Germany's False Rectitude

Includes: ERO, EWG, EZU, FXE
by: Michael Shulman

One definition of "rectitude" is, “uprightness: righteousness as a consequence of being honorable and honest.” This is the behavior Germany projects to the world about its frugality and fiscal discipline.

Everyone needs to think again -- Germany’s “rectitude” is an illusion. German banks have been reckless, are grossly overleveraged and undercapitalized, have used political clout to keep the real amount of “dodgy” sovereign debt out of the public eye and forced central bankers to water down the new Basel III capital standards to a level that is meaningless. The bottom line: Germany’s stance on “fiscal rectitude” means it will not bail out is banks, its leaders will block reforms that will expose their banks’ lack of capital and while creating this uncertainty will do nothing to repair the consequences of this uncertainty.

· The “fiscally prudent and disciplined” Germans now have a budget deficit that is roughly 4.5% of GDP, well beyond the 3% “mandated” by their participation in the euro, and have been outside that 3% limit for many of the years that have passed since the inception of the euro.

· German banks are the most leveraged in Europe and possibly the developed world. Some state banks are rumored to be levered up to 50 to 1. German authorities fought and watered down the eventually meaningless stress tests and have fought and significantly watered down new Basel III capital standards to 3%.

· As part of their stress tests many German banks did not reveal their complete exposure to sovereign debt, by country, as promised.

· A big chunk of money lent in Germany has been to privately held Mittlestand companies – the backbone of the German economy – export driven family businesses that keep private books and have borrowed an unknown amount of money to re-tool over the past few years. To pay back these loans they must continue to grow exports at the expense of their neighbors and others, from car parts to electronics useful for a nuclear weapons program that end up in Iran (details here and here). The country cannot respond to calls to balance its exports with imports as export revenue and profits is key to the Mittelsand paying back all those loans.

· The Germans, aware of their own hypocrisy, have done something about it – the worst possible thing they could do – they have passed a constitutional change that essentially mandates a balanced budget regardless of circumstances, by 2016. This means when Greece defaults, and when austerity hits the eurozone economies and pushes back into recession, the EU and ECB will be unable to call on Germany for resources.

Where does a hypocritical, self centered and fiscally contracting Germany leave Europe? At the center and as the driving force behind the upcoming multi-year muddle that will keep the eurozone economy stagnant, push the euro down and have ripple effects across the globe. Here is how the muddle might play out in the coming months.

· On August 30 the Greeks have to meet five metrics to qualify for bailout money. If they hit these metrics they will receive money first from the IMF, and that in turn triggers a payout from the EU bailout fund. As things stand, the Greeks are going to miss on several of these metrics, the IMF will not dispense funds, then the EU will balk, and the muddle begins again. Alternative view: the IMF waffles, the EU waffles, and the further institutionalize investor uncertainty about the real value and future of Greek bonds.

· As the Greek muddle plays out, problems in sovereign debt markets spread. This has already begun – after steep declines spreads between Greek and other PIGS debt and German debt are increasing as is the cost of credit default swaps on this debt.

· As this crisis heats up – 50% chance the Greeks and IMF cannot fake it this time around, and eventually the Greeks will violate the terms of their agreement – heads will turn to look at the balance sheets of the banks holding sovereign debt from risky nations. And the murkiest balance sheets belong are the German banks.

· The Germans, unwilling to directly re-capitalize their banks due to the potential political response if they make any move in this direction, will push to muddle through some more, dragging out the crisis.

· The ECB will behave as it has in the past – like a traffic cop on Valium – and provide temporary liquidity but will not do anything dramatic since it too is beholding to Germany. And, next summer, a German takes overt the ECB.

Markets hate uncertainty and muddle. The weakness in German banks and the inability of the German government to fix them means years of uncertainty and muddling through with a possible default or two thrown in. Long term, this is very bad news for eurozone economies and the euro.