Steven McClurg

@steven_mcclurg

Europe has Ended Quantitate Easing, Now will Tackle Inflation

July 17th 2018
Inflation is the fiscal complement of statism and arbitrary government. It is a cog in the complex of policies and institutions which gradually lead toward totalitarianism.
-Ludwig von Mises

The ECB has ended quantitative easing, their 9 year experiment of keeping rates low by initially purchasing covered bonds, and later expanding to sovereign credit, government agency and institution bonds, and even European corporate debt. The ECB’s balance sheet, which reached levels equal to 30% of the GDP of the entire European Union, is now set to unwind. The reason for hawkish policy in Europe is inflation, but more importantly, I believe Europe attack the fear of inflation quickly and aggressively. Here is why:

In 1921, Germany owed the Allies the first installment of the £6.6 billion war reparation to help restore the rest of Europe after the Great War. The payments were due in a combination of raw materials and Gold Marks, of which the answer to satisfy such a large amount was to print additional DeutschMarks. However, this debasement of the Mark led to an increase of costs in foreign trade, such as purchasing raw materials and food from other countries. Germany rapidly printed more Marks to keep up with the increase in price of goods. However, the production of goods due to deliver became more difficult. In a failure to sustain the demand for payment, in December 1922, Germany was unable to make part of the second reparation payment, a delivery of timber to France.

The Conference of Cannes was held between WWI allies France, United Kingdom, and Belgium where it was determined that in order to protect sovereign security of Europe, Germany must be kept weak and be forced to continue to pay reparations, regardless of ability. Another default occurred in January of 1923, this time delivery of coal, which was important to fuel steel smelters in France. Premiere Poincare then led France to occupy the Ruhr region of Germany that same month so that France may extract the payment owed. The workers in Ruhr were instructed to practice passive resistance towards the occupation by refusing to work. Germany, however, was forced to print more Marks to cover the loss of production out of Ruhr. This event marked the beginning of hyperinflation in Germany. Eventually, the French were pressured by the US and UK, who now showed sympathy to Germany and the economic burden it suffered under reparations, to agree to the Dawes Plan in 1924 which significantly reduced reparations payments. A year later the Franc collapsed, partly due to dependance on free raw materials and gold from Germany, and subsequently withdrew from Ruhr. However, the occupation and hyperinflation had already set in motion events for broad support of nationalism in Germany, leading to the creation and growth of the right wing movement known as Vereinigten Vaterländischen Verbände Deutschlands (United Patriotic Associations of Germany). Eventually, the National Socialist German Workers Party would consolidate power from the VVVD’s base, and its leader, Adolf Hitler, was appointed Chancellor of Germany in 1933 by President Paul von Hindenburg. Germany did not make a single Treaty of Versailles reparation payment thereafter.

Europeans are terrified of inflation. Ludwig von Mises and the Austrian School of economic thought reflect many Europeans’ fear of the rise of fascism and totalitarianism from the motivations and actions of power-holders, such as policies that induce inflationary environments. The current economic cycle which began with easy monetary policy is now ending with resulting inflation. The US had a 2.8% inflation print for May, and now the ECB believes that they have effectively battled deflation with Quantitative Easing. The Fed has now embarked on a path to battle inflation, with the ECB hinting at future hawkish policy. Though the primary objective of the Fed at the moment is to control inflation, the overarching concern in the US has never been inflation. The defining experience on monetary policy in the US has always been the Great Depression. In the 1930s, the Fed reversed loose monetary policy too quickly, helping to fuel the Great Depression. The defining moment in Europe has always been World War 2 and the events that lead to Adolf Hitler coming to power: Hyperinflation of the Weimar Republic. If the dual mandate of the Fed is to control inflation and unemployment, the single mandate of the ECB is to battle inflation. With Germany and France both printing inflation rates over 2% in May, the attention of the ECB has shifted.

As I mentioned in The FOMC Inverted Yield Curves, and Digital Assets, higher short term rates in the US will cause higher corporate defaults as companies refinance maturing debt. Similarly, hawkish policy in the ECB will lead to higher interest rates which will cause the large European corporate debt market to experience higher default rates. The difference in Europe is that the rate hikes will come more suddenly than they have in the US, possible causing a recession earlier for Europe, sometime in 2019.

Generally, corporate credit, both US and European, should be rotated out of in preparation of these events. I would also begin to sell most other risk assets such as equities. It is a good idea to begin to invest in defensive assets, uncorrelated assets, and inflation-protection assets. Inflation protection assets I prefer are art, wine, and real estate. Suitable defensive assets are defensive stocks, high dividend paying stocks, short-duration US Treasuries, and agency mortgage backed bonds. I am also focused on assets uncorrelated to US/European equity and fixed income are gold and crypto-currencies, though as I mentioned in Bitcoin is No Longer an Uncorrelated Asset, there are growing correlations between crypto-currencies and Emerging Market equities, particularly China.

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