On Winning the War in Europe and Relative Sizes of QE Programmes
10th March, 2012
If history is any guide (and it usually is!), the recent successful completion of the Greek Bond Swap following the announcement of the third bailout package, is likely to provide only temporary relief before another debt crisis engulfs the Eurozone down the road. Scott Minerd, the CIO of Guggenheim Partners (and an ex-colleague from my Morgan Stanley days!), draws parallels between the current debt crisis and financial crises which dominated the financial landscape in Europe during the interwar periods – with poster child of current European woes, Greece being replaced then by Germany. To summarise:
- During the period 1918 to 1939, European nations were also saddled with huge debts without the means to repay them, and lurched from one crisis to another, with a series of bailout plans providing only temporary relief but not solving the fundamental problem.
- After the ending of WW1 in 1918, punitive war reparations were imposed on Germany amounting to 300% of its GDP. Other nations were also heavily indebted as a result of financing the War – UK (154% of GDP), France (258% of GDP) and Italy (153% of GDP).
- Then, as now, there were strict demands for austerity plans, refusals to accept losses on certain debts, missed deadlines and bailout plans which ultimately failed, only to be replaced by another bailout plan.
- Germany lacked the ability to repay its enormous debt, and spent the next 14 years on multiple restructurings, occasional payments and numerous defaults. War devastated countries like France demanded full payment on the debt, and Germany responded by printing more and more money leading to hyperinflation (with eventually 1 US$ being equal to 4 trillion marks!).
- The first restructuring of Germany’s war debt occurred in 1924 with the Dawes plan – which focused on financial reforms and involved massive lending by American banks to stimulate growth to help repay the debt.
- The second restructuring took place in 1929 with the Young plan – which reduced Germany’s debt by 50% and a 58 year repayment period. However, the stock market crash of 1929 and the onset of the Great Depression put a hold on all repayments.
- Another restructuring was attempted in 1932, with a proposal made to eliminate Germany’s debt (to Europe) contingent on the US writing of all debt owed to it by other European nations – this was rejected by the US congress (and eerily similar to the ECB refusing to take losses on Greek debt).
- Eventually currency debasement emerged as the only viable economic strategy, as nations abandoned the gold standard in an attempt to inflate away their debt and kick start their economies. Countries which left the gold standard recovered faster from the Great Depression than countries which remained.
- -Ben Bernanke, in his well known 1991 paper, concluded that “a mismanaged interwar gold standard was responsible for the worldwide deflation of the late 1920s and early 1930s”. He noted that countries which held onto the gold standard the longest (i.e. the US) suffered most from the Great Depression.
- The period of the 1920s was one of very easy monetary policy and robust economic expansion, despite Europe being mired in excessive debt and deep structural problems.
- The strategy of currency debasement is prevalent today, with the aggressive monetary easing by the Fed, the ECB, the BOE and the BOJ. And this is unlikely to end anytime soon.
- Based on Assets-to-GDP ratios the ECB is now the largest quantitative easer in the world (32%) followed closely by the BOJ (which is projected to be at 33% after completion of its programme), the BOE (24%) and finally the Fed (19%).
- However, austerity programmes are simultaneously being imposed by governments – making it akin to “pushing on the accelerator while standing down on the brake”. It is just a matter of time before serial restructuring sagas resume.
- To put it into a time perspective – Germany finally repaid its war debt with a $94 million payment on October 3, 2010 – 98 years after the end of WW1.
- The US has now entered a period of self-sustaining economic expansion, driven primarily by the Fed’s (and now supported by the ECB) monetary policies making the US the economic locomotive of the global economy. This is bullish for all US risk assets-equities, high-yield bonds and bank loans.
- The situation is similar to the aftermath of the LTCM crisis in 1998, when the Fed eased aggressively leading to a major bull market in equities from 1998 until 2000.
- The Fed is unlikely to change its stance on monetary easing given the three risks facing the global economy – continuation of the European debt problem, a slowdown in emerging markets and a potential hard landing in China. Despite strong job growth numbers in recent months, Bernanke told the Senate Committee on February 7 that the job market is a “long way” from returning to normal, signalling that Fed policy will remain aggressive.
- With the Fed pleading to keep rates low until 2014, the Taylor rule suggests that rates will remain too low for too long. The improving US economy should upward pressure on interest rates over the next 6 to 12 months. Treasuries are exceptionally overvalued and are likely to yield a total negative return in 2012 – something which has only happened 3 times (1994, 1999 and 2009) over the last 38 years.
- There are consequences to these actions as we set the stage for another crash in a few years – but risk assets should produce healthy returns in the interim.
- Europe is on the brink of falling into a recession following a negative GDP number for the fourth quarter of 2011 – a significant debasement of the Euro is on the horizon and the slowdown will put pressure on emerging markets and China as their export markets suffer.
A fascinating perspective – and the parallels between Germany in the 1920s and Greece today are rather illuminating. One would have thought that Germany would have learnt its lessons and therefore handled the current crisis differently – but that would have taken tremendous political will which is sorely lacking today! I agree with his view that risk assets are likely to perform well over the next few years – but do not expect a significant uptrend in interest rates until 2014 as further QE policies are likely to keep a lid on rates (and any significant sell-off should be viewed as a temporary buying opportunity) . In addition, while emerging markets growth is likely to slow down, EM equity markets are likely to perform well as the tightening monetary policies undertaken over the last year are reversed.
The significant factor over the next few years is the competitive currency debasement in the developed world, as each country aggressively pursues that objective de facto via further QE programmes. There are different ways to look at the relative scale of QE policies – assets-to-GDP ratios as described above is one method – another is looking at the increase in the monetary base from pre-crisis levels (as espoused by Nomura’s Richard Koo) – on this basis the Fed is the most aggressive having increased its monetary base by 3.21 times, the BOE by 2.97, the BOJ by 3.13 (but over a longer period) and the ECB by a relatively smaller 1.96. So it seems that the ECB still has a lot of catching-up to do (about 1 trillion Euros!).
A yet another way to look at this is to take a simple ratio of the central bank assets – and the ratio between the assets of the Fed and the ECB have tracked the EUR/USD exchange rate closely over the last few years as the graph below illustrates (via Zero Hedge). Recently, a large gap has opened up between the two implying either a rather large fall in the Euro (and a sharp fall in risk assets) or QE3 ($650-700BN) by the Fed. I suspect it is the latter or even perhaps the first quickly followed by the latter (as what happened in 2010 and 2011)
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