The Great Repression in Germany

The global financial crisis will be two years old in less than two months. It was in August 2007 that investors and fund managers first began to wake up to the implications of defaults on sub-prime mortgages in the United States. Yet they woke up remarkably slowly. The U.S. stock market continued to climb until October of 2007. And it was not until September 2008 that ordinary Americans finally grasped how close Wall Street was to the biggest banking collapse since the early 1930s.

In psychological terms, there was a period of repression, which lasted for nearly a year, during which Americans were in denial about the risk of a second Great Depression-which was why, at the time, I called the crisis “the Great Repression”. Then, with the bankruptcy of Lehman Brothers on September 15 last year, came the breakdown. Since then the patient has been in therapy, in the form of massive doses of monetary and fiscal stimulus. Symptoms of denial still persist (in the form of the “green shoots” or “second derivative” delusion, which holds that because things are getting worse more slowly, they must be getting better). But the patient is at least on the long road to recovery.

The same cannot be said of Germany. To visit Berlin is to be transported back to the pre-Lehman phase of the American crisis. Despite overwhelming evidence that this crisis is going to hurt Germany more than the United States, German politicians and voters alike remain in deep denial. Welcome to the Great Repression on the Spree.

Germans think of the crisis-if “think” is the right word-in the following way. This crisis is not really a German problem, any more than the Iraq War was. First, it is an American crisis. “Anglo-Saxon” finance is to blame: deregulated financial markets, over-leveraged banks, hedge funds, derivatives and the rest. Secondly, Germany did not have a housing bubble-because most Germans are happy to rent their homes and 100 per cent loan-to-value mortgages are unknown. Thirdly, prudent German politicians have resisted the temptation to run huge deficits and print money. Indeed, Chancellor Angela Merkel recently delivered a strongly-worded attack on the Federal Reserve and the Bank of England for adopting the policy of “quantitative easing”.

To underscore Germany’s refusal to go down the Anglo-Saxon road to perdition, the German parliament has just passed a balanced budget amendment to the federal constitution. From 2016, it will be illegal for the federal government to run a deficit of more than 0.35 per cent of gross domestic product. From 2020, the federal states will not be allowed to run any deficit at all.

The German attitude was perhaps best summed up last year by Finance Minister Peer Steinbr?ck’s prediction that, as a result of the crisis, the United States would “lose its status as the superpower of the global financial system”. It would not be too much to say that this thought gave many Germans a certain Schadenfreude. The headline in Der Spiegel was: “The End of Hubris”-meaning American hubris.

But, as they say in New York, what goes around comes around, and pretty soon it will be turn of Americans to feel Schadenfreude. The moment is fast approaching when Germans will be forced by harsh economic reality to come out of denial. Here, as in America, the Great Repression has to end at some point. And the moment of breakdown is likely to be especially traumatic for a country that for so long has clung to the delusion that this crisis is somebody else’s problem.

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The first and most obvious point that Germans do not want to face is that their economy will probably be the second-worst performing of all the world’s major economies this year. According to the International Monetary Fund’s April World Economic Outlook, German gross domestic product is set to contract in real terms by -5.6 per cent. Only Japan will do worse. The comparable figure for the United States is -2.8 per cent. There are two reasons for this. The first is that Germany is much more dependent on exports to drive the growth of its manufacturing sector than the United States. The second is that the monetary stimulus administered to the U.S. economy by the Federal Reserve system is working, not only to avert bank failures but also to ease credit conditions in the economy as a whole. While the magnitude of this year’s deficit (13 per cent of GDP) is seen by some commentators as excessive and likely ultimately to push up long-term interest rates, the $787 billion that has been directed at job creation has had at least some effect.

Secondly, if the effect of American monetary and fiscal policy is to weaken the dollar and to reverse its temporary strengthening during the worst phase of the crisis, then German exporters will come under even more pressure. Whereas China and other Asian economies will likely intervene to resist any appreciation of their currencies relative to the dollar, the European Central Bank has shown little readiness in the past to intervene against the euro in the currency markets. So dollar weakness will almost certainly translate into euro strength, just as it will translate into yen appreciation, tightening the screw on Japan. Small wonder the German stock market has been the second-worst performer in the entire world this year (down 7 per cent since January 1). According to MSCI, only Poland’s has fared worse

Thirdly, and perhaps most importantly, it is a complete myth that the financial crisis-and especially the problem of excessive bank leverage and risk-taking-was a purely “Anglo-Saxon” phenomenon. The reality (of which most Germans I meet seem to be oblivious) is that, on average, German banks were more highly leveraged than American banks. Indeed, according to calculations published last year by the New York Times, German banks were the most leveraged of all developed country banks.

Although national definitions vary, the newspaper suggested that the average ratio of assets to capital for American banks was 12 to 1. For British banks it was 24 to 1. For Belgian banks it was 33 to 1. But for German banks it was a staggering 52 to 1. This reflects the fact that German regulators appear to have taken an exceptionally relaxed view of bank capital adequacy, more or less uncritically applying the Basel accords.

Under the Basel I rules, agreed in 1988, assets of banks are divided into five categories according to credit risk, with risk weights ranging from zero (for example, home country government bonds) to 100 per cent (corporate debt). International banks are required to hold capital equal to 8 per cent of their risk-weighted assets. Basel II, first published in 2004 but only gradually being adopted around the world, sets out more complex rules, distinguishing between credit risk, operational risk and market risk, the last of which mandates the use of Value at Risk (VaR) models, which calculate the likely exposure of a bank to losses on the basis of date from a relatively short time-period (e.g. the last two or three years). Liquidity risk is combined with other risks under the heading “residual risk”.

The lesson of the crisis is that the more countries followed these rules, the more vulnerable their banks became. First, risk-weighting assets ceased to be a meaningful exercise when rating agencies conferred Triple-A ratings (the highest possible score) on no fewer than 64,000 structured financial products such as Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDOs). These securities mainly originated in the U.S. and were often based on subprime mortgages. Bundled together, with their revenue streams divided into three different tranches, these lousy loans were transformed by financial alchemy from lead into gold, combining Triple-A ratings with higher returns than equivalently rated government bonds. German banks were among the most eager buyers of this fool’s gold.

Point two: Value at Risk models gave those who believed in them a completely misleading sense of their own security. Financial risk is not in fact normally distributed (as these models assumed), and no meaningful inferences can be drawn from just a few years of data about the probability of a major financial crisis.

Finally, Basel II completely understated the importance of liquidity risk. When credit markets seized up in 2007 and again in late 2008 it swiftly became apparent that banks which had expanded their assets to the maximum extent-and often beyond it, by using off-balance-sheet vehicles like conduits and structured investment vehicles (SIVs)-were hugely vulnerable on the liabilities side of their balance sheets. Deposits are all very well, and are unlikely to vanish overnight if they are covered by some kind of government-mandated insurance, but loans from other banks or from the commercial paper market are another matter. Suddenly banks that could not roll over their debts teetered on the brink of collapse.

For all these reasons, European banks-and especially German banks-are in fact in a worse position than their American counterparts. Fact: EU banks have combined assets of around 330 per cent of their GDP, compared to U.S. banking assets of 50 per cent. Fact: EU banks have approximately 75 per cent as much exposure to U.S.-originated “toxic assets” as American banks. Fact: The German government estimates that there are toxic assets with a nominal value of over $1 trillion (?800bn) on the balance sheets of German banks.  Only a lack of pressure from national regulators and a lack of scrutiny by investors has postponed (and I emphasize the word “postponed”) the day of reckoning. But that day is now fast approaching.

The European Central Bank recently estimated that Eurozone banks face additional losses of more than $283 billion this year. That could be an underestimate, however. According to the International Monetary Fund, Eurozone banks have so far written down $504 billion of losses on toxic assets, compared with write-downs of $738 billion by American banks. The IMF thinks that European write-downs still to come this year and next year will total $540 billion.

And remember: European banks also have more exposure than American banks to both Asia and Eastern Europe, with loans respectively of around $700 billion and $1.3 trillion. Though not quite as exposed to Eastern Europe as the Austrian and Swedish banks, Germany’s banks are not far behind.

And what does the German government propose to do about all this? The answer is to create so-called “bad banks” to which banks can transfer their toxic assets in return for government-guaranteed securities with 90 per cent of the toxic assets’ book value. The idea is that the bad securities can sit in those off-balance-sheet warehouses for up to twenty years. Surely by then (the reasoning runs) they will have recovered most of their value. Since today many of these assets are only saleable at around 20 per cent of their book value, the government is effectively buying time for the banks. What it is not doing is recapitalizing them. That would be much too “Anglo-Saxon”. I do not always agree with Wolfgang Munchau of the Financial Times, but his verdict on the plan strikes me as about right: “obviously daft”.

In the United States, commentators worry all the time about the danger of a “lost decade” of the sort suffered by the Japanese economy in the 1990s. But it is Germans, not Americans, who should be worrying about that. All the ingredients are in place. Zombie banks. Plunging exports. An appreciating currency. And a government moving too cautiously to keep pace with events. The supreme irony is that the deterioration of the economy is already forcing Berlin to run larger deficits than anybody envisaged when German politicians were striking poses of fiscal virtue at April’s G20 summit in London. Last week the government announced that the deficit in 2010 could be as much as ?100 billion, or 4.2 per cent of GDP. That still seems modest by Anglo-Saxon standards, but it leaves out of account existing bailout commitments that already exceed ?554 billion. And who knows how much those commitments could grow by if the line of firms requiring federal assistance grows significantly longer?

Yet a Japanese lost decade is not the worst-case scenario for Germany. A worse one occurred to me as I reflected on the fact that, if this really does turn out to be a re-run of the Great Depression, then we are currently in April 1931 (dating the two crises from the peaks of the U.S. stock market in August 1929 and October 2007). That was also a time when some commentators ventured the thought that perhaps the worst was over. Unfortunately, an event then occurred that plunged the world economy over another cliff, and ensured the greatness of the depression. That event was the Central European banking crisis, which began with the bankruptcy of the Austrian Creditanstalt on May 11, 1931, and reached its climax with the failure of the German Darmstdter und Nationalbank (Danat-Bank) two months later.


History does not repeat itself exactly

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