10/08/2012 06:29 PM
The Inflation Monster
How Monetary Policy Threatens Savings
By Ferdinand Dyck, Martin Hesse and Alexander Jung
Germany's central bank, the Bundesbank, has established a museum devoted to money next to its headquarters in Frankfurt. It includes displays of Brutus coins from the Roman era to commemorate the murder of Julius Caesar, as well as a 14th-century Chinese kuan banknote. There is one central message that the country's monetary watchdogs seek to convey with the exhibit: Only stable money is good money. And confidence is needed in order to create that good money.
The confidence of visitors, however, is seriously shaken in the museum shop, just before the exit, where, for €8.95 ($11.65) they can buy a quarter of a million euros, shredded into tiny pieces and sealed into plastic. It's meant as a gag gift, but the sight of this stack of colorful bits of currency could lead some to arrive at a simple and disturbing conclusion: A banknote is essentially nothing more than a piece of printed paper.
It has been years since Germans harbored the kind of substantial doubts about the value of their currency that they have today in the midst of the debt crisis. A poll conducted in September by Faktenkontor, a consulting company, and the market research firm Toluna, found that one in four Germans is already trying to protect his or her assets from the threat of inflation by investing in material assets, for example.
Germans Fear Assets at Risk
The German economy may be doing relatively well, with low unemployment and better economic performance than in many other industrialized countries. But Germans sense that they will end up paying for the current debt crisis, one in which politicians and monetary watchdogs are playing for time, through inflation that will gradually reduce the value of their savings.
It's a silent but insidious and cold form of expropriation that has now begun.
Andrew Bosomworth can offer some insights into how this form of indirect theft of assets is taking place. When Bosomworth, the head of portfolio management in Germany for PIMCO, the world's largest investment management firm, talks about the calamity that the debt crisis will bring upon mankind, he sounds like a concerned doctor. "The industrialized world is stuck in a severe debt and growth crisis," he warns. "The central banks are fighting the disease with monetary infusions of previously unknown proportions, and the side effect is a slow but dangerous devaluation of money."
Bosomworth argues that a gigantic redistribution from the bottom to the top has begun. "Gradual inflation has a numbing effect. It impoverishes the lower and middle class, but they don't notice," says Bosomworth. He believes that the Germans' fear of inflation is more than justified.
For the past five years, governments from Berlin to London and from Brussels to Washington have been in crisis mode. They rescued the banks in 2007 and 2008, then they stimulated the economy and, since 2010, have threatened to drown in their own debts. The burdens are being pushed up the line, from private investors to central banks and government bailout funds. But this doesn't make the debts any smaller. In fact, the opposite is true, as the example of Greece and other countries shows.
Governments Accepting Higher Inflation
Since September, when the central banks of the United States, the euro zone, Great Britain and Japan jointly announced their intention to pump even more cheap money into the financial markets, the people have become increasingly aware of the growing influence of highly indebted governments on central banks. They also recognize that governments seem to be willing to accept higher inflation if it facilitates debt reduction.
The official inflation rates are still moderate. According to recent figures, consumer prices rose by 1.7 percent in the United States, 2.2 percent in Germany and 2.6 percent in the euro zone as a whole, compared with the goal of about 2 percent inflation set by the European Central Bank (ECB).
Nevertheless, economists, like American Nobel laureate Paul Krugman and Peter Bofinger, a member of Germany's Council of Economic Experts, which advises the government in Berlin, believe that fears of a new era of inflation are nothing but hysteria. They argue that unemployment is too high and demand is too weak for companies to be able to achieve higher prices in the long term.
But perhaps the public does have a good nose for what is really happening, because consumer prices don't tell the whole story. "The inflation debate is being conducted in an extremely abbreviated way," says Thomas Mayer, a former chief economist at Deutsche Bank who still serves as an advisor to the company.
"The consumer price index does not reflect major purchases, like real estate, so that perceived inflation is higher than official inflation. Real consumer buying power is consistently declining." And didn't Anshu Jain, the new co-CEO of Deutsche Bank -- who as a man born in India is less likely to be burdened by thoughts of hyperinflation that worry many average Germans -- recently declare, with great conviction, that inflation will come?
The truth is that inflation isn't some specter. It's already here -- still halting, but unmistakable and insidious.
It is evident at gas pumps in Germany, where the price of gasoline reached a new record high in September of €1.70 per liter (about $8.35 a gallon). It's evident in real estate ads, which reveal considerable price increases in major cities like Munich, Hamburg and Berlin. And it's also reached the precious metal markets, where gold is currently being traded at the record price of $1,775 per ounce.
Inflation, in the form of inflation of asset values, is already taking place in the financial markets.
The new price bubbles are being fed with cheap money from central banks, as well as by investors and savers fleeing into supposedly safe material assets. And there is something else people have figured out: If they are earning minimal interest or no interest at all on their savings, a hint of inflation is already chipping away at reserves.
The Flood of Money from Central Banks
One word from Italian economist Mario Draghi on Sept. 6 was enough to trigger jubilation in the financial markets. "Unlimited," the head of the European Central Bank (ECB) said, along with his trademark crooked smile. What he meant was that the ECB would buy unlimited quantities of government bonds from euro-zone countries if they requested aid from the European Stability Mechanism (ESM), the permanent euro bailout fund that went into operation this week, and accepted the conditions of their euro partners -- a statement Draghi reiterated last Thursday.
The ECB has already spent more than €200 billion on government bonds, and now the central bank's balance sheet could continue to swell. The mood in the markets was further improved when the central banks in London and Tokyo also announced their intention to continue their bond purchase programs and, above all, when "Helicopter Ben" Bernanke, chairman of the US Federal Reserve, lifted off for another rescue flight.
In a speech in 2002, Bernanke cited economist Milton Friedman, who had once recommended throwing money out of a helicopter to avert deflation, which is when prices decline throughout the economy.
Bernanke certainly earned his nickname with his announcement, on Sept. 13, that the Fed would buy up $40 billion in mortgage loans every month to bolster the housing market and stimulate demand. It's the third load of money that "Helicopter Ben" is tossing out over America since 2008. The Fed's balance sheet already contains close to $3 trillion in government bonds, mortgages and other securities.
But that isn't everything. The prime rate has been at zero since the end of 2008, and now Bernanke has announced that banks will likely be able to continue borrowing money for free from the Fed until at least mid-2015. "Helicopter Ben" is promising not to land before the American economy takes off and there is a significant drop in unemployment. That may all sound good and well, but it no longer has very much to do with monetary policy.
In the eyes of PIMCO executive Bosomworth, Bernanke's approach marks a departure from the Fed's independence. "We are experiencing a 'reverse Volcker moment' in the United States," he says. What he's referring to is this: After the oil crises of the 1970s had driven up inflation in the United States, former Fed Chairman Paul Volcker rigorously combatted inflation with high interest rates. During that period, the Fed emancipated itself from the government's influence. "Today the Fed is increasingly becoming subservient to fiscal policy," Bosomworth says critically.
The US government debt has just exceeded the $16 trillion threshold. Inflation could help reduce this enormous mountain of debt. "The alternative is to reform and save -- and to accept higher unemployment as a short-term consequence," says Bosomworth. "But that isn't as attractive politically."
Instead, the US government is behaving the way governments have always behaved when their debts have gotten out of hand. The history of money is a history of almost constant devaluations.
The Return of Inflation
It began in the 4th century B.C. with Dionysius, the tyrant of Syracuse. When he was broke, he had all coins collected and re-minted, turning one drachma into two. He then returned half of the new coins to the people and used the other half to pay his debts.
Later on, following the introduction of paper currency, monetary value could be manipulated even more easily. Now all it took was a money-printing press to inflate the money supply and devalue the currency. This was how the German Reich, overwhelmed with war debts and reparation claims after 1918, averted national bankruptcy, albeit at the cost of galloping inflation. The trauma of 1923 can still be felt to this day.
For American economist Friedman, this historic borderline experience was the best proof of a relationship between the money supply and inflation. The central message of the so-called monetarist is that if the volume of money is expanded while the supply of goods remains unchanged, inflation will be the inevitable outcome. Inflation, Friedman said, "is always and everywhere a monetary phenomenon."
But inflation can also be triggered by rising costs -- when, for example, workers succeed with their demands for higher wages or spending on commodities imports rises. This happened in 1973, when the increase in the price of oil raised the overall price level. Psychology also plays a role. When people lose their faith in money and question its stable value, a dangerous dynamic can develop as a result.
Many developments that have led to inflation in the past are evident once again today. The central banks are printing money, high commodity prices are driving up costs and both businesses and households distrust the stability of banks and, to some extent, that of the political system. But no one really knows when and to what extent this mélange will lead to inflation.
The central banks, by flooding the markets with money, are still offsetting the reluctance of commercial banks to lend money. At some point, however, the floodgates will have to close and will in fact do so, as those who are optimistic about inflation, like German expert Bofinger, believe. But will the central banks truly step on the brakes?
Economist Mayer is especially skeptical when it comes to the United States. "When the Fed raised interest rates in 2006 to offset inflation, the US real estate bubble, which the Fed and the government had helped to inflate, burst," says Mayer. "After that experience, the Fed is unlikely to decisively step on the brakes this time." And that is precisely when the ECB will struggle with raising interest rates again, because if the gap in interest rates between Europe and the United States becomes too large, the euro will likely appreciate, jeopardizing the economic recovery.
An Acceleration in Prices
The large money supply is already indirectly stimulating prices today. International borders no longer apply in the global financial game of Monopoly. "The US's extremely loose monetary policy affects large emerging economies like China, which don't have these problems," says Mayer. "Interest rates are too low there, and the main problem there is that the economy is becoming overheated." Through these growing markets, hungry as they are for commodities and machinery, the acceleration in prices could also increase in Europe.
As early as the 1990s, globalization prompted economists like Briton Robert Bootle to proclaim the "end of inflation." They conjectured that higher wages and prices could no longer be achieved, due to cost pressure from the emerging economies. "For a long time, globalization slowed down rising prices. But the effect is running out, and the example of Foxconn shows that the limits of outsourcing have been reached," says major investor Bosomworth.
One day, the name Foxconn could become a beacon for the end of an era in which globalization kept inflation in check. There has been unrest in recent months at the Taiwanese technology company, which operates plants in China that produce for Apple. Workers in emerging economies are increasingly demanding higher wages and better working conditions.
It is possible that weak demand in Europe will continue to prevent the company from achieving significantly higher prices for a long time to come, particularly given that the United States, with its policy of the weak dollar, has set a devaluation race in motion to boost its export economy. If Europe loses this currency war and the value of the euro rises, it could become even more difficult for the struggling peripheral countries to get back on their feet.
If this does happen, it will be yet another indication that inflation is already here, although it is largely restricted to the financial markets today. "Monetary policy drives the prices of financial instruments more strongly than growth and employment," Bosomworth says, explaining the phenomenon. "In this way, it drives a dangerous wedge between the financial economy and the real economy." The first consequences can already be seen today.
The Bubble Economy
The German Stock Index, or DAX, is above 7,000, a level normally seen in the best of times, even though there is every indication that the economy is cooling down. The situation with the commodities markets is similar. For months, the price of a barrel of crude oil has been almost consistently above $100.
Anyone who can afford it is seeking protection from inflation and fleeing to material assets. This includes the customers of Berenberg Bank. The Hamburg institution, founded in 1590, is the oldest private bank in Germany. Its offices are located directly on the shore of the Binnenalster, a man-made lake in Hamburg.
Berenberg sponsors a golf tournament, polo matches and classic-car races at Germany's Nürburgring racetrack -- the sorts of things a bank does for its exclusive customers. Anyone interested in having the bank manage his or her money has to show up with assets of at least €1 million, and the customers classified as "ultra high net worth individuals," or people with assets of more than €30 million, numbers in the hundreds. These are the sorts of people who have a lot to lose.
Today's Investor Focus: Preserving Value
In the past, the most important goal for these customers was to earn returns, says Berenberg Managing Director Jürgen Raeke. Today the emphasis is on preserving value. "Customers want to know that their assets are safe," says Raeke. This means investing in anything that's tangible. Raeke runs a Berenberg subsidiary that specializes in material assets, from apartment buildings to precious metals like gold and silver. Land, including forestry and agricultural land, is especially popular at the moment, although it takes a few hundred hectares of land to make an investment worthwhile.
Depending on the quality, the price per hectare of land in Germany ranges from €5,000 to €40,000.
According to Raeke, art is also a hot investment at the moment, with buyers especially interested in the Old Masters, including famous names from Canaletto to Rubens, as well as Impressionists and Expressionists. Raeke views such works of art as "blue chips" in the art market, or "almost foolproof investments." Average investments in art range from €25,000 to €500,000, and higher.
Precious stones, says Raeke, are also now being viewed as alternative investments. Rough diamonds are rare, and the better qualities, in particular, have become noticeably more expensive. Some gems have doubled in value in the last 10 years.
Nevertheless, Raeke remains cautious, warning that the diamond market requires special knowledge, and that markups of 30 to 60 percent are common in the wholesale trade. Besides, he says, a 19-percent turnover tax is also assessed in Germany. "In addition, you can't just sell the gems to a jeweler."
A Dramatic Surge in Gold Prices
These are the luxury problems of the rich. Everyone else in German society is left to invest their savings in the two classic material assets: real estate and gold.
That goes a long way toward explaining why business has become dynamic to the point of hysteria. Last week, the price of a gram of gold rose to a record €44.48. The price of gold has increased sixfold within the last decade. Whereas only a small group of currency apocalypticists nurtured the cult surrounding gold in the past, today the upper middle class, consisting of skilled craftsmen, doctors and university instructors, is starting to invest some of its assets in gold.
Another option is the real estate market. Residential real estate has become especially sought-after and expensive in Munich, where the average price per square meter of a mid-level condominium is €2,850, or 21.3 percent more than a year earlier. Even in Berlin, years of disinterest on the part of investors have turned into wild speculation.
When Markus Gruhn talks about the real estate market in the German capital, he doesn't use words like "bubble" or "speculation," of course, instead calling it "the big commotion." It began five years ago, says Gruhn, the chairman of the Berlin branch of the German Realty Association, in his conference room on Kaiserdamm, decorated with oil paintings and a wall clock. At the time, a large comparative study on real estate prices in European capital concluded that Berlin was the most inexpensive market of all.
Only then did the Austrians, Danes and Norwegians arrive, followed by Spaniards and Italians, says Gruhn. The investors bought up entire blocks, often paid for with 100-percent credit financing. And when the euro crisis struck fear into the hearts of investors in 2010, historic apartment buildings in formerly troubled neighborhoods like Kreuzberg and Neukölln suddenly became hot investments for attorneys from Stuttgart and general practitioners from Upper Bavaria.
"With them, it's often a mixture of naïveté, media hype and a lack of investment alternatives," says Gruhn. The broker remembers one older building in the eastern part of the city, in particular. There was mold on the basement walls, the groundwater level was high and an unattractive ground-floor commercial unit was empty. There were no real prospective buyers for years.
"I wouldn't have bought the building, either," says Gruhn. But suddenly everything happened very quickly. Three of four bidders drove up the price, and a year ago a private investor bought the property for €820,000. It would be sold for €900,000 today.
The real estate boom is also beginning to spread to rental apartments. In the eastern city of Dresden, rents have gone up by almost 14 percent in only 12 months. This is how the inflation in asset prices ultimately affects the broader population. And the poor end up paying for the anxiety of the rich.
Udo Reifner, founder of the Hamburg Institute for Financial Services (IFF), doesn't think much of the attempt to protect assets by fleeing into supposedly stable real values. "If you're going into material assets now, you really must be desperate. The security of these assets is an illusion, as the burst real estate bubbles in the United States and Spain have recently shown." The dangerous moments will come, he says, when too many people begin to doubt that "the spiral in which the financial economy is circling itself can be turned up any higher," says Reifner, a former board member of the Hamburg Consumer Assistance Office.
"If the new bubble bursts, the central banks will hardly be able to react anymore," says PIMCO manager Bosomworth. "That's when things will get exciting."
But it isn't just the danger of a crash invoked by Reifner and others that should have savers and investors worried. There is yet another distortion in the markets that is worrying people in a far more subtle way.
"The bubble is the biggest with German and American government bonds," says Deutsche Bank advisor Mayer. The United States and Germany are also deeply in debt, and their debt levels are only increasing. Nevertheless, investors are currently even paying, at least in real terms, for the privilege of investing in German government bonds. Things are no different in the United States.
One could see this as a result of the flight into supposedly safe government bonds. But there may be a method behind interest rates approaching zero, at least in the United States: With the combination of very low interest rates and palpable inflation, the government can pay off a portion of its debt over the years and borrow money at cheap rates. Economists call this financial repression.
This is how the trick works: The central bank buys government bonds, thereby pushing the interest rates to levels below the rate of inflation. This means that inflation is greater than the growth in interest rates, so that real interest rates become negative. Put differently, inflation consumes assets. Or, to put it even more bluntly: Saving becomes pointless.
After World War II, the United States, through a combination of growth, low interest rates and an average of four percent inflation, was able to reduce the ratio of debt to economic output from 109 percent to about 25 percent within three decades.
A similar scenario would also be conceivable today. The initial situation is similar, as US economists Joshua Aizenman and Nancy Marion have determined: Then, as today, the crisis was preceded by a period of borrowing and low inflation rates. "Both factors increase the temptation to reduce the debt burden through inflation," Aizenman and Marion conclude.
A model calculation shows that a 6-percent rate of inflation could push the debt ratio down by 20 percent within four years. The saver, be it a giant country like the People's Republic of China or a small investor in Germany, foots the bill.
Thomas Mayer has already calculated what this means for private retirement funds. "If I go into retirement in Germany today and hope for a supplementary private pension of €2,500 a month for 20 years, I have to have €500,000 in initial capital, at an interest rate of 2 percent a year," the economist explains.
But if the interest rate is pushed down to zero, the fund would only yield €2,100 a month. "And if another 3 percent of annual inflation eats away at my savings, after 20 years my pension will only have a purchasing power of €1,100." In other words, even moderate inflation leads to a loss of purchasing power of more than 50 percent.
Inflation, speculative bubbles and financial repression don't affect all citizens in the same way. As a result of the sovereign debt crisis and the way in which governments deal with it, billions are being redistributed and risks are being deferred.
"The aspect of the debt crisis that relates to distribution policy is underestimated, even though the effect is enormous," says Harald Hau. A finance expert at the University of Geneva, Hau studied at Princeton University under US economist Kenneth Rogoff, considered something of a godfather of government debt research. According to Hau, banks in Europe have managed to unload a large share of their risks onto governments.
"From the standpoint of private lenders, it's the best strategy for deferring a government bankruptcy and unloading the risk onto others, such as taxpayers or creditor countries. That's exactly what is happening in the euro zone."
Ironically, it was the governments, which ought to be advocates for taxpayers, that helped the financial companies. "The relationships between the banking economy and the political world are generally such that the transfer of risks can succeed," says Hau. For example, he explains, government regulators have a natural interest in avoiding problems among "their" institutions. "If government bonds are reallocated from private investors to the ESM and the ECB, risks are shifted from rich to poor, and from foreign financial investors to domestic taxpayers," says Hau. It would be different if a government bankruptcy had been allowed to occur. According to Hau, the ownership of financial stocks is very heavily concentrated among extremely affluent households. If a bank runs into difficulties as a result of losses on government bonds, this primarily affects the rich, and not savers who have their money in life insurance policies. "Contrary to what the banking lobby is suggesting, life insurance policies are very widespread in their investments and, therefore, tend to be exposed to relatively little risk in the peripheral countries of the euro zone," says Hau.
In contrast, if governments reduce their debt through low interest rates and inflation, says Hau, this primarily affects the holders of life insurance policies and similar types of investments. "Those who buy highly regulated products like life insurance are forced into bonds, where the low interest rates make a big dent," explains economist Mayer. That's because insurance companies and pension funds are required by law to invest their depositors' money in supposedly safe havens, like government bonds. "If people watching the news everyday could see how their savings are losing value as a result of low interest rates, they would be appalled," says Mayer.
So what is to be done? Should people simply go into debt, like major borrowers? Consumer advocate Reifner doesn't see that as a solution for people with average incomes. "They're always saying that interest rates are low. But even in Germany, rates for weaker borrowers, including hidden commissions, are often higher than 20 percent."
This is why consumers are being squeezed from two sides. "Ordinary citizens are taken advantage of as borrowers and, as savers, are slowly being expropriated through negative real interest rates."
But there are alternatives to more and more debt excesses, inflation and price bubbles. The euro-zone countries, at least, are still trying to get their debt under control through austerity budgets and reforms. And although all eyes are on Southern Europe at the moment, the German government could also face some uncomfortable questions soon.
Investor Bosomworth sees Germany in a situation similar to that of Ireland, Spain and Greece after the euro introduction, when these countries profited from low interest rates. "Now Germany mustn't repeat the mistake that led to speculation bubbles and the current problems in those countries," says Bosomworth.
He suggests curbing the real estate market. "Possibilities include higher real estate transfer taxes, a speculation tax on real estate or limiting the issuance of loans in relation to the value of properties." Besides, he adds, the government should generate surpluses to reduce debt.
A bankruptcy regulation for countries would also be necessary so that debts could be reduced in a more orderly fashion in the future, and at the expense of creditors instead of taxpayers. "Government bankruptcies are not at all unusual. In the last 200 years, this already occurred at a debt level of 40 to 50 percent of GDP," says Geneva financial expert Hau.
And the central banks? ECB President Draghi and "Helicopter Ben" Bernanke should, once again, pay closer attention to making sure that the money supply and economic growth are in equilibrium.
Anyone paying a visit to the Bundesbank's money museum can see how difficult this is. All it takes is to step up to a podium and move a joystick. When you pull back on the stick, liquidity is withdrawn from the economy, and when you push it forward the economy supplied with fresh capital. Two light pillars demonstrate how the money supply circulates and the corresponding volume of goods develops. The goal is to achieve a highly fragile balance. Whoever moves the stick too forcefully is immediately punished by the computer: "Sorry: Complete failure!"
Translated from the German by Christopher Sultan