May 7, 2012
Let’s talk about Germany. What does Germany want? Why is it important? How does what the Germans want affect us?
This week, we have an American flavour to the column because I am writing this from southern California, where I have just had the pleasure of listening to probably the most important player in the global bond market, Mohamed El-Erian, the chief executive of Pimco, the world’s largest bond fund.
When this guy speaks and shares his view of the world, we should listen, not only because he is one of the most influential people in the market but because, unlike many financial market superstars, he is thoughtful, analytical and sensitive.
Equally significant is the fact that he is also addressing a group of investors who will have an impact on how the world reacts to political news from Europe and, to a small extent, from us in the months ahead. (The details are at https://hedge-fund-conference.com/2012/invitation.aspx.) Before we think they are worried about Ireland, they are not. However, they are concerned about Germany and the euro and what happens next.
If you believe that we even have a small amount of leverage over German decisions, it is important to figure out what the Germans want. When we say the “Germans”, we are not talking about the average man on the street in Munich, but the German establishment and the power behind the political throne, the industrial interests of Germany.
Germany doesn’t want a United States of Europe; it wants a Federal Republic of Europe, based on the model of the Federal Republic of Germany.
Constitutionally, it doesn’t want an American-style republic, but something much more like Germany. It also wants this with the minimum of fuss.
The reasons are simple. It wants to do with banks what it couldn’t – historically – do with tanks. It wants a Europe that looks and feels democratic, but in which Germany really rules the roost and makes the final decision in all the big calls. This it will achieve by financial dominance.
It wants the euro to stay intact for internal European and external global reasons. First, the EU is Germany’s biggest export market. It is therefore in its economic interests to keep the single currency going in order not to disrupt trade. Secondly, Germany has been the main beneficiary of the euro because the euro is a much weaker currency than the Deutschmark would be. This means that the euro gives Germany, as the world’s biggest exporter per head of population, a huge competitive advantage against the US and China. It is not unreasonable to suggest that if the Deutschmark were around today, it would be worth two dollars, as opposed to the $1.31 that the euro is worth today.
Again, the reasons the Deutschmark would appreciate rapidly against the dollar are simple. Unlike the US, Germany is a country with no debt problems, no budget deficit, no competitive problems, no current account deficit and no political gridlock issues. From the German standpoint, it is getting a free competitive lunch with the euro, and it doesn’t fancy losing that.
So what do the Germans want? They want a federal Europe with a weakish euro and no political or financial shocks coming from some of its unruly peripheral neighbours.
What is the obstacle to attaining this?
Well, Germany is like the good, house-proud neighbour in a bad area. The rest of peripheral Europe are the bad neighbours. France is the neighbour that copies the German lead, trying to match the Germans in terms of their hanging baskets and their freshly-swept drive. If you’ve ever had a neighbour who copies your home improvements, you know how annoying this can be. But at least this neighbour doesn’t bring down the tone of the area.
Unlike Germany’s lawn, which is pristine, peripheral European neighbours live in houses that have plywood on broken windows, and their lawns are full of weeds, overgrown and tatty. The paint is peeling off the neighbours’ porches and the slates have not been fixed. Unlike some of the neighbours, the German house is the picture of order, symmetry and solidity. But the problem for the Germans is that the value of their house is more dependent on the state of the rest of the houses on the estate than on the quality of their own manicured hedge.
As the estate worsens and becomes more and more anti-social, hoodies-up, menacing-the-old-people, the value of German’s property plummets. So the Germans have a massive personal interest in cleaning up the neighbourhood. They will pay to have the other houses tarted up, to get the delinquent kids off the street and for the neighbours generally to act a bit more like them.
In the past, the Germans could at least enlist the support of the French in their efforts to clean up the area. But now, even the French are threatening to go rogue. The Germans fear that it is only a matter of time before the French put an old Renault up on blocks and leave it on the driveway.
So the Germans need to sort the estate out if they want to continue living there. But they know too that they can’t move. They are stuck. How much are they prepared to pay? Well, obviously, the less the better for them. If they can clean up the estate cheaply, they will do so. But if they have to fork out a bit more, they will do that too.
What they know is that they can’t isolate the bad houses with a wall, because that just attracts attention to the problem and potential buyers will always worry about what is happening on the other side and whether the delinquents will jump over and rob them in the night.
They also know that just policing the area with security guards and rules will just make the situation worse because even if the delinquent neighbours promise to clean up their properties, they won’t stick to the promise.
So the Germans are trying to change the rules of the management committee of the estate, but they need to do this voluntarily. They can’t just call a meeting of the residents and upbraid some of the delinquents in public. They have to do it so it appears on the outside that the area has had a change of heart and is now going to clean up its act.
Here’s where the leverage is. If the neighbours tell the Germans where to go, the price of their house may fall but it has already fallen hugely, so they don’t care. Or at least they don’t care as much as the Germans, who have devoted so much time and effort to the house. If the neighbours prove difficult, will the Germans pay a gardener to do their lawns and a painter to refurbish the exteriors? Yes, if they think it will achieve their goal of cleaning up the street.
But how will the Germans know the intentions of their neighbours or the price their neighbours demand for compliant behaviour? Well, they won’t know unless we tell them. Otherwise, they are only guessing and it is in their interest to offer the lowest price to clean up the street. Obviously, it is in their neighbours’ interest to drive that price up because the management agreement is about to be changed permanently.
By the way, the head of the largest bond fund in the world largely agrees with this way of looking at things.