Commentary

Sind Wir Die Weimarer?

August 23, 2004

Please pardon my high school German if the title question is not grammatically correct.

With all the hoopla centered on the inflation/deflation debate, the resurgent gold market, and the decline of "King" dollar, we have begun to see references to Germany's ill-fated Weimar Republic and questions as to whether hyper-inflation could happen here in the USA, given that our currency is subject to the whims of political favor over sound management, and it is not backed by anything (read: Gold) that could cap this excess.

While much reference on the Weimar Republic focuses on its fall, and the subsequent rise of Hitler, I want to focus instead on the conditions that caused its failure. When drawing parallels between the US and Germany of the early 20's however, we need to keep in mind that this was the post-WWI period and Germany was burdened with reparations for its role in the war as well as major internal divisions between political parties and the "Länder" or states, with Bavaria standing out notably. These facts alone could invalidate any realistic comparisons between the two situations. Professor Gerhard Rempel's essay on the Weimar's economic and political problems, illustrates the turmoil that existed in Germany at that time. But in the interest of adventure, open-mindedness and curiosity, I'd like to push forward with the comparison and see where it leads.

First, a passage from the above noted essay, which shows obvious parallels to the current situation in the US:

"Another reason for the prominence given to reparations is their alleged contribution to the runaway inflation of the early 1920s. In fact, however, inflation, far from being the consequence of reparations, preceded them. Successive governments then seized on it as a means of evading reparations payments, as well as for internal social purposes. No German government before 1923 made any attempt to stabilize the currency, because German industrialists worked out a system of ''inflation profiteering.'' They would obtain short-term loans from the central bank for improvement and expansion of their plant, and then repay the loans with inflated currency.

Similarly, the large agriculturists paid off their mortgages with virtually worthless currency. By contrast, everybody with a fixed income-broadly speaking, the middle class, was a victim of the inflation. Even union wages always lagged behind prices. The dislocation caused by inflation brought unemployment, despite the apparent industrial boom. The inflation was obviously deeply divisive in its social effects and contributed to lack of confidence in the fledgling republic among large groups of the population."

Does any of this sound familiar? Our bond market is currently running a similar operation. "Industrialists" and speculators (I suspect mostly the latter) of all stripes are playing the bond carry trade to the fullest extent possible. Since the traumas of the tech stock crash, recession and 9/11, the liquidity spigot has been wide open through near rock bottom short rates, "vendor" financed long rates, tax cuts/credits and global labor arbitrage. American consumers, dutifully playing their critical role, have stepped up and tied it all together. It's a virtuous circle.

But then there's a part that the mainstream financial media seems to have forgotten about. The part where all the cheap credit actually needs to be paid back. Maybe this is our version of "reparations" that must be made. And they are massive. The government can indeed pay its debts, as it has direct control of Dr. Bernanke's inflation machine, the printing press. But what about the linchpin of the "greatest economy on earth"? What about the American consumer?

Again, we look to the bond market. On the surface, all seems well. Rates are behaving quite nicely and official inflation, aside from the oil price (which can be conveniently blamed on geo-politics), is at reasonable levels. But there is a huge counter party to the American consumer and his debt load, and that party is made up of our collective foreign bond holders. If the Fed tries to inflate its way out of debt reckoning, our vendor financiers (Japan and China primarily) will be none too pleased being paid back in increasingly worth-less dollars. But assuming the game can go on indefinitely, the denial by both parties will need to get deeper. An ending has to come sooner or later, however. At least I think so. The non-gold-backed, easy money dynamics sometimes make me wonder.

I find the yin/yang quality of the situation very interesting. You can't talk about inflation without mentioning the underlying force causing it to be created. Namely, the big D; deflation. In many ways, I see our situation as more complex, if not more dire, than that of the Weimar Republic. Whereas Germany experienced a situation where the country's tenuous position was exacerbated by the effects of the war's aftermath, political in-fighting and industrialist exploitation, our problem seems much less volatile (after all, we're still living the American dream here in relative comfort) on the surface. But the global components of production and consumption, credit and debt, derivatives and currency creation are really quite awe-inspiring. Inflation begets deflation, which in turn creates more man-made inflation.

This cycle has been playing out for decades, as a look at home prices over the last 40 years will show. It has played out thus far to the benefit of many. By contrast, the Weimar Republic was a blip in time, it's dynamics much different. Maybe our cycle will remain on a long, slow path to hyper-inflation, or maybe we will never get there. But the economic foundation is not a cement slab. It is actually a wooden structure, on the Carolina coast, sitting atop four posts: 1) Continued domestic and foreign credit expansion, 2) Consumer willingness to spend as opposed to pay down debt, 3) The lack of a major, leveraged financial "accident" and 4) Public confidence that all is as it has been. The high risk nature of the global financial system can not be denied. High risk does not mean a disaster will happen. But it also does not mean it won't.

If you held hard assets in the 1920's Weimar Republic, you did quite well. If you held paper only, you wheeled a barrow full of it to the corner bread shop for a loaf of what might be your meal for the day. Whether more extreme inflation, deflation or status quo is right around the next bend, it is wise to have some insurance.

Status Quo (continued creeping inflation) Have gold, commodity, real estate and other hard asset exposure. Stock market may or may not provide good returns and fixed income savers may fall behind over time, depending on interest rates.

Hyper-Inflation Hold hard assets. Gold, silver, commodities. Possibly real estate. But this is a slippery slope into...................

Deflation / Depression Debt will be addressed, prices will fall remarkably on most assets, including gold in my opinion. But gold (and maybe silver) is the one asset to hold (other than possibly your primary home if you can stand to see its value cut to a fraction) outside of cash. Gold as insurance would be a good idea, as your deflated dollars would eventually come to reflect the full faith and credit of a federal government itself trying to deal with declining revenues and cutbacks.

I truly have no idea whether we will suffer a Weimaresque hyper-inflation. I am not a financial alchemist and may be missing Mr. Greenspan's master plan on how this is all going to end up okay. I certainly can not predict deflation, since it has been fought tooth and nail by the Fed for the last 15 years. I can only live life, enjoy my family, and do the best I can to financially prepare for any and all events. I care for my country, but fear that too many of its citizens have not prepared themselves for anything other than a bull market in paper assets. This is too bad for those citizens, but potentially threatens the entire country and the future of our children as free, enterprising Americans. Economic instability begets political and social instability. This is something quite foreign to modern America, which has stood for the opposite in a world more often in turmoil than not.

I believe we are being induced to throw caution to the wind at the exact time when the opposite strategy should be employed. In traders' parlance, I'm fading the liquidity bubble, paying down debt, and hoping for the best, whatever the outcome.

Gary Tanashian

PS: Further reference on 1906 -1925 Germany can be found here.

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