Financial Arson, Fire Protection & the Real Economy

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The financial crisis was bad enough before the US government let Lehman go bankrupt. Thereafter, panic took over, necessitating unprecedented emergence action by European governments. But at the same time, an International Financial Summit for a new multipolar financial architecture has been put on the agenda by the European Union. What is still missing, is concerted action for the protection and stimulation of Europe’s real economy.

by Michael Liebig


In the year 1900, the great Heidelberg legal expert Georg Jellinek published his „General Theory of the State“, which contains the famous dictum „the normative power of the factual“. The financial analyst Thorsten Schulte has noted that Jellinek’s dictum precisely sums up what has happened in Germany vis-à-vis the financial crisis since Sept. 16, the day the American investment bank Lehman went bankrupt.

Following the Oct. 10 worldwide stock market crash and complementary media hysteria, on Oct. 13 the German government announced a 500 billion Euro program “to stabilize the financial markets and avoid adverse effects on the real economy”. The German measure was closely coordinated with the other member states of Euro zone.

The government has created a 100 billion Euro “financial market stabilization fund” (FMSF), for which the German state is liable. Via the FMSF, the government will guarantee interbank refinancing transactions of up to 400 billion Euro until Dec. 31, 2009. Up to 80 billion Euro of the FMSF can be used to recapitalize banks, including “the option to acquire problematic assets” – derivatives – of financial institutions. Access to the FMSF is tied to strict “conditionalities” including “business strategy, management salaries, dividend payments and readiness to provide loans to SMEs [small and medium-sized enterprises]”. Also, accounting standards will be changed for financial assets EU-wide – again, mainly derivatives – in frozen, “illiquid” markets.

The most significant of these conditionalities is the power to examine and overhaul business strategies. Moreover, Finance minister Peer Steinbrück wants to give the German Financial Supervisory Agency (Bafin) the general authority to examine and overhaul the “business strategies” of all financial institutions.

Lehman: “Maximum Credible Accident”

Why would the German government take such radical and unprecedented action after having strongly – and correctly – emphasized that the cause and main impact of the financial crisis are located first of all in the United States and Britain? Is the mantra out the of USA and Britain that the financial crisis is a-priori “global” afterall correct, and no other country can decouple from the USA?

That assertion is indeed correct, insofar as the decision to let Lehman go bankrupt gave the final blow to an already badly shaken base of confidence among banks internationally. Whether the decision by the US government to let Lehman go under, involved the calculation that much of the ensuing losses would be suffered outside the USA, should not be dismissed as conspiracy theory.

On Oct. 15, Steinbrück told the German parliament that the Lehman bankruptcy was a “maximum credible accident,” as “some $400 billion” – half of Lehman’s total business – were contracts with European financial institutions. Jochen Sanio, head of the the German Financial Supervisory Agency (Bafin), said on Oct. 13: “We are still licking the wounds” suffered through the Lehman bankruptcy.

The reason given by the German government for its policy shift is the collapse of confidence among banks and the ensuing credit freeze on the interbank market. And the freeze has indeed been staggering: During the first half of October, Euro zone banks had overnight deposits of up to 200 billion Euro with the European Central Bank, while simultanously drawing massively on the ECB’s emergency liquidity facility. But, the exposure of German banks to the Lehman bankruptcy certainly is a most relevant factor for the German government’s policy shift. A very reliable source told me that, besides Hypo Real Estate, two more German financial institution were in a critical condition on Oct. 10.

Nevertheless, the Anglo-American “we are all in one boat”-thesis conveniently ignores some most basic facts. In the case of Germany, one should not forget: No real estate bubble; low levels (compared to US or UK) of indebtness of private households, enterprises, and the state; an 11% saving rate; 2/3 of the banking system under public law; a vast trade surplus; and, most importantly, a largely intact and technologically competitive industrial and Mittelstand base.

But the German strength in the real economy and the vast export surplus do have a dangerous downside. Behind China and Japan, Germany is the third-largest creditor nation worldwide. And, almost 60% of the lending of German banks has gone abroad in 2007. Most of it into the EU, but the US market has been quite significant for German banks. Of course, such an exposure to foreign debtors means an enormous vulnerability.

In presenting the financial emergency package to the German parliament, and right after pointing to the fallout of the Lehman bankruptcy, Steinbrück used the following metaphoric formulations: “When the world financial markets are burning, first the fire has to be extinguished – even if it’s case of arson.”

World Financial Summit

Then, Steinbrück continued: “We must make sure that the arsonists can’t do it again. And, fire accelerants must be banned and the fire protection must be upgraded.” In other words: Along with immediate crisis management, a new institutional framework and architecture must be created for the international financial system. Last week, Steinbrück had presented his “8 [regulatory] Traffic Rules” for “sustainable efficiency” of financial markets in servicing real economic development. (see Letter from the Rhine, Oct. 10, LINK ) Also, he wants the International Monetary Fund (IMF) to be “reorganized” with “new statutes” and “very different personnel” possessing “different professional skills”.

Merkel told the Bundestag that she wants a “World Financial Summit” to be held in late November, including the G7 and Russia, China, India, Brazil and other “emerging countries”. Merkel said that the Oct. 24 “Asia-Europe Meeting” (ASEM) in Beijing will be key in preparing the World Financial Summit . The ASEM Summit involves the 27 heads of government from the EU and 18 state leaders from Asian countries, including China, India, Japan and South Korea and the ASEAN states.

I would guess that Merkel’s choice of the term World Financial Summit is not merely a matter of semantics. British Prime Minister Brown prefers a different term, he is now passionately calling for a “new Bretton Woods.” President Sarkozy and other French government officials, Italian Economics Minster Tremonti, and even German President Koehler have spoken out for a “Bretton Woods II”. Obviously they have in mind the decade-long stability and regulatory soundness of the Bretton Woods system.

But, it should be clear that a “new Bretton Woods” is incompatible with the multipolar realities in today’s world. Bretton Woods meant the absolute domination of world finances by the USA, with Britain as the junior partner. Even after the Nixon administration abolished the Bretton Woods system in 1971, the US dollar remained the world’s reserve currency. After delinking the dollar from gold, the USA were able to expand astronomically the volume of dollars in circulation internationally. These dollars have bought real wealth around the globe for the next decades, as demonstrated by the secular US trade deficit. While the USA got more and more indebted to the rest of the world, the giant foreign debt was denominated in their own currency. And here we are the root of the current financial crisis. Therefore, the emerging new, multipolar financial architecture will mean the termination of the dollar’s role as global reserve currency – the core of the Bretton Woods and post-1971 “floating exchange rate” monetary system.

That would explain why both the USA and Britain so far have opposed the international financial conference with the format “G7 + BRIC + other emerging countries”. Since approximately mid-October the Anglo-American position seems to have changed, before French President Sarkozy’s trip to Canada and the United States. What this shift would really means, we may know after November 4, when the next US president is elected.

Protecting and Stimulating the Real Economy

For the next couple of weeks, besides continued crisis management, Europe and Germany will have to focus on protecting the real economy from the fallout of the financial crisis.

Well-informed sources in Germany tell me that a big public investment program is being prepared in Germany. And other EU countries will do the same. The national programs will be combined into a Europe-wide concerted action for stabilizing and stimulating the economy in all EU countries. About that, I’m told, there is full agreement in Germany and the other governments in the EU.

At the same time, economic cooperation with Russia, Asia and Latin America is to be further expanded and upgraded. The ASEM summit will be important in this respect, just as Sarkozy’s proposal for creating a “joint economic space”of the EU and Russia.

On Oct.15, the Frankfurter Allgemeine Zeitung interviewed the
CEOs of three leading German machine tool producers. The FAZ asked them how pessimistic they were? They were not. “We should be glad that there are China and the other emerging countries, which have gained such strength in world that the domination of the American market has disappeared. Currently, we are capable to offset the consequences of a recession in America,” said Joachim Rohwedder of Rohwedder AG, a world leader in automation technology.

In the midst of hectic governmental and parliamentary negotiations on the financial emergency package, Chancellor Merkel addressed the “3rd German Machine Tool Summit”, organized by the “Association of German Machine Tool Producers” (VDMA) and attended by the Chinese Minister for Science & Technology. The financial system must “serve the real economy”, said Merkel, and the “decoupling” of the “financial economy” from the “real economy” must be reversed.

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