DR.

KURT RICHEBACHER
Frankfurt
GERMANY

CURRENCIES AND CREDIT MARKETS

No. 243 I July 1993

"Should the Fed raise the rediscount rate, and deliberately invite a violent reaction? Or should
it wait for the raging speculative fever on Wall Street to play itself
out and risk an almost certain
depression in the longer run -
for prosperity could not continue indefinitely if such an extensive
proportion of the nation's credit was imprudently diverted from the actual production and
exchange of goods and services into financial speculation."
1929 The Yearof the Great Crash, W.K. Klingman
Harper and Row, New York 1989, p. 114

HIGHLIGHTS

This letter disentangles the U.S. monetary muddle. It shows the causal linkage between the Fed's
oversupply of reserves, soaring Ml and raging financial speculation on the one hand, and
contracting broad money supply and sluggish economic activity on the other.

) Another wrong-headed dollar rally appears to be under way. A huge crowd of currency traders,
clutching their chart books, have again been mobilized into an unthinking frenzy. Simple logic
and fundamentals rule out a dollar bull market.

The outbreak of euphoria over stronger U.S. employment is misplaced. It signifies that the widely
trumpeted productivity-led recovery is disappearing into thin air. Now that the economy is
employment-led, it means higher labour costs and lower profits.

The biggest risks for the U.S. economy are in the stock and bond markets. Although the Fed talks
tough, its action betrays continuing
aggressive ease. But instead of stimulating the economy, it
stokes a financial mania.

Surging Ml is sign of an inflation that has nothing to do with the real

a
economy. It's a most
disastrous kind: financial inflation. Big financial bubbles, sooner or later, must end in a
bust. The
experiences of 1929, 1937 and 1987 are undeniable
evidence.

The D-mark and the Bundesbank are currently under attack. The Bundesbank,
though, shouldn't
be underestimated. Recent events have considerably strengthened the hawks in the
Bundesbank.

There is risk that an emerging interest rate war between France and Germany could lead to some
trouble for the French franc and its bond market. French politicians are in a panic about the
possibility of a deepening recession raising
unemployment higher than it already is.

\I Long...term capital conservation and liquidity continue to be the top priorities. We continue to
) recommend safe harbour in the short-term money securities and bonds of the strong-policy
currency countries Germany, the Netherlands, Switzerland as well as Austria and Belgium.
-
LEMMINGS AND PIED PIPERS

The world economy continues to weaken and recovery expectations continue to come up short. Yet,
financial markets, although somewhat jittery and confused, still take strange comfort from unfavourable
news. To their interpretation, the more economic disappointments there are, the easier money will
is taken of the fact that
become and the surer will be the prospect of an eventual recovery. Little note
this circularity in thinking has
already stretched out for one or more years in the case of some countries
_ notably the U.S., Britain, Canada, Australia, and Japan with little convincing result. Similarly
-

ridiculous has been the dollar's recent jump against the major currencies particularly the D-mark.
-

U and a widening trade deficit.

Ttùs move blatantly flies in the face of a sharply slowing .5. economy
How can one make sense of all this? We can only say that the fundamentals will eventually reveal their
ugly truth. It's only a matter of time.

Before turning to the fundamentals, why the sudden spurt in the dollar? When outlining the many
past letters, we have always pointed out that
fundamental reasons for our long-tenn dollar bearishness in
the majority of the world's currency traders and economists have always been loaded for
"bull" when

it comes to the dollar. For years at least since

-
the mid-1980s -

the consensus has been incessantly

it has always been a gaggle of traders
bullish on the dollar, expecting to rise and never to fall. There
ready to intetpret the slightest dollar blip as the beginning of a new long-term trend. And since the vast
majority of currency traders and institutional investors are guided by little more than price and
they tend to move en masse. All they need is a pied piper to rally
momentum charts, like lemmings,
George Soros, the man famous for pushing the
them. This time it's the reputed Midas touch of Mr.
pound sterling out of the ERM (European Rate Mechanism) and launching the recent gold rally, that
triggered the rallying cry for the dollar.

exploded
Adding to this volatile brew is the fact that the world's currency trading resources have literally {
during the last decade. Currency trading volumes have more than
tripled during the last six years, egged \.

Given such a large

on by the fast-growing cross-border transactions of investors and portfolio managers.
herd of foot-loose money, virtually anything can happen over the short run.

is always plausible for a short time. The truly

The point of all this is to say that some dollar strength
is whether or not the assumptions and fundamentals underlying the move are
important question, though,
strength be anticipated.
in alignment for the long-run. Only then can a long period of dollar

Reviewing the case for the dollar, we conclude that we're seeing another of the many dead-end rallies.
glad midwife.
It's based on little more than hype, psychology and speculation with the media playing a
absurdly distorted on the negative side,
Reports about the Gennan economy and the Bundesbank are
positive side. Any trivial
while those on the U.S. economy and the Fed are even more stretched on the
negative n~ws about me Gennan and other European economies makes headlines. Even worse, there
particularly
from British and
seems to be virtual campaign to tarnish the Bundesbank's credibility,
a
probability of a devaluation of the D-mark.
French economists, conjuring up the future

THE DOLLAR: CHECKING THE FUNDAMENTALS

It'sbest to concentrate on the fundamentals. We have had long experience at it, being able to see
past years. Just what are the chief
through the smoke and mirrors of numerous false currency moves in
is the one monotonous drumbeat: that a strengthening U.S. recovery
arguments of the dollar bulls? There
will cause rising interest rates and pull in foreign capital, thereby driving up the dollar. This argument

\ July 1993
Currendes and Credit Markets
 3

is faulty on more that one count. First, instead of seeing a strengthening econom y there is a fragile ~
-

in fact weakening recovery with record-low: interest rates. Second~ it~s a mystery how conditions of
-

sluggish credit growth and low interest rates are supposed to attract foreign capital U.S. stocks and
bonds are already among the most ovelValued in the world. That simple logic alone explains why the
recent dollar bull speculation will again go sour. The dollar~s upturn is driven by speculation, not by
long-term capital inflows.

[n our opinion~ the final test that will settle the bull or bear case for the dollar is now imminent. Recent
economic and monetary data overwhelmingly and compellingly indicate that the U.S4 economy is slipping
back into recession. even before the new depressants of tax increases and spending cuts begin to bite.
. .

Activity is soft acrossa broad spectrum of the

economy. Yet, so far, bad news is either ignored or
treated as good news. A case in point is the sharp rise in the May U.S. trade deficit. It occurred in the
face of extremely weak: domestic demand~ signifying very negative news both for GOP (gross domestic
product) growth and U.S. competitiveness. Instead~ the rise in the trade deficit is being broadly
interpreted as a sign of economic strength.

Perverse psychology is at play here. Weakness is literally perceived as strength in the stubborn belief
that a continuing U4S. recovery is solely predicated on low inflation and low interest rates. Rather than
seeing a feeble recovery as being inherently vulnerable, the logic is turned on its head with the
paradoxical argument that the recovery must be durable precisely because it is slow4 Such is the
sophistry of today's economists in the absence of theory. the study of causes and effects. It reminds
.. .

us of 1989-90 when it was happily argued that falling interest rates precluded any possibility of a

recession the so-called I1soft landing." Since it had never happened before in the post-war period it
-

was thought to be impossible. Y et~ the recession did occur.

FED POLICY: TOUGH TALK. SOFT STICK

Despite compelling evidence to the contrary~ a U4S. economic rebound in the second half of the
year-
to a 3% growth rate and more is simply taken for granted.
- A by-product of ttùs view is persistent
talk of an impending Fed tightening4 This expectation is revealed in the Eurodollar futures market which
is discounting a rise in the Federal funds rate to 4% by year-end, up a full 1 % from today.

Abetting these expectations is the Fed's "open-mouth" anti-inflation policy: couching soft action with
strong words. The story that the Federal Open Market Committee has put a tightening bias on its policy
stance, smacks of a deliberate leak in order to give the impression of anti-inflation vigilance and to mould
market expectations in favour of lower long-term interest rates.

Given the massive speculative bubble in U45. bonds, the markets are understandably eager to take all of
tlùs very seriously. And besides7 this kind of talk: tends to prop up the dollar. To us, it's a transparent
1Iconfidencel1 ploy.

Talking strongly but acting softly is the Fed~s real policy. The evidence clearly shows that to be so.
To begin with~ if the Fed were truly vigilant against intl.ation~ it would meanwhile have tempered its
prodigious reserve injections that have been flooding the banking ~ystem. The marùfest fact is this: In

trying to keep the Fed fund interest rate at its low level of 3%~ it has been buying Treasury bonds -

monetizing government debt at warp speed. With the resulting excess reserves that this action creates,
-

the Fed~ in turn~ has been pressuring the banks to expand their own bond portfolios. Last year, bank
-\
-J
Currencies and Credit Markets \ July 1993
 4

u.s. REQUIRED AND EXCESS RESERVES

FEDERAL RESERVE BANKING SYSTEM
2.5
Monthly, $U.S. Billions é:JJ

Required Reserves
RH Scale
50
2
'4
40
1.5

Excess ReseNes 30
LH Scale

\. 20

0.5 10

a a

89 90 91 Q2 93

Source: Federal Reserve

25% and higher.

reseIVes temporarily skyrocketed upwards at an armual rate of

the Fed
The rapid rise in bank reserves -

deposits to be held by the banks has four

with -

bank purchases of bonds create a corresponding amount of

intercormected reasons: first, the record-high
new deposits; second, tþe stampede of the public into securities precipitates a large-scale switch from
savings and time deposits into demand deposits (MI) which are needed for the related payments; tlúrd,
has been increasing the
tlùs boost to demand deposits, solely subject to the Fed's reserve requirements,
bank's demand; and fourth,
reserve the Fed fosters this process, as the chart above shows, with a

permanent oversupply of reserves.

interest rates. But the

Normally such surging reserve demand would put upward pressure on short-term
Fed's generous reserve supply clearly testifies to its eagerness to keep short-term interest rates low. This
the
combination of a 3% funds rate and excess reserves has still another effect which the Fed and
markets really like: as long as there are excess reserves, it pushes the banks to make massive bond

purchases which act to lower the long-tenn interest rate. During the three months to April of this year,
bonds at a record annual rate of $150 billion. In short, the buoyancy of the U.S. bond
U.S. banks bought
maI'ket is the product of the Fed's lavish reserve injections. It couldn't be clearer: Despite its
as we'll explain, it can't very well do
protestations, the Fed continues to be a softy. Why? Because,
The Fed has become a hostage of its past largesse.
anything else.

GREA T INTENTIONS. SMALL EFFECT

Looking at the actions of the Fed or any other central bank, we always distinguish between the intent
of monetary actions and their effects. In principle, we fully agree with those who accuse the Fed of
clearly evident in the explosive rise of bank
pursuing a policy of reckless monetary expansion. That's
reserves, the monetary base and narrow money (Ml).

\
Currendu and Credit Markets July 1993
 5

point is this: It's miserably failing to achieve

But, as over-expansive as the monetary policy is, the crucial
its aim of stimulating the economy. To do so would require re-starting the credit engine. more .
..

precisely, boosting bank lending to businesses and consumers. In this way, the Ped's monetary ease
would be passed through to the private sector. That's the nonnal way how money growth takes place.
But this time., the channel to the real economy fails to function.

That brings us to the recent inflation The many American economists who see rapid inflation of
scare.
intent and effect of
consumer prices just ttaround the corner" fail to draw a distinction between the
by many American monetarists who tend to regard
monetary policy. Apparently., that's a fear shared
threemonetary indicators bank reserves~ the monetary base (also called high-powered money) and
-

narrow money (MI) -

as the best indicators of the current monetary thrust and inflation outlook..

aggregates and economic activity

How do these monetarists explain the connection between these three
and historical correlations.
or inflation? They don't. They simply rely on the evidence of econometrics
why they these indicators and totally neglect credit and broad
That's have slavish and narrow
a focus on
money trends.

By these gauges, policy evidently appears extremely inflationary. That's

U.S.. monetary
present
absolutely correct. point to see is that these prodigious reserve injections and the
But the crucial
associated Ml surge., while inflating the financial markets, completely fail to impact the real economy..
tipushing on a string" just as in the 1930s
As far as economic activity is concerned, the Fed is obviously
when this expression was first coined.. The main channel, through which monetary policy impacts the
signals is a
real economy., is credit and broad money growth. And both remain stalled. What tlús
progressive shrinkage of overall liquidity.
\
.J
Although our view is almost trione voice in the wilderness" it's by no means a maverick view
a
a
..
~

figment of our imaginaùon, so to speak. It

is rooted in the tradition of European credit theory~ The
fathers of tlús school of thought both British
-

and Continental European were Europe's-

leading
economists over a period of more than two centuries.

A GROUNDING IN THEORY
is guided by four
This original European approachy stressing the role of credit and broad money,
is
important insights: (1) No one -borrows money to hold it in an idle bank account Borrowed money
mostly consisting of bank deposits is driven by growth
normally spent (2) The growth of money
-

of bank credit, both loans and invesunents. Every increase in bank assets mecharùcally translates into
(3) Only credit expansion
an equal increase in liabiliùes and therefore in the supply of broad money.
a

production
makes it possible for spending to increase beyond current income growth, leading to rise in
a

which, in turn, Leads to a subsequent increase in incomes.

(4) Credit analysis., as well, allows valuable
insights into the pUIposes for wmch borrowed (created) money is used~ It makes a fundamental

difference., for example, whether a monetary

expansion finances business investment which has high
multiplier effects on the rest of the economy or increased government spending which has low multiplier
is in the latter category.
effects. Today, virtually all of the credit growth

considerably because
Yet, the relaúonship between credit or money growth and GDP growth can vary
a large and
varying share of
spending does not affect output. There are, principally, three different
outlets for money spending: (1) domestic goods and services the current output of the economy; (2)
-

-) Currencies and Credit Markets \ July 1993

 6

existing financial and real assets that are not a current product of GDP; and (3), foreign goods, services
and assets. Of these Ùlree types of spending, only the first impacts domestic production. If only the
latter two types of transactional spending are stimulated, there will be little relationship between GDP
growth and money and credit.

THE U.S. MONETARY

SCmZOPHRENIA RECENT U.S. MONETARY TRENDS
Annualized Percent Changes
A review of recent U.S. monetary
growth rates illustrates this point
Non-
vividly. Take a look at the money
Financial
trends shown in the neighbouring table M2
Ml M3 Debt
and the graph on page 8. There is an
eye-catching discrepancy between 1992 Year 14.2 1.5 -1.3 5.1
soaring narrow money growth and flat
broad money growth. This gap was Six Month Chan~es to:
even more pronounced for a time last 14_5 1.4
January -1.3 4.5
year. It has shrunk considerably since 11.8 0.2
February -2.1 4.4
then, since Ml suddenly slowed as of
March 9.2 -0.4 -2_6 4.8
late last year, too. The second most I
April 7.4 -1.0 -2. 5.0
remarkable feature in the monetary
May 9.4 0.4 -0.4
picture is the fact that whatever broad
Source: Economic Indicators, Department of Commerce
money growth there was since last

year, has come from its soaring Ml-

component. The other components of M2 and M3 their so-called non-transaction
-

parts -

have
virtually collapsed. As such, tlùs development is unprecedented.

All these numbers and technicalities may appear complicated and tedious. But they are unavoidable.
Their investigation is crucial to understanding the future. What we read from most economists even -

from the Federal Reserve itself -

gives us the frightening impression that they lack such insight

In the mÙlutes of the Federal Reserve Board Open Market Committee Meeting of February 3, 1993~ the
Fed expressly attributes the protracted weakness of the broad money to the steep yield curve which is
causing investors to switch from deposits into securities. Deposits are counted as part of the money
supply, whereas securities are not. This explanation, in line with the market view, has the great attraction
of dispelling any concerns, and instead, even puts the money weakness into a rosy light

Do securities purchases stocks, bonds and/or mutual funds

-
by the public reduce the money supply?
-

Does the purchase of an automobile reduce the money supply? Of course not. Such amisju9gment by 1
a What really happens in connection with such purchases is. that Ml is
central bank is frightening.
boosted at the expense of the other components of broad money because it requires an increase in
l
transaction money. But since MI is a component of broad money, broad money must remain unchanged.

Even more shocking is the Fed's reference to the unprecedented steepness of the yield curve, citing it
as a main depressant of broad money growth. Precisely the opposite is truc. lbe steep yield curve is
the very incentive for the banking system's massive purchases of government bonds. Having bought
roughly $90 billion worth over the last 12 months, it is in reality the one outstanding source of current
.{
1
Currencies and Credit Markets \ July 1993 ~"""---
 7

u.s~ money creation. OUf May letter described the significance of tlùs process as well as monetization
and other related topics~

Although bank purchases of bonds have been strong over the past year, there was a sharp slowdown
during the November-February period which was promptly reflected in temporarily weaker money
growth. Since then, there has been a renewed thrust of bond purchases to record Levels as already
mentioned~ This has provided a new boost to money growth~ How the Fed can blame low money
growth on the steep yield curve is beyond us~ It would be more correct to say that the massive
, monetization of goverrunent debt has prevented a liquidity collapse in the private sector.
)
TWO CIRCULATIONS: Ml AND THE SPECULA TORS~ BROAD MONEY AND PRODUCTION

Why is it hugely aggressive monetary policy is so ineffective in stimulating the real economy?
that this
As already explained, the main cause is that the banking system is failing to pass the stimulus through
to the economy by more lending to the private sectoc Is most of the Fed-induced stimulus just

disappearing down a black hole without any effect? No, it's just that the impetus is careening down a
different charmel: namely, into the financial markets~ This has important and dangerous implications.

Two unusual developments set the stage for this discussion as we've already briefly explained. Compared
with past recoveries, the great anomaly in the U..5. monetary situation is the fact that bank lending to the
private sector is non-existent That does not mean that the banking system is inactive~ Though it may
not be monetizing private debt, it is busily monetizing government debt at an unprecedented scale~

The second anomaly is a dramatic shift in the composition of money growth in favour of soaring MI.
While MI jumped over the last 12 months by 13%, broad money has virtually stagnated. Were it not
for the surging Ml component, broad money and overall liquidity would have sharply contracted~ The
graph on the next page illustrates this point.

Most observers dismiss this divergent behaviour of narrow and broad money as being a result of
superficial velocity changes. For us, this extreme decoupling in the behaviour of the different M's has
an obvious, ominous implication: inflation.

Yes, surging Ml signals inflation, but not in the way most economists think. Plainly caused by
artificially low short-tenn interest rates, it fuels rampant inflation in the fmancial markets. As explained,
sharply rising turnover in the financial markets, both cash and derivatives, requires rising cash balances
which boosts the growth of demand deposits and related reserve requirements~ But, tlús money circulates
outside the gross national product That's why it doesn't generate inflation in goods and service prices~

1: What, then, about the unusual weakness of broad money? Just as clearly., it reflects very opposite
conditions in the real economy: credit deadlock and illiquidity. It's plain to see that there are two
)" circulations at work~

This brings us again to the role of the Fed. What's driving U.S. financial markets and forcing up s~ock
and "bond prices? Oearly~ the ability of the banks to buoy the bond market with their huge purchases~
It's the Fed that ~tokes the speculative furnaces with an oversupply of reserves. Some brokers expressly
cite the rapid reselVe growth as being bullish for the markets.. not realizing that this is the stuff of which
dangerous "bubbles" are made.

Currencies and Credit Markets \ July 1993

 8

u.s. MONEY SUPPLY TRENDS

16.0'1. Year-over-year Percent Changes

v
14.0'1.

12.aI. Ml
10.(11. ~
8.(11.

6.0'1.

4.0-1.

2.aI.

0:(11.

Q()
-2.0It

4.0% M3-Ml
-ó.C1It

Source: .Feda'al Reacrve

What's wrong with a lice financial inflation? Doesn't it benefit many while apparently hurting very
few? Firstly, big financial bubbles inevitably must end sooner or later. in a crash. The experien~es
. .

of 1929, 1937 and 1987 in the U.S. and 1989-90 in Japan are undeniable evidence. A second debilitaüng
effect of a
runaway financial mania is that it artificial wealth and consumer purchasing power
generates
that distorts and imbalances the economy. Lastly, over time, a central bank becomes the prisoner of such
a bubble because any
monetary tightening would risk pricking it.

WISIHNG UPON A RECOVERY

Recently, markets grasped at the big upward revisions of employment as proof that the U.S. economic
situation is in much better shape than it previously seemed. By contrast, the persistent money and credit
crunch and the flood of data signalling a softening economy is being flatly ignored.

There is little or no logic in this new outbreak: of euphoria. We have reservations for many reasons.
Firstly, the employment numbers relate to the past and say nothing about the future; addiùonally, they
reveal a drastic worsening in the quality of job growth; and lastly, it's a fact that two-thirds of the
t
estimate in job gains is based on computer modelling techniques and not on true counts and surveys.

Our biggest reservation, however, is of a different kind. Of course, stronger employment growth would
be very welcome following all the past wailing about a "jobless recovery." There is no dispute on that
point But, to conclude happily that this must brighten the economic outlook is most dubious. It ignores
the ugly flip-side: lower productivity growth and higher labour unit costs which both act to squeeze
business profits.

Economists, apparently, have yet to learn that they Call1lot have it both ways. Either the service sector

Curreada &ad Credit Markets \ July 1993

 9

gains in employment which tends to be more

generates superior productivity gains or it generates stronger
inflationary. One must come at the expense of the other.

The first unpleasant by-product of this is already evident.. though ignored by the markets. Revisions
.. ..

0..1 % to minus 1.6%. For

for the first quarter of 1993 have already slashed productivity growth from
productivity slip from the previously reported 3.1 % all the
1992, the year-to-year increase in may well
way down to 0.5% or less.. The widely trumpeted productivity-led recovery is disappearing into thin air.

lynch pin of a future global recovery.. The

The world continues to look to the U..S economy as the
question is Where is the economy heading? Early in the
following therefore of central importance: U.S.
we a rather lonely voice warning of a renewed slowdown in the U..S. economy.. even using
year~ were .. ..

1993 will be the abortion of the

the evocative phrase in the February letter, uthat the biggest surprise in
U..S. recovery.u It
clearly put us out on a limb. But our assessment was born of the strict analysis of
sluggish private credit, broad money and
the irrefutable fundamentals of persistent and unusually
invesunent

subject of a forecast..
Now at mid-year, the U.S.. economy's sharp slowdown is a fact and no longer the
For us, the evidence of a weakening economy becomes more compelling with every new statistic..

A STRUCTURAL" NOT A CYCLICAL RECESSION

cyclical growth differentials between the UlÚted

Globally, markets and economists are obsessed with the
States and the rest of the world particularly Germany.
-
But such temporary swings in these
cycle.
differentials are nothing new. That's always been the typical pattern of the internaùonal business

general failure of the countries that went

What's unprecedented., however, is something else: namely the
into recession earlier, to stage a normal recovery and to return to "trend growth.
II
The result is a
disturbing international synchronization towards longer-tenn, sub-par growth.. The structural, rather than
cyclical cause of this sub-par growth pattern is only vaguely understood, if at
alL

It used to be conventional wisdom before thinking was relegated to computer models

-
that the -

severity and depth of a recession depends on the magnitUde of the imbalances and maladjustments which
developed during the preceding boom. Considering the new record-low national savings and investment
they have suffered the greatest debt excesses
ratios of the major Anglo-Saxon countries, it is evident that
and related structural damages..

promises future
For the time being, markets interpret sluggish U..5. economic growth as a panacea that
buoyant fmancial markets forever. Unfortunately., there ìs
growth, low inflation, low interest rates and
just no precedent for sub-par, non-inflationary growth. Consider these figures: During the last four years
compound real GDP
from the first quarter of 1989 to the first quarter of 1993, the U.S.. economy had
had compound growth of 21 %. The proper name for
growth of 3.8% whereas consumer-price inflation
that is tfstagflation,f1 not fmancial nirvana. Just how such an abysmal performance can exhilarate markets
for so long is beyond us.

All told, by far the greatest risk for the U..S. economy is the rapidly expanding bond bubble because it
gives rise to mind-boggling interest rate risk. nUs growing vulnerability of the markets and the economy
larger bond
stems from the fact that speculators, above all banks and brokers, have been building up ever

\ July 1993
Currencies and Credit Markets
 10

holdings financed by cheap borrowed money. Of the total bond holdings of banks and brokers, now
amounting to approximately $1 trillion, no less than half has been accumulated during the last three
is that any rise in short-term interest rates dimirúshing the profit spread,
years. The danger involved here
risks triggering a massive selling avalanche forcing bond prices down.

The Fed is widely praised for its supposed ingeniousness in having salvaged the banking system by
engineering record-low short-term interest rates. Few seem to realize that these artificially low interest
rates, by fuelling the enonnous stock and bond bubble, are sowing the seeds for an even bigger liquidity
crisis later. A vicious circle is in play.

PROSPECTS FOR EUROPE AND GERMANY

For years, we have been pointing to the large, chronic budget and external deficits of the Anglo-Saxon
and other countries as a serious threat to their future growth and stability. Such concerns were generally
ignored. The typical counter-argument was that such deficits didn't matter any more in a world of free
cross-border capital flows.

Currently, we learn from Anglo-Saxon and other foreign economists that Germany's big budget deficit
resulting from the high unification costs has disastrous implications for the economy. Furthermore, we're
told that Germany's rather small current-account deficit reflects a drastic loss of competitiveness. We're
perplexed. There must be two sets of theories: one for Continental Europe and one for Anglo Saxony.

"Should the DM
be devaluated? asks a recent research letter from Paribas Capital Markets in London.
"Yes:' was the answer. In line with the apparent consensus opinion in the markets, its author presented
a list of fundamentals that should lead to a decline in the D-mark inflation, budget deficit, current-
-

account deficit, wage levels, and lack of international competitiveness. Let's consider some of these
points from a broader perspective.

As one of the toughest critics of budget deficits, we share the worries about the long-term consequences
of the German budget deficit. But using this as an indicator of future currency weakness only makes
sense if budget deficit is relatively worse than that of other countries. That's not at. all the
Germany's
is not of chronic dimensions; it only began two years ago.
case. First of all, Gennany's large deficit
Other countries the U.S., Italy and Canada, to name a few
-
haven't experienced a budget surplus
-

in two decades or more. Secondly, and most importantly, Germany's large budget deficit is more than
amply covered by domestic personal savings.

A brief comparison shows this to be so. The total public sector deficit presently accounts for 750/0 of
personal savings in Germany and France, 140% in Britain, and 150% in the United States. Given these
r
much lower savings ratios, the existing budget deficits are definitely far more daunting for the Anglo-
Saxon countries.
i
f'"

How bad is German inflation? To quote the previously mentioned bank: "Germany used to be the
bastion of inflationary virtue. No longer. Western Germany has now inflation above the EC average
and above the U.S. and Japan. Moreover, this is not temporary. Relative to its key competitors in the
widening.1T
core of the ERM German inflation has been worse for approaching two years and the gap is
7

the Gennan inflation perfonnance just over the last two years and to extrapolate it over the
To judge

Currencies and Credit. Markets \ July 1993

 11

long-term is either stupid or malicious probably both.. In the first place~ there are special reasons.
~
.. ..

by the self-righteous Mr. Kohl, it'll

While there has been gross mismanagement of German unification
a longer span of time,
take more than just two or three years to ruin a strong economy. Looking over
quite reasonable: Over the 19805, Gennan annual consumer-price
Gennany's inflation perfonnance looks
inflation averaged 3%. Comparatively, inflation averaged 5.1 % in the U.S., 6.9% in Britain and 7% in

France.

The OM bears will object and say that more recent period would make a more valid comparison. To
a
1987 and
placate them~ let's take the compound consumer price inflation rates for the five years between
year-end 1992: U..S. 26%, Germany 17%, Britain 33%, and France 17%.. To recall, German
unification
changes in international
started in 1990. Measuring underlying inflationary pressures and relative
growth with
competitiveness, the best gauge is nominal labour unit costs which combines wage
productivity growth. comparison on this in the just published Annual
We found an illuminating
Economic Report of the European Commission.

Basing 1980 at tOO, the major countries experienced cumulative rises in their labour unit costs to the end
of 1992 as follows: U.S~ 165%, Britain 208%, France 176%, Germany 134%, Japan 114%. It should
price
be clear that the factor that contained the lmpact of German and Japanese wage rises in the
main
indexes was strong productivity growth.

Is Germany's current inflation problem indicative of a long-term trend? True, hovering at rate
a of 4.2%,
fairly But the main reason for that perception is the
Gennan consumer-price inflation appears resilient..

effect of one-time tax increases and administrative prices. Without their influence, the inflation rate
would be nearer 3%, as it will be when these effects drop out. The trend of producer prices tells a very
different Compared to a year ago,
story.
producer prices in Germany are down by O_3%~ in France by
2.3%, up by 2% in the United States and 4% in Britain.

CONCLUSIONS

The D-marlc and the Bundesbank are currently under attack. However, the Bundesbank shouldn't be
underestimated. Recent events have considerably
strengthened the hawks in the Bundesbank. There is

an old saying: A central bank is like whipped cream. The longer you whip it, the harder it gets.

against the Bundesbank lacks any substance. In the same

The smear campaign by the French and British
its credibility by being overly soft and criticise it for ignoring foreign
bre(\th, they accuse it of wasting
interests by acting too slowly.

Internally, the Bundesbank is in a Public sentiment is finnly on the side of the bank,
strong position.
Already,
,
too. The Gennan recession is widely seen as a necessary, but painful, adjustment process.
West German trade unions have slashed their wage increase demands to little more than 3%. Any blame
falls overwhelmingly on the Kohl government and its fiscal mismanagement.

When will the dollar bear market resume? The assault on the O-mark is fuelled by two beliefs: that
that
economic weakness will compel the Bundesbank to slash interest rates soon~r rather than later and
assumptions lack
the U.S. economy will shortly rebound again. Both any substance.

is slowing and is in the process of bottoming

The evidence we see suggests that the German downturn

Currencies and Credit Markets \ July 1993

 12

out The U.S. economy, on the other hand, is set for a new dip. In short, we can't find any fundamental
reasons for a sustainable dollar rally.

We conclude that we're seeing another fake-out move in the dollar.. It's based on little more than hype
and speculation. And as far as hype goes, sentiment indicators already suggest that the dollar frenzy is
near a peak. Actually, for investors wishing to make new commitments to European investments, this
would be a good time to do so.

We now French politicians are

see an open interest rate war emerging between France and Germany.
in a panic about the possibility of a recession starting from an already-high unemployment rate of 11 %..
France is paying a high price for the ambition of its politicians to dethrone the D-mark as Europe's
'tanchor currency" It
We smell some trouble ahead for the franc and its bond market.

There is an enonnous financial bubble building up in the U..S. even more bloated than in the infamous
19208. We can't overemphasize the risks involved. The Fed is caught ill the web of its own design
having allowed a runaway financial speculation in the interest of propping up the domestic banking
system and stimulating the sluggish economy.. In due time, a devastating bust will inevitably follow..

Long-tenn conservation and liquidity continue to be the top priorities.

capital We continue to
safe in the securities and bonds of the strong-policy
recommend harbour short-tenn money currency
countries Gennany, the Netherlands, Switzerland as well as Austria and Belgium.
-

\
}

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Curreada aad Credit Markdl \ July 1993