Is the German Eagle a Grey Swan?

The Amphora Report

Mon, Sep 13, 2010 - 3:00pm
  • IS THE GERMAN EAGLE A GREY SWAN? While the several sovereign debt crises in the euro-area have taken markets largely by surprise–thus leading them to be labeled as unforecastable, “Black Swan” events–we see a potentially much greater risk ahead, that Germany, at some point, will reconsider its commitment to the bail-out framework agreed with other EU states in May. If so, the crises to-date are likely to escalate and spread into additional euro-area countries, causing a general, global credit crisis perhaps as large as that catalysed by the Lehman Brothers bankruptcy in Q4 2008.
  • DIVERSIFICATION IN A WORLD OF DEFLATION, DEFAULT AND DEVALUATION: With all financial assets ultimately containing some risk of bankruptcy or default, however remote, and with currencies in general no longer providing reliable stores of value in a world of weak financial systems and deteriorating government finances, diversification benefits across global financial assets are at historic lows. Maintaining portfolio diversification in these conditions requires investors to increase their holdings of alternative assets, in particular commodities, which by nature cannot default.


Earlier this month, in a previous report, we discussed how European monetary union (EMU) did not eliminate intra-EMU currency risk but rather transformed it into credit risk. In recent weeks, this credit risk has surged again, with spreads for Greek, Portuguese and Irish bonds soaring relative to benchmark German government bonds, known as Bunds. Why now? Has the economic situation or state of government finances in these countries suddenly deteriorated again? Well, no. Things were bad before and they remain bad now. There are, however, two good reasons why spreads are widening, one related to credit markets generally and the other more specific to EMU.

Let’s consider first what has been happening in credit markets generally. Following an improvement in credit conditions and tightening of spreads during the summer, when it appeared that the global economy was continuing to recover, there was a sharp deterioration in a broad range of leading indicators which began in July and then intensified in August. As such, it was perfectly reasonable to expect that credit markets and risky asset markets generally would suffer a setback, with spreads widening back out.

However, whereas the widening in credit spreads generally has been rather modest, spreads for the weaker EMU sovereigns are back to their crisis highs of the spring. At first glance, this seems rather odd, because back then it was still far from clear whether the European Central Bank (ECB) would step in to provide support or whether the EU would agree some sort of bailout package. But step in the ECB did, together with the EU, which at an emergency summit over the weekend of May 8-9 agreed a bailout framework for Greece and other countries potentially in need. So why are Greek, Portuguese and Irish bond spreads to Bunds back to their crisis wides, implying a significant risk of default?

To help answer this question, we need to turn the focus away from the weaker EMU sovereigns and place it on the strongest anchor of EMU, namely Germany. German economic performance has been impressive this year to say the least. Growth is the strongest it has been for many years. Unemployment has declined substantially. Exports have been particularly strong, notwithstanding a relatively strong currency and weak demand in most European countries. This has been possible because Germany is a leading producer of capital goods, in strong demand in the rapidly growing manufacturing economies of China, India and Brazil, and also numerous smaller ones. Indeed, German exports have been one of the biggest beneficiaries of all the stimulus that the US has thrown at the global economy in the form of low dollar interest rates. While the intent of US policymakers was no doubt to stimulate domestic demand, much of this stimulus has leaked out of the US economy because credit impairment and weakening confidence has led to a substantial increase in the private-sector savings rate.

One of the many accounting identities of economics is that savings = investment. But this does not need to hold at the local level. Global capital flows can be substantial, in particular when there are major shocks, such as the collapse of the US housing market and impairment of the banking system. For years, global capital flowed to US firms and households. Yet now the US private sector is deleveraging and, facing unusually high tax and regulatory uncertainty as well as an impaired banking system, US businesses are understandably reluctant to take this savings and invest. But for savings to equal investment, there must be investment somewhere, and it has been showing up, among other places, in German exports to rapidly growing developing countries.

Yet while German economic performance has been impressive, this highlights the extent to which a number of other euro-area members have lost economic competitiveness. Ever since EMU began in 1999, the gulf between Germany and the so-called "PIIGS" (Portugal, Ireland, Italy, Greece and Spain) has never been greater. This implies that, for EMU to be sustainable, Germany is going to have to provide far larger subsidies to these countries than the architects of EMU ever imagined.

Let’s look back briefly at the history of EMU. EMU blueprint arrangements comprised a large part of the Maastricht Treaty of 1992, which established the European Union (EU) out of what had previously been known as the European Coal and Steel Community (ECSC), the European Economic Community (EEC) and the European Community (EC). Yet long before the Maastricht Treaty was signed, France, Germany and the Benelux countries had envisioned a single currency as a means both to cement existing and promote future economic integration. Let’s now turn specifically to Germany for a moment.

Of all the post-WWII European economic success stories, Germany stands head and shoulders above the rest. It is difficult today for us to imagine what it must have been like in Germany in the late 1940s. First of all, Germany was divided and militarily occupied as the European front line in the Cold War between the US and the Soviet Union. Second, German industry had been completely and utterly devastated in the war. Third, a generation of potentially economically productive, young German men had been killed, placing an enormous burden on young and old survivors alike. Yet within 20 years, Germany would emerge as the most prosperous major country in Europe. What made this possible?

First, there was massive external assistance. The US needed West Germany as an ally in the Cold War and thus helped to rebuild the German military and the economy needed to provide for it. Second, Germany had a hugely successful industrial past which provided much of the blueprint for what could be rebuilt. Third, notwithstanding a socialist political streak in certain parts of the country, Germany had a culturally strong work ethic. Finally, and perhaps most pertinent to our discussion here, the West German Constitution (known as the Grundgesetz or Basic Law) provided not only for a completely independent central bank but also one with a single, overriding mandate of maintaining price stability.

During the 1950s and more so during the 1960s and 1970s, the contrast between Germany and southern Europe and even with France became increasingly stark. Whereas the Mediterranean countries responded to economic weakness with the occasional currency devaluation, Germany grew its economy faster notwithstanding a strong currency, as a result of high rates of business investment and worker productivity growth. Indeed, this combination became a virtuous circle: A strong currency meant that German firms could grow their global market share and profits only to the extent that they increased productivity. So they invested in their infrastructure, capital goods, education, research and technological development. When the going got tough, the central bank would not devalue the mark to ease the pressure. No, if industry faced a squeeze, they would need to find another way out. They would need to reorganise and innovate. Frequently this was done with the blessing and involvement of the government but, regardless, profit-seeking German firms, not politicians or central bankers, were in the driver’s seat.

When EMU was being planned, it was generally assumed that, once wearing the single-currency "straightjacket", the Mediterranean countries, unable to devalue their way out of periods of weak growth, would focus on increasing their competitiveness instead. A German-style, independent monetary policy and associated hard currency would widen the German virtuous circle to include all participating countries. It was nice to think so, but something else happened on the way. As has been the case repeatedly in many parts of the global economy in recent years, asset bubbles began to form, in particular in real estate and euro sovereign debt.

Once EMU was a done deal, euro sovereign borrowing costs converged rapidly down toward the German level. Previously funding their debt at several percentage points above Germany, countries ranging from Ireland in the extreme European northwest to Greece in the southeast discovered that their borrowing costs were less than one percent greater than Germany’s. Faced with sharply lower borrowing costs, the governments of these "windfall" economies had the option of paying down debt and reducing deficits. In a few cases, such as in Ireland, Italy and Spain, for awhile they did just that. With governments requiring less savings to fund deficits, there was more available for private sector investment. But this led, in time, to large real estate bubbles in several of these “windfall” economies. Underneath the surface, something sinister was afoot. While public sector finances were looking rather better for a time and property prices were booming, workers’ wages were rising fast, faster than in Germany. This implied that these “windfall” economies were losing competitiveness. By the mid-2000s, there had been up to a 20% appreciation of the real effective exchange rate in the “windfall” economies, implying a 20% loss of competitiveness and yet, with borrowing costs low and asset prices rising, no one seemed to care.2

At the time, I was working as a bond strategist for a major US investment bank in London and it was my job, among other things, to have a view on the relative attractiveness of the various euro-area government bond markets. Ever since EMU had begun, spreads for euro-area sovereign bonds relative to German Bunds had generally continued to converge even for the least competitive countries. In 2005 and 2006, borrowing costs narrowed to as little as 0.25%. This was completely inconsistent with the 20% loss of competitiveness in these countries, which implied far lower relative growth rates and difficulty with debt service in future. As such, we began to recommend that investors aggressively underweight these bonds. It may have taken a general global credit crisis to catalyse a reaction but now it is plain for all to see just how unsustainable the original EMU arrangements were from the start.


With that EMU history lesson behind us we are now brought up to date. Once again, notwithstanding the introduction of a single currency "straightjacket", Germany has gained in competitiveness. A strong euro has not been an impediment to an impressive German export performance. Yet the European Central Bank and the EU, which helps itself annually to a substantial portion of German taxes, are throwing all manner of support and subsidies at those countries that have chronically underperformed the hard-working Germans and are unable, without assistance, to service their massive and growing debts.

Consider now how Germans feel about this. For decades they have provided vast subsidies and support to other European countries, both via the EU and bilaterally. They spent a huge amount of their savings to help rebuild East Germany following reunification. They thought they were doing Europe a great favour through their willingness to enter into EMU, thereby sharing the fruits of their successful hard-currency policy with their neighbours. Yet how have several of these neighbours returned the favour? By encouraging and subsidising real estate speculation; by standing by while public and private sector unions demanded ever higher wages, eroding competitiveness; by using accounting tricks to hide the true size of their public sector deficits; and then, when it all blew up in their faces, they had the audacity to BLAME THE GERMANS for being wary of more hazard and thus slow to acquiesce to ECB emergency lending facilities and a massive, open-ended EU bailout commitment.

Many Germans are, in a word, furious. However, what should be of greater concern to financial markets is that Germans are now openly debating, in academic and policy circles and well as in the press, just what is in Germany’s best interest. Few believe that the current bailout arrangements are. And in this debate there is little if any sympathy for the club of euro-area countries that have in their view betrayed German good-will and perhaps permanently compromised the hard-earned, hard-currency legacy of the Bundesbank.


Several prominent German economists are now openly advocating that Germany reconsider participation in EU-bailout arrangements which do not require a substantial debt restructuring. Perhaps the most outspoken of these is Dr. Hans-Werner Sinn, President of the prominent IFO Institute and member of the German Council of Economic Advisers, colloquially known as the "Five Wise Men". In a recent paper, Rescuing Europe, he argues that not only have various euro-area countries taken advantage of low borrowing costs to artificially amplify growth by failing to deliver meaningful cuts in fiscal spending; but also that the capital that flowed into housing and unsustainable government spending in the "windfall" economies was German capital that should in fact have stayed in Germany, where investments would have been less speculative and ultimately more sustainable. In other words, German capital has been misallocated and is now at risk of being outright squandered by German participation in ill-conceived bailouts which do nothing to remedy the underlying malaise of the bail-out recipients. Rather, such bailouts create a massive moral hazard problem which virtually ensures that German capital will continue to flow to inefficient, dysfunctional governments.3

Needless to say, this paper has caused quite a stir in European financial and political circles. Martin Wolf of the Financial Times, arguably the most influential European financial columnist, has proclaimed Mr. Sinn’s views as being both dangerous and wrong, arguing that Germany is a huge beneficiary of EMU and of European integration in general. While Mr. Wolf’s rhetoric is impressive, his economics are somewhat less so. Ultimately his argument can be reduced to circular logic: Germany’s neighbours, using German capital, buy German exports, thereby helping Germany. Everybody wins, right? Wrong. That capital has multiple potential uses. That portion that goes to wasteful, unsustainable government policies could, and should, be deployed elsewhere, such as in Germany itself.

We side with Dr. Sinn on this one. There is no free lunch in economics. Capital that is misallocated is capital that is forever wasted, never to return. Germans–indeed, all Europeans–would have been better off if, following the start of EMU, capital had flowed to efficient firms, regardless of location, rather than to inefficient governments and property speculation. The former would have used such capital to invest, to innovate, to improve their competitiveness, rather than have used it to keep bloated, inefficient welfare programmes afloat while hiding their true cost behind a dazzling array of derivative transactions designed by the most sophisticated investment banks in the world. Money well spent, to be sure, from the perspective of those who earned enormous bonuses by structuring and executing such transactions. But from an economic point of view, such spending was capital flowing down the proverbial toilet.

As Dr. Sinn raises his voice, Germans listen, and the political momentum to do something about the current, open-ended bailout arrangement, grows. A handful of current and former German politicians, including former SDP Bundestag member Prof. Wilhelm Noelling, are now pressing the German Constitutional Court to rule one way or the other as to whether open-ended bailouts are permissible under the Maastricht Treaty.4 Of course they are not. The Court probably already knows this, hence they are reluctant to hear the case. But if the issue is not to be decided by the Court, it will be decided by politics. Up to now, those in favour of the bailout have had the votes on their side. But not by a wide margin. A small shift of just a few votes would swing things the other way.

The German economy is now beginning to weaken. It is early days yet, but the signs are there. Exports are slowing as the global economy runs out of all the stimulus thrown at it in 2008 and 2009. Extrapolate current trends out a year or so and what you have is a German economy that has slowed by enough to push up the unemployment rate slightly. Amidst a continuing debate as to whether Germans should be continuing to provide open-ended bailout funds to others, rising unemployment could well shift the political balance slightly. The risk of Germany reneging on current, tenuous, arguably unconstitutional (i.e. Treaty-violating) bailout arrangements is going to be higher a year from now that it is today.

Now, who wants to be holding that Greek debt, or shares of European banks exposed to Greece, if that shift occurs? That’s right. No one will touch it. It will be game over. The question then becomes, how large a haircut (loss of capital) will bondholders face in a restructuring? And how will this impact European bank balance sheets and earnings? Well, it won’t be pretty. Now repeat with Ireland. With Portugal. With Spain. With even Italy perhaps.

If Germany does choose to remove its support for open-ended bailouts in favour of qualified support for meaningful sovereign debt restructuring, it could set off another round of disorderly deleveraging in a fragile global financial system which has not yet meaningfully restored capital lost in the 2008 crisis.


Other than the obvious, which is to avoid risky euro-area sovereign and financial debt and equity, how should investors prepare for the very real possibility that Germany, at some point, will have had enough? There are several things to consider.

First, with the global financial system still as fragile as it is, the ripples across credit markets created by a shift in the German position on bailouts will spread much farther than the euro sovereign debt markets. Credit conditions in general are likely to tighten in Europe and to some extent globally. If occurring alongside intensifying credit problems in other areas, such as US states and municipalities, for example, or commercial lending in China, the ripples could turn into large waves, toppling some weaker financial institutions. While we would not anticipate liquidations on the scale of Q4 2008, including of course Lehman Brothers, they would probably be large enough to lead to a general repricing of risk across markets, both corporate debt and equity.

Second, in the event of a general deleveraging across markets, safe haven assets would outperform. But this begs an increasingly difficult, complex question: Amidst weakness in sovereign debt markets and financial systems in most countries, what exactly are the safe haven investments these days? The crisis might originate in Europe, with a shift along German political fault lines, but does this imply that US government bonds would be preferred over German? After all, by pulling the plug on possibly endless, wasteful bailouts, Germany would, by implication, strengthen its future financial position. As such, German Bunds might be perceived not only as a safe haven, but as an improved one. On the other hand, US Treasuries would probably benefit to some extent, but what if around the same time, the US Treasury is arranging bailouts for US states and municipalities? That would be an interesting role reversal: As Germany withdraws support for various European governments, the US steps up support for states and municipalities. What does this imply for relative debt levels going forward? For relative debt servicing costs? For the risks that, at some point, central banks are going to be called in to help with debt service by printing ever more money? And what does this imply for currencies? Can both the euro and dollar weaken at the same time? And if so, against what?

It is difficult to draw firm conclusions for how financial markets are going to respond to a degree of uncertainty unprecedented in modern times. With even government bond markets now of dubious credit quality and currencies no longer functioning as reliable stores of value amidst widespread and growing efforts to stimulate growth or at least prevent further system deleveraging, investors are finding it increasingly difficult to find places to hide.

This is why investors need diversification. But not ordinary diversification across primarily financial assets, all of which are linked, in some way, to the growing, twin risks of default and devaluation. Rather, investors need diversification across a range of assets which, by their nature, are not directly linked to either default or devaluation risk and, as such, are generally uncorrelated to traditional financial assets. Such diversification can be found, if one knows where to look, in commodities markets.

Traditionally thought of as speculative investments, due to their volatility and lack of income-providing yield, in a world of weak financial systems and growing sovereign default risk, commodities offer both relative safety and superior diversification. Consider that, unlike a corporate, financial or even government bond, commodities cannot "default". A bushel of wheat is not going to shrink in size as its price falls. It will provide as much nourishment as before. A pound of fine cotton will provide for a new shirt. A gallon of gasoline will propel an average car some 30 miles. A few pounds of copper will provide wiring for a new house. And so on. Their prices may rise and fall, and they might not pay an income, but they are all useful, across all countries in the world, and they are all traded, in high volumes, on major exchanges. They are not going to go bankrupt, restructure their debt, or devalue by "printing" themselves into existence, as currencies have a tendency to do from time to time.

But what causes commodity prices to rise and fall? Weather patterns perhaps? Supply disruptions? Growing demand from developing countries? The factors are so numerous and so varied that the diversification provided by commodities is to a large extent a natural phenomenon. The prices of commodities are therefore highly unlikely to rise or fall in tandem, with one major exception: When the value of a currency suffers a major decline, then the prices of all commodities, priced in that currency, are indeed likely to rise in tandem. In the case that all commodities rise, their price movements may no longer be as diversified. But who needs diversification on the upside?

But then isn’t the big risk that, instead of a currency devaluing, it rises sharply in value, pushing commodity prices in that currency lower. Perhaps. But as discussed above, how are central banks likely to respond to another round of severe debt deflation and deleveraging, threatening the solvency of the financial system and the default of their sovereign governments? Are they going to embrace it? Let it take its course and it takes down one major bank after another? Or are they more likely to resist as before, print even more money in various ways, both conventional and not? If history is any guide whatsoever to the future, it will be the latter. Investors had better be prepared.

The Amphora Liquid Value Index (through August 2010)

Source: Bloomberg LP


1 In the financial jargon, the term "Grey Swan" has come to mean a risk event which is considered highly unlikely and hence disregarded by most but, for those who have the necessary expertise and who take the trouble to look and do the proper analysis, it is regarded as, in fact, likely enough to have a material impact on asset valuations and, if it should occur, will lead to abrupt swings in asset prices due to the surprise factor involved. While some regard the US housing market collapse as a completely unforecastable "Black Swan" event, there are those who believe it was, in fact, rather grey instead. Michael Lewis explores this possibility as part of the narrative of his hugely entertaining book, The Big Short.

2 Poor competitiveness can have many causes. We have not discussed it here, but Michael Lewis has penned an entertaining article in Vanity Fair exploring the depths of economic and political corruption in Greece. For those seeking a better understanding of just how a society can ruin itself from within, the article is well worth a read. Link:

3 Although requiring some basic knowledge of economics to appreciate fully, Dr. Sinn’s paper is highly readable, avoiding economic jargon and emphasizing common sense over quantitative analysis. He also presents a balanced argument, pointing out where relevant that the German economy has problems of its own. The paper can be found here: https://www.cesifo-

4 This story is not followed much outside Germany, although it certainly should be. For a background in German of the legal wrangling around this issue taking place in Germany, please see an interview of Prof. Noelling at:

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About the Author

Vice President, Head of Wealth Services