November 18, 2013
If you want to understand the economic power of Germany, just drive here. You can feel the vibrations of this great superpower on the inside lane of the A1 autobahn from Dusseldorf to Cologne. Unlike motorways in other countries, which can be empty or when full are full of cars, the German motorways are unambiguously part of the industrial infrastructure. They are the manufacturing arteries of the economy and the inside lanes shudder with juggernauts moving goods in and out of this extraordinary trading phenomonen.
The trading success is nothing more than the amalgamation of the excellence of thousands of companies, employing millions of meticulous craftspeople, who through serious application to the business of commerce have made this country what it is.
Sitting in the dark paneled surroundings of the Hofbrauhaus Fruh in the shadow of Cologne cathedral, watching elderly Germans scoff down schnitzel and local red wine, it’s hard to imagine that this generation – Germany’s post-war greatest generation – could have, even in their wildest dreams, conceived of the success they have made of their national enterprise.
A few yards away, up and down the great Rhine, huge barges mirror the inside lane of the autobahn, ferrying manufactured goods up the river and out to the world via Rotterdam a few hundred miles upstream.
Unlike other rivers, this is not a silent place. On the contrary, the Rhine’s background noise is the relentless drum and bass of the barges – tud, tud, tud – all day and all night.
This is the monotonous sound of successful business. This is the repetitive, trance-like sound of businesses doing the same things again and again, brilliantly, day in day out, without drama. This process is what produces the massive current account surplus, that last week the Americans were complaining bitterly about – which is kind of rich given the Americans have just been caught bugging the phone line of Mrs. Merkel!
But the German current account surplus is a problem in the sense that a current account implies by definition that the country is a massive net lender. This means that German money leaves Germans and cascades into other countries looking for a return. In this way, German banks financed Irish banks and the banks of the other periphery countries. That is what a current account surplus means: the surplus country finances the ones in deficit.
The German current account surplus means that there is a surplus of savings in the heart of Europe. This surplus of savings puts downward pressure on both Eurozone interest rates and retail prices.
The excess savings leave Germany looking for a home and that home might be Irish government bonds, which yield more. But it’s not just Irish bonds, the IOUs of all peripheral governments have benefitted from this German surplus. Long-term rates everywhere have fallen. Could this be more a reflection of the excess of German savings than the notion that the economies of Ireland, Italy, Spain, Portugal or Greece have become better credits overnight? With huge debt burdens in all countries and faltering growth everywhere, a betting man would vouch for the former rather than the latter interpretation.
This week, emboldened by the lower interest rates, our government decided to eschew a precautionary insurance fund and go for the “clean” bailout exit. Let’s see how wise this is.
The government cited the much better financial conditions of recent months, suggesting that we are now in much better times. That may be so, although recent financial history indicates that the worse financial decisions are taken in what appear to be the best of times.
The notion of the best of times is simply an assessment of the ebb and flow of investor sentiment at a particular point in time. The financial markets are always prone to wild swings between greed and fear, between excessive optimism and unbridled pessimism.
Normally the best indicator of where we are is the price. High prices bring high risk, by definition. The higher the price, the more people try to get on the bandwagon, because they believe that high prices are a sign of lower risk but in reality the opposite is the case. As prices fall, risk falls too. Conversely, as prices rise, risk rises too.
In economics, pupils are taught that when the price of something rises, the demand should fall. However, in financial markets the opposite is observed: when prices rise, the herd get on the bandwagon driving prices yet higher, before the whole house of cards collapses and we start again at lower prices.
Look at the graph. It explains how bubbles start and how they end and where the value is for the savvy investor. This pattern is observed in all assets from the paintings of Francis Bacon and Andy Warhol, to houses with sea views and to government bonds of countries that are dependent on foreigners buying their IOUs.
The progression is similar in all cycles. Initially the asset is unloved. No one wants to touch it. This is the stealth phase. There are far more sellers than buyers. The assets are going for a song. Then we move into the awareness phase, where prices begin to tick up and institutional investors begin to show interest, committing some capital. Look at the mean price, which is the dotted line and you can see we are beginning to move away from it.
Then we enter the mania phase. This is heralded by media reports swooning over the assets telling us “this time it is different”. Then we get the enthusiasm, the greed phase and we are away.
Irish people know how this story ends. Once asset prices start to fall, not only does the psychology of the investor whiplash but so too does the credit cycle. Credit moves from being abundant to become scarce, cash calls are made and the borrower ends up being squeezed. We’ve all seen this happening.
Now ask yourself what makes you think that Irish government binds are any different to any other asset in terms of this cycle? And where do you think Irish government bonds – an asset whose price has sky-rocketed in recent years on the back of old Germans keeping Euro interest rates close to zero – might be in this age old cycle?
As the barges of the Rhine, laden down with new cars made for export, plough up the great waterway and the productive local Germans take their post lunch stroll on the banks, one wonders if they cop onto what is happening in the Irish bond market again, will that gentle stroll lead to a run?
David McWilliams writes a regular economics column for the renowned German financial magazine “Capital”. They can be seen at http://www.capital.de/