5. German national character. To invoke culture in a discussion of economic or political policy is always fraught with risks, and even more so when discussing Germany. Yet however much people would like to deny it or ignore it, there is such a thing as national culture. And Germans, while hardly monolithic, tend to possess certain traits or combination of traits that distinguish them as a people.
I would say that high on the list of cultural traits that distinguish the German national culture is a characteristic that I will call "idealism" (not to be confused with the more technical philosophical sense of this term). In economic affairs, this idealism is reflected in a perceived need to adhere strictly to orthodox (i.e. "ideal") theories of balanced budgets and hard money in terms of fiscal and monetary policy. For example, expansionary monetary policy by the central bank is viewed as "money printing" by many Germans, and is anathema to their (idealistic) national sensibilities regarding how a central bank should manage the money supply. Similarly, Germans are apt to think that if fiscal deficits are a problem, that the solution must logically (ideally) be to immediately cut government spending and/or raise taxes.
The reality of Europe's economic and political situation today is one that I believe that many Germans will find it very difficult to come to terms with. Cutting spending and raising taxes at this time is precisely the wrong way to deal with the problems ailing Europe, both economically and politically. The most immediate requirements in Europe are more nearly the opposite of what their instincts impel them to pursue. The current economic and political situation in Europe requires unorthodox compromises and/or deviations to standard modes of thinking. Unlike Americans, that tend to have a more "pragmatic" outlook, the German tendency toward uncompromising "idealism" poses a severe obstacle to such flexible policies being embraced by the Germans.
I will note that the idealist that I refer to may be especially prevalent in the old Prussia (also the former East Germany), which is where Chancellor Merkel is from. This factor may not be entirely irrelevant in the current historical context.
6. International pressure. It would be a mistake to underestimate the international pressure that will be exerted upon Germany and its leaders in the coming weeks and months. Germany is essentially isolated in the world in its insistence on austerity policies. Even the IMF has come out strongly in favor of a course reversal, warning ominously of disastrous consequences if Germany does not strongly support monetary and fiscal stimulus.
It must be remembered that much of this pressure will be coming from allies and friends of the current German government. This includes the center-right technocrats that they have helped install in Greece and Italy and the center-right president of France whom Merkel has forged a close alliance with.
Indeed, as the crisis evolves, Germans will feel like the entire weight of international opinion will be falling upon them. This factor, combined with No. 3 above ,will exert a strong influence on German policy makers.
7. Domestic politics. In mid 2011, Chancellor Merkel and her government were in serious trouble according to the opinion polls. Merkel had committed a series of major political blunders on internal domestic matters and prospects for her reelection were looking extremely bleak.
The euro crisis has breathed new life into Merkel's political career. How did she engineer this turnaround? Merkel has cultivated what some Germans have called a "protestant poverty aesthetic." Others in Germany have conjured imagery of Merkel as the frugal and industrious housewife that looks after every last penny of her family's money. The bottom line is this: Merkel's hard-line policy of austerity for PIIGS is extremely popular in Germany. For example a recent poll revealed that an overwhelming 73% of all Germans oppose more contributions to a European rescue fund. Germans are even more strongly against ECB monetization of PIIGS debts.
Merkel has staked her political reputation on her tough EU policy of demanding PIIGS austerity. Indeed, given some of her own domestic policy missteps and the weakness of her government's coalition partner, her political viability probably depends on it. It is going to be very hard for Merkel to live down her own words and the austerity "brand" that she has cultivated.
Under these circumstances, it is difficult to envision the German Chancellor acquiescing to the sort of radical monetary and fiscal expansionism that would be necessary to save the PIIGS from their current economic and fiscal free-fall. Such an about-face would probably spell the end of her political career and could devastate her party.
Trying to predict the evolution of Germany's policy response is no easy matter.
On the one hand, Germany is under enormous international pressure to reverse course and abandon its insistence on austerity. On the other hand, judging by recent remarks and behavior by public officials, the German position does not seem to have budged at all. Furthermore, Merkel's performance in the polls seems to be internally ratifying her hard-line position, if not constraining her to it.
Clearly, German leaders are being buffeted by pressures on all sides and the decisions ultimately taken in this context will depend a great deal on the character and timing of a slew of events that are completely out of German control.
In this regard, I believe that a variety of factors between now and the end of April will strengthen the German impulse to resist further bailouts and erode the case in favor of them. For example, I expect that severe economic and fiscal deterioration in the PIIGS will make future bailout propositions much more costly and seemingly hopeless in the long term from the point of view of the ordinary German. Another factor relates to domestic politics in various European countries. I believe that politics in many European nations will take on an increasingly anti-German tone. For example, Greek and French elections in April will probably see the rise of parties that outwardly reject German austerity. Anti-austerity movements could also gain momentum in Italy and perhaps Spain.
Under such circumstances, I believe that a counter-reaction could develop within Germany. Aside from the sentimental revulsion involved, many Germans will conclude that bailing out the PIIGS would simply be throwing good money after bad in the long run.
The perceived inevitability of a PIIGS crisis, which is gaining ground in Germany, will constrain Merkel's ability to soften her policy, even if she was so inclined. Indeed, I doubt whether Merkel will be able to shift her policy unless the recession is already hitting ordinary Germans so hard that she will be able to present expansionary fiscal and monetary policy as a tool to protect German jobs as opposed to a rescue operation for the benefit of PIIGS. The problem is that by the time the pain is being felt to a sufficient degree in Germany, much damage will already have been wrought to the PIIGS and other economies and financial markets in the rest of the world.
Furthermore, it is important to understand that decisions regarding bailouts are not a matter that the Merkel and high level German officials can decide on their own. Germany's highest court has ruled any expansion of bailout commitments must be approved by parliament. German parliamentarians will be loath to go on the record supporting such bailouts.
Global markets seem to be discounting the belief that Germans will do whatever it takes to avoid a full-fledged euro crisis. This belief is usually based on a simplistic analysis of what Germany "should" do. The problem is that I do not think that it is clear that the Germans are convinced or can be convinced that financing ever larger bailouts is the "right thing to do." And even if Germany's top policymakers believed that, I think that many cultural and domestic political constraints stand in the way of such implementation.
If you believe that the Germans will reverse course quickly and underwrite a massive and comprehensive bailout scheme as proposed by the PIIGS themselves and now seconded by the IMF, then you should go out and buy equities such as Apple (AAPL), Microsoft, Citigroup (C) and Chevron (CVX) as well as ETFs such as (SPY), (DIA) and (QQQ), hand over fist.
On the other hand, if you believe that the Germans and other EU members will recoil at the prospect of a drastic policy about-face, then the downward economic spiral in the PIIGS will continue, diplomatic acrimony will rise, the prospect of major defaults will become more imminent and global financial markets will get hammered. Under such circumstances investors should either be heavily in cash and bonds or outright short.
I personally do not think that market participants really understand what an effective bailout of the PIIGS will entail or what constraints German leaders face in implementing such a bailout. I therefore believe that financial markets are not properly discounting the probabilities that German policy will impede a sufficiently quick and efficient response to the European crisis.
I reiterate my view that by the end of April, the S&P 500 (^GSPC) will initiate another leg down that will take the index down to the area of 950-1,020.