Today’s press announced that Germany’s industrial sector recorded a 12.1% increase on the previous year, outperforming most of the other Eurozone peers, and was boosted by another rise in business morale, as ZWE indicator of economic sentiment climbed 2.5 points in November.

Many countries, especially Ireland, Portugal, Greece, Italy, have particularly strong problems with their finances, facing difficulties raising money to fund their state budgets. Spain is currently in the news due to Moody’s, a rating agency, threatening to downgrade the country’s creditworthiness again (currently at Aa1). For Spain, the main trigger is to recapitalise its struggling banks and to coordinate cost cuttings with the regional governments (Spain being a federal state, the central government has not as much influence as it would wish for).

Nevertheless they start to take drastic measures to improve their own finances, cutting costs and dressing up for international investors. Huge efforts are on their way to bring their first fruits and as soon as the reforms are confirmed and the budgets back to normal the formerly falling countries will be back on a growth path.

The strong recent German economic performance supports German government but could lead to a phase of a slower path of reform. As the economy seems to outperform most of its peers, we are less likely to see any unpopular cost cutting measures. It is simply not in the blood of a politician to start painful measures when most of the population is doing well (unemployment being on the lowest level since years). And as the polls are currently rather gloomy for the current conservative government (forecast to lose their majority in parliament if there would be an election next Sunday), the chancellor will probably scale back some reforms in order to improve the negative image and gain some ground for the next elections.

One might think that the Euro is currently the biggest problem but as in any crisis of confidence, and I believe that it is only a crisis of confidence, as soon as reforms start to show their merits, and as soon as the panic calms down and investors get back to normal, the Euro will recover. Additionally, a weak Euro helps most of the Eurozone members to boost their exports and thus stimulate their economy artificially.

The real risk for Europe is that in a couple of years, Germany is the sick man of Europe again due to the lack of significant reforms and cost cutting measures undertaken by the federal government. As Europe’s largest economy, a struggling German would be another drawback for the Eurozone’s economy. It is therefore right to refuse the euro bond idea as it would increase refinancing costs for the German government, but refusing euro bond is one thing, necessary and painful reforms are another thing, yet to be undertaken.

Inflation vs deflation

We are currently facing a heated debate whether we have a risk of deflation or inflation. Not that this is a passionate subject for most of the people but it might well influence our future – especially our purchasing power. What do we know about these two? We know that deflation is that kind of thing which the Japanese have been facing for a decade or so already. Do they seem unhappy? When they travel around and block our inner cities with their tourist busses they all seem quite happy. What about inflation? That’s that kind of stuff which is going on in Zimbabwe: the government issued on January 16th a ZWD 100 trillion bill. You can be a millionaire so quickly!!

The problem is that, as a citizen of one of these countries or as a corporation, we do not really think that this is funny. Why? Because if we receive a bill of LCY[1] 100 and some days it is only worth 90 we are rather pissed. This is inflation. Inflation makes things more expensive and thus we can buy less with our 100. Deflation is more complicated. Consider that you are the head of XYZ Inc. and that you want to make an investment in Yokohama. Today that investment costs you JPY100, tomorrow probably JPY90. What will you do? Yeah right, you’d probably wait. But the thing is that once the investment would cost JPY90 today it would cost JPY80 tomorrow, so you keep on waiting. That’s pretty embarrassing for the country because suddenly no one is investing because prices are falling. It is a vicious circle because for prices to rise again, someone would need to invest. But because no one does so prices keep on falling.

So to keep it simple, inflation is caused because too many people are spending too much money and deflation is that too many people are not spending anything. Thanks to globalization all this becomes somewhat complicated. Investors can transfer funds from place A to place B quite easily. Inflation is low in Japan, the Central Bank lowered interest rates to 0 and thus investors enter the market to take on a credit and invest it in a country with a higher inflation such as the US a couple of years ago. The difference they made was their gain. The trade is called a carry trade. Normally the exchange rate is going to prevent that kind of trade from happening but exchange rates are not always free-floating which gives place to arbitrage opportunities.

Are we now facing deflation or inflation? What should the Central Banks policy be?

According to some inflation can only be caused when consumers are spending more nominal dollars. They argue that the state has so far been reluctant to pure money to consumers’ pockets and thus the risk of inflation is low. The state funds consist basically in guarantees meaning that there is most of the time no exchange of cash. Consequently, there can not be inflation. They argue that the bigger threat is deflation. Consumers stop spending, companies stop investing, employment rises and a downward pressure on prices is exerted.

If the crisis continues and recession deepens, deflation becomes a real threat. Drying liquidity causes deflation, money is hold back by consumers as well as lenders. Mr. Bernanke said in 2002 that a healthy banking system is the best defense against deflation. The banks now being in a shaky situation, the economy can no longer rely on that defense. Thus the risk of deflation increased significantly.
All also depends on the currency. If the LCY is getting stronger, import prices are decreasing which adds deflationary pressure on prices.

Today, the money-in-circulation is not so much of a problem because so far the consumers are careful and lenders are keeping their money. According to an article published in the Wall Street Journal, the M1 aggregate rose so far by 10%. The biggest problem comes from the bank reserves. Banks now have huge reserves enabling them to make new loans. The question is now how quickly do the banks make these loans? Consider that banks are hungry for new business and make loans quickly in order to have higher returns. Money-in-circulation skyrockets and creates inflation. The phenomenon is even intensified by the low demand – due to high unemployment and low investments - and high supply of money.

Some more factors do enter into the inflation figure: commodity prices. Commodities are the basic element of all products. If commodity prices rise – what they are doing again since May – product prices might follow. Why do commodity prices rise? So far analysts expect the Asian economies, especially China, to recover from the crisis. According to Chinese newspapers, Chinese industrial production rose by 8.9% in May. This is a sign that the economy is recovering but especially an indication that Chinese manufacturers are starting again to import raw materials which pushes up prices again.

Gold price which is usually considered as an indicator for inflation has been pretty volatile during the recent weeks probably indicating that investors are considering the risk of inflation. Inflation indexed bonds also start pricing in an increase of inflation. Especially the 10yr bonds are showing some sensitivity to that issue (they currently price in an inflation of 2%).
It is therefore probably safer to say that there will be inflation. Not now but in the next years and if the Central Banks do not take the necessary steps – such as reducing the money-in-circulation by increasing the reserve requirements for banks – we might see a strong and persistent inflation. This damages parts of our economy. For sure it would be unwise to say that deflation is not going to happen but the chances that we enter a deflationary cycle are pretty low. Finally everything depends on the
[1] LCY = Local Currency ; FCY = Foreign Currency