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Orders and Production: No Time for Complacency
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John Mauldin
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Aug 06, 2012





We have been assaulted with economic news of all sorts, from every corner of the globe, while trying to watch the Olympics and while we would rather be enjoying summer and decompressing (at least in the Northern hemisphere).





But the data keeps coming. My friend John Silvia, the Chief Economist of Wells Fargo, has been with me in Maine this past weekend. And as we caught fish and shared our thoughts, we also both managed to get out our respective writing done. His note this morning is a particularly interesting analysis of US data, which has him wondering about his call for tepid growth but no recession.





“A run of weaker-than-expected economic data in recent weeks has engendered the usual speculation of whether or not the economy is poised to slip back into recession. In this piece, we describe the critical role of industrial production in the current cycle and discuss how deterioration here could signal trouble for the broader economy. We also analyze what has happened in past cycles when these components have simultaneously slipped into contraction territory.”





My son Trey and I have been going to these Maine summer events for six years. The last time the conversation was as, let’s say, “concerned,” was in August of 2008. This year the concern about Europe has been evident. My main thesis is that the US should not fall into recession unless it is pushed. And Europe could be the catalyst, if they do not control their problems. Much of the continent is in recession, and Greece, Portugal, and Spain are in what can only be called depressions.





The longer the Europeans vacillate about what to do, and continue to offer up nothing more than hope and endless summits, the worse it will get. They cannot avoid a very costly decision. Either breakup or a full fiscal union is going to be massively expensive. The only thing that can be more costly is to avoid doing either. If they don’t act decisively, they will most certainly drag the US and global economy into recession as well.





The last month has been perhaps the most intellectually stimulating of my life. I write this on a plane home. (The economy may be tepid, but the planes I have been on in the US have been oversold for the last few months. Which means the free upgrades are getting harder to come by.) I am looking forward to digesting what I have been confronted with. Some of it has been enormously positive, and some of it disturbing. The true surprises really have been to the upside.



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The past month has reinforced my very-long-time (admittedly almost extreme) positive outlook, though we face an immediate future that we may best characterize as not so bullish. And if I were a citizen in most any European country, my prospects would seem dark indeed.



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But that is a topic for later letters. For now, let’s look at what John Silvia and his most solid team have to offer us.



Your mind on overload analyst,

John Mauldin,
Editor Outside the Box






Orders and Production: No Time for Complacency
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Wells Fargo Securities, Economics Group
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Special Commentary





A run of weaker-than-expected economic data in recent weeks has engendered the usual speculation of whether or not the economy is poised to slip back into recession. In this piece, we describe the critical role of industrial production in the current cycle and discuss how deterioration here could signal trouble for the broader economy. Against a backdrop of deterioration in the orders components of various purchasing managers’ indexes (Figure 1), we also analyze what has happened in past cycles when these components have simultaneously slipped into contraction territory. Our mantra of slow growth, no double-dip” has withstood similar soft patches before, but the recent run of weaker-than-expected data warrants a thoughtful look at where we are in the business cycle. The difference between slow growth and slow contraction is a vital distinction; this is no time for complacency.
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Source: Federal Reserve Banks of New York, Philadelphia, Richmond, Kansas City and Dallas, Institute for Supply Management, ISM Chicago, U.S. Department of Commerce and Wells Fargo Securities, LLC





Comparing This Recovery to Past Cycles



The recovery, which began in July 2009, is clearly losing momentum. U.S. economic growth slowed from a 4.0 percent rate in the fourth quarter of 2011 to a tepid 1.5 percent annual growth rate in the second quarter (Figure 2). Some parts of the economy continue to eek out modest gains, while other sectors have slipped into outright declines.
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Source: Federal Reserve Banks of New York, Philadelphia, Richmond, Kansas City and Dallas, Institute for Supply Management, ISM Chicago, U.S. Department of Commerce and Wells Fargo Securities, LLC






Since 1954, there have been six recoveries that have lasted at least 36 months. We compared the current recovery, which has now hit the 36-month mark, to those past six recoveries. To evaluate where we are in the cycle, we consider the four primary coincident indicators used by the National Bureau of Economic Research (NBER) when it determines whether or not the economy is officially in recession. These indicators are: employment, real income growth, real wholesale sales and industrial production.


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We indexed these indicators to the trough of each respective business cycle, an idea first explored by the St. Louis Federal Reserve. This method allows us to measure each of these various vital signs for the economy and consider the position of each in this cycle relative to past cycles.
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Employment: Another “Jobless Recovery”?





Strictly speaking, the U.S. economy has technically transitioned from recovery to expansion. Total real GDP at present is 1.7 percent larger than its prerecession peak. However, many parts of the economy are struggling to get back to previous highs. Perhaps nowhere is this deficiency more evident than in the labor market. The U.S. economy lost 8.8 million jobs in the recession but has only recouped roughly 3.8 million of those lost jobs (Figure 3). That leaves an “employment deficit” of roughly five million jobs. Try telling one of these five million people that the economy has transitioned from recovery to expansion.
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Source: U.S. Department of Labor and Wells Fargo Securities, LLC







In Figure 4, we reveal the first of our charts comparing this cycle relative to the past six recoveries that have lasted at least this long in duration. Since we will repeat this chart for each of the four NBER coincident cyclical indicators, it is worth taking a second here to describe what is depicted in the chart.


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Each series is indexed to 100 at the trough of the cycle. The lighter solid line indicates the current expansion. The darker solid line indicates the average of the previous six expansions that have lasted at least 36 months. The two dashed lines report the best and worst values across these previous expansions.



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The legend in each graph identifies the date for which cycle was the “best” or “worstexpansion. Taking employment in the chart below as an example: the best jobs recovery was following the 1975 recession, the worst was following the 2001 recession and the current cycle is well below average and only slightly better than the 2001 cycle.
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Source: U.S. Department of Labor and Wells Fargo Securities, LLC



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Real Income: Well Below Average



In an environment where employers have been reticent to add new workers, it comes as little surprise that income growth has been rather muted as well. Transfer payments, such as social security, unemployment insurance and food stamps, have been a key driver of income growth in this economic cycle as opposed to wages and salaries. In fact, between the prerecession peak for income in the second quarter of 2008 and June 2012, transfer payments increased 18.9 percent while over the same time period wages and salaries increased only 4.2 percent.





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After subtracting transfer payments and adjusting for inflation, income growth in this cycle has been close to the weakest recovery in our study. From the absolute trough of the economic cycle in June 2009, personal income less transfer payments is up just 6.6 percent. The average expansion would have posted an 11 percent recovery by this stage of the recovery.
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Just as employment is still a far cry from it prerecession peak, personal income ex-transfer payments is also a shadow of its former self, still 3.4 percent smaller than its high in March 2008 (Figure 5). The weakest real income recovery in our study was the 2001 cycle, though if one looks carefully at Figure 6, one will note a spike in income about three years into that expansion. Recall that the one-time special dividend payout to shareholders of Microsoft occurred in 2004 and is the best explanation for the pop in income during that cycle. Barring a similar surge in real income in the next few months, this cycle is about to become the worst on record with respect to income growth.
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  Source: U.S. Department of Commerce, U.S. Department of Labor and Wells Fargo Securities, LLC



Source: U.S. Department of Commerce, U.S. Department of Labor and Wells Fargo Securities, LLC






Real Wholesale Sales Holding Up, but What Will Happen as Retail Sales Fade?



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Real manufacturing and wholesale-retail trade sales is the next of our four NBER coincident indicators. Here, again, we find that, although the economy as a whole is now larger than it was before the recession, this category of sales is still clawing its way out of the hole (Figure 7). Despite having rallied 12.6 percent from its level at the depth of the recession, wholesale sales are at present 3.9 percent lower than they were before the recession began.
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Source: U.S. Department of Commerce and Wells Fargo Securities, LLC




Source: U.S. Department of Commerce and Wells Fargo Securities, LLC




It comes as little surprise to learn that, in terms of how this cycle stacks up with regard to wholesale sales, the current period is below average. Yet, the current recovery in real wholesale sales compares more favorably to previous trends than the recoveries in the job market and real income. Indeed, on a three €‘month annualized basis, this series is growing at a 4.1 percent rate through June.




This rate of growth hardly seems sustainable given the rapid deterioration in U.S. consumer spending. Retail sales have fallen for three consecutive months. Granted, the component we are focused on in this section is real manufacturing and trade sales, so retail sales will not perfectly lead this series, but a three-month backward slide for retail sales does not bode well for sales at the wholesale level. A move into negative territory in the orders component of various purchasing manager surveys suggests little support for the manufacturing portion of orders.




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Industrial Production: The Only Component Firing on all Cylinders




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Industrial production has been the strongest—or at least the least weak—of the four NBER business cycle indicators during this recovery. Although output has increased 16.7 percent from its recession low, it remains 3.3 percent off its prerecession peak (Figure 9). None of the four business cycle indicators have yet crested above their respective prerecession high water marks, but industrial production is the closest of the four. In terms of how it stacks up relative to previous cycles, the current run is almost a perfect retracement of the average of the other six recoveries in our study (Figure 10). Industrial production has been critical to the recovery so far.



  Source: Federal Reserve Board and Wells Fargo Securities, LLC



Source: Federal Reserve Board and Wells Fargo Securities, LLC





Output at the nation’s factories, utilities and mines turned positive at precisely the same time as the broader economy in the summer of 2009. It may seem somewhat unexpected that industrial production has retraced most of its recession losses while there has been little improvement in terms of manufacturing payrolls (Figure 11). Unfortunately for manufacturing workers, this was not unlike the previous recovery following the 2001 recession or several other cycles before that.



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In fact, the total number of workers on manufacturing payrolls peaked in 1979; this helps explain why payrolls can be so weak even as industrial production comes back in a relatively typical way. Having said that, Figure 12 shows how industrial production gains have been hit and miss, falling twice in the past four months.


Source: U.S. Department of Labor, Federal Reserve Board and Wells Fargo Securities, LLC

Source: U.S. Department of Labor, Federal Reserve Board and Wells Fargo Securities, LLC




Where Are We Now?



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For two of these indicators, employment and income growth, this cycle has been extraordinarily weak. Given the stubbornly high unemployment rate, this probably comes as little surprise. However, for the other two indicators, industrial production and real manufacturing and trade sales, the current cycle has been fairly typical, at least until retail sales started to come unglued in April. The last remaining stalwart of growth in this cycle, at least among these four components, is industrial production. Perhaps more than at any time in the past several years, the outlook for industrial production is critical to the outlook for the overall economy. Among the key factors to consider to get a sense of what the future holds for output is what purchasing managers are saying about their orders.





The major regional and national PMI surveys include a sub-index on new orders, which provide an early look at the strength of future production. A monthly decline in the new orders component in one series may not in and of itself signal a future decline in production, but when multiple new orders indexes slip into contraction territory, it can signal broad-based weakness in the manufacturing sector and a potential decline in total economic output.




Of seven major manufacturing surveys, five signaled a decline in new orders in July. Given that these surveys cover different geographies and are based on the sentiment of respondents, orders rarely contract simultaneously in each survey on a monthly basis.




Indeed, the only time all seven surveys have been in contraction territory was during a five-month period that began in October 2008. By that point, the economy was already 10 months into the recession. As a result, there is limited value in waiting for all seven indicators to go negative at the same time. What if we look instead at other periods when five or more of these new orders series—the same number currently showing a declinefirst slipped into negative territory? We find a more valuable warning signal. The last time five of these orders components first went negative was February 2008, 10 months before the NBER announced that the recession began in December 2007.



For the 2001 recession, the new orders indexes signaled broad weakness ahead for the economy. The new orders index for the four PMIs available at the time showed concurrent declines as early as January 2001, although the recession did not officially start until March of that year.





While the number of purchasing managers’ indexes currently signaling a decline in new orders is concerning, it is important to note that a simultaneous decline in these surveys has not always meant the onset of a recession. Looking at the four PMIs with history through the 1990s, a majority signaled declining orders in the mid-cycle slowdown of the 1990s, which did not result in a recession. Our outlook of sluggish growth reflects the softness seen in orders in many of the major PMIs, but we do not believe the economy is currently in recession.



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Conclusion: Avoiding Complacency



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In a world of uncertainty, it is important not to ignore the shots across the bow. As human beings, we are limited by a confirmation bias—the tendency to favor information that validates our beliefs or world view. We have been repeating our call of “slow growth, no double dip” since the outset of this recovery three years ago, and so far this has been the right call. However, we must guard against confirmation bias in our analysis. In this essay, we make the point that, because of the critical role industrial production has played in this recovery, we cannot afford to ignore evidence that orders are falling. The unraveling in orders may lead to a broader weakening in the outlook for industrial production and overall economic growth.



08/06/2012 08:14 PM

Interview with Italian Prime Minister Mario Monti


'A Front Line Between North and South'
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Italian Prime Minister Mario Monti: "I will remain in office until April 2013, and I hope that I can rescue Italy from financial ruin by then ..."


In a SPIEGEL interview, Italian Prime Minister Mario Monti says Europe is showing traces of a "psychological dissolution" in the debt crisis and that leaders are doing too little to stop it. He also warns that governments cannot allow themselves to become "fully bound" to parliament in determining policies to save the euro.




SPIEGEL: Mr. Prime Minister, the euro is once again under pressure and voices speaking of a possible breakup of the common currency zone are growing louder. Have you completely given up on the idea of having a summer vacation?




Monti: I only have six days and I hope they don't disappear. Still, I am rather serene when I look at the summer. There is, of course, still a risk when it comes to Greece ...




SPIEGEL: ... because it appears that bankruptcy is unavoidable ...



Monti: ... but following a long period of preparation, we achieved good results on the whole at the most recent European Union summit at the end of June -- resolutions that should give the markets a better idea of how solid the euro zone really is.




SPIEGEL: But they haven't helped to reduce pressure on Italy and Spain. Last week, European Central Bank head Mario Draghi announced that the ECB is prepared, possibly together with European bailout funds, to buy sovereign bonds from indebted member states, but only at an undefined point in the future. Are you disappointed with the bank's hesitation?



Monti: I can only welcome the ECB's statement that the market for sovereign bonds in the euro zone is undergoing a period of "severe malfunctioning." It is also true that some countries face "exceptionally high" costs in financing their debt. That is exactly what I have been saying for some time. It is self-evident that banks are pulling back behind their national borders, making it even more difficult for those countries that are suffering from market mistrust. These problems must be solved quickly so that there can be no further uncertainty regarding the euro zone's ability to withstand the crisis.


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SPIEGEL: Do you not think that the solution presented by the ECB reduces the pressure on the affected countries to clean up their state finances?



Monti: No. If you read the requirements of the European bailout funds, or even just last Thursday's ECB statement, you would have to admit that such concerns are unfounded. That is exactly the kind of distrust that has prevented us from embarking on a clear path toward a solution. We have to quickly surmount that and begin trusting one another once again.



SPIEGEL: Is there a reason to do so?




Monti: I think there is. Italy's current government has ensured a rapid reduction of the budget deficit, has passed structural reforms and has improved growth potential. Despite great sacrifice, Italians have accepted this course.



SPIEGEL: There is significant skepticism in Germany regarding ECB sovereign bond purchases. Can you not understand that those who back the bank are concerned about taking on unlimited guaranties?




Monti: The decisions facing Germany right now are not easy and I understand the difficulties German politicians are facing. To remain functional within a common currency, all countries would have had to implement reforms and arrange their budgets in a way that doesn't place a burden on others. That is why the progress that has already been achieved is so important to guarantee budgetary discipline -- like with the fiscal pact, for example.



SPIEGEL: That hasn't yet been of much help to the euro.




Monti: We have all made mistakes, even with the formation of the euro, even in an early phase when France and Germany in 2002 and 2003 violated the rules imposed by the Stability and Growth Pact and became poor examples for others. We now have to create a more responsible currency union.



SPIEGEL: That is exactly why you were asked to take on a leadership role in Italy. At last now, Rome is once again an important player in Europe.



Monti: For several years, we apparently didn't play a central role. I think it is completely normal that the third-largest economy in the euro zone has now become more active when it comes to reaching consensus on decisions facing the union.




SPIEGEL: Your meeting with French President François Hollande and Spanish Prime Minister Mariano Rajoy last week sparked concern that a southern alliance was being created to better counter demands coming from the north.



Monti: Between the two meetings, I was also in Finland. Of the three countries, I spent the most time there. In this case, it is not about north and south, it is about the currency used by 330 million Europeans. The more cohesively we act, the quicker we will find our way back onto a safe path, with fewer costs for all of us. Just now, I spoke on the telephone with Chancellor Angela Merkel, who invited me to Berlin at the end of August.



SPIEGEL: In general, however, it would seem that relations between the Italians and the Germans are somewhat clouded. Many are complaining about German rigidity and arrogance. How do you explain this atmosphere?




Monti: That has indeed been very unsettling for me in recent months and I told Chancellor Merkel of increasing resentment here in parliament -- against the EU, against the euro, against the Germans and sometimes against the chancellor herself. That, though, is a problem that goes beyond just Germany and Italy. The tensions that have accompanied the euro zone in recent years are showing signs of a psychological dissolution of Europe. We have to work hard to put a stop to it. If we were to compare Europe to a cathedral, then the euro would be its most perfect spire to date.




SPIEGEL: One which we, unfortunately, are afraid might come crashing down.




Monti: If the euro becomes a factor promoting Europe's drifting apart, then the foundation of the European project is destroyed. That is why it is the utmost duty of national leaders to explain to their people Europe's true situation and not to give in to old prejudices.



SPIEGEL: Do you believe that this problem is still solvable?



Monti: Yes and in this regard there is also a front line between North and South, there are mutual prejudices. That is very disquieting and we need to fight it. I am certain that most Germans have instinctive liking for Italy, just as Italians admire Germans for their many qualities. But I also have the impression that the majority of Germans somehow believe that Italy has already received financial aid from Germany or the European Union, which simply is not the case. Not a single euro.




SPIEGEL: How would you explain to a small business owner in Germany, who is already liable for diverse bailout packages with his or her tax money, that that person would, indirectly through the European Central Bank, have to provide guarantees for a restructuring of a bankrupt bank in Siena?



Monti: I would try to explain to that person that the reality sometimes looks totally different from the perception that one has of something. The reality is namely also that Italy, in relation to its economic size has more or less provided the same percentage of aid for Greece, Ireland, Portugal and more recently the Spanish banking sector as Germany. But also just take a look at the net benefit of this aid.




SPIEGEL: You mean that aid for the indebted states also benefits Germany?



Monti: Much of what Germany and France have done in the rescue of Greece has also helped German and French banks, who for a long time were major creditors for Greece and Greek banks. That practically doesn't apply to Italy at all, though. Seen in this way, Italy has not only not been the recipient of any aid, but we have actually given more than France or Germany if you consider the net return. This year our national debt will amount to 123.4 percent of our gross domestic product. Without the aid payments, it would be 120.3. I would explain that to a German businessman.



SPIEGEL: And you believe the German businessman would buy that?



Monti: I would also explain to him that Germany also profits from the fact that sovereign bonds in the Federal Republic of Germany are so cheap and that they can at times even be issued with negative interest rates. It is because of the risk of a euro collapse that the difference between Italy's interest rates and those of Germany is so great. In this way, the high interest rates that Italy is now having to pay are subsidizing the low ones that Germany pays. Without this risk, Germany would pay somewhat higher rates. In addition, no one can deny that Germany, simply because it is big, so productive and so efficient, is the greatest beneficiary of the common market.




 

SPIEGEL: Are you certain that a breakup of the euro zone is still preventable?



Monti: Yes, it is still possible, but it isn't just going to fall out of the sky.




SPIEGEL: But it also doesn't appear that the problems are going to be solved by continuing to flood them with more money. That creates breathing room for a few days, but then the pressure on the financial markets increases again. Is it possible to break this vicious cycle?



Monti: Yes.



SPIEGEL: Without constantly throwing fresh money at it?



Monti: Correct, that can't be. It would help if the communication following euro-zone decisions were improved.




SPIEGEL: But the issues here are the mountains of debt and not press conferences.



Monti: But there are these mistakes with not completely identical information being distributed that leads to new turbulence on the markets. However, much more serious is the fact that there are a few countries -- and they lie to the north of Germany -- who every time we have reached a consensus at the European Council (the EU body representing the leaders of the 27 member states) then say things two days later that call into question this consensus.



SPIEGEL: You are now referring to the Finns as well as others?



Monti: I can understand that they must show consideration for their parliament. But at the end of the day, every country in the European Union has a parliament as well as a constitutional court. And of course each government must orient itself according to decisions made by parliament. But every government also has a duty to educate parliament. If I had stuck to the guidelines of my parliament in an entirely mechanical way, then I wouldn't even have been able to agree to the decisions that were made at the most recent (EU) summit in Brussels.



SPIEGEL: Why not?



Monti: I was given the task of pushing through euro bonds at the summit. If governments let themselves be fully bound by the decisions of their parliaments without protecting their own freedom to act, a breakup of Europe would be a more probable outcome than deeper integration.




SPIEGEL: Silvio Berlusconi boasts of fighting communism in Italy. How do you want to be remembered by Italians and Europeans?



Monti: If everything goes according to plan, I will remain in office until April 2013, and I hope that I can rescue Italy from financial ruin by then -- and this with moral support from a few European friends, led by Germany. But I will also say very clearly: moral support, not financial. And, finally, I hope that Italy will simply become a little bit more boring to outside observers. If Germany and other countries are interested in ensuring a future for the current policies in Italy, then ...



SPIEGEL: ... they should make more concessions to Italy?



Monti: Again, not with financial aid. But they should allow a bit more leeway to those states in the euro zone that follow European guidelines the most closely.



SPIEGEL: Your relationship with Angela Merkel, who many saw as the loser of the last summit, is now back on solid footing?





Monti: We maintain a very friendly, cordial relationship. We have known each other for many years and I have been very pleased with the recognition I have received from both the chancellor and from Finance Minister Wolfgang Schäuble for the progress made in Italian politics.




SPIEGEL: A few weeks ago, when your predecessor Silvio Berlusconi said that he too had a cordial relationship with the chancellor, she quickly had a denial issued.



Monti: Then we can sit back and wait to see if another denial is forthcoming.



SPIEGEL: Mr. Prime Minister, we thank you very much for this interview.



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Interview conducted by Fiona Ehlers and Hans Hoyng