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Germany's economic and political generals are fighting the wrong war

By Saul Eslake - posted Thursday, 24 November 2011


The most recent attempt at a comprehensive solution to the European sovereign debt crisis – the package of measures announced on 27th October after a week of summitry – appears, like others before it, to have failed. Secondary market yields on Italian and Spanish government ten-year bonds have risen by around one percentage point since the latest 'deal' was announced. Governments whose financial position had hitherto not been seen as vulnerable – such as France, Austria and Belgium – have seen their ten-year bond yields rise by between one-half and two-thirds of a percentage point. The 'spread' between French and German government ten-year bond yields (a measure of the additional 'risk' that the markets perceive to be associated with lending to France) has widened by almost 90 basis points (hundredths of a percentage point) to around 180 basis points, which is where the spread between Italian and German ten-year bond yields was in June (it's now 500 basis points). And the euro has fallen by more than 4% against the US dollar.

One of the key elements of the 27th October package was a proposal to 'leverage' the European Financial Stability Facility – established last year to provide financial assistance to euro zone governments in financial difficulty, including by buying their bonds – up from €440 billion (A$595 billion) to €1 trillion (A$1.35 trillion), by enticing investments from China and other developing countries. Prima facie, it seems odd for the euro area, whose per capita GDP the IMF estimates at around US$33,600 this year, to be passing a 'begging bowl' around countries with per capita GDPs of one-quarter of that amount, or less. And now that these countries have politely declined Europe's requests, financial markets sense that Europe still hasn't been able to erect a credible 'firewall' around Italy and Spain.

The only European institution which can credibly promise to purchase the bonds of highly-indebted but nonetheless solvent governments in whatever quantity is required to ward of the deepening market panic is the European Central Bank. But Germany, whose willingness or otherwise to shoulder a disproportionate share of the cost of any bail-out of other euro zone member states gives it a de facto veto, is implacably opposed to any suggestion that the European Central Bank use its balance sheet in this way. The European Central Bank itself, located in Frankfurt and deeply imbued with the culture of the German Bundesbank, feels much the same way.

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Germany's implacable opposition to anything that smacks of the 'monetization' of government debt stems from its fear that such measures would inevitably result in higher inflation. That fear is deeply rooted in Germany's historical experience. Twice during the first half of the twentieth century, Germany experienced hyper-inflations that are almost impossible for those who haven't lived through such episodes to understand.

Between 1921 and 1923, the value of bank notes in circulation in Germany rose from 120 billion marks to 400,000,000 trillion. By November 1923, a kilo of butter cost 250 billion marks; a ride on a Berlin tram cost 15 billion. According to one account Cited in Liaquat Ahamad, Lords of Finance, Windmill Books, London, 2010, p. 122., such was the effect of dealing with such astronomical numbers on a regular basis that 'perfectly sensible people would say they were ten billion years old or had forty trillion children'. It was against this background that many German people, their lifetime savings wiped out, began losing their faith in democratic institutions, and that extremists first began to attract broader public support.

As David Marsh records in his 1992 history of the Bundesbank, 'at the height of the inflation, a young man named Adolf Hitler was arrested in Bavaria, two days after he attempted to lead his stormtroopers on a march on Berlin' David Marsh, The Bundesbank: The Bank that Rules Europe, Heineman, London, 1992, p. 100. .

Germany experienced another bout of hyper-inflation – albeit not as serious as the first – in the aftermath of the Second World War, following a more than five-fold increase in the amount of currency in circulation under the Nazis between 1939 and 1945.

Yet despite those terrible experiences, which remain seared in the memory of the German people to this day, it is an egregious mis-reading of history to argue (as Angela Merkel's government does) that large-scale purchases of government bonds by the European Central Bank would inevitably result in something similar.

Those hyper-inflations, and similar episodes in other countries occurred not simply or solely because central banks printed enormous quantities of money: but rather because they did so in order to maintain demand in circumstances where, for very different reasons, the supply side of their economies had been massively eroded.

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In the case of Weimar Germany, the Reichsbank began printing money in order to pay the reparations imposed by the Treaty of Versailles. And those money-printing operations were dramatically stepped up after January 1923 when, after Germany failed to deliver one hundred thousand telegraph poles to France, forty thousand French and Belgian troops invaded and occupied the Ruhr Valley, Germany's industrial heartland, dramatically curtailing Germany's export income (and hence its capacity to earn the foreign exchange needed to pay reparations to France).

The post-WWII inflation resulted not simply from the Nazis' inflationary financing of its war machine, but also from the destruction of Germany's physical infrastructure under Allied bombing and the loss of so much of its human capital.

Similarly, the hyper-inflation experienced in Nationalist China under Chiang Kai-Shek in the 1930s and 1940s resulted from his Finance Minister's TV Soong's recourse to central bank financing in circumstances where the most productive parts of China's economy were increasingly captured by Imperial Japan. The hyper-inflations experienced throughout Eastern Europe in the late 1980s and in the nations which emerged from the ashes of the former Soviet Union and Yugoslavia in the early 1990s were the combined result of central bank money-printing and the collapse of the centrally-controlled 'supply side' of these economies. The hyper-inflation experienced more recently in Robert Mugabe's Zimbabwe resulted from his government's printing of huge amounts of currency to pay for the continued activities of his government while simultaneously destroying the productive capacity of Zimbabwe's agricultural sector by handing it over to his cronies.

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This article was first published in The Age and the online version of the Sydney Morning Herald.



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About the Author

Saul Eslake worked as an economist in the Australian financial markets for 25 years, including as Chief Economist at McIntosh Securities (a stockbroking firm) in the late 1980s, Chief Economist (International) at National Mutual Funds Management in the early 1990s, and as Chief Economist at the Australia & New Zealand Banking Group (ANZ) from 1995 to 2009. Since leaving ANZ in August 2009 Saul has had a part-time role as Director of the Productivity Growth Program at the Grattan Institute, a non-aligned policy ‘think tank’ affiliated with Melbourne University, and more recently also as an Advisor in PricewaterhouseCoopers’ economics practice. The views expressed are his own.

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