Churchouse Letter
October 2012          by Peter Churchouse

History Repeats, or at Least Rhymes. Winners Will Learn From It – Here’s How

Lessons for Today from the Last Century

Inside This Issue:
As 1930’s economic history seems set to repeat itself and government responses today mirror those of the last century, there are clear lessons we can learn and implement.
The ‘rentiers’ and owners of hard & productive assets will be best positioned to profit from the impending inflationary surge.
A trip to New Zealand provides an update on opportunities that lie therein.
Portwood Portfolio: trimming US financials on the rally, new positions in US homebuilders and global inflation linked bonds.

Conventional wisdom that says history repeats itself or at least rhymes is frequently applied to the current global economic environment of excess leverage, deleveraging, asset bubbles, and widespread recession. There is much reference and comparison of the current economic malaise with that of the great depression of the early 1930’s. The current literature on today’s economic condition is peppered with comments such as “….the worst since the great depression”, or “….has not been seen since the 1930’s”.

Today’s economic conditions and policies have much in common with those of Europe and the US during and following World War 1.

As we all know, the true root of the 1930’s great depression lay in the events and politics of the post World War 1 era (1914-1918), yet most current comparisons hark back only to the events immediately surrounding the 1929-1933 period.

Much of what is going on today has interesting parallels with a slightly earlier period, that of the years immediately following WW 1. The policies adopted by the main players of that time echo much of what we are seeing today.

Most importantly for investors, the main winners and losers of that post World War 1 era are likely to be similar to the winners and losers of today’s economic malaise. Here we wish to explore a little of the background of that era, with a view to identifying what investment strategies worked then and may work again now.

The winners and losers in today’s environment may be similar to those of that era. We can learn from this.

I recommend reading “Lords of Finance – The Bankers Who Broke the World”, Liaquat Ahamed, Penguin, 2009.

Pundits Predicted a Short, ‘Over by Christmas‘, Low Cost War – How Horribly Wrong They Were.

At the commencement of WW1 in 1914, the major powers were still in the grip of the gold standard and the economic orthodoxy surrounding that agreed discipline of monetary affairs. The start of WW1 is viewed by many as almost an accident, but one which Britain and France were obliged to respond to. The prevailing thought at the time was that the war would ’be over by Christmas‘, and to the extent that anyone really thought about it, the French, British and Americans believed that due to its likely short duration, the cost of the war would be small and very manageable. The prevailing convention held that the nature and duration of the war would be limited by the level of the gold reserves of the main participants, and once these reserves were used up the war would be forced to an end. Politicians and bankers all fully believed that there would be no massive money printing to fund the war effort. Well, we all know how wrong that was, both in terms of duration and cost, and money printing. The war lasted more than four years, a far cry from the four months that many politicians in Britain, France and America believed would be the case.

World War 1 Indebtedness Parallels Huge and Growing Indebtedness Today of Many Developed Nations.

The three main players in the war, Germany, Britain and France, all used similar devices for funding the war but in very different combinations. Tax increases, borrowing and money printing were the core funding methods. Of the three, Germany turned the printing presses on most aggressively with currency in circulation increasing fourfold over the war period. France followed with a threefold increase in money in circulation, while in Britain money doubled. In each country inflation increased roughly in line with the increases in money in circulation. Of the three countries, Britain funded the most through tax increases, around 20% of its US$43 billion expenditure, with the balance coming from borrowing domestically and to a large extent from the US. For France only about 5% of the US$30 billion spending came from tax increases, but issuing of domestic bonds and borrowing from Britain and the US made up a big part of the war funding.

Taxes, borrowing (both locally and from abroad) and money printing were used by the core players to fund the war that went on way longer than expected and cost massively more than countries could afford. Does this not sound a bit familiar?

In Germany’s case about 10% of the US$47 billion war spending came from increased taxes, with most of the balance being raised through issuance of notes, including “Belgian” francs which Germans could buy at low rates.

Germany expanded money in circulation fourfold, this being the principle source of war funding.

America was a major financial beneficiary of the war through its sale of goods and materials to Europe. Much of this was funded by British and French borrowing, however it resulted in a huge influx of gold to the US, which in turn led to a surge in credit and a doubling of the money supply in the US. This, of course, led to a surge in inflation in the US and potential destabilizing of the US banking system.

Two concerns faced US central bankers. First, that at the end of the war the gold would all flood back to Europe, creating a severe recessionary jolt to the US economy. Second, was the fear that the gold would remain in the US, bringing with it the threat of even greater levels of inflation.

When the war finally ended, all three major European participants – Germany, Britain and France were deep in debt. The war had cost around US$200 billion, about half of the GDP of the countries concerned. Much of this cost was funded by borrowings from domestic citizens and from the US. In addition, Europe was flooded with newly printed currency, igniting dangerous inflationary pressures.

WW1 cost Germany, Britain and France approximately half of their collective GDP.

Present Day Policies in Europe and the US Echo Those of Post World War 1

Much funded via printing of money.

The government responses in Europe and the US to dealing with the current economic mess is to expand public sector debt in much the same way that countries did during WW1. In the US today, the government has effectively socialized a great deal of the debts incurred during the property boom of the 2000–2006 period. It continues to stand in the market place to soak up more and more of the debt incurred during the boom years.

The European Central Bank (ECB), after prevaricating for a good three years has embarked finally on its own version of the US quantitative easing program. Countries facing some of the worst financial problems in Europe fell victim to their own versions of property bubbles, most particularly Ireland, Spain and the UK.

When all is said and done, the ECB program is essentially transferring debts and obligations from the private sector to the European “collective” where the ultimate responsibility for paying the bills will fall on European governments and ultimately the taxpayers. This will all need to be paid for at some point, and it is here that the responses of different governments today might be compared with those of governments in the immediate aftermath of WW1.

It is possible to make a very simple characterization of policy responses of that earlier era:

Today’s responses to the current economic mess are chillingly similar to those of WW1 and its immediate period following.

  • Britain essentially followed conventional economic orthodoxy of the time. It made great efforts to maintain the value of the currency against gold and the US$. For this it was prepared to pay the price of an extended period of either recession and/or very slow return to growth. This response imposed significant austerity both in government spending and on the population at large. In today’s parlance it was a case of “just suck it up!”

  • France’s response was one of prevarication with constant bickering and indecision between various factions of government. The French did not seem prepared to live with the austerity that Britain chose to adopt. Does this sound a bit familiar with today’s policy response? Over time the French currency fell dramatically. At the onset of the war, it took around five French francs to buy one US$. At its peak, that was closer to 50 francs to the US$. Following measures finally introduced by the French Central Bank, the currency rose to around 25 to the US$, still representing a devaluation of around 80%. At this level the French economy rebounded strongly with exports growing solidly and credit starting to flow back into the domestic markets. US investors proved eager to bring cash back into the French economy, and its recovery left Britain some way behind.

  • Germany’s response proved disastrous. In order to finance day to day economic life, its government simply resorted to printing, literally, train loads of bank notes which were distributed across the country. The result, as we know, was hyperinflation on a scale rarely seen before or since. Like in Zimbabwe a few years ago, a wheelbarrow full of notes was needed to buy a loaf of bread. Such inflation wiped out savings of ordinary people, pensions became worthless, and inevitably, poverty grew sharply sowing the seeds of mass discontent. It was during this era that Hitler made his first foray into national prominence with ill fated attempts at unseating the government of the time through encouraging great protests and gatherings of the masses.

  • Britain followed an austerity route, as it is largely doing now.

  • The French had trouble with austerity then, and now also it seems.

  • Germany is the odd man out – from total monetary madness then, to the toughest today on the austerity front.

 

Reparations Imposed on Germany Post WW1 Draw Comparisons with Austerity Now Being Imposed (led by Germany) on the Likes of Greece and Spain. What is the Difference?

Following WW1, the financial mix was not simply about the debt issue but also that of reparations the allies were attempting to impose on Germany. The victors were bent on forcing Germany to cough up funds to compensate the allies for their costs of going to war. The three main players in this game were France, Britain and the US. The levels of reparations to be imposed were a source of great disagreement and debate for a very long time. There seemed to be no real formula, method or rationality to the process of determining an appropriate amount and as a result the early numbers thrown out by this erratic process were huge in relation to Germany’s economy, representing many years worth of entire GDP. The French proved the most intransigent in these discussions, with the Americans not too far behind.

The British, largely at the prompting of one John Maynard Keynes, ended up taking a softer line recognizing that the amounts being proposed could simply not be paid by Germany, the sums were simply too large in relation to the size of its economy.

War reparations imposed enormously painful and debilitating austerity on Germany - which now seems insistent on imposing similar pain to its European neighbours.

It is possible to draw some parallels with the national attitudes on reparations post WW1 with today’s attitudes towards austerity in the wake of the global financial crisis.

And there is some irony in this.

Just as Germany was very much on the receiving end of the allies insistence on massive, and economically debilitating war reparations, it is the Germans today who are at the vanguard of insisting on massive fiscal and monetary austerity in Europe with its potentially debilitating effects on economic recovery potential, as well as toxic implications for various national political arenas (witness Greece’s ultra-nationalist Golden Dawn party surge in popularity). The shoe is very much on the other foot...



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