Thursday, March 19, 2015
In the closing months of 2014, Germany faced a difficult dilemma. Although its own economy was holding up well, incoming data showed that the rest of the Eurozone was rapidly slipping into recession. As a result, the calls for the European Central Bank (ECB) to unleash its own quantitative easing campaign grew louder. However, the policy had always been unpopular in Germany, both among high financial officials and rank and file Germans, where a strong euro has been prized. But in the end, Berlin was ‘persuaded’ to drop its efforts to forestall a QE campaign that everyone else in the world seemed to want.
On January 22, 2015, Mario Draghi, president of the ECB, announced a QE program of 1.1 trillion euros. Such a move could never have occurred without the approval of the Germans. Larger than expected, it sent the euro down to $1.14. On March 5th, Draghi announced the program in more detail. This helped send the euro plunging further to close at $1.05 on March 13th, a 12-year low against the dollar, for a total drop of 20% since September 1st, 2014. The Germans may have started to wonder what kind of a deal with the devil they had made.
The Bank of Japan (BOJ) christened the term Quantitative Easing (QE) as a term to describe the creation of fiat money in order to buy bonds on the open market, thereby pushing down long dated yields, in an environment where short yields have already approached zero. Even as it launched this policy, primarily due to pressure from Japanese politicians, the BoJ doubted it would be “effective.” Fourteen years later, evidence indicates that they were right. QE appears to have worked for financial markets but not the economy.
Despite the evidence of failure in Japan, the U.S. Federal Reserve nevertheless came to adopt a $3.8 trillion QE policy when the American economy entered a deep recession in 2008. The results were met with mixed reviews, but many other central banks, including the Bank of England (BoE) followed suit. Only the reticence of the Germans prevented the ECB from joining the QE party. Their reasons are historic and particular.
Germany had suffered the rigors of wealth destruction, economic chaos and acute human suffering caused by massive currency debasement in the 1919-1933 Weimar Republic. In 1914, 4.2 German ‘gold’ Marks bought one U.S. dollar. By 1918, one U.S. dollar commanded 8.4 ‘fiat’ Reichsmarks.
In an effort to pay the massive French-inspired war reparations, Germany printed huge amounts of paper Marks. By November 1923, one German gold Mark was worth one trillion paper Marks. One U.S. dollar was worth 4,210,500,000,000 German paper Marks, or almost exactly 4.2 German gold Marks, the exchange rate of 1914! (sourced from Thorsten Polleit."Hyperinflation, Money Demand, and the Crack-up Boom", Mises Daily, January 2010. Referenced 2010-06-26.) There may be a valuable message here for those who continue to eschew holding gold.
With this experience burned into the German collective memory, the German government assured its people that it would drop the Deutsche Mark in exchange for the euro only if the euro remained a ‘sound’ currency and protected savings and retirement funds. It remains to be seen how angry German citizens will become if the euro falls much further. Perhaps the monetary authorities believe that monetary anxiety will be overcome by stock market euphoria, which inevitably follows the appearance of QE.
From mid-December to mid-March, the German DAX index was up a stunning 27%. Such performance may buy a lot of support inside Germany. But, looked from outside the fog of QE, the performance is not nearly as impressive. Over the same timeframe the euro has lost about 16% of its value, thereby blunting the magnitude of the stock gains. As happened with QE in the United States, much of the money in Draghi’s QE likely will find its way into stock and bond markets, boosting prices.
For the price of debasing the euro and boosting European share prices, the QE move by the ECB threatens to create global instability that may unfold over the medium to long term.
Clearly, non-Eurozone tourists will flock to Europe, boosting tourism. Conversely, the numbers of Europeans coming to tour America likely will drop. This will shake up the outlook for many very large public companies. In recent years, Eurozone countries and corporations have been tempted by low interest rates and a relatively strong euro to borrow from the vast pool of cheap U.S. dollars created by the Fed. If those borrowing costs increase substantially, it may lead to serious problems down the road, threatening even defaults.
Meanwhile, non-euro based corporations looking to buy European business assets likely will look quite aggressively for acquisition targets, boosting M&A activity.
It is not just the level of the euro’s fall, but also the speed of its fall which can prove to be so challenging. Even U.S. companies have been given little opportunity to hedge their euro-denominated revenues. As Jim Cramer said recently on CNBC, “You have to really steer clear from companies that are 35 to 40 percent Europe, of which there are a bunch”. Also, U.S. corporations, which for tax reasons hold an estimated aggregate of over $2 trillion worth of cash offshore, may now be faced with significant currency losses.
Clearly, a fall of twenty percent in the euro, the world’s second currency, is a most important event. If such a debasement proves successful in reversing the recessionary trend in the EU (in essence succeeding where Japan and the U.S. have failed), it could have a major positive impact on the attractiveness of investment in Europe and perhaps globally. Conversely, should Draghi’s QE fail, the world could be facing an increasing threat of a fiat currency crisis and a rising gold price.
Source: John Brownes Market Commentary