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Well, first there was the exchange rate mechanism (ERM) that linked certain European currencies in a semi-fixed exchange rate system. That system was highly asymmetric, with Germany enjoying de-facto monetary independence that no other member shared. The other member countries simply had to follow the German lead.

This was tolerable for a small country like the Netherlands, which shared much of the same Teutonic monetary tradition and where people in the central bank joked that they had about 45 minutes of monetary independence. The latter referred to situations of monetary policy changes in Germany, which the Dutch central bank had to follow in due course, if not to endanger the link between the Guilder and the D-mark or the interest rate spread with German bunds.

This state of affairs was only acceptable for big countries like France and Italy in so far they could use it to - by 'tying the hands' of their central banks - 'import German credibility' which would get their inflationary expectations down and served to discipline policy makers.

France was more successful in pursuing this strategy than Italy, but in the end it didn't like to be under the German monetary directive so it jumped on an alternative that got us into the present mess, the euro (or EMU, European Monetary Union).

At least the French and the Italians would be equals with the Germans in the Council of the European Central Bank (ECB), or so they thought. But economic realities have a nasty habit of reasserting themselves in different guises when the institutions are changed.

Funny flows

What ensued was the following. The creation of the EMU had currency risk disappearing overnight. As a result, capital flew from the center to the periphery, creating a bit of a boom there, greatly reducing borrowing cost, creating credit bubbles in places like Greece and Portugal and housing bubbles in Spain and Ireland. In the center, it led to banks having even bigger balance sheets, the result of supplying most of this credit.

But the mirror image of capital flows are current accounts, of which trade balances are the most important component. The periphery's trade balances moved negative, but nobody warned as the thinking was that the inflows of foreign capital was part of 'catching up' with the center, part of a grander convergence.

For almost a decade, this indeed played out and it seemed like countries like Spain and Ireland were indeed catching up fast. Others, like Italy and Portugal (let alone Greece) were wasting chances. Meanwhile, Germany was quietly reforming which enabled it to pull even further ahead.

Even if they had wanted to, the countries on the receiving end of these capital flows were unable to do much against these, having given up their independent monetary policies and currencies, and capital controls not possible thanks to the Single Market.

Click to enlarge

(GIPS: Greece, Ireland, Portugal, Spain)

Then the 2008 financial crisis came and the capital flows stopped. Then the euphemistically called private sector involvement (PSI) for Greek debt (the various 'haircuts') came, waking investors up that while currency risk had gone, default risk had come back with a vengeance, and the capital flows reversed course.

Here lies much of the problem. Not only can the periphery not devalue to restore competitiveness or embark on expansionary monetary policy to soften the impact of austerity, what the ECB does in terms of easing is more than offset by capital fleeing the periphery.

So much so that Richard Koo of Nomura suggested that it would be a good idea to sell debt only to nationals and prevent capital fleeing to the center leaving the periphery with the danger of public finance insolvency on top of all the other problems. But when investors and depositors alike can, at no currency risk, invest in German paper or put their money there, why wouldn't they?

Germany reflating

So while the periphery was doing well in the decade leading to the financial crisis, on an influx of capital and cheap borrowing, the reversal of the capital flows has created a big crisis.

But guess where the capital is going? To Germany. We see now some of the same funny things happening there as we saw before the financial crisis in the periphery. A 6.3% wage rise for civil servants. This will likely be followed in other sectors, because Germany is the only country where unemployment has actually fallen since the financial crisis of 2008.

The public sector deficit will exceed a fraction of 1% of GDP, despite all those bailouts. No surprise either because the economy grew by 3.7% and 3% in 2010 and 2011, even though forecast for this year is a meager 0.6% growth but that's still a whole lot better than the periphery which is mired in depression.

And, apart from the rather sumptuous wage rises, there are some small signs of froth:

House prices in Spain plunged 11.2 percent last year; in Germany they rose 5.5 percent, the most since the country's post-reunification property boom in the early 1990s.

And there is a bit of a rally on the bond markets in Germany as well, serving as a 'safe haven' trade. How much of that is perception, rather than reality remains to be seen, but for now long-term interest rates are near record lows in Germany.

The German reflation trade

Rising wages and improving balance sheets, that could be the start of a bit of a consumer boom in Germany. Perhaps it is time for a little German reflation trade. German stocks can be traded via the iShares German ETF (EWG) listed in New York. It's top ten holdings are:

We would also say that companies like Hochtief AG (OTCPK:HOCFY) and would do well. German like Commerzbank (OTCPK:CRZBY) should do better than most. If you don't like banks because you're not entirely sure what's on their balance sheets (in terms of derivatives or debt to the Euro zone periphery), you can buy stuff that profit from the domestic market like health care groups like Rhön Klinikum (OTC:RHKJF) or travel groups like Tui AG (OTC:TTVLF).

One might think that this time, the Germans have no way of stopping this reflation, like the Euro zone periphery didn't a decade ago. After all, ECB policy is an average for the whole Euro zone and much of it is experiencing terrible deflationary forces with shrinking money supplies. One might think that the Bundesbank, devoid of the interest rate instrument, can't do much about reflation in Germany, but alas, it has a different opinion:

The Bundesbank made clear last week that it stood ready to crush any sign of nascent demand in Germany, preparing to check "excessive credit growth", impose "maximum leverage ratios", and set "counter-cyclical capital buffers" to nip inflation in the bud. Already alarmed by house price rises of 5.6pc in 2011, the bank is mulling "loan-to-value" limits. In other words, it looks as if Germany will not let inflation creep up to 3pc or 4pc over the next half decade to help rebalance the North-South gap in intra-EMU competitiveness. [Telegraph]

But one can still dream.

Source: The German Reflation Trade