on the hill has always been a sand castle. Two tsunami waves are about to hit. And Germany’s economic exceptionalism will be swept away in 2015.
Everyone agrees that Germany’s strength is tied to its export machine. To understand how Germany did so well 2010-2012 one needs to appreciate that two powerful developments in Asia gave Germany a giant gift over the years immediately after the Great Recession – and that gift is now being taken back. The first and most obvious? China embarked on a frenzied infrastructure and real estate build out, in an effort to insulate itself from the contractionary forces that the Great Recession foist[ed] upon the world. This created a booming market for German capital goods exports. The second, and often overlooked, is the insane appreciation of the Japanese yen. The global financial market collapse engendered a powerful unwind of the so-called carry trade. As yen denominated debts were paid off, the yen rose by an astounding 35% versus the U.S. dollar and the euro!
In combination these two developments created a bonanza for German exporters. A market for their capital goods was booming. And their biggest competitor in that market, Japan, was suffering from a near 35% loss of competitiveness, due exclusively to the swing in their bilateral exchange rate. And as a bonus? Germany’s motor vehicle exports to the U.S. compete mightily with Japan’s car offerings. In the U.S. as well, Germany saw their competitive position leap, as the yen soared versus the euro. In combination, these developments allowed for a storyline of wunderkind German exporting companies, thriving due to home grown virtues.
But the world has radically changed over the past year. More to the point, both of the powerful currents supporting German growth have changed direction and the Tsunami is about to hit. How so? China’s construction boom was meant to be a bridge. A three year commitment, to allow healthy developed world growth to resume, and thereby engender a resumption of growth for China’s export machine. China thought they were building a bridge. As it turns out, they have been building a pier. Investment excesses in China now require a sharp curtailment of growth. German exports to China are bound to fall. In addition, Japan, after suffering brutal economic performance at the hands of a soaring yen, is on a mission to sharply devalue its currency. The yen/euro cross peaked at 1.05, in late 2012. At that level the yen had appreciated by 35% versus the euro. Late 2012 through mid-2013 the yen plunged amid the first round of aggressive bank of Japan QE, erasing the lion’s share of the climb. And over the past few weeks, with the BOJ surprise announcement of a second larger commitment to QE, the yen has resumed its swoon versus the U.S. dollar. And it is threatening to move lower still versus the euro.
Thus Germany now faces a world in which its locomotive, China boom, has been derailed. And its competitive edge has been blunted by a plunge for the yen. It could well be that Germany, in the quarters immediately ahead, will underperform the rest-of-Europe. Spanish and Italian exports to China are quite small. And Italy and Spain do not see Japan as a major competitor for markets.
The End of German Sanctimony?
What might this portend for European policy? Angela Merkel has stood her ground on the value of fiscal austerity. Bundesbank and finance minister proclamations call into the question the legality of a more substantial version of European QE. Belt tightening exhortations warmed the heart of folks in the hinterland – amid good German growth and with the jobless rate at an astoundingly low 5%. How firm will German officialdom sound, if German economic circumstances go south? Perhaps Germany will finally sound more like its southern neighbors, when its economy begins to look similarly distressed.
This week we saw Mario Draghi finally lose the inexplicable timidity he has shown in not instituting a European version of quantitative easing. (For whatever reason my speech recognition software always wants to interpret Draghi as “Druggie” – maybe because he’s getting ready to push €1 trillion into the European blood system?)
I maintained in Code Red that as the yen fell Germany would eventually have to allow the European Central Bank to monetize, or they would see their export economy fall apart. Goldman Sachs now forecasts that the euro will be at $1.15 to the dollar by the end of 2015 and then weaken to parity by the end of 2017. It is at $1.24 today. Back in 2002, when the euro was at $.88, I was forecasting that the euro would rise to $1.50 and then fall all the way back to parity over a decade or more. And while my forecast is not quite as precise as Goldman Sachs’, we are on the same page.
The Chinese central bank cut its interest rates this week in what will be a process of continual cutting, as they have to respond to the fall of the yen. My friend Joan McCullough speculates they would be better off going the route of Mexico in 1994 and simply devaluing their currency, catching everybody off guard and making it too late to exit. Whatever the process, this is going to create massive problems in China, which we have touched on in past letters and which my associate Worth Wray will deal with in depth next week.
The Bank of Korea recently cut its benchmark interest rate and lowered its economic forecast. Central banks all over Asia as well as the rest of the world have got to be having long meetings trying to decide their policy options. While the situation varies from country to country, most have no good choices, and that’s before the unintended consequences kick in. I would really like to be a fly on the wall at the monthly meeting and dinners of the major central bankers in Basel at the Bank for International Settlements. Besides good food and wine, I would expect there would be some low-key fireworks served with the main course.
What we see starting is a cascade of competitive devaluations by central banks all over the world. This is like some old grade-B Japanese movie where Godzilla wreaks havoc. Eventually we’ll have sequels in which Godzilla is portrayed as the good guy and battles all sorts of other monsters from around the world. Cue the Chinese dragons and European bears. King Kong anyone?
Seriously, the Fed Is Doing What?
As cynical as I am, and as much as I read, I manage to find new things that both surprise and disturb me on a regular basis. Joan McCullough sent me a link to a very insightful piece that appeared in theFinancial Times a few weeks ago, which commented on the speech by Federal Reserve Vice Chairman Stanley Fischer at the recent IMF meeting. Ousmène Mandeng writes in an opinion piece entitled “The Fed has built a thorny central bank divide” (emphasis mine):
Top Federal Reserve officials were careful to be seen to be understanding of the plight of lesser central banks during the International Monetary Fund’s meetings in Washington last month.
However, they may have unintentionally made things worse. By confirming their reluctance to assume greater international commitments, they underlined the divide between central banks that have access to the Fed’s dollar swap facility and those that do not – in other words, between those with and without a Fed backstop.
In an environment of record-low government bond yields, an indication of a scarcity of safe and liquid assets, it is likely to make a big difference whether or not a country has access to an unlimited source of dollar liquidity. Fed Vice-Chairman Stanley Fischer focused on the international transmission of monetary policies and the Fed’s responsibility to the global economy. This appears to have been in response to repeated complaints, in particular from emerging markets, that highly accommodative monetary policy has caused a surge of capital inflows to their economies and made them unduly vulnerable to sudden reversals. The Fed acknowledges there may have been adverse spillovers from changes in its policy stance (such as the “taper tantrum”), and that a normalisation of monetary policies may bring further volatility. There is therefore a considerable premium on access to dollar liquidity. Mr. Fischer merely offered that the Fed will “promote a smooth transition by communicating our assessment of the economy and our policy intentions as clearly as possible”. At the same time he stressed that the Fed is not a “global central bank.”
The Fed is effectively a global central bank, but only for some. Recognising the importance of adequate dollar funding beyond its borders, the Fed extended temporary dollar liquidity facilities to 14 central banks during 2008, including to the central banks of Brazil, South Korea, Mexico and Singapore. Those expired in February 2010. In May 2010, amid renewed short-term dollar funding strains, the Fed reauthorised dollar liquidity swap lines with the central banks of Canada, the euro area, Japan, Switzerland and the UK; in October 2013, the Fed converted those into standing arrangements. This suddenly established a segmented dollar liquidity sphere.
Fischer’s remarks echo a similar speech from a few years back by Ben Bernanke, which a number of the world’s emerging-market central banks interpreted as saying, “Kiss off. We have our own problems to worry about.”
(My co-author Jonathan Tepper and I laid out the very scenario that is playing out today in Code Red.In it we predicted that the developing currency war would start with Japan. We had laid out the rationale for that theme four years ago in our book Endgame, but then we were focused on Europe. Both books will help you understand the current environment. Seriously, I make very little when you buy a book on Amazon, but a lot of people think Code Red is a perfect primer for understanding our times. If nothing else, go buy a cup of coffee at Barnes & Noble and read the two chapters on Japan.)
The upshot of Fed policy is that we are likely to see a continued move into the dollar as a safe-haven currency, causing the dollar to strengthen against other emerging-market currencies and creating problems for dollar-denominated debt around the world. Shades of 1998. The demand for dollars at a time when the Federal Reserve is putting fewer dollars into the system (appropriately so) is only going to increase volatility in the currency markets.
But a global currency war is just the most obvious impact of what the major central banks of the world are doing.
Okay class, for those who want a little extra credit, I’m going to give you some extra reading and viewing. Lacy Hunt encouraged me to listen again to our friend Niall Ferguson’s speech entitled “Empires on the Edge of Chaos” (Note: the introduction is 10 minutes long and can be skipped. You know who Niall is. And there is considerable Q&A at the end, so the speech itself is roughly 40 to 45 minutes. But the Q&A has lots of laughs, which makes it worth it.) Or you can read this article by Niall inForeign Affairs, which has much of the same content.
I want to repeat the two quoted paragraphs that opened this letter, along with one more from theForeign Affairs article. (Again, all emphasis mine.)
Great powers and empires are, I would suggest, complex systems, made up of a very large number of interacting components that are asymmetrically organized, which means their construction more resembles a termite hill than an Egyptian pyramid. They operate somewhere between order and disorder – on “the edge of chaos,” in the phrase of the computer scientist Christopher Langton. Such systems can appear to operate quite stably for some time; they seem to be in equilibrium but are, in fact, constantly adapting. But there comes a moment when complex systems “go critical.” A very small trigger can set off a “phase transition” from a benign equilibrium to a crisis – a single grain of sand causes a whole pile to collapse, or a butterfly flaps its wings in the Amazon and brings about a hurricane in southeastern England.
Not long after such crises happen, historians arrive on the scene. They are the scholars who specialize in the study of “fat tail” events – the low-frequency, high-impact moments that inhabit the tails of probability distributions, such as wars, revolutions, financial crashes, and imperial collapses. But historians often misunderstand complexity in decoding these events. They are trained to explain calamity in terms of long-term causes, often dating back decades. This is what Nassim Taleb rightly condemned in The Black Swan as “the narrative fallacy”: the construction of psychologically satisfying stories on the principle of post hoc, ergo propter hoc.
Defeat in the mountains of the Hindu Kush or on the plains of Mesopotamia has long been a harbinger of imperial fall. It is no coincidence that the Soviet Union withdrew from Afghanistan in the annus mirabilis of 1989. What happened 20 years ago, like the events of the distant fifth century, is a reminder that empires do not in fact appear, rise, reign, decline, and fall according to some recurrent and predictable life cycle. It is historians who retrospectively portray the process of imperial dissolution as slow-acting, with multiple overdetermining causes. Rather, empires behave like all complex adaptive systems. They function in apparent equilibrium for some unknowable period. And then, quite abruptly, they collapse.
The single most commented-upon letter that I have written was called “Fingers of Instability.” Longtime readers know it well, and I would suggest new readers take the time. It contains extremely important concepts for understanding why financial markets can advance smoothly for so long, and then all of a sudden there is chaos. The fingers of instability distributed throughout the sand pile of the global economic system end up getting triggered by some event that may in
