Germany is the new China

“So where were you?” she asked, as soon as I got back home, totally drenched by the first showers of the season.

“Oh. I was spending some time with J, consoling his broken heart,” I replied.
“And did that help?”

“Well, not really. We were watching this Orson Welles movie, The Lady from Shanghai.”
“How was it?” she asked.

“Nice, but the last lines of the movie mouthed by a character played by Welles really depressed J.”
“What were the last lines?” she asked.

“‘Well, everybody is somebody’s fool. The only way to stay out of trouble is to grow old. So I guess I’ll concentrate on that. Maybe I’ll live so long… that I’ll forget her. Maybe I’ll die trying.’ These were the last lines.”

“Looks like he is really missing L. Poor him. Guess he needs to get out of the city for a while.”

“Yeah he has got a job in Germany, will be moving there.”
“Ah. Germany, the land of engineering, exports and the euro.” she said.

“You make his movement sound so poetic. But its interesting how closely the rise of Germany as an export oriented nation is linked to euro as a currency.”
“How is that?”

“Before 1999, Germany’s currency was the deutschemark. It was supposed to be second strongest currency in the world after the US dollar. When Germany moved to the euro along with 12 other European countries on January 1, 1999, the strength of the deutschemark as a currency moved onto the euro. Euro became the new deutschemark.”
“But how did that benefit Germany?”

“It benefited Germany in two ways. One of course was that with a single currency being used across most of the larger countries in Europe, trade between countries became easier. And that helped German exports shoot up. But that’s an obvious point. The subtle point is that euro inherited the strength of the deutschemark. The world looked at deutschemark as a strong currency. And since January 1, 1999, the world looked at euro as a strong currency.

This benefited countries such as Portugal, Italy, Ireland, Greece, Spain (PIIGS) etc. Before they moved onto using euro as a currency, they had to borrow money at interest rates much greater than the rate at which Germany could borrow. When they moved onto using euro as a currency, they inherited this strength of Germany and the deutschemark. So they could also borrow at interest rates close to the rates at which Germany could borrow.

This meant lower interest rates for the PIIGS and other countries using the euro. And lower interest rates led to more borrowings. A part of these borrowings was used to buy stuff from Germany, which meant German exports shot up big time. What also helped Germany is the fact that it had 50% lower labour costs than the PIIGS, making its products competitive cost wise as well.”
“And all this helped Germany to boost its exports?”

“Yeah, it did. In fact, Germany’s exports at €1trillion  are nearly equal to that of China’s at €1.1 trillion. Now compare this to the exports in 1995, which were at €487 billion. The number in 1999, the first year of the euro being used as a currency was at €469 billion. This increased to €548 billion in the year 2000. Since then the exports have short up to €1 trillion. Having a single currency across 16 other countries has helped Germany boost its exports by removing the cost of dealing in multiple currencies.”

“Pretty interesting. But who was lending money to these countries and its citizens?” she asked.

“Well, a part of the lending was carried out by German banks. So the way it worked was Germany lent money to PIIGS economies at low interest rates, which they in turn spent to buy German goods. Let me get into a little more detail. Italy owes Germany $190 billion. Spain owes $238 billion. Ireland owes $184 billion and Portugal owes $47 billion. And the smallest of them all, Greece, owes Germany $45 billion. That adds up to $704 billion. Given this interest of German banks in the PIIGS economies, Germany had to back the $962 billion (€750 billion) rescue package for these economies.

If there was no bailout, German banks would have to bear the brunt of debt defaults from these countries. And over and above that, the well-oiled export machinery of Germany would have slowed down as well, due to lesser demand from the PIIGS economies.”

“Oh that sounds so similar to the China model of growth,” she said.

“Yes it does. As we have discussed in the past, the US over the years has been the biggest importer in the world. And this benefited China and Japan. The US imported, China earned dollars. These dollars found their way back into the US, as China bought financial securities issued by government and quasi-government firms in the US,” I explained.

“So what we are seeing is the US-China story playing out with different countries?” she asked.

“Yes,” I replied. “The equation between Germany-PIIGS is pretty similar, with Germany lending to these countries at low interest rates, and they in turn buying German goods and services and helping boost German exports. But now they are in trouble. And like the Chinese have to continue to buy financial securities issued by the US government, Germany has to rescue the PIIGS economies, so that its own economy does not suffer.”

“So what is the twist?” she asked, a quirky smile on her face.
“Oh, the twist is that all such rescue efforts boil down to a money printing exercise, where governments print money to pay off debtors. And Germany is suspicious of any process that smells of money printing. Basically, to finance their efforts in World War I, Germany had printed a lot of money. As Liaquat Ahamed points out in Lords of Finance, “Germany… expanded its money supply by 400%. By the end of 1920, German prices stood at 10 times the 1913 level.”

Above this, after losing the war, Germany had to pay had to pay the victors, and that made the situation worse. The Reichsbank (the German central bank) printed ever increasing amount of marks (the German currency) to finance the deficit. With more and more money being printed, the mark started to lose value dramatically — one dollar was worth 4.2 marks in 1914. By 1920, it was worth 65 marks. In August 1923, it was worth 620,000 marks. By early November, it was worth 630 billion marks. Given this hyperinflation, Germany is suspicious of any rescue effort which smells of money printing, like the current rescue of the PIIGS.”

“So they are essentially in a Catch-22 like situation?”
“If they do not rescue the PIIGS, they will be in trouble now, if they do as they are, they will be in trouble later.”
“But what if something else were
to happen?”

“Well, what if I do not answer your question?”
“Oh, yeah?”

“As Ghalib, the king of urdu poetry, once said, ‘Hui muddat ki ghalib mar gaya par yaad aata hai, wo hur ik baat par kehna, ki yun hota to kya hota?’”

(The example is hypothetical)
 
References:
Lords of Finance, Liaquat Ahamed, 2010, Windmill
Deewan-e-Ghalib, Editor: Nandkishore Acharya, Vagdevi Prakashan, 2009