Global Strategy. Alternative view France Japan

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1 18 November 2011 Global Strategy Alternative view Popular Delusions Exorcising von Havensteins ghost Dylan Grice (44) Angela Merkel recently told Greece to make its mind up. But Germany should do the same. What s more important: its hard money principles, or the euro? My guess is we ll see a compromise on principle. And if we don t, I think we ll see a coup inside the ECB. Depending on the magnitude of the market riot which causes either of these events, we might go maximum bullish. In the meantime, valuations are selectively attractive. So we re still minimum bullish. A widely accepted truth is that the horrors of the Third Reich were caused by the 1923 hyperinflation. Indeed, it is a part of modern Germanys founding myth. But while Hitlers first attempted power grab occurred in Bavaria at the peak of the hyperinflation the November 1923 Beerhall Putch by the late 1920s the Nazis were little more than one of the larger fringe groups whose best days were judged to be behind it. But as the world economy collapsed in the early 1930s the gold standard broke up. Successive countries chose to devalue their currencies and inflate their way out of painful deleveraging (chart below). Germany was the exception. Haunted by von Havensteins ghost, it fatefully chose to bear instead the brunt of gold standard deflation, experiencing a depression arguably greater even than Americas. It was then that something broke in Germanys collective psyche. With resurgent Nazi support, Hitler won power in 1933, his rise facilitated not only by the 1923 inflation, but by the subsequent fear of inflation. The following charts tell the story. The first shows how the gold standard broke up during the Great Depression. The UK was first to devalue, quickly followed by Japan. FDR devalued the dollar in Global Strategy Team Albert Edwards (44) albert.edwards@sgcib.com Dylan Grice (44) dylan.grice@sgcib.com Break-up of the gold standard: traumatised by the hyperinflation, Germany kept parity despite being in depression (gold parities, 1929=100) US UK Germany 20 France Japan Societe Generale (SG) does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that SG may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE APPENDIX AT THE END OF THIS REPORT FOR THE ANALYST(S) CERTIFICATION(S), IMPORTANT DISCLOSURES AND DISCLAIMERS AND THE STATUS OF NON-US RESEARCH ANALYSTS Macro Commodities Forex Rates Equity Credit Derivatives

2 These exchange rate devaluations and the domestic reflation they enabled were instrumental in Japan and Britain avoiding deep depressions. But the US and Germany, who hung on for longer, suffered depressions of catastrophic magnitude. Those who clung on longest suffered the deepest depression (industrial output, 1929=100) Germany France UK Japan US As the front page chart shows, of the main countries entering the Great Depression on the gold standard only Germany and France maintained their parities. For France, this was easier. In 1928, it had re-pegged to gold at an artificially cheap rate. As other countries left the gold standard the franc went from being very undervalued to merely less undervalued. For Germany the situation was very different. The trauma of the hyperinflation presided over by then-reichsbank-president Rudolf von Havenstein remained painfully vivid in the collective memory. Having been through so much to achieve currency stability in the 1920s, policymakers were loath to entertain any action which might weaken it. Now, strictly speaking, Germany did actually leave the gold standard in in that it imposed capital controls, thus eliminating the free international flow of gold. But as can be seen in the chart, it kept the value of the mark pegged in gold terms. And more importantly it kept its gold standard mentality. The dictates of high interest rates and economic deflation were strenuously adhered to. German and US unemployment rates compared (% unemployment rate, 12 mcma) Stabilisation US repatriation of capital from Germany after 1929 crash exchange rate appreciation as other countries leave gold standard 25 Hyperinflation 20 US % unemployed German % unemployed 0 Its important to understand just how devastating the 1920s and 1930s had been for Germany. The US great depression is usually held up as the most distressing economic catastrophe of the 20 th century. But the above chart shows that by the time America was in the depths of its 2 18 November 2011

3 depression, the Germans were going through what was arguably their fourth in a decade. If we use the unemployment rates to gauge the despair, three of Germanys four peak rates were higher than the worst of what was seen in US in the 1930s. The depression broke something in the German people. Even after the horrors of hyperinflation, which peaked in 1923, and the subsequent currency stabilisation of 1924, which caused a deep depression in 1925, the Nazis were barely on the electoral radar (see chart below). But, by the time Germanys late 1920s depression was in full swing, the situation had changed. (As the chart shows, the depression began sooner in Germany than in America. This was because the US, as Germanys main creditor and most important financier of its reconstruction, began to repatriate funds back to the US in the late 1920s, first to earn better returns in the then booming US economy, then to cover the losses caused when the boom turned to bust). German unemployment and the Nazi vote 35 % Nazi Vote (rhs) 30 % unemployment And here enters a wistful historical counterfactual: how different might history have been if the Germans had inflated their economy when the crisis broke? If Germany had inflated (unemployment rates, =100) UK leaves gold standard German % unemployed UK % unemployed November

4 Its impossible to say, of course. By the world was in depression. Germany would have been too, with our without its pathological fear of inflation. The Nazis would presumably have made the same electoral gains. But suppose Germany had inflated in, like the UK did. The following chart compares the trajectory of the UK unemployment rate after it had left the gold standard with that of Germany, who stayed on. After leaving the gold standard, the UK saw its unemployment rate decline by about a third from to 1933, while Germanys rose significantly over the same period. If Germany had been willing to follow the UK in inflating, and its unemployment rate had followed a similar trajectory, it would have stood at 17% rather than 33%. Would this have averted what followed? Would Hitler have won that March 1933 election with 45% of the vote? Would the world have experienced the evils of the Nazis in power? World history might have been very different. There might not even be a euro today, let alone a euro crisis. So even a hard money libertarian like me can see that there have been times in history when creating inflation would have been the right thing to do. Germany today has to decide if now is one of those times. Europes crisis today is orders of magnitude smaller than that in the early 1930s. The stakes are much lower today than they were then. But they are not low. And, just as it might have done in the 1930s, flexibility on hard money principles might help turn the tide. ECB involvement cannot solve the underlying problems of the eurozone economies, which are antientrepreneurial and too heavily regulated. But it will buy time with which to address these problems and so allow eurozone policy makers to get ahead of the panic for now. But whether or not Germany wants to do that is its decision. To be clear, Im not recommending any particular course of action and offer no comment on what I think they should do. Im only trying to understand what I think will happen. In a very real sense it is entirely rational for Germany not to sanction an ECB funding of a bailout organisation with adequate fire power if theyre so fearful of the dangers of playing fast and loose with the credit system. Who can blame them for that? Central banks over-willingness to play such games in recent decades has been instrumental in creating the overleveraged world we live in today. 1 But its no use saying we shouldnt have started from here. We are where we are. A risk of sticking to the über harte währung strategy is that ever-more austerity creates ever-more deflation which creates ever-more misery in ever-more troubled countries (Greece, Spain and Italy today France tomorrow?). We can argue about how big that risk is and over what time horizon, but that it is real and non-zero is undeniable. A second risk is that such misery will act as oxygen for opportunistic politicians who will blame the euro in general and Germany in particular for their misery. Again, we cant quantify that risk but we know that its real and nonzero (we also know that it is already happening across Europe today). Therefore, the logical implication of a refusal to sanction ECB money printing is that the euro breaks up and Europe splinters apart, in keeping with the various cycles of European history over the millennia. And the logic of Germanys uncompromising stance against the ECB money-printing is that it is happy to run that risk. But its difficult to reconcile with the logic implied by Merkels continued reassurances that the euro is more than a currency ; that if the euro fails, Europe fails ; or that The task of our 1 Frankly, its a bit late for one of the key architects of the single currency - perhaps the greatest monetary experiment in financial history - to be so concerned by monetary experimentation November 2011

5 generation is to complete economic and monetary union and build a political union in Europe step by step. That does not mean less Europe, it means more Europe. A couple of weeks ago Merkel and Sarkozy bluntly asked Papandreou whether or not Greece wanted to remain in the euro. Make your mind up she said. But its now time for the Germans to conduct some introspection of their own. They should make their mind up. Whats more important: the euro or their hard money principles? My guess is its the euro. Merkel thinks German budgetary responsibility has created todays resurgent locomotive economy and that the rest of Europe should take a leaf out of its book. But growth in exports to the Chinese credit bubble has contributed nearly a full percentage point alone to Germanys GDP growth. If that credit bubble bursts as seems to be happening now I suspect the Germans might be more sympathetic to a modest amount of inflation (even Germany ran with a near 8% CPI inflation rate in the 1970s). And anyway, it would be an easy operation to set up: giving the EFSF a banking license would allow it to open up a line of credit with the ECB for up to, say, 2tr (which might never even be drawn); the EFSF would then act like a euro IMF, with the power to bail out countries which got into trouble in return for certain conditions being met (e.g., labour market, tax, and welfare reforms); conditionality of lending would prevent the moral hazard issue which Germany fears (that once governments know the ECB is behind them theyll slack off on reform) and there would be no breach of existing treaties. The treaties would be changed to make it easier for countries to take a euro sabbatical. Willingness to sanction such an operation would also allow Germany to obtain its pound of flesh on issues like euro deepening. So theres a clean deal to be done. I think Merkel will do it. And if she doesnt, Id expect a market riot which forces an ECB coup, where printers overrule non-printers. When von Havensteins ghost is exorcised, I might go maximum bullish, but until then Im still minimum bullish on valuation grounds alone. The first chart below shows that there is a decent percentage of good quality stocks which are cheap and safe in our universe. The second shows that most of those stocks are in the UK and the US. Most of these are businesses which will still be around regardless of what happens to the euro (names available on request from your SG salesperson). Percentage of cheap and safe stocks in the universe Breakdown of cheap and safe stocks by region Source: SG Cross Asset Research, Factset 18 November

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