We are at debt risk because Germany hasn’t learnt its lesson

We are at debt risk because Germany hasn’t learnt its lesson

We are at risk because Germany hasn’t learnt its lesson | David McWilliams

Contrary to the popular myth, Hitler was voted into power in Germany because of deflation, not inflation. Hitler was elected in 1932, following three years of deflation – the consequence of restrictive polices after the great crash in 1929. In contrast, inflation – often quoted as being responsible for Hitler’s victory – peaked in Germany in 1923. This was a full decade before the Nazis democratically entered the Reichstag.

The reason the European elite is now panicked about deflation in the Eurozone is because the political implications of deflation are impossible to predict. In the next two years, every major European country, with the exception of Germany, has an election. The Hitler example is not meant to be in any way portentous or analogous to today’s Europe, it is simply a way of reinforcing to you how dangerous deflation is and why Europe’s politicians are taking enormous risks in allowing deflation to take hold, particularly as Europe’s economy is mired in debt both public and private.

Of all the financial pathologies to afflict an economy, too much debt combined with simultaneously falling prices, can tip an economy from recession into depression, from which it is extremely difficult to escape. The ECB is just now beginning to realise that the gravitational pull of falling prices is so strong that it cannot be counteracted using monetary policy alone. There is a real danger that the debt deflation dynamics that afflicted the world in the 1930s become embedded with catastrophic consequences. Here’s why.

In a normal economy, people and companies buy and sell stuff to each other. In the Eurozone, we all buy and sell to each other. As the Eurozone is a pretty closed economy, each country’s spending is another country’s income. France buys from Italy and vice versa. France’s spending is Italy’s income. The same equation holds at a personal level: your spending is also my income and vice versa.

If there is a shock to demand, such as a massive Eurozone financial crisis, people and companies get worried about the future and they start saving for the rainy day. But if everyone is saving, who is spending? And if no one is spending what happens to income? Typically, if the private sector is saving, governments will take up the slack, but if they don’t, overall spending falls and so too does, by definition, income. As debts are expressed in terms of income, if income is falling, debt ratios are rising without any new debt being incurred.

Out on the street, retailers experience a sharp fall in demand for their products. So what do they do? They cut prices to coax people into the shops. But because our incomes are falling, something strange happens deep inside our heads. We don’t see the new lower price as a bargain, but as a harbinger for further price falls. So rather than encouraging people to come out and spend, the very fall in prices repels demand.

We are at risk because Germany hasn’t learnt its lesson | David McWilliams.