By: Daniel Amerman | Mon, Apr 19, 2010
Germany is a nation that fears inflation for good historical reason, and among the nations of the world, Germany places a particularly high priority on price stability. Yet, so long as Germany remains in the European Economic and Monetary Union (EMU) with the euro as its currency, Germany may not be in control of German inflation. In particular, the current crisis with Greece, and the crises that may follow with other nations such as Portugal, Italy, Spain and Ireland may prove disastrous for German investors and taxpayers. For so long as it is in the EMU, Germany may have no effective choice but to bail out countries that have been running up huge deficits - despite Germany itself not having the economic capacity to do this for all of Europe on an indefinite basis, let alone the political will to do so. These are among the reasons why in a letter to clients late last week, Morgan Stanley warned that Germany may leave the euro and the EMU and that investors should be prepared for this event.
If this event happens, it may create an enormous financial windfall for millions of individual Germans, as well as German companies, not to mention the German government. While leaving the monetary union is still far from certain as Germany also has strong economic and political incentives to stay in the EMU, in this article we will say "what if" and explore some of the startling benefits for nations and individuals of quickly exiting a failing monetary union - as well as the many perils. But while the specifics of this article are about Germany (and France), the implications go far beyond Germans and Germany (although there are very important implications for arbitrage opportunities with German companies). Rather, in this world of financial crisis and sovereign debt crisis, there are powerful related wealth and financial security implications for individuals in every country.
(Please note that the European economic and monetary union (the EMU) is not the same thing as the European Union (the EU), and Germany may potentially leave the monetary EMU without exiting the political EU.)
The German Government Windfall
First let's consider the current German government situation. Total outstanding government debt in Germany is equal to about 1.7 trillion euros, and as of 2009, equaled about 77% of the German GDP (according to the CIA World Factbook). Now let's assume that Germany does exit the economic and monetary union, and when it does so, it creates new Deutsche marks that are exchangeable one for one at the valuation for euros as of that exit date. After the exit of Germany, let's make the reasonable assumption that Germany's economy remains strong, at least relative to much of the rest of Europe. Let's also assume that with Germany exiting, and perhaps France exiting behind it, that the European monetary union is left with the weaker members where the world in general and investors in particular are quite unsure about the ability of these nations to repay their debts. So the euro plunges.
For our scenario, we'll assume an immediate sharp drop of the euro in the neighborhood of 30-40% when Germany exits the EMU, relative to the new Deutsche mark. This value differential is assumed to rapidly increase as an inflation differential builds, and more strong nations leave the euro. After the passage of a period of time - and it could be months or could be years - we'll assume the currency exchange rate is now 10 euros for every Deutsche mark. In other words, we'll assume that the euro loses 90% of its value relative to the Deutsche mark. (This assumption is not a precise projection, there are cases for higher and lower projections, but it does have the virtues of being a round number and reasonable.)
With this scenario, Germany's euro-denominated national debt is now worth 10% of what it was when we look at things in Deutsche mark terms rather than the euro, and keep in mind that the German government income from taxes is in Deutsche marks, rather than euros. Germany is now repaying debt at 10 cents on the dollar (so to speak) and the value of its outstanding debt has fallen from 1.7 trillion euros down to 170 million Deutsche marks - a 90% reduction in net debt. Thus, German national debt (ignoring any new debt issuance) as a percentage of the German economy has dropped from 77% of German GDP down to 7.7% of German GDP.
How much of that extraordinary benefit is realized in practice depends on what happens with German contract law internally. It is highly likely that if Germany leaves the European Economic and Monetary Union and replaces the euro with a new Deutsche mark, that there will be a wholesale statutory revision of internal German contracts, such that what was once payable in euros is now payable in the new Deutsche marks. If this happens, it will minimize many of the internal effects such as the value of German bonds held by a German bank, and this may effectively keep the German banking systems' government bond portfolio from being effectively wiped out. However, this probably won't apply on an international basis, except in the unlikely event that Germany can get full reciprocity from other nations (with German investors who hold euro denominated investments in other nations receiving payments in Deutsche marks instead of euros). Therefore international transactions are where the major transfers of wealth are likely to occur, and Germany may reap a major windfall profit with foreign investors in government bonds, while not enjoying a windfall at all with domestic investors.
(The key principle discussed above is that repegging a currency under statutory law has quite different internal legal consequences than ordinary inflation domestically destroying the purchasing power of a currency.)
The Economic Essence & A Race For The Exits
Germany repaying euro-denominated debts when it is no longer in the EMU illustrates two essential elements of sovereign debt. The first is whether the debt will be repaid, and the second is how much the repayments will be worth. International investors in German debt identified Germany as being a financially responsible nation that pays its bills, and they are quite likely to have every euro of debt repaid to them (particularly under the circumstances outlined in this article.)
However, Germany didn't actually borrow in its own currency, but rather the currency of a monetary union. While it is an unintended consequence, the EMU monetary crisis creates a windfall profit opportunity in that if Germany exits the EMU, it has a one time opportunity to effectively repay its external debts in drachmas and liras rather than marks. This windfall opportunity will carry its own accelerant, because the exit of Germany would shift the burden to France. France would now face the choice between carrying much of Europe's financial burden on its back - or making its own exit from the euro, and reaping its own windfall profit, much like Germany. This exit would of course accelerate the destruction of the euro, which would increase the size of Germany's windfall.
There is indeed a chance that if France thinks Germany is about to exit, then French national interest may require it to exit first. Being the first to exit means reaping the maximum windfall profits from the destruction of the value of a nation's national debt.
Now this is not to say that there won't be any economic chaos and turmoil in Germany, or that the resulting potential shrinkage of the German economy may not more than offset this fantastic windfall, or perhaps much more than offset it (with the same holding true of France). All else being equal, the German and French governments would strongly prefer that there were no monetary crises with their monetary union partners. The one time debt windfall from the destruction of the value of the euro may not provide anywhere close to enough value to voluntarily "cheat" bond investors.
However, if Germany feels it is forced to exit the economic and monetary union, the debt windfall effect provides a powerful incentive to do it sooner rather than later. The lower the euro falls, the greater the damage to Germany, and the less the benefits of the windfall. If things are right on the edge - the greater the chance that France will strike first, and reap the disproportionate benefits of being the first strong power to leave. Taken in combination, this means that while Germany will likely continue to do everything it can to avoid having to drop the Euro, if and when it decides an exit is inevitable - Germany will have powerful financial incentives to move with breathtaking speed in destroying the euro. As will France.
Which leads us to the next essential point. That which applies to the nation also applies to individuals and companies. And this debt windfall - if it occurs - will likely leave many German companies and individuals much wealthier than they were before the crisis, even if Germany as a whole becomes somewhat poorer.
Two Individuals And The Redistribution Of Wealth
Let's consider two hypothetical German individuals, Dieter and Gretchen, and examine how the collapse of the euro relative to the new Deutsche mark affects each of their personal situations. We'll say that Dieter, the first individual, recently retired after having responsibly paid down all his personal debts, and that his life savings consists of having accumulated a bond portfolio with holdings in blue chip European companies as well as various government bonds, with a value of 500,000 euros. And we'll say that while his income is coming in the form of euros from outside of Germany, Dieter pays his bills in the new Deutsche marks within Germany. Furthermore, let's be charitable and say that despite the global financial crisis, none of the corporate and government bonds in Dieter's portfolio actually default.
Once the euro has collapsed relative to the Deutsche mark, the income that Dieter has coming in falls by 90% in purchasing power terms. For instance, if he was earning an average of 5%, or 25,000 euros per year in interest, these payments would now have a purchasing power of 2,500 Deutsche marks. Simultaneously, the principal value of Dieter's savings has fallen from the 500,000 euros down to 50,000 Deutsche marks.
After a lifetime of work, what was a very comfortable financial safety margin has now almost entirely disappeared. So that instead of comfortable bond interest payments to finance holidays abroad, Dieter finds himself relying on the public pension plan in an already stressed Germany with very little money available on interest income on his portfolio, and with the capital value of the portfolio itself only worth 10% of what it was terms of what he consumes in his native Germany.
Gretchen, our second individual, owns a small company that does business primarily in Germany, but has funding from a United Kingdom bank denominated in euro terms. Gretchen then sees the income from her business staying in Deutsche mark terms even as the value of the debt that she owes must be repaid in euros, and becomes worth ten cents on the dollar. So if 70% of the value of the Gretchen's company was in fact borrowed funds, this 90% reduction in the value of the euro means that 90% of the value of her company's debt has been destroyed to the direct benefit of Gretchen. So her effective equity in the company has gone from 30% of assets to 93% of assets. As a direct result of what happened with Greece and then Germany, Gretchen experiences a fantastic increase in wealth from the very same factors that are devastating the value of Dieter's life savings.
When we look at these two situations, what we can plainly see is that there is a massive redistribution of wealth that goes on when we have monetary crises. Millions of innocent people who've been playing by the rules and responsibly saving and investing are financially devastated. Other millions of people are enjoying lucrative profits and tax-advantaged surges in their personal net worth. With the distinguishing factors in this case being whether they owe debt or own the debt of others, in which currency are their sources of income, and in which currency they pay their bills.
Winners & Losers
Across German society and across the entire German business landscape there will be many kinds of winners and many kinds of losers.
Anyone who owns euro-denominated bonds loses, particularly if their expenses aren't paid in euros. On the other hand, anyone who owes large sums of money in euros, but has the ability to earn money in the new Deutsche marks wins fantastically, as their debts are essentially paid off for them by the monetary crisis.
German financial institutions that pay their depositors in Deutsche marks, but have large portions of their investments in euro-denominated bonds and loans outside of Germany - where their investments will be repaid in euros - can expect to be devastated.
On the other hand, the German manufacturing firms who have borrowed extensively in euro terms internationally, but earn income in Deutsche marks (or that have the ability to have their international earnings float with exchange rates), will benefit in a major way as they make their own debt payments effectively in drachmas and liras. This may indeed drive the internal German political debate, as we have to look at the sections of German society that will benefit, and the sections of German society that will lose.
Individuals who own bonds and assets but don't have current income from the economy, such as retirees, may face devastation.
However, German manufacturing firms will gain a huge global advantage and the benefits will flow to the domestic German workforce, particularly those workers who are younger or in middle age, with many years remaining until retirement.
So as is always the case - and this is crucially important whenever we look at monetary crisis - we not only have an international redistribution of wealth, but a generational redistribution of wealth within each society. Germany will be no exception.
Taking Personal Action
Another major development at the end of last week was that the European Central Bank forecast a second upcoming stage to the global financial crisis, as a result of sovereign debt crises around the world, as well as unsustainable trade deficits (two subjects I have been warning about for some time). As these crises continues to develop around the world, the headlines and the financial focus are likely to be on such subjects as currency speculation as well as other derivatives strategies. Fortunes will indeed likely be made and lost with currency speculation and sovereign debt credit swaps, but the redistribution of wealth from those strategies is actually likely to be relatively minor compared to what we've just discussed in this article.
Across the globe, for hundreds of millions of retirees and other long-term investors in the developed countries, while the specifics will vary by the country and currency - the inflation and debt driven redistribution of wealth may end up being the number one determinant of financial security and ongoing standard of living.
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This has been true in past crises. For instance, everyone talks about gold during the US monetary crisis in the late 1970s and early 1980s. Yet the redistribution of wealth that occurred in the United States via mortgages dwarfed the redistribution of wealth that occurred because of gold, both in domestic dollar terms and most particularly in the number of households affected.
What's best for you? The correct answer of course is neither debt strategies, nor precious metals, nor generational strategies, nor what you can do inside of a 401(k), but all of the above combined. As I have been exploring in my most recent work, it is in the integration of all these factors, with each component doing what it does best, that is the best way for individuals to not only preserve but increase their after-inflation and after-tax wealth during times of crisis.
However there is something that has to occur first before any of these components can be put into place. You need to thoroughly understand them. Education is the key. Understanding the different factors, understanding how they affect you, their interrelationships, understanding how to protect yourself and how to turn them to your advantage is the first and irreplaceable step in these times of turmoil and crisis.
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