again pressured into taking out the check book, of course concessions are being forced upon the most profligate EU members in order to secure the long-term viability of the Euro project.

The far more important point is that Germany will not leave the Euro, irrespective of local election results. Membership of the Euro is one of the geopolitical imperatives Germany must live with, as it is the guarantee against ever again having to fight a two-front war. Following the defeat in 1945, clear-headed thinkers across Europe understood that in order to make Germany change her ways, it was necessary to change the strategic position, whereby Germany was facing Russia on one side and France/UK on the other side.

By tying Germany into the EU, the most important military enemy, France, was turned into an ally. When the Berlin wall fell, French President Mitterrand managed to convince (maybe even bluff) then-Chancellor Kohl that a currency union was the best way of anchoring Germany in Western Europe, now that the big enemy in the east was retreating.

Germany has not at any point – irrespective of whether the foreign minister came from CDU, SPD, FDP, or indeed the Green Party – questioned Germany’s Euro membership. No matter whether this week-end’s skirmishes will eventually undermine Chancellor Merkel, whoever succeeds her as German Chancellor must accept the geopolitical situation and embrace the EU solution of having a single currency.

However expensive it is to support the Euro’s continued existence, the alternative to doing so would be a major transformation in Germany’s geostrategic situation. It would require a complete political about-face and would mean that Germany again had to ready herself for a two-front war, as the demise of the EU would follow. Given the price of this alternative, Germany will remain a firm supporter of the Euro. But will of course not be willing to be taken for granted to pay for the foibles of everybody else.

Friday, 18 March 2011

Three weeks into the market correction, dynamics may be changing

The guessing game has been on for some days now: Will the Japanese disaster be positive or negative for the world economy. Personally, I believe that initially it will be negative and then turn positive as the efforts to rebuild gathers steam. But it really is anybody’s guess, and to be cynical about it, it does not really matter. At least not for the financial markets. So while my thoughts go to all those who have lost lives and property in the disaster, the markets are more interested in the global policy reactions.

In that respect it looks fine. Japan finally joined the club of countries embarking on “Quantitative Easing”, also known as monetising public sector deficits. G7 and others are intervening in order to drive down the JPY, which adds strength to the monetary initiatives already taken. It all looks good and the markets have taken their cue from the developments. Stock markets will profit in the short term.

Over the past five-six months the stock markets have been supported by the fact that global economic data have surprised on the upside, indicating that the world economy is doing a good deal better than expected around the middle of last year.

This will not continue. Markets do not really react to good or bad news. Markets react to surprisingly good or bad news. Markets react to change rather than predictability.

Despite decades of economic research on the formation of economic expectations, most economists and stock market analysts display “adaptive expectations”: if they are surprised positively, they revise forecast upwards. If they are surprised negatively, they revise downwards.

So now that we have all been surprised positively for some months, you can be absolutely sure that forecasts are now being adjusted upwards. At some point in time they will have caught up with reality. From that point on, they will begin to have negative surprises. A new revision cycle will begin and the market mood will again turn.

On 22 February I wrote that the market had a set up for a correction. Not because of overvaluation or what not, but simply too many had become complacent about risk. I thought the unrest in North Africa and the Middle East would be the trigger. In the end it was a combination of that and the Japanese disaster that caused the markets to run for cover. The policy reaction around Japan has already taken some of the uncertainty way. I am not sure that it is enough to put an end to the current market correction.

Wednesday, 2 March 2011

More on the New Inflation

In a recent article in New York Times, Christina Rohmer, former chairwoman of the Council of Economic Advisors to President Obama, describes a debate that limits Fed’s ability to act decisively to support economic growth. It is between “empiricists”, i.e. those who want to see solid evidence of inflationary pressures before they begin to rein in the monetary policy, and the “theorists”, who claim that one has to step on the brake in rational expectation of future inflationary pressures.

It is Rohmer’s claim that the schism between these two approaches effectively paralyses Fed at a point in time when it needed to do more to stimulate the US economy. She lays out the most important channels through which low interest rates stimulate the economy. Courteously, she remains silent on the theories that would be used to explain to explain the emergence of inflation when a large excess capacity is available.

Rohmer should know what she is talking about. A scholar renowned for her studies of the Great Depression in the 30’s, her contention is that by keeping the interest rates low, the interest sensitive sectors of the economy will eventually pick up. Manufacturing (cars!), construction etc. will all be strengthened as a result of lower interest rates. Just like it happened in the 30’es.

By making it clear that deflation will be fought at almost any cost, real interest rates are reduced. Since the difference between present nominal interest rates and expected inflation is reduced. That reduces the perceived financing cost and stimulates investment.

Given the recent data from the US housing market, there is no doubt that Christina Rohmer has a strong point. House prices are still falling, and sales of repossessed property are a significant part of the overall turnover in the market.

At the same time, there are no signs of inflationary pressures. And yet we see that across the world, central bankers are now beginning to worry about inflation creeping upwards. As I wrote in my blog earlier, it has to do with your definition of inflation. As long as one only considers “core inflation”, I share Christian Rohmer’s view.

But there is a little snag. In the 30’s the financial markets were not as developed and integrated as now. Financial institutions could not freely invest abroad. Commodities markets were largely reserved for those who needed the physical product. I need not describe how that has all changed. Just note that banks and other financial institutions are now major players in the commodities markets.

We know that the QE programs have given the banks access to tons of liquidity that they have not passed on the consumers. It seems fair to assume that the money instead has remained within the financial sector, invested in stocks, bonds, and commodities worldwide. Given that the commodities markets are the smallest by volume there is every reason to assume that the combination of monetary policies and the freeze in the normal credit markets has led to significant asset reflation. Even Ben Bernanke has stated this publicly. And of course it has also been a contributing factor that the Asian economies have recovered nicely from the downturn.

US monetary policy has contributed in a significant way to the headline inflation through the price increases in food and energy, the two “volatile elements” of inflation.

It has already given Rohmer’s “theorists” more reasons to be aggressive about reining in the monetary policy prematurely. Same situation in Europe where Axel Weber’s withdrawal from the race to become ECB’s next chairman has left the situation wide open. Prospective candidates are now jockeying for position by improving their hawkish profile, well knowing how tough talking on inflation could garner support from Germany.

So the situation is that the spill-over into the commodities markets from the US monetary policy is now leading central bankers everywhere to indicate that monetary tightening should be just around the corner. That would not be the right thing to do just yet.