Since the Second World War, no other country in Europe has personified exemplary currency strength, fiscal prudence and export prowess more than the German economic machine.

Long a bastion of quality manufactured goods, the Germans take pride in producing some of the world’s best products and historically have protected the purchasing power of the deutschemark until the introduction of the single European currency in 1999.

History of Economic Pain

Germany knows about economic hardship.

Over the last 100 years the world’s third largest economy has participated in two World Wars while experiencing the devastating effects of hyper-inflation or quintuple-digit inflation during the Weimar Republic in the 1920s.

At its peak, hyperinflation in Germany skyrocketed almost 30,000% by October 1923. Combined with harsh war reparations evoked by the Versailles Treaty following WW I, Germany fell into the economic abyss.

In my office, hanging on a wall is a frame showing several Reichsbanknotes or bills. Literally, these bills became worthless by 1923 and barrels and barrels of paper money were amassed just to buy basic necessities.

More than any other industrialized nation, Germany is inflation-phobic, always mindful of expanding bank credit beyond fiscal responsibility while not afraid to drain excess bank liquidity even if the economy is slowing. Indeed, with euro zone inflation accelerating heading into July 2008, the European Central Bank (ECB), heavily influenced by the Bundesbank, raised interest rates while the euro zone economy was in the midst of contracting and the credit crisis was escalating.

Inflation Fighting Legacy

For years, the world viewed the German Bundesbank, the central bank, as a true inflation fighting institution with a mandate to defend the currency’s value at all costs from the long-term consequences of inflation and fiscal deficits. Indeed, since gold broke from the dollar in August 1971, the deutschemark gained a cumulative 53% until the euro was introduced ten years ago.

But that inflation-fighting legacy is being put to the test now as deflation or an environment of falling asset prices accelerates in early 2009 as the global financial crisis stifles exports and domestic consumption.

The German economy is forecast to contract by 2.25% in 2009, according to the German Federal Statistical Office, as the country comes to grips with a growing banking crisis, accelerating euro zone economic morass and several failed or scrapped government bond auctions since October. And from its all-time high in July 2007, the Frankfurt DAX Index has plunged 46%.

According to the German Federal Statistical Office, the economy grew by 1.3% in 2008, about half the rate of 2007. But in 2009, Germany is expected to record its largest post-war deficit as the economy shrinks for the first since 2004 and suffers its deepest recession since unification in 1989-90.



Reluctant Spenders

Reluctant to spend amid a major economic slowdown since last summer, the Germans have made a u-turn since December following a 25% government stake in Commerzbank AG and the recent approval of a €50 billion ($65 billion) spending package on January 27.

Throughout European capitals, especially in Paris, Germany has been urged to increase her spending package while several euro zone governments plead for financial assistance.

Some European Union (EU) members, including Ireland and possibly Greece, might require some sort of financial rescue; the Germans are adamant about contributing to any euro zone bailout. If the economic crisis deepens in Europe the International Monetary Fund, or IMF, might have to provide emergency funding. This would mark the first time since the creation of the single currency that a non-EU agency would provide financial assistance to an EU member.

In order to keep the IMF out of the euro zone, the Germans would have to contribute and fully support an emergency bailout. And the markets are running out of patience.

Credit default swaps (CDS), or insurance-like derivative contracts protecting bondholders against default, continue to rise for weaker euro zone sovereign borrowers; credit spreads, or the difference in interest rates between super safe German bonds and other euro zone bond markets remains strained as investors place a big risk premium on holding weaker issuers like Ireland, Spain, Greece, Portugal and Italy. Indeed, credit rating agencies in January downgraded the sovereign debt of Spain, Greece and Portugal resulting in higher financing costs.

The Reality of Distress

The Germans were initially reluctant to expand their fiscal budget in 2009 and even hesitated in rescuing Commerzbank with a 25% stake.

Yet the reality of the global crisis is that Germany cannot be isolated from the ongoing carnage surrounding her European trading partners.

Its largest bank, Deutsche Bank AG, has been saddled by massive losses on mortgage-backed securities and other loans while its stock market capitalization has shrunk by more than 80% since late 2007. Deutsche Bank, like America’s largest banks, is basically insolvent. The German government in all likelihood will probably have to shove hundreds of billions of euro into Deutsche Bank and, perhaps, others.

Once the world’s exemplary fiscal student, the Germans have now been forced to join the bailout parade in 2009 as her economy comes undone and deflation grips its banking sector.

Perhaps Germany’s chancellor, Angela Merkel, poignantly expressed the country’s sentiment best following the recent passage of the country’s first post-war budget deficit exclaiming “it was the hardest decision in my entire political life.”