Lehman Brothers and Germany: An Opera in Two Acts

By George Friedman

Yesterday was the eighth anniversary of the collapse of Lehman Brothers. Also yesterday, we learned that eurozone exports to the rest of the world fell by 10 percent in July compared to the same time last year, days after it emerged that German exports that month fell by 10 percent as well. The two events are intimately linked and in many ways the decline in German exports is more significant and ominous than the collapse of Lehman Brothers.

Lehman Brothers collapsed because it was trapped in a normal process in capitalism. As the business cycle peaks, one of its manifestations is the emergence of a class of assets that “cannot possibly fall,” and therefore it makes sense to borrow large amounts of money to buy these assets. In 1825, a British business cycle peaked as it was discovered that bonds of Latin American nations could not possibly decline. Vast amounts of money were borrowed to buy this failure-proof asset class. The problem was that many of the bonds were issued by Latin American states that didn’t exist. When people accept the preposterous notion that something cannot fall in price, they have already stopped examining reality. It is a small step to buying bonds of non-existent countries.

The 2008 crisis was built around the notion that housing prices couldn’t fall. If they couldn’t fall, then bizarre derivatives based on rising housing prices couldn’t help but being vastly profitable, especially when bought with borrowed money – leveraged, in the charming jargon of the financial sector. But since housing prices were boosted by lending money for houses to people who couldn’t repay their loans, not only was decline in housing prices likely, it was guaranteed. Lehman Brothers got caught in the game of musical chairs.

By my count, 2008 was the fourth time since World War II that a class of “can’t-fail” financial products brought down the house. In the 1970s, tax-free municipals couldn’t fail because of their tax advantage. In the 1980s, Third World debt based on natural resource development couldn’t fail because earth was running out of raw materials and their price could only rise. Then there was the savings and loan failure, built around the assumption that the tax advantages of being an investor in shopping malls made them locks – until the tax code changed. This was all accompanied by the normal amount of corruption, but was based on a single principle. At the top of the business cycle there is a vast amount of money available for investments, a lot of people looking to make a lot of money with little effort, and well-dressed con artists prepared to make their dreams come true. It’s the price you pay for the business cycle, and that’s the price you pay for capitalism. On the positive side, you get cars without drivers and cellphones without headphone jacks.

The United States has always solved this problem in the following way. First, the economy overheats and irrationality creeps in. Then, the failure-proof asset class declines, people get wiped out and major financial institutions are near collapse. The Federal Reserve and the Treasury step in to maintain the liquidity of the markets. Remember the Brady bond? The financial institutions stabilize. The economy goes into recession, crushing the irrationality and the excess. Finally, the financial community condemns the federal government for being irresponsible.

The point is that the United States has a fairly well-travelled road for dealing with this phase of the cycle. The European Union does not. Institutionally, the system for rapid decision-making does not exist. More important, the idea of geographical transfer of resources is not there. Texas may not want to refinance U.S. banks, but the Fed doesn’t really care. Germany may not want to refinance Greece, and the European Central Bank can’t compel it to. Each country in Europe had to cope with the European crisis on their own. But within the eurozone, they lacked the ability to reprice money. So in Europe, a chaotic crisis is taking place.

The European example of a can’t-fail asset class is Germany. Greece can fail, Italy can fail, Hungary can fail, but not Germany. But Germany is in a crucial way the most vulnerable country in all of Europe. It derives about 47 percent of its GDP from exports. For every 10 percent of exports it loses, it loses nearly 5 percent of GDP – an oversimplified but true way of looking at it. The world still has not recovered from 2008. The United States has shown real, if sluggish, recovery since that time. Russia, the Middle East and China are all in serious trouble and struggling to stay stable. They’re not worried about buying German goods.

Here we have the largest economy in Europe, the fourth largest in the world, utterly dependent on other countries’ ability to buy German goods. If they can’t or won’t, the result is unemployment in Germany, and with unemployment, increasing hostility toward both the EU – which some see as abusing German generosity – and mainstream German parties. We have seen the Christian Democratic Union fall to third place in Chancellor Angela Merkel’s own district as German exports contracted significantly.

It is easy to dismiss this as a farfetched scenario, but I see the opposite. The world has still not recovered from 2008, and there is global stagnation or worse. Germany depends on exporting to these countries for its well-being and stability.They can’t buy more, and they are likely buying less. That means that Germany’s economy will contract. And if it contracts, then there will be social and political consequences in the European heartland. It seems to me, the idea that Germany can sustain its economy at its present level is far more farfetched than the idea of significant decline. Germany is hypersensitive to fluctuations in exports, and decline is likely given the global environment.

The 2008 crisis was different than prior crises in that it has been so long-lived and has had so many iterations. What symbolically began with the Lehman Brothers collapse has not finished playing out yet, and the country that will star in the next act logically is Germany.