Germany After the EU and the Russian Scenario

29. May 2010 by admin.

Germany After the EU and the Russian Scenario

By George Friedman

Discussions about Europe currently are focused on the Greek financial crisis and its potential effect on the future of the European Union. Discussions these days involving military matters and Europe appear insignificant and even anachronistic. Certainly, we would agree that the future of the European Union towers over all other considerations at the moment, but we would argue that scenarios for the future of the European Union exist in which military matters are far from archaic.

Russia and the Polish Patriots

For example, the Polish government recently announced that the United States would deploy a battery of Patriot missiles to Poland. The missiles arrived this week. When the United Statescanceled its land-based ballistic missile defense system under intense Russian pressure, the Obama administration appeared surprised at Poland’s intense displeasure with the decision. Washington responded by promising the Patriots instead, the technology the Poles had wanted all along. While the Patriot does not enhance America’s ability to protect itself against long-range ballistic missiles from, for example, Iran, it does give Poland some defense against shorter-ranged ballistic missiles and substantial defense against conventional air attack.

Russia is the only country capable of such attacks on Poland with even the most distant potential interest in doing so, and at this point, this is truly an abstract threat. In removing a system that was really not a threat to Russian interests — U.S. ballistic missile defense at most can handle only a score of missiles, meaning it would have a negligible impact on the Russian nuclear deterrent — the United States ironically has installed a system that could affect Russia. Under the current circumstances, this is not really significant. While much is being made of having a few U.S. boots on the ground east of Germany within 40 kilometers (about 25 miles) of the Russian Baltic exclave of Kaliningrad, a few hundred technicians and guards are simply not an offensive threat.

Still, the Russians — with a long history of seeing improbable threats turning into very real ones— tend to take hypothetical limits on their power seriously. They also tend to take gestures seriously, knowing that gestures often germinate into strategic intent. The Russians obviously oppose this deployment, as the Patriots would allow Poland in league with NATO — and perhaps even by itself — to achieve local air superiority. There are many crosscurrents in Russian policy, however.

For the moment, the Russians are interested in encouraging better economic relations with the West, as they could use technology and investment that would make them more than a commodity exporter. Moreover, with the Europeans preoccupied with their economic crisis and the United States still bogged down in the Middle East and needing Russian support on Iran, Moscow has found little outside resistance to its efforts to increase its influence in the former Soviet Union. Moscow is not unhappy about the European crisis and wouldn’t want to do anything that might engender greater European solidarity. After all, a solid economic bloc turning into an increasingly powerful and integrated state would pose challenges to Russia in the long run that Moscow is happy to do without. The Patriot deployment is a current irritation and a hypothetical military problem, but the Russians are not inclined to create a crisis with Europe over it — though this doesn’t mean Moscow won’t make countermoves on the margins when it senses opportunities.

For its part, the Obama administration is not focused on Poland at present. It is obsessed with internal matters, South Asia and the Middle East. The Patriots were shipped based on a promise made months ago to calm Central European nerves over the Obama administration’s perceived lack of commitment to the region. In the U.S. State and Defense department sections charged with shipping Patriots to Poland, the delivery process was almost an afterthought; repeated delays in deploying the system highlighted Washington’s lack of strategic intent.

It is therefore tempting to dismiss the Patriots as of little importance, as merely the combination of a hangover from a Cold War mentality and a minor Obama administration misstep. Indeed, even a sophisticated observer of the international system might barely note it. But we would argue that it is more important than it appears precisely because of everything else going on.

Existential Crisis in the EU

The European Union is experiencing an existential crisis. This crisis is not about Greece, but rather, what it is that members of the European Union owe each other and what controls the European Union has over its members. The European Union did well during a generation of prosperity. As financial crisis struck, better-off members were called on to help worse-off members. Again, this is not just about Greece — the 2008 credit crisis in Central Europe was about the same thing. The wealthier countries, Germany in particular, are not happy at the prospect of spending taxpayer money to assist countries dealing with popped credit bubbles.

They really don’t want to do that, and if they do, they really want to have controls over the ways these other countries spend their money so this circumstance doesn’t arise again. Needless to say, Greece — and countries that might wind up like Greece — do not want foreign control over their finances.

If there are no mutual obligations among EU member nations, and the German and Greek publics don’t want to bail out or submit, respectively, then the profound question is raised of what Europe is going to be — beyond a mere free trade zone — after this crisis. This is not simply a question of the euro surviving, although that is no trivial matter.

The euro and the European Union will probably survive this crisis — although their mutual failure is not nearly as unthinkable as the Europeans would have thought even a few months ago — but this is not the only crisis Europe will experience. Something always will be going wrong, and Europe does not have institutions that could handle these problems. Events in the past few weeks indicate that European countries are not inclined to create such institutions, and that public opinion will limit European governments’ ability to create or participate in these institutions. Remember, building a super state requires one of two things: a war to determine who is in charge or political unanimity to forge a treaty. Europe is — vividly — demonstrating the limitations on the second strategy.

Whatever happens in the short run, it is difficult to envision any further integration of European institutions. And it is very easy to see how the European Union will devolve from its ambitious vision into an alliance of convenience built around economic benefits negotiated and renegotiated among the partners. It would thus devolve from a union to a treaty, with no interest beyond self-interest.

The German Question Revisited

We return to the question that has defined Europe since 1871, namely, the status of Germany in Europe. As we have seen during the current crisis, Germany is clearly the economic center of gravity in Europe, and this crisis has shown that the economic and the political issues are very much one and the same. Unless Germany agrees, nothing can be done, and if Germany so wishes, something will be done. Germany has tremendous power in Europe, even if it is confined largely to economic matters. But just as Germany is the blocker and enabler of Europe, over time that makes Germany the central problem of Europe.

If Germany is the key decision maker in Europe, then Germany defines whatever policies Europe as a whole undertakes. If Europe fragments, then Germany is the only country in Europe with the ability to create alternative coalitions that are both powerful and cohesive. That means that if the European Union weakens, Germany will have the greatest say in what Europe will become. Right now, the Germans are working assiduously to reformulate the European Union and the eurozone in a manner more to their liking. But as this requires many partners to offer sovereignty to German control — sovereignty they have jealously guarded throughout the European project — it is worth exploring alternatives to Germany in the European Union.

For that we first must understand Germany’s limits. The German problem is the same problem it has had since unification: It is enormously powerful, but it is far from omnipotent. Its very power makes it the focus of other powers, and together, these other powers can cripple Germany. Thus, Germany is indispensable for any decision within the European Union at present, and it will be the single center of power in Europe in the future — but Germany can’t just go it alone. Germany needs a coalition, meaning the long-term question is this: If the EU were to weaken or even fail, what alternative coalition would Germany seek?

The casual answer is France, as the two economies are somewhat similar and the countries are next-door neighbors. But historically, this similarity in structure and location has been a source not of collaboration and fondness but of competition and friction. Within the European Union, with its broad diversity, Germany and France have been able to put aside their frictions, finding a common interest in managing Europe to their mutual advantage. That co-management, of course, helped bring us to this current crisis. Moreover, the biggest thing that France has that Germany wants is its market; an ideal partner for Germany would offer more. By itself at least, France is not a foundation for long-term German economic strategy. The historic alternative for Germany has been Russia.

The Russian Option

A great deal of potential synergy exists between the German and Russian economies. Germany imports large amounts of energy and other resources from Russia. As mentioned, Russia needs sources of technology and capital to move it beyond its current position of mere resource exporter. Germany has a shrinking population and needs a source of labor — preferably a source that doesn’t actually want to move to Germany. Russia’s Soviet-era economy continues to de-industrialize, and while that has a plethora of negative impacts, there is one often-overlooked positive: Russia now has more labor than it can effectively metabolize in its economy given its capital structure. Germany doesn’t want more immigrants but needs access to labor. Russia wants factories in Russia to employ its surplus work force, and it wants technology. The logic of the German-Russian economic relationship is more obvious than the German-Greek or German-Spanish relationship. As for France, it can participate or not (and incidentally, the French are joining in on a number of ongoing German-Russian projects).

Therefore, if we simply focus on economics, and we assume that the European Union cannot survive as an integrated system (a logical but not yet proven outcome), and we further assume that Germany is both the leading power of Europe and incapable of operating outside of a coalition, then we would argue that a German coalition with Russia is the most logical outcome of an EU decline.

This would leave many countries extremely uneasy. The first is Poland, caught as it is between Russia and Germany. The second is the United States, since Washington would see a Russo-German economic bloc as a more significant challenger than the European Union ever was for two reasons. First, it would be a more coherent relationship — forging common policies among two states with broadly parallel interests is far simpler and faster than doing so among 27. Second, and more important, where the European Union could not develop a military dimension due to internal dissensions, the emergence of a politico-military dimension to a Russo-German economic bloc is far less difficult to imagine. It would be built around the fact that both Germans and Russians resent and fear American power and assertiveness, and that the Americans have for years been courting allies who lie between the two powers. Germany and Russia would both view themselves defending against American pressure.

And this brings us back to the Patriot missiles. Regardless of the bureaucratic backwater this transfer might have emerged out of, or the political disinterest that generated the plan, the Patriot stationing fits neatly into a slowly maturing military relationship between Poland and the United States. A few months ago, the Poles and Americans conducted military exercises in the Baltic states, an incredibly sensitive region for the Russians. The Polish air force now flies some of the most modern U.S.-built F-16s in the world; this, plus Patriots, could seriously challenge the Russians. A Polish general commands a sector in Afghanistan, something not lost upon the Russians. By a host of processes, a close U.S.-Polish relationship is emerging.

The current economic problems may lead to a fundamental weakening of the European Union. Germany is economically powerful but needs economic coalition partners that contribute to German well-being rather than merely draw on it. A Russian-German relationship could logically emerge from this. If it did, the Americans and Poles would logically have their own relationship. The former would begin as economic and edge toward military. The latter begins as military, and with the weakening of the European Union, edges toward economics. The Russian-German bloc would attempt to bring others into its coalition, as would the Polish-U.S. bloc. Both would compete in Central Europe — and for France. During this process, the politics of NATO would shift from humdrum to absolutely riveting.

And thus, the Greek crisis and the Patriots might intersect, or in our view, will certainly in due course intersect. Though neither is of lasting importance in and of themselves, the two together point to a new logic in Europe. What appears impossible now in Europe might not be unthinkable in a few years. With Greece symbolizing the weakening of the European Union and the Patriots representing the remilitarization of at least part of Europe, ostensibly unconnected tendencies might well intersect.

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Europe, Nationalism and Shared Fate

23. May 2010 by admin.

Europe, Nationalism and Shared Fate

May 11, 2010

 

 

By George Friedman

The European financial crisis is moving to a new level. The Germans have finally consented to lead a bailout effort for Greece. The effort has angered the German public, which has acceded with sullen reluctance. It does not accept the idea that it is Germans’ responsibility to save Greeks from their own actions. The Greeks are enraged at the reluctance, having understood that membership in the European Union meant that Greece’s problems were Europe’s.

 

And this is not just a Greek matter. Geographically, the problem is the different levels of development of Mediterranean Europe versus Northern Europe. During the last generation, the Mediterranean countries have undergone major structural changes and economic development. They have also undergone the inevitable political tensions that rapid growth generates. As a result, their political and economic condition is substantially different from that of Northern Europe, whose development surge took place a generation before and whose political structure has come into alignment with its economic condition.

 

European Unity and Diversity

Northern and Southern Europe are very different places, as are the former Soviet satellites still recovering from decades of occupation. Even on this broad scale, Europe is thus an extraordinarily diverse portrait of economic, political and social conditions. The foundation of the European project was the idea that these nations could be combined into a single economic regime and that that economic regime would mature into a single united political entity. This was, on reflection, a rather extraordinary idea.

 

Europeans, of course, do not think of themselves as Mediterranean or Northern European. They think of themselves as Greek or Spanish, Danish or French. Europe is divided into nations, and for most Europeans, identification with their particular nation comes first. This is deeply embedded in European history. For the past two centuries, the European obsession has been the nation. First, the Europeans tried to separate their own nations from the transnational dynastic empires that had treated European nations as mere possessions of the Hapsburg, Bourbon or Romanov families. The history of Europe since the French Revolution was the emergence and resistance of the nation-state. Both Nazi Germany and the Soviet Union attempted to create multinational states dominated by a single state. Both failed, and both were hated for the attempt.

 

There is a paradox in the European mindset. On the one hand, the recollection of the two world wars imbued Europeans with a deep mistrust of the national impulse. On the other hand, one of the reasons nationalism was distrusted was because of its tendency to make war on other nation-states and try to submerge their identities. Europe feared nationalism out of a very nationalist impulse.

 

The European Union was designed to create a European identity while retaining the nation-state. The problem was not in the principle, as it is possible for people to have multiple identities. For example, there is no tension between being an Iowan and an American. But there is a problem with the issue of shared fate. Iowans and Texans share a bond that transcends their respective local identities. Their national identity as Americans means that they share not only transcendent values but also fates. A crisis in Iowa is a crisis in the United States, and not one in a foreign country as far as Texans are concerned.

 

The Europeans tried to finesse this problem. There was to be a European identity, yet national identities would remain intact. They wrote a nearly 400-page-long constitution, an extraordinary length. But it was not really a constitution. Rather, it was a treaty that sought to reconcile the concept of Europe as a single entity while retaining the principle of national sovereignty that Europe had struggled with for centuries. At root, Europe’s dilemma was no different from the American dilemma — only the Americans ultimately decided, in the Civil War, that being an American transcended being a Virginian. One could be a Virginian, but Virginia shared the fate of New York, and did so irrevocably. The Europeans could not state this unequivocally as they either did not believe it or lacked the ability to militarily impress the belief upon the rest of Europe. So they tried to finesse it in long, complex and ultimately opaque systems of governance that ultimately left the nations of Europe with their sovereignty intact.

When the Berlin Wall came down in 1989, there was no question among the Germans that East and West Germany would be united. Nor were serious questions raised that the cost of economically and socially reviving East Germany would be borne by West Germany. Germany was a single country that history had divided, and when history allowed them to be reunited, Germans would share the burdens. Ever since the 19th century, when Germany began to conceive of itself as one country, there was an idea that to be a German meant to share a single fate and burdens.

 

This was the same for the rest of Europe that organized itself into nation-states, where the individual identified his fate with the fate of the nation. For a Pole or an Irishman, the fate of his country was part of his fate. But a Pole was not an Irishman and an Irishman was not a Pole. They might share interests, but not fates. The nation is the place of tradition, language and culture — all of the things that, for better or worse, define who you are. The nation is the place where an economic crisis is inescapably part of your life.

 

When the Greek financial crisis emerged, other Europeans asked the simple question, “What has this to do with me?” From their point of view, the Greeks were foreigners. They spoke a different language, had a different culture, shared a different history. The Germans might be affected by the crisis — German banks held Greek debt — but the Germans were not Greeks, and they did not share the Greeks’ fate. And this was not just the view of Germany, the economic leader of Europe, by any means.

 

In the past, Mexico has had several economic crises in which the United States intervened to stabilize Mexico. This was done because it was in the American interest to do so, not because the United States and Mexico were one country. So, too, in Europe: The bailout of Greece is designed not because Greece is part of Europe, but because it is in the rest of Europe’s interest to bail Greece out. But the heart of the matter is that Greece is a foreign country.

 

The Question of European Identity

During the generation of prosperity between the early 1990s and 2008, the question of European identity and national identity really did not arise. Being a European was completely compatible with being a Greek. Prosperity meant there was no choice to make. Economic crisis meant that choices had to be made, between the interests of Europe, the interests of Germany and the interests of Greece, as they were no longer the same. What happened was not a European solution, but a series of national calculations on self-interest; it was a negotiation between foreign countries, not a European solution growing organically from the recognition of a single, shared fate.

 

Ultimately, Europe was an abstraction. The nation-state was real. We could see this earliest and best not in the economic arena, but in the area of foreign policy and national defense. The Europeans as a whole never managed to develop either. The foreign policies of the United Kingdom, Germany and Poland were quite different and in many ways at odds. And war, even more than economics, is the sphere in which nations endure the greatest pain and risk. None of the European nations was prepared to abandon national sovereignty in this area, meaning no country was prepared to put the bulk of its armed forces under the command of a European government — nor were they prepared to cooperate in defense matters unless it was in their interest.

 

The unwillingness of the Europeans to transfer sovereignty in foreign and defense matters to the European Parliament and a European president was the clearest sign that the Europeans had not managed to reconcile European and national identity. Europeans knew that when it came down to it, the nation mattered more than Europe. And that understanding, under the pressure of crisis, has emerged in economics as well. When there is danger, your fate rests with your country.

 

The European experiment originated as a recoil from the ultranationalism of the first half of the 20th century. It was intended to solve the problem of war in Europe. But the problem of nationalism is that not only is it more resilient than the solution, it also derives from the deepest impulses of the Enlightenment. The idea of democracy and of national self-determination grew up as part of a single fabric. In taking away national self-determination, the European experiment seemed to be threatening the foundation of modern Europe.

 

There was another impulse behind the idea of Europe. Most of the European nations, individually, were regional powers at best, unable to operate globally. They were therefore weaker than the United States. Europe united would not only be able to operate globally, it would be the equal of the United States. If the nation-states of Europe were no longer great individually, Europe as a whole could be. Embedded in the idea of Europe, particularly in the Gaullist view of it, was the idea ofEurope as a whole regaining its place in the world, the place it lost after two world wars.

That clearly is not going to happen. There is no European foreign and defense policy, no European army, no European commander in chief. There is not even a common banking or budgetary policy (which cuts to the heart of today’s crisis). Europe will not counterbalance the United States because, in the end, Europeans do not share a common vision of Europe, a common interest in the world or a mutual trust, much less a common conception of exactly what counterbalancing the United States would mean. Each nation wants to control its own fate so as not to be drawn back into the ultranationalism of a Germany in the 1930s and 1940s or the indifference to nationalism of the Hapsburg Empire. The Europeans like their nations and want to retain them. After all, the nation is who they actually are.

 

That means that they approach the financial crisis of Mediterranean Europe in a national, as opposed to European, fashion. Both those in trouble and those who might help calculate their moves not as Europeans but as Germans or Greeks. The question, then, is simple: Given that Europe never came together in terms of identity, and given that the economic crisis is elevating national interest well over European interest, where does this all wind up?

 

The European Union is an association — at most an alliance — and not a transnational state. There was an idea of making it such a state, but that idea failed a while ago. As an alliance, it is a system of relationships among sovereign states. They participate in it to the extent that it suits their self-interest — or fail to participate when they please.

 

In the end, what we have learned is that Europe is not a country. It is a region, and in this region there are nations and these nations are comprised of people united by shared history and shared fates. The other nations of Europe may pose problems for these people, but in the end, they share neither a common moral commitment nor a common fate.

 

This means that nationalism is not dead in Europe, and neither is history. And the complacency with which Europeans have faced their future, particularly when it has concerned geopolitical tensions within Europe, might well prove premature. Europe is Europe, and its history cannot be dismissed as obsolete, much less over.

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The U.S.-Pakistan Conundrum and Europe’s Existential Test

22. May 2010 by admin.

The U.S.-Pakistan Conundrum and Europe’s Existential Test

 

 

May 20, 2010

 

 

U.S. NATIONAL SECURITY ADVISER JIM JONES and CIA Director Leon Panetta met with Pakistan’s top civil and military leadership Wednesday and reportedly urged it to take more aggressive action against jihadists, especially in North Waziristan. (The region is the main hub of an array of international jihadist actors, which the Pakistanis have yet to target in their yearlong counterinsurgency campaign.) The visit was prompted by revelations about the deep connections the would-be Times Square bomber, Faisal Shahzad, had with Pakistan’s jihadist community as well as its military. Shahzad’s father is a retired Air Vice Marshal, the third highest rank in the Pakistani air force. His uncle is a retired two-star general who once headed the Frontier Corps in Khyber-Pakhtunkhwa Province, formerly known as the North-West Frontier Province. The Frontier Corps is the paramilitary force currently playing a key role in the counterinsurgency campaign against Taliban rebels in northwest Pakistan.

Given the level of religious radicalization that the country has experienced over the past three decades or so, it is not unusual for a person with Shahzad’s pedigree to have joined al Qaeda transnational jihadists. Furthermore, being from an elite family also does not mean that senior people within the army have ties to the global jihadist nexus involved in plots to attack the United States. However, Tuesday there were reports that Pakistani authorities had arrested a serving army major suspected of being an accomplice to Shahzad, which further exacerbates an already complicated U.S.-Pakistani relationship.

 

Cooperation between Washington and Islamabad on dealing with the jihadist menace had just begun to improve when the Times Square bomb incident took place. It had hardly been three months since U.S. Central Command chief Gen. David Petraeus had applauded Pakistani efforts against the militant infrastructure. He said Islamabad’s forces were doing the best they could with limited resources, and should not be expected to expand the scope of their operations anytime soon. The shifting paradigm in Washington vis-a-vis Islamabad came to a screeching halt when it became clear that Shahzad had been dispatched by jihadist elements based in Pakistan.

 

The problem is not that the United States has completely reverted to the old policy of pressuring Pakistan. Rather it has to do with the dilemma where on one hand U.S. President Barack Obama’s administration needs to stabilize Pakistan to deal with the Afghan Taliban, while on the other it needs to pressure Pakistan to take tougher action against al Qaeda, which could further destabilize the already dangerously weakened Pakistani polity. In other words, the U.S. strategy for the region has been knocked off balance.

 

This precarious situation should not be considered an unintended outcome of the plot to detonate an improvised explosive device in the heart of Manhattan. It is very clearly the work of transnational jihadists headquartered in Pakistan who view increased U.S.-Pakistani cooperation as a lethal cocktail. The jihadists have been able to exploit the weakness of the Pakistani state and the contradictions within its security establishment to their advantage.

 

But in the past year they have faced a major onslaught and find themselves caught between U.S. unmanned aerial vehicle strikes and Pakistani ground assaults. They are in no position to resist the combined U.S.-Pakistani offensive. Their only way out is to undermine the bilateral relationship, which, given its fragility and the tools at the disposal of the jihadists, is not hard to do.

 

This strategy mimics efforts to ignite conflict between India and Pakistan by staging attacks in India in an attempt to force New Delhi into taking unilateral action against militant facilities on Pakistani soil. Doing so would lead to an all-out war between the two South Asian rivals, giving militants even more room to maneuver. In the case of the United States and Pakistan, an attack does not have to be successful, such as the case with the Times Square plot. All that is required is an attempt by an individual with easily traceable connections to Pakistan and its security establishment, which would undermine the ties between the two. Ideally, the goal is to create a situation where the United States is forced to be more aggressive about unilateral action on Pakistani soil. Doing so would create further chaos, which is the environment in which the jihadists thrive.

 

It should be noted that the whole idea of the al Qaeda-allied Pakistani Taliban claiming responsibility for the failed Times Square attack makes no sense. Why would the jihadists expend resources on an individual who did not have the skill set to pull off a real bombing? It only makes the organization appear weak, unless of course the intent was not to stage an actual attack, but rather undermine U.S. strategy for the region by creating problems between Islamabad and Washington.

 

Lest our readers think there isn’t anything going on in the world beyond Pakistan, the financial crisis in Europe has not gone anywhere — in fact, it continues to build. German Chancellor Angela Merkel told parliament that Europe is facing an “existential test” from the Greek-triggered crisis, noting that “if the euro fails, then Europe fails.” The chancellor is laying the groundwork for a Friday vote on approving Germany’s 123 billion euro contribution to a eurozone bailout fund.

 

While it was not designed that way, the euro has become the EU. The euro was intended to inject German economic dynamism into the rest of Europe, providing capital and markets that would act like the ocean tide and raise all boats. Instead, the common currency allowed poorer Southern Europe to delay reforms.

The issue of the day focuses on German subsidization of the South versus a series of rolling collapses should Berlin refuse. Unintended or not — and economically beneficial or not — the link between Germany’s checkbook and “the preservation of the European idea” is undisputed. If Germany is to seek global stature, it will have to make donations of similar scale to the European South over and over again. And should it refuse to participate, the great unraveling of Europe will begin with a vengeance.

 

It is not so much that we are attracted to the drama in Berlin — although it is worth noting that there has not been this type of drama in Berlin since the 1940s — but rather that the Germans are enacting policies that have a hint of desperation to them. On Wednesday the Germans instituted a ban on naked short selling, market parlance for betting that a certain horse will lose badly. Such trades usually only affect the margins of the market, and governments only get nervous about them when the ship seems about to go down. 

 

For comparison, the United States instituted a similar policy in July 2008, just before the American markets degraded from wobbly to free fall.

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Geopolitics of European Monetary Union

19. May 2010 by admin.

The Geography of the European Monetary Union

As we consider the future of the euro, it is important to remember that the economic underpinnings of paper money are not nearly as important as the political underpinnings. Paper currencies in use throughout the world today hold no value without the underlying political decision to make them the legal tender of commercial activity. This means a government must be willing and capable enough to enforce the currency as a legal form of debt settlement, and refusal to accept paper currency is, within limitations, punishable by law.

 

The trouble with the euro is that it attempts to overlay a monetary dynamic on a geography that does not necessarily lend itself to a single economic or political “space.” The eurozone has a single central bank, the European Central Bank (ECB), and therefore has only one monetary policy, regardless of whether one is located in Northern or Southern Europe. Herein lies the fundamental geographic problem of the euro.

Europe is the second-smallest continent on the planet but has the second-largest number of states packed into its territory. This is not a coincidence. Europe’s multitude of peninsulas, large islands and mountain chains create the geographic conditions that often allow even the weakest political authority to persist. Thus, the Montenegrins have held out against the Ottomans, just as the Irish have against the English.

Despite this patchwork of political authorities, the Continent’s plentiful navigable rivers, large bays and serrated coastlines enable the easy movement of goods and ideas across Europe. This encourages the accumulation of capital due to the low costs of transport while simultaneously encouraging the rapid spread of technological advances, which has allowed the various European states to become astonishingly rich: Five of the top 10 world economies hail from the Continent despite their relatively small populations.

 

Europe’s network of rivers and seas are not integrated via a single dominant river or sea network, however, meaning capital generation occurs in small, sequestered economic centers. To this day, and despite significant political and economic integration, there is no European New York. In Europe’s case, the Danube has Vienna, the Po has Milan, the Baltic Sea has Stockholm, the Rhineland has both Amsterdam and Frankfurt and the Thames has London. This system of multiple capital centers is then overlaid on Europe’s states, which jealously guard control over their capital and, by extension, their banking systems.

 

Despite a multitude of different centers of economic — and by extension, political — power, some states, due to geography, are unable to access any capital centers of their own. Much of the Club Med states are geographically disadvantaged. Aside from the Po Valley of northern Italy — and to an extent the Rhone — southern Europe lacks a single river useful for commerce. Consequently, Northern Europe is more urban, industrial and technocratic while Southern Europe tends to be more rural, agricultural and capital-poor.

 

Introducing the Euro

Given the barrage of economic volatility and challenges the eurozone has confronted in recent quarters and the challenges presented by housing such divergent geography and history under one monetary roof, it is easy to forget why the eurozone was originally formed.

The Cold War made the European Union possible. For centuries, Europe was home to feuding empires and states. After World War II, it became the home of devastated peoples whose security was the responsibility of the United States. Through the Bretton Woods agreement, the United States crafted an economic grouping that regenerated Western Europe’s economic fortunes under a security rubric that Washington firmly controlled. Freed of security competition, the Europeans not only were free to pursue economic growth, they also enjoyed nearly unlimited access to the American market to fuel that growth. Economic integration within Europe to maximize these opportunities made perfect sense. The United States encouraged the economic and political integration because it gave a political underpinning to a security alliance it imposed on Europe, i.e., NATO. Thus, the European Economic Community — the predecessor to today’s European Union — was born.

 

When the United States abandoned the gold standard in 1971 (for reasons largely unconnected to things European), Washington essentially abrogated the Bretton Woods currency pegs that went with it. One result was a European panic. Floating currencies raised the inevitability of currency competition among the European states, the exact sort of competition that contributed to the Great Depression 40 years earlier. Almost immediately, the need to limit that competition sharpened, first with currency coordination efforts still concentrating on the U.S. dollar and then from 1979 on with efforts focused on the deutschmark. The specter of a unified Germany in 1989 further invigorated economic integration. The euro was in large part an attempt to give Berlin the necessary incentives so that it would not depart the EU project.

 

But to get Berlin on board with the idea of sharing its currency with the rest of Europe, the eurozone was modeled after the Bundesbank and its deutschmark. To join the eurozone, a country must abide by rigorous “convergence criteria” designed to synchronize the economy of the acceding country with Germany’s economy. The criteria include a budget deficit of less than 3 percent of gross domestic product (GDP); government debt levels of less than 60 percent of GDP; annual inflation no higher than 1.5 percentage points above the average of the lowest three members’ annual inflation; and a two-year trial period during which the acceding country’s national currency must float within a plus-or-minus 15 percent currency band against the euro.

 

As cracks have begun to show in both the political and economic support for the eurozone, however, it is clear that the convergence criteria failed to overcome divergent geography and history. Greece’s violations of the Growth and Stability Pact are clearly the most egregious, but essentially all eurozone members — including France and Germany, which helped draft the rules — have contravened the rules from the very beginning.

 

Mechanics of a Euro Exit

The EU treaties as presently constituted contractually obligate every EU member state — except Denmark and the United Kingdom, which negotiated opt-outs — to become a eurozone member state at some point. Forcible expulsion or self-imposed exit is technically illegal, or at best would require the approval of all 27 member states (never mind the question about why a troubled eurozone member would approve its own expulsion). Even if it could be managed, surely there are current and soon-to-be eurozone members that would be wary of establishing such a precedent, especially when their fiscal situation could soon be similar to Athens’ situation.

 

One creative option making the rounds would allow the European Union to technically expel members without breaking the treaties. It would involve setting up a new European Union without the offending state (say, Greece) and establishing within the new institutions a new eurozone as well. Such manipulations would not necessarily destroy the existing European Union; its major members would “simply” recreate the institutions without the member they do not much care for.

 

Though creative, the proposed solution it is still rife with problems. In such a reduced eurozone, Germany would hold undisputed power, something the rest of Europe might not exactly embrace. If France and the Benelux countries reconstituted the eurozone with Berlin, Germany’s economy would go from constituting 26.8 percent of eurozone version 1.0’s overall output to 45.6 percent of eurozone version 2.0’s overall output. Even states that would be expressly excluded would be able to get in a devastating parting shot: The southern European economies could simply default on any debt held by entities within the countries of the new eurozone.

With these political issues and complications in mind, we turn to the two scenarios of eurozone reconstitution that have garnered the most attention in the media.

 

Scenario 1: Germany Reinstitutes the Deutschmark

The option of leaving the eurozone for Germany boils down to the potential liabilities that Berlin would be on the hook for if Portugal, Spain, Italy and Ireland followed Greece down the default path. As Germany prepares itself to vote on its 123 billion euro contribution to the 750 billion euro financial aid mechanism for the eurozone — which sits on top of the 23 billion euros it already approved for Athens alone — the question of whether “it is all worth it” must be on top of every German policymaker’s mind.

This is especially the case as political opposition to the bailout mounts among German voters and Merkel’s coalition partners and political allies. In the latest polls, 47 percent of Germans favor adopting the deutschmark. Furthermore, Merkel’s governing coalition lost a crucial state-level election May 9 in a sign of mounting dissatisfaction with her Christian Democratic Union and its coalition ally, the Free Democratic Party. Even though the governing coalition managed to push through the Greek bailout, there are now serious doubts that Merkel will be able to do the same with the eurozone-wide mechanism May 21.

 

Germany would therefore not be leaving the eurozone to save its economy or extricate itself from its own debts, but rather to avoid the financial burden of supporting the Club Med economies and their ability to service their 3 trillion euro mountain of debt. At some point, Germany may decide to cut its losses — potentially as much as 500 billion euros, which is the approximate exposure of German banks to Club Med debt — and decide that further bailouts are just throwing money into a bottomless pit. Furthermore, while Germany could always simply rely on the ECB to break all of its rules and begin the policy of purchasing the debt of troubled eurozone governments with newly created money (“quantitative easing”), that in itself would also constitute a bailout. The rest of the eurozone, including Germany, would be paying for it through the weakening of the euro.

 

Were this moment to dawn on Germany it would have to mean that the situation had deteriorated significantly. As STRATFOR has recently argued, the eurozone provides Germany with considerable economic benefits. Its neighbors are unable to undercut German exports with currency depreciation, and German exports have in turn gained in terms of overall eurozone exports on both the global and eurozone markets. Since euro adoption, unit labor costs in Club Med have increased relative to Germany’s by approximately 25 percent, further entrenching Germany’s competitive edge.

Before Germany could again use the deutschmark, Germany would first have to reinstate its central bank (the Bundesbank), withdraw its reserves from the ECB, print its own currency and then re-denominate the country’s assets and liabilities in deutschmarks. While it would not necessarily be a smooth or easy process, Germany could reintroduce its national currency with far more ease than other eurozone members could.

The deutschmark had a well-established reputation for being a store of value, as the renowned Bundesbank directed Germany’s monetary policy. If Germany were to reintroduce its national currency, it is highly unlikely that Europeans would believe that Germany had forgotten how to run a central bank — Germany’s institutional memory would return quickly, re-establishing the credibility of both the Bundesbank and, by extension, the deutschmark.

 

As Germany would be replacing a weaker and weakening currency with a stronger and more stable one, if market participants did not simply welcome the exchange, they would be substantially less resistant to the change than what could be expected in other eurozone countries. Germany would therefore not necessarily have to resort to militant crackdowns on capital flows to halt capital trying to escape conversion.

Germany would probably also be able to re-denominate all its debts in the deutschmark via bond swaps. Market participants would accept this exchange because they would probably have far more faith in a deutschmark backed by Germany than in a euro backed by the remaining eurozone member states.

 

Reinstituting the deutschmark would still be an imperfect process, however, and there would likely be some collateral damage, particularly to Germany’s financial sector. German banks own much of the debt issued by Club Med, which would likely default on repayment in the event Germany parted with the euro. If it reached the point that Germany was going to break with the eurozone, those losses would likely pale in comparison to the costs — be they economic or political — of remaining within the eurozone and financially supporting its continued existence.

 

Scenario 2: Greece Leaves the Euro

If Athens were able to control its monetary policy, it would ostensibly be able to “solve” the two major problems currently plaguing the Greek economy.

First, Athens could ease its financing problems substantially. The Greek central bank could print money and purchase government debt, bypassing the credit markets. Second, reintroducing its currency would allow Athens to then devalue it, which would stimulate external demand for Greek exports and spur economic growth. This would obviate the need to undergo painful “internal devaluation” via austerity measures that the Greeks have been forced to impose as a condition for their bailout by the International Monetary Fund (IMF) and the EU.

If Athens were to reinstitute its national currency with the goal of being able to control monetary policy, however, the government would first have to get its national currency circulating (a necessary condition for devaluation).

The first practical problem is that no one is going to want this new currency, principally because it would be clear that the government would only be reintroducing it to devalue it. Unlike during the Eurozone accession process — where participation was motivated by the actual and perceived benefits of adopting a strong/stable currency and receiving lower interest rates, new funds and the ability to transact in many more places — “de-euroizing” offers no such incentives for market participants:

• The drachma would not be a store of value, given that the objective in reintroducing it is to reduce its value.

• The drachma would likely only be accepted within Greece, and even there it would not be accepted everywhere — a condition likely to persist for some time.

• Reinstituting the drachma unilaterally would likely see Greece cast out of the eurozone, and therefore also the European Union as per rules explained above.

   

The government would essentially be asking investors and its own population to sign a social contract that the government clearly intends to abrogate in the future, if not immediately once it is able to. Therefore, the only way to get the currency circulating would be by force.

The goal would not be to convert every euro-denominated asset into drachmas but rather to get a sufficiently large chunk of the assets so that the government could jumpstart the drachma’s circulation. To be done effectively, the government would want to minimize the amount of money that could escape conversion by either being withdrawn or transferred into asset classes easy to conceal from discovery and appropriation. This would require capital controls and shutting down banks and likely also physical force to prevent even more chaos on the streets of Athens than seen at present. Once the money was locked down, the government would then forcibly convert banks’ holdings by literally replacing banks’ holdings with a similar amount in the national currency. Greeks could then only withdraw their funds in newly issued drachmas that the government gave the banks to service those requests. At the same time, all government spending/payments would be made in the national currency, boosting circulation. The government also would have to show willingness to prosecute anyone using euros on the black market, lest the newly instituted drachma become completely worthless.

 

Since nobody save the government would want to do this, at the first hint that the government would be moving in this direction, the first thing the Greeks will want to do is withdraw all funds from any institution where their wealth would be at risk. Similarly, the first thing that investors would do — and remember that Greece is as capital-poor as Germany is capital-rich — is cut all exposure. This would require that the forcible conversion be coordinated and definitive, and most important, it would need to be as unexpected as possible.

Realistically, the only way to make this transition without completely unhinging the Greek economy and shredding Greece’s social fabric would be to coordinate with organizations that could provide assistance and oversight. If the IMF, ECB or eurozone member states were to coordinate the transition period and perhaps provide some backing for the national currency’s value during that transition period, the chances of a less-than-completely-disruptive transition would increase.

 

It is difficult to imagine circumstances under which such support would not dwarf the 110 billion euro bailout already on the table. For if Europe’s populations are so resistant to the Greek bailout now, what would they think about their governments assuming even more risk by propping up a former eurozone country’s entire financial system so that the country could escape its debt responsibilities to the rest of the eurozone?

 

The European Dilemma

Europe therefore finds itself being tied in a Gordian knot. On one hand, the Continent’s geography presents a number of incongruities that cannot be overcome without a Herculean (and politically unpalatable) effort on the part of Southern Europe and (equally unpopular) accommodation on the part of Northern Europe. On the other hand, the cost of exit from the eurozone — particularly at a time of global financial calamity, when the move would be in danger of precipitating an even greater crisis — is daunting to say the least.

 

The resulting conundrum is one in which reconstitution of the eurozone may make sense at some point down the line. But the interlinked web of economic, political, legal and institutional relationships makes this nearly impossible. The cost of exit is prohibitively high, regardless of whether it makes sense.

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The U.S.’ Eurozone Problem

15. May 2010 by admin.

The U.S.’ Eurozone Problem

Authors:

Ashraf Laidi, Chief Market Strategist, CMC Markets Adolfo Laurenti, Deputy Chief Economist and Managing Director, Mesirow Financial Carmen Reinhart, Research Associate, National Bureau of Economic Research; and Vincent Reinhart, Resident Scholar, American Enterprise Institute Uri Dadush, Director, International Economics Program, the Carnegie Endowment Ron Sloan, Chief Information Officer, Invesco Anna Gelpern, Associate Professor of Law, American University

May 14, 2010

 

The debt crisis that began in Greece and spread to other eurozone countries has served as a painful reminder of the risks associated with high public debt in a globalized financial system. The threat of contagion to countries outside Europe has divided experts on what the impact will be on the U.S. economy–whose debt is expected to rise to 90 percent of GDP by 2020. Some economists argue the U.S. economy will benefit from the eurozone crisis, since the euro’s continued weakness will secure the U.S. dollar’s status as a global reserve currency. Others say the U.S. debt problem will escalate if bloated entitlement programs go unaddressed. Some analysts argue the greater impact of the crisis will be on U.S. growth, which relies on market confidence and exports to Europe.

 

CMC Markets’ Ashraf Laidi, Mesirow Financial’s Adolfo Laurenti, the National Bureau of Economic Research’s Carmen Reinhart and the American Enterprise Institute’s Vincent Reinhart agree that the crisis buys the U.S. government time to tackle its debt–for better or worse. Of greater concern is the impact of the crisis on U.S. market confidence and growth, say the Carnegie Endowment’s Uri Dadush and Invesco’s Ron Sloan. Finally, American University’s Anna Gelpern says the crisis heightens the need for strong financial reforms that can “shield banks–and by extension the public–from government failure.” –Roya Wolverson, Staff Writer on Economics, CFR.org

Ashraf Laidi, Chief Market Strategist, CMC Markets

The most common arguments against a destabilization of the U.S. economy by the eurozone sovereign debt crisis are 1) the activism of the U.S. federal government in mobilizing another TARP-like aid package for U.S. banks, 2) a compliant Federal Reserve willing to reopen the liquidity taps by buying (again) U.S. government bonds, and 3) the sole ability to print a currency in which globally held U.S. debt is denominated. These measures–enacted in 2008 and 2009–effectively restored confidence in U.S. and global financial markets. The 60 percent surge in equity markets since March 2009 offered a jolt of confidence, while government-stimulus programs helped cap the unemployment rate and revived the role of consumers in lifting the U.S. economy out of recession.

To be sure, these solutions came at a cost. The Federal Reserve balance sheet swelled to a record $2.29 trillion as a result of purchasing government debt, while the U.S. debt ceiling was raised to $14.3 trillion, nearly triple the level of 2001. Currency and bond markets took notice. The U.S. dollar lost more than 20 percent of its value, and U.S. bond yields doubled throughout the stimulus period. Yet, as debt concerns escalated in the eurozone, the U.S. dollar benefited from flows exiting risky European currencies into the safety of U.S. treasury paper.

Today, German and French banks are exposed to as much as $900 billion in Greek and other eurozone countries’ debt. This exposure could bolster speculative attacks on U.S. equities on the rationale that a deteriorating European economy could quash the recovery of the Chinese economic engine as well as the U.S. consumer. Under such a scenario, a double dip U.S. recession is a stark possibility. Yet, as long as the corroding euro retards the process of global currency diversification away from the greenback, the United States will have little difficulty continuing to finance its debt from overseas lending. The power of printing its own currency will deflect credit agencies’ scrutiny from the United States, as they focus on more pressing cases in the eurozone and Britain.

 

Adolfo Laurenti, Deputy Chief Economist and Managing Director, Mesirow Financial

The 750 billion euro stabilization package implemented in the eurozone was instrumental in stopping the panic and restoring some semblance of order in increasingly volatile financial markets.

Nonetheless, upon closer scrutiny, the plan doesn’t fix the structural fiscal imbalances that impair countries like Greece, Spain, Portugal, and to a lesser extent, Italy and Ireland. The massive aid package only buys time for these embattled states to execute much-needed corrective policies. In order to bring government spending under control, additional measures of fiscal tightening must be adopted.

The eurozone plan also buys some time for the United States. The sovereign debt crisis in the eurozone has reasserted the position of the dollar as the world’s reserve currency. Yet the flight to safety out of Europe and the resulting strong demand for Treasury bonds should not be an excuse to delay action on our own weak fiscal position.

The concern is twofold. In the short run, we need to pay for the cost of bailouts and stimulus policies that followed the financial crisis and the “Great Recession.”

More importantly, long-term demographic trends make the burden of Social Security and Medicare unsustainable. Within a decade, American public finances will be under severe pressure to keep up with the exploding costs of our entitlement programs. Unless Congress resolves to undertake prompt and profound revision of the federal budget, the country may face dire consequences from our current profligate spending attitudes.

Thus, fiscal complacency is a major threat to the economic outlook for the United States. A slowdown in Europe will reduce our exports across the Atlantic, but the overall effect on the U.S. economy will be negligible when compared to the potential damage that a fiscal crisis may produce on our economy–if we let the opportunity to reduce our deficit and debt slip by.

The European malaise has given us some precious, borrowed time. We’d better not waste it.

 

Carmen Reinhart, Research Associate, National Bureau of Economic Research; and Vincent Reinhart, Resident Scholar, American Enterprise Institute

Recent weeks have shown that, although Greece may have a small footprint on global economic output, it casts a long shadow on financial markets. These funding difficulties have mostly resonated in the United States as a morality play. Borrowers with dubious prospects of repayment will ultimately be confronted by angry lenders.

The message has taken hold with such force domestically because our own fiscal path seems unmoored. While the current debt stock relative to national income, at 85 percent, does not directly trigger alarms, fiscal deficits run at 10 percent of income. More worrisome, public confidence that there are enough political leaders with the courage to arrest the process seems at a low ebb.

All true. But there was another message from Europe with equally profound implications. This was quieter and directed to an elite group controlling the official foreign exchange reserves of about a dozen sovereign governments, mostly located along the Asian Pacific Rim. Greece’s funding problems and the continent’s contagion established that the euro is not ready to be a reserve currency.

The economies in the world that are growing faster than the rest–China, India, and Korea, among others–are also saving more. After the Asian Crisis of 1998–a devastatingly deep but localized predecessor to what the world just went through–those countries have been directing a good-sized share of that saving to building up foreign exchange reserves.

Reserve managers, however, do not buy foreign currencies. They buy the safest assets, government securities, denominated in those foreign currencies. Buying safe dollar-denominated assets is easy; they are called U.S. government securities. Buying safe euro-denominated assets has been revealed to be patently more difficult. Many gilt-edged bonds have an embossed “€” somewhere, but their repayment prospects differ according to where they were printed, say, in Germany or Greece. Simply put, U.S. government securities satisfy a need as a reserve asset that is less likely to be satisfied by those from Europe, at least for some time.

In these circumstances, any noble exhortation based on the European experience is likely to fall flat. As long as reserve managers are buying U.S. government securities, U.S. politicians will not be pressed to change their ways by financial markets. A benefit, but perhaps only for a time. Politicians who are not disciplined are not likely to show discipline on their own. Thus, the faltering of the euro as an asset class because of the bad behavior of some may enable bad behavior for longer here at home.

 

Uri Dadush, Director, International Economics Program, the Carnegie Endowment

The United States has a vital interest in assuring that the euro crisis is controlled. The EU represents 20 percent of U.S. exports. More than 50 percent of U.S. overseas assets are held in Europe, while close to 40 percent of Europe’s foreign assets invested in the United States.

 

In fact, the euro crisis has already had a significant impact on the U.S. economy: Since late November, the euro has lost 17 percent of its value vis-à-vis the dollar, making U.S. exports less competitive, even as the Obama administration’s goal is to double exports in five years. U.S. exports are also adversely affected by Europe’s sluggish recovery–in the first quarter, European GDP was up only 0.3 percent on the same quarter a year before, compared to a 2.5 percent rise in the United States and 11.9 percent in China. U.S. investors in Europe should expect to take large balance sheet and income translation losses due to the lower euro.

But the most important effects of the euro crisis on the United States will operate not through the real channels of trade and foreign direct investment, but through broader effects on confidence and banks. Stock market volatility (as measured by the VIX index) has more than doubled in the last two months, and the confidence that banks have in lending to each other–measured by the TED spread (the difference between three-month inter-bank lending rate and the yield on Treasury Bills) was as wide as 30.8 basis points at the end of last week, a nine-month high, up from this year’s low of 10.6 basis points in March.

 

This is against a backdrop of a crisis largely confined thus far to Greece, a country accounting for a mere 2.6 percent of the eurozone GDP. Imagine what would happen if the crisis spread to Spain or Italy, countries five or six times larger. Though the exposure of U.S. banks to the most vulnerable countries in Europe is limited–about $176 billion, or 5 percent of their total foreign exposure–the indirect exposure is much larger, since U.S. banks do business with all the large international banks, which are themselves exposed to these vulnerable countries.

A spreading euro crisis would hurt U.S. interests in two other ways. First, although U.S. government debt may increase in popularity initially due to a safe haven effect, a spreading crisis would likely eventually place the spotlight on rising U.S. debt as well, aggravating the country’s unstable debt dynamics.

 

Ron Sloan, Chief Information Officer, Invesco

The 2009 private sector debt crisis has morphed into the 2010 sovereign debt crises, as the private debt was swapped into government debt. In fact, the pea was just moved under a different shell in a replay of this classic scam. Deleveraging on this scale is going to take a long time, and not everyone has the patience for this. Hence, rioting in Greece.

The eurozone crisis begs the question of what will fuel the growth that an increasingly export-driven developed world needs. We can’t all export to the smaller emerging world, and we can no longer count on significant growth within the developed world as new austerity measures become the rule of thumb throughout much of Europe. Once inventory restocking is finished, sustainable growth assumptions will have to move lower in the debt-laden developed world, and an emerging world that is increasingly moving to tighten its own fiscal and monetary policies.

The eurozone crisis is really a growth crisis. Debt-laden companies and countries–including those in the United States–will lose many reinvestment/growth options. Without growth, social instability and economic volatility will follow. The euro is certainly at risk in its current configuration. Southern European countries are looking to revalue their way out of their crisis, and German and French citizens are becoming more resistant to the austerity measures required to save the euro. The developed world has absorbed two decades (the ’80s and ’90s) of social and economic tailwinds–driven by low interest and tax rates, inflation, and increasing consumption and leverage–that are now turning into headwinds. Deleveraging will be a long and messy process.

 

Anna Gelpern, Associate Professor of Law, American University

The crisis in Europe reinforces the central message of the past two years: Governments and financial institutions are locked in a dysfunctional loop. When banks and shadow banks go under, they draw in governments to protect credit flows, payment systems, and people’s savings. When governments go under, they sink their creditors–banks, pension funds, insurance companies. Financial reform is essential not only to shield people from bank failure, but also to shield banks–and by extension the public–from government failure.

Greek banks and pension funds hold more than a quarter of Greek government debt. If Greece defaults, it wipes out popular savings and freezes credit essential to recovery. Elsewhere, European banks, pension funds, and insurance companies hold over half of Greek debt. Thus default threatens the broader European financial system, needed to finance Greek growth. This is the same system that nearly collapsed in 2008 from the U.S. housing bust, and was deeply shaken by the failures of Lehman Brothers, Fortis and Dexia, and the Icelandic banking crisis. But it is also the system that benefited from the U.S. government support for AIG, which had sold credit derivatives to European banks, absorbing their risks so they could hold less regulatory capital.

This leads to a paradox: Even if Greek debt is deeply unsustainable, and even if Greek debt contracts contain relatively few barriers to restructuring, uncertainty about the effects of default on the financial systems threatens to reduce or eliminate the benefits of debt reduction. To be sure, links between governments and financial institutions were central in the crises of the 1980s and 1990s as well, but now no part of the global financial system can be presumed immune.

In the past, we had thought that the best way to ensure a timely and orderly sovereign debt restructuring was through reforming sovereign debt contracts, or sovereign bankruptcy. One lesson from Greece is that stronger financial reforms–on both sides of the Atlantic–may be the surest way forward to manage sovereign distress. That means boosting capital so firms can absorb losses, comprehensive resolution so conglomerates may die in peace, and transparent derivatives markets to reveal the true risks of default.

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The Eurozone: Looking For Solutions

9. May 2010 by admin.

The Eurozone: Looking For Solutions

 

After an all-night meeting on the Greek debt and eurozone crisis, the eurozone members have preliminarily announced an emergency fund in an attempt to prevent the crisis from deepening.

 

So far there are no details on the size or scope of the emergency fund. All that has been released is that the EU’s central authorities will gain the ability to issue bonds to pay for currency protection programs, or bailouts. Supposedly, such debt will be guaranteed by eurozone members, but there are no details as yet as to how such debt would be paid back. The EU has no independent fund-raising capacities, suggesting that this is somewhat akin to cosigning for an open line of credit for a college student with no independent income.

 

We assume that is not precisely what they have in mind — in addition to being fiscally…questionable, the eurozone countries have already put forward all of the spare cash they will likely be able to independently generate for the next several months to pay for Greece’s bailout thus far — but we are waiting along with everyone else to see what the real deal is. It is highly likely that there will be some sort of an implied role in the process for the European Central Bank. Full details of the plan will be announced just before the Asian markets open Sunday May 9.

What we can say is that the Europeans do seem to be moving toward a plan with considerable speed, and we are not referring just to this emergency summit. European summits that run into the early morning hours are commonplace — one downside of a “consensus-based” governing system — but something else happened Saturday May 8 that is unprecedented.

 

Germany’s constitutional court rejected a case asserting that the Greek bailout announced just a few days ago was unconstitutional. It is not so much that the court rejected the case, but that it rejected it so quickly. The case was only filed last week, and the court rejected the case May 8 (a Saturday!) so that Berlin would have the needed legal cover to move immediately on this new crisis fund. Normally EU policy is hashed out over years. Now it is being done in hours, and Berlin is taking charge.

 

Something big is coming, and something big needs to come considering the scope of problems that the Greek crisis has imposed. The Greek crisis is clearly spreading to other eurozone members. Investors are beginning to shed the debt of a host of other eurozone states, Spain most notably, and unlike tiny Greece, there is no financial force in Europe — or the world — that can possibly bail out these larger states. The Greek bailout has not been sufficient to calm the markets. There is also fear — whether grounded in reality or not — that Europe’s problems could also spread to the United States and other global markets.

 

If the European Union — normally known for expansive, poorly enforced legalisms — is going to sequester the damage, it needs to do it fast. The EU is not known for speed, which is why a fast solution would be unprecedented in and of itself. And that may be exactly what Berlin and other eurozone capitals are thinking, that shocking the markets at this point is no longer about money, but rather the scope and speed of a European response.

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The Making of a Greek Tragedy

25. April 2010 by admin.

The Making of a Greek Tragedy

April 23, 2010 

GREECE HAS NOT HAD MANY GOOD DAYS in 2010, but Thursday was a particularly bad day. First, Europe’s statistical office (Eurostat) revised up the Greek 2009 budget deficit, which placed Athens’ accounting shenanigans in the spotlight again. The bottom line is that the situation is even worse than previously thought, and the budget deficit may very well be adjusted up as more Greek accounting malfeasance comes to light. Following the announcement, credit rating agency Moody’ s dropped Greece’s credit rating one notch, immediately prompting a rise in Greek government bond yields, thus increasing Athens’ borrowing costs.

The yield on a Greek 10-year bond shot above nine percent, while a two-year bond rose above 11 percent, both record highs since Greece joined the eurozone. Particularly daunting is the fact that short-term debt financing is now more expensive than long-term funding. This situation is referred to as an “inverted yield curve,” and it is generally considered a harbinger of financial doom. This means that investors are sensing that Athens is more likely to experience problems sooner rather than later.

Higher yields mean that Greece is facing increasingly larger interest payments on an increasingly larger stock of debt. This all but confirms that Athens’ claim that its stock of public debt will peak at 120 percent of gross domestic product (GDP) is simply wishful thinking. Worse still, Greece is also facing continued economic recession, induced in part by Athens’ austerity measures designed to reduce its budget deficit. Given this vicious dynamic, we cannot see how Greece’s debt level will stabilize at anything below 150 percent of GDP range.

The point is that the financial writing is now on the proverbial wall; some form of default is simply unavoidable. Exactly how the Greek default will unfold is unclear, but the bottom line is that the question now is not “if” but “when.” Under “normal” circumstances, when the IMF becomes involved with a country in a situation similar to Greece’s, the standard procedure is to devalue the local currency. By lowering the relative prices within the economy, the devaluation increases the competitiveness of the country’s export sector and helps to reorient the economy toward external demand. Devaluation is also politically expedient because regaining competitiveness does not require employers to slash employees’ wages, as the devaluation adjusts the relative costs silently and discreetly.

However, Greece does not have the option of devaluation because it is locked into a monetary union. The eurozone’s monetary policy is controlled by the Frankfurt-based European Central Bank. The fact that Greece is locked in the “euro straitjacket” raises two questions, the first being how the Greek debt crisis will play out.

Without the option of devaluation, the Greeks will have to implement and endure draconian austerity measures — in addition to the ones it has already enacted — similar to what Latvia and Argentina endured as part of their IMF programs. Argentina in 2000 and Latvia in 2008 also could not go the currency devaluation route because neither country controlled its monetary policy. In Argentina’ s case, the austerity measures were so severe that they caused considerable social unrest — including a brief period of outright anarchy in late 2001, which saw the country go through five heads of government in about two weeks — ultimately culminating in the country’s partial debt default in 2002. To this day, Argentina is still dealing with the fallout of that financial calamity.

An EU-IMF bailout of Greece would ultimately give Athens the choice of becoming either an Argentina or a Latvia. A financial assistance program that does not involve substantial structural reform on Greece’s part would lead to a default a la Argentina. A bailout that forces Greece to get serious about reforms would mean Greece becomes an IMF-ward like Latvia, with default still a serious possibility down the line. In either case, Greece will essentially lose control over its destiny.Latvia is a case of more recent vintage. In late 2008, Latvia agreed to what the IMF itself has called one of the most severe austerity programs since the 1970s. To accomplish it, Latvia has done everything from slashing public sector wages by 25 to 40 percent, increasing taxes, reducing unemployment and maternity benefits and cutting the defense budget. The crisis has already cost the Latvian prime minister his job and stoked social unrest. Despite all of that, the budget deficit has not budged much, remaining around eight percent of the GDP mark. Spending has been cut to the bone, but Latvia is simply too small of an economy to emerge from recession on its own. Since the broader European economic recovery remains moribund at best, less government spending has translated directly to less growth. Less growth means less tax income, and less tax income means that the country’ s budget deficit remains stubbornly high. Latvia has essentially become a ward of the IMF, and will remain so until either the broader European economic recovery is more robust or the Baltic state is fast-tracked into the eurozone itself.

The next question is what the rest of Europe will look like, and there is no shortage of impacts. Europe, and Germany in particular, must decide whether and to what extent it should “bail out” the Greeks. How that might happen is now the topic of the day in Europe. Driving the urgency is this simple fact: In the absence of substantial (and subsidized) financial assistance, Greece will inevitably default on its debts, thus generating write-downs for all those who hold Greek government debt (mostly European banks). The Greek default therefore is no longer an isolated problem, but a problem that threatens to aggravate an already weakened European banking sector. One of the most misunderstood facts of the international financial world is that even at the peak of the U.S. subprime crisis, in the dark hours when American hedge funds seemed to be snapping like matchsticks, Europe’s banks were in even worse shape. As the Americans stabilized, so did their banks. But Europe never cleaned house, and now a Greek tsunami is poised to wash over the whole mess.

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Europe: The Ash Cloud’s Aftermath

22. April 2010 by admin.

Europe: The Ash Cloud’s Aftermath

April 21, 2010

Smoke and ash erupt from the Eyjafjallajokull 

volcano in Iceland on April 1

Iceland’s Eyjafjallajokull volcano continued to spew ash April 21, although at lower altitudes than during the previous five days. Up to 75 percent of Europe’s flights are expected to return to normal as result of the shift in Eyjafjallajokull’s activity level. The ash cloud has affected air cargo transport and many of Europe’s airlines. Because of its economic effects, the ash cloud could end up having political effects in Europe as well.

The volcano under Iceland’s Eyjafjallajokull glacier continued spewing ash into the atmosphere April 21, though at an altitude of around 1.8 miles. This is far lower than the 3.7-6.8 miles the ash reached during most of the recent eruption, which began affecting European air travel April 14. The changes in ash altitude have allowed most airlines to slowly begin getting back to regular schedule, with Europe’s air traffic on its way to 75 percent of capacity April 21. Furthermore, seismologists in Iceland have said the worst of the eruption is probably over. However, there is still a chance that winds could circulate the ash already above Europe, thus continuing to impede air traffic. (See the graphic below showing the Norwegian Meteorological Institute’s forecast of ash cloud progression to April 23).

Short- and Medium-Term Effects

Europe is downwind from the volcano eruption in Iceland, and so has borne the brunt of the ash cloud’s adverse effects. The first such adverse effect is on Europe’s air cargo supply chain.

 

In terms of weight — often the standard measurement of transportation — air cargo only accounts for 1-2 percent of transportation conducted in Europe, as widely reported by the media. However, in terms of value, air cargo amounts to 10.6 percent of the European Union’s total trade. The disparity between weight and value is particularly acute for the United Kingdom, which not only is geographically isolated from its main EU trade partners but also is a highly advanced economy with a robust pharmaceutical sector. For the United Kingdom, air cargo accounts for 13.3 percent of trade value, not weight.

All of Europe’s advanced economies rely on air cargo for approximately 6.5-10 percent of overall trade turnover. The prolonged disruption in air traffic eventually will force exporters to find alternative supply chain mechanisms — enriching railway, truck and sea shipping companies in the process — but some products that rely on next-day delivery, like certain medicines and food items, could very well suffer irreversible losses.

This is a problem for Northern Europe’s economies, which are particularly reliant on air cargo transportation due to the economies’ technological advancement and dependence on “just-in-time” supply chain logistics. These supply chains enable the delivery of components critical to the manufacturing process very close to when they will actually be used, but they also make such business more vulnerable to even slight disruptions. Northern European economies also produce high-value but low-weight finished products, such as microchips and pharmaceuticals, which need to be shipped quickly to destinations around the world. A number of key northern European countries — not only the United Kingdom, but also Denmark, Sweden and Finland — also are relatively geographically isolated from the European continent, and it simply makes economic sense for these countries to fly their exports out rather than send them by ship or rail.

The effects of the ash cloud come amid ongoing economic problems for Europe, where the economy saw little growth in the fourth quarter of 2009 and a tepid recovery in the first quarter of 2010. The short-term effects of the ash cloud most likely will not be severe enough to derail recovery, but the current political climate in Europe is sensitive to even the smallest adverse economic events. Considering the countries being affected are mainly the large northern European economies — the same countries currently deciding the fate of Greece in the context of the eurozone and the EU — the ash cloud’s aftermath could compound an already negative public opinion of rescuing Greece and other profligate spenders in Club Med (Portugal, Italy and Spain), especially if bailing out various national airlines becomes necessary.

Volcanic ash impedes air travel because it can wreak havoc with jet engines. Ash sticks to the interior parts of the jet engine — particularly turbines, where the heat from the plane’s engine melts it into a coating that can restrict air flow through the engine. According to the International Air Transport Association, the airline industry is losing $250 million per day as result of the ash cloud, and in total has estimated losses to be around $1.7 billion. Major airport hubs, which are a key component of many local economies — and are major employers — in major European cities also are suffering daily losses that could lead to layoffs if the delays continue. Travel disruption also could wreck what was going to be an already dismal tourist season in Mediterranean Europe — particularly in troubled Greece where tourism accounts for around 18 percent of gross domestic product and where most tourists come from northern Europe.

Aside from the economic consequences, there also are rumblings in Europe that the European Union did not handle the crisis competently. French Foreign Minister Bernard Kouchner said April 21 that the EU “failed” to act in the crisis. The criticism leveled at the EU is unsurprising since cross-border crisis events usually elicit criticism of the union’s efficiency, even when it does not have policy competence to resolve such problems. In this case, closing various national airspaces was a decision made at the nation-state level. While the knee-jerk reaction in Europe to blame the EU for everything — even a volcano eruption in Iceland — may be an amusing anecdote from the event, it actually reaffirms the fact that Brussels is slowly losing what little legitimacy it had in the eyes of Europe’s public. In the current environment of economic recession, political elites will not be able to ignore and dismiss such criticism.

Potential Long-Term Effects

Nobody can accurately predict the seismic activity of a volcano, especially STRATFOR, which specializes in geopolitical rather than geological forecasting. However, in the long term the Eyjafjallajokull glacier volcano is not as big a problem as its neighbor, Katla.

According to climatologists, the current eruption is not producing enough sulfur dioxide to produce a significant climatological effect, such as blocking out the sun long enough to adversely affect Europe’s temperature. However, nearby Katla, which has erupted in tandem with Eyjafjallajokull in the past and seems to have been triggered by Eyjafjallajokull’s eruptions before, could produce such an effect. One of Katla’s major eruptions in the early 1700s resulted in such extreme cold temperatures on a global scale that the Mississippi River froze just north of New Orleans.

Another Icelandic volcano, Laki, is not in danger of erupting due to the current volcanic activity, but in the past it has produced what could be considered a worst-case scenario of the potential effects of an Icelandic volcano eruption. It is a scenario worth examining when discussing what a potential major Katla eruption could do. In 1783, Laki erupted for eight months, allegedly causing a drop in Europe’s surface temperature. Aside from eventually killing a fifth of Iceland’s population through the expulsion of toxic fumes and livestock degradation, Laki’s thick ash cloud is postulated to have affected Europe’s agriculture so dramatically that it contributed to the eventual social unrest leading to the 1789 French Revolution. Adverse health effects were also recorded in Europe, with a rise in deaths in the United Kingdom and France in particular.

The Eyjafjallajokull eruption could end soon, although it is difficult to tell how much longer the ash cloud will continue to swirl around Europe. It will take both the abating of the ash expulsion and a change of wind patterns for air traffic to return to normal completely. But with Europe already in a testy mood due to the slow economic recovery, arguments between EU member states on how to bail out Greece and rising economic and political nationalism, the ash cloud could cast more than just an economic pall on the continent by affecting its policies.

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The Opposing Interests of the U.K. and Germany

7. April 2010 by admin.

The Opposing Interests of the U.K. and Germany

QUEEN ELIZABETH II GRANTED BRITISH PRIME MINISTER Gordon Brown’s request to dissolve the Parliament on Tuesday, confirming that May 6 would indeed be a general election day in the United Kingdom, as has long been suspected. The ruling Labour Party — in power since Tony Blair’s landmark 1997 election — now faces a stiff challenge from the opposition Conservative Party in an electoral showdown with one central focus: the economy. The U.K. is facing a nearly 12 percent of gross domestic product (GDP) budget deficit, and a general government debt of nearly 90 percent of GDP — numbers that approach levels of the sovereign debt crisis going on across the Mediterranean. The combination of the dire domestic economic crisis which will consume whichever government emerges from the elections, as well the possible domestic political gridlock if there is no clear winner — the dreaded “hung parliament” scenario — means that the U.K. is likely going to continue to be consumed internally in the short term.

 

London’s inward focus comes at a time when Germany is acting again as a “normal” country, at least according to German Finance Minister Wolfgang Schaeuble, who used that very phrase in a recent interview. Not only is Germany looking out for its own interests, but also doing so under the relatively firm leadership of Chancellor Angela Merkel, a first on both counts for post-WWI Germany.

 

A united and politically consolidated Germany has diametrically opposed interests vis-à-vis Europe from the U.K. The British posture towards Europe has historically been one of divide and conquer, or at least divide-and-keep-on-a-short-leash. London’s strategy has oscillated from directly intervening militarily, to preventing the European continent from coalescing into a whole to actively participating in unification efforts to assure that they remain only surface deep. This strategy stems from U.K.’s geography as an island, which gives it extraordinary security (by European standards), but means that it has to prevent at all costs a strong continental Europe, unified and ready to challenge London militarily and economically. The U.K.’s participation in the European Union, therefore, has always stressed individual member state sovereignty and enlargement of the EU to prevent integration that would be too deep for London’s tastes.

Germany, on the other hand, is situated in the middle of the continent, which leaves it relatively defenseless. For this reason it has always stressed the need for Berlin to establish an alliance structure — or outright domination — of a large portion of the continent to prevent the likelihood of a two-front military engagement. In the modern context, Germany’s need for security — which still exists — is further augmented by its need for markets for its export-led economy. As such, today’s “normal” Germany prefers a united continent, as long as Germany gets to be the leader, as this benefits its security and economic policy.

 

From the German perspective, the EU is a worthy project as long as it allows Berlin to project its economic power on the continent while situating itself in the middle of an alliance that caters to its security needs. From the British perspective, the EU is a worthy project because it gives London access that it can use to subvert exactly the kind of continental-wide domination that Berlin has plotted many times.

 

The coming elections in the U.K. and their results, however, could very well consume London, giving Germany the opportunity to use the aftermath of the Greek debt crisis to its advantage.

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The Rise and Fall and Rise of the Reich

7. April 2010 by admin.

 

 

The Rise and Fall and Rise of the Reich

By Peter Zeihan

The first lesson of geopolitical theory is that location matters: The behavior of states is rooted in where they are; the idea of place is fundamental. Rivers are roads of commerce and cultural unifiers. Plains are easy for armies to march across and thus engender a sense of vulnerability — and a culture of pre-emption.

 

These principles hold for all regions, and Europe is no exception.

For example, any government running the United Kingdom lives in fear of the emergence of a united Europe, which would present a titanic threat east of the Isles. If the various powers of Europe are quarreling amongst themselves, however, Britain has no fear of invasion and can more freely intervene in Continental affairs. It invariably uses this freedom to ensure the Continental powers remain in competition. So long as Europe remains divided and busy counteracting itself, London has the option of expanding its reach well beyond Europe’s shores.

 

This freedom of action, a blessing derived from geography, allowed for the birth and sustenance of the British Empire. That empire endured until Europe actually did unite — first under Nazi Germany and later under NATO. Moreover, when Britain finally entered the European Union in 1973, it was not because of the privileges of membership, but because the EU was now where European conflicts were played out — joining the fray would give London greater ability to influence policies in its own favor and sabotage aspects of European development that did not serve its interests. Foreseeing this, French President Charles de Gaulle consistently vetoed London’s application as long as he was alive.

 

For a country like Germany — which always has been geographically and politically right in the thick of things — policy options are far more constrained than they are for the United Kingdom, however.

German security rests on three fundamental conditions. First, Germany has to be perfectly happy in its borders and have no designs or ambitions to expand its relative power. Second, Germany must believe all of its neighbors are similarly content. Third, the second condition must actually be true.

 

To put it bluntly, European history is a chronicle of what occurs when those three conditions are not met.

Germany’s central location and greater size and population relative to the rest of the major European powers mean it is destined to always be a massive geopolitical weight in the center of Europe. Its mere existence demands that other powers react to it, and it has a profound effect on every aspect of their planning — particularly as regards security policy. Germany’s size and location make it unique, in that with a few minor tweaks of circumstance, it has a realistic chance of dominating the Continent politically, economically and even militarily — and all of its neighbors know this.

 

This reality, which has had a weighty effect on 500 years of European history, again is becoming extremely relevant, as Germany’s interests versus those of its neighbors and partners change dramatically.

Now, it is true that Germany is a democratic, highly advanced state that is well entrenched in transatlantic and European institutions. But it must be remembered that institutions are built to serve a purpose arising from a set of circumstances — and the circumstances in existence when NATO and the European Union’s predecessor organizations were founded are very different from those in place today.

 

Germany itself is much changed as well. For all practical purposes, Germany ceased being an independent state in 1945 and did not again join the global community until reunification was completed, with the return of the federal government to Berlin in 1999. It was only with the end of the Cold War and the beginning of reunification that a real German state emerged from the geopolitical wilderness and began to make its presence felt once again.

 

Germany: The Heart of Europe

It is difficult to understate the effect this simple fact has had on both German and European history. Since the Renaissance and before, European history has been a tale of turmoil, conflict and war among the major and minor powers of the Continent.

What we now call “Germany” first existed as the Holy Roman Empire, founded in 800 by Charlemagne. This first empire, or First Reich, played a leading role in European affairs until the schism of Protestantism from Catholicism fractured it into a gaggle of disunited and squabbling mini-states in the 16th century. The Thirty Years War in the early 17th century shattered what was left, and the Peace of Westphalia of 1648 formalized the final disintegration of Germany’s first incarnation as a major power.

 

Germany’s declining power during the 16th century and its de facto non-presence in the 17th and 18th centuries created the geopolitical conditions necessary to forge the foundations of modern Europe. If some version of a unified state had survived Europe’s religious wars, it would have created a massive, unavoidable geopolitical presence. Its mere existence would have exerted pressure on all of its borders, and the history of what we know as “Europe” would have been radically different.

 

But instead, a melange of squabbling principalities and statelets formed a kind of no-man’s-land in the center of the Continent. Prussia, the foremost of the First Reich’s successor states, was certainly no pushover, but it certainly lacked the punch of a consolidated mega-state. This geopolitical vacuum afforded the other major powers — notably the British, French and Russian Empires — a chance to grow into their own in relative security.

But the Germans were merely down, not out.

Throughout the 19th century, the three dozen-odd mini-Germanies began pulling together economically, politically and militarily. Initial efforts to unify the German states, in 1848 and 1849, were derailed by the efforts of an outside power, Austria. The result was the Treaty of Olomouc, which, in essence, gave legal weight to Austria’s domination of the German Confederation.

The humiliation enshrined in the treaty triggered German resentment — and action. In 1866, Prussia roared to life under the leadership of Otto von Bismarck, won the Austro-Prussian War and ejected Austrian influence. Bismarck then went on to lead a smattering of allies into the Franco-German War. The end result was the consolidation of various pieces of “Germany” into the second incarnation of the “German” state in 1871. The Second Reich was born.

 

This development of a new-old major power in the center of the Old Continent massively disrupted the balances that had defined European affairs for 300 years. This was Europe’s first taste of just how fast Germany could change: In 1865, Germany effectively did not exist. Within six years, it not only existed but was capable of dealing decisive defeat to the Continental superpower of the time.

 

Germany Re-Reiched

The next 40 years chronicle the formation of alliances and counteralliances that were designed almost exclusively to offset or engage the new Continental hegemon. Those networks of competing alliances — often referred to as the “managing” of European relations under the Concert of Powers — ultimately spun into World War I.

 

World War I has been often misunderstood. Before the United States entered the conflict in 1917, the war was hardly a stalemate. Russia was not only on the ropes, but collapsing; Serbia already had surrendered, and Romania was about to. The Eastern and Balkan Fronts, therefore, no longer required German troops. Faced with a war on only one front, the Second Reich likely would have been able to overwhelm France, far and away Germany’s military inferior, but for U.S. intervention. Berlin was forced to accept the terms of the Treaty of Versailles — terms that, similar to those of Olomouc before it, were humiliating.

 

Versailles stripped Germany of many strategic pieces of territory and vastly limited its military capabilities. As the Great Depression crashed into Europe, the Weimar Republic, like Russia to the east, was written off as a state in terminal decline.

Here is where most misconstrue the true vector of German policy. Though most ascribe Germany’s interwar revival to the Nazis in general and to Adolf Hitler in particular — and these forces did indeed play a part — the true seeds of revival were sown with the 1922 Treaty of Rapallo, fully 11 years before Hitler’s rise to power.

 

At Rappallo, the Germans and the Soviets not only formalized a peace agreement, they forgave each other’s debt, renounced all war claims and implemented a free trade accord. They also agreed to circumvent the Treaty of Versailles by allowing Germany to develop and build advanced weapons in Soviet territory, far from prying eyes. All when Germany had been crushed. All when Germany had been forgotten.

All before the rise of Hitler and the dawn of the Third Reich.

 

Germany had been defeated in World War I, but it had never stopped acting like a state that occupied the heart of Europe. It was still a power in its own right, with policies dictated by its location. For its very survival, it required at least one secure flank, which would enable it to focus its efforts against the others. To thrive, it needed resources, markets and a military. The Treaty of Rappallo not only achieved this, but laid the groundwork for the Molotov-Ribbentrop Pact of 1939, which would lead to the conquering or cowing of the bulk of Europe.

 

Though Hitler was head of the German state during the war, geopolitical realities would have been the same no matter who would was in charge. Specific policies such as the Holocaust perhaps would not have manifested under a different leadership, but it is extremely unlikely that World War II could have been avoided altogether.

 

What happened after World War II was strikingly similar to the Peace of Westphalia of 1648: Crushed and occupied, Germany simply ceased to matter.

During the entire Cold War, the geopolitical needs and desires of the Germans were sublimated by the cold clash of the superpowers. For the first time in its history, Europe was not at war. That extremely significant fact occurred for but one reason: the entire continent was occupied by powers with no interest seeing a cold war turn hot.

 

Europe Today — and Tomorrow

It is said that nature abhors a vacuum, and the same is true of geopolitics. With Germany occupied and divided, France sought to exploit its neighbor’s weakness and the American security guarantee to forge a new Europe — which would be led, of course, by France. It is no surprise that Paris chose twice to veto London’s attempts to join the European Union’s predecessor entity: The French had no use for a pro-American spanner in the works.

 

For 60 years now, French strategy has depended on a singular characteristic of the post-World War II European reality: German quiescence. But with Germany reunited and active, that circumstance no longer exists. France will soon discover — indeed, already is discovering — that its interests and Germany’s are not in lockstep. The United States’ partial disengagement is allowing the Concert of Powers to return to Europe.

 

Germany’s reunification — which put it back on the scene with its own interests and policies — robbed Paris of its German booster chair. True, the vast majority of German and “European” policy preferences have remained in alignment since the German capital moved back to Berlin in 1999, but cracks are showing — and widening.

 

Though Paris and Berlin forged a “common European” position in opposition to the Iraq war, most EU members disagreed — turning the idea of a Franco-German-led Europe into a mockery. France’s reaction was to attempt to revive its Cold War free agent role the world over; Germany’s response has been much less coherent, largely because it once again is a new country. During its Cold War occupation, there was little need for Bonn to think strategically, and Germany’s position in the six years since reunification has not been fully defined. The country’s Continental location — and the fact that it lost two world wars — means that, unlike France, it does not have a colonial legacy on which to fall back. German influence must be won or lost in Europe, not elsewhere.

Changes to the European Monetary Union (EMU) are symptomatic of Germany’s growing unease with its geopolitical position. In a nutshell, the EMU dictates not only European monetary policy, but aspects of each individual country’s fiscal policies as well. Germany, flirting with recession, finds these policies cumbersome and unnecessarily restrictive, and Berlin is going to great pains to revise them more to its liking — to the vast consternation of its more fiscally conservative EU partners.

The European Commission also is rubbing Berlin the wrong way. The commission is headed by Portugal’s Jose Manuel Durao Barroso, an economic liberal who assembled a team of like-minded folks to implement softer versions of the United States’ free-market policies. Most of these policies clash with the German way of doing things, so Berlin regularly finds itself locking horns with the nominal leadership of the EU’s policy arm.

The United States is attempting to reforge its most valuable military alliance, NATO, into a form more useful to its current foreign policy goals. Specifically, the United States needs NATO to act as an enabler for its war against militant Islamists, whether in Iraq or Afghanistan, as well as to mount a renewed offensive that would isolate Russia from its former provinces such as Georgia and Ukraine. For Germany, that means being swept to the side while countries further east, such as Hungary and Poland — which traditionally have fallen into the German sphere of influence — become more important, and receptive, to U.S. strategic doctrine. So Germany, under Gerhard Schroeder, not only has skipped the step of challenging U.S. efforts within NATO, but directly and publicly questioned the relevance of NATO itself.

 

Germany’s options for breaking out of its box are limited at present. But there are two lessons from the past that the state appears to be drawing upon to increase its options and its reach.

 

First, Germany is beginning to close ranks at home, and not in terms of political parties. During the past year, rhetoric in the press and among politicians has shifted inexorably away from such modern values as multiculturalism. This is partially due to growing dissatisfaction with Schroeder’s government, but there also are glimpses of something darker. For instance, after state elections in Schleswig-Holstein brought a small ethnic Danish party to power Feb. 20, party leaders found themselves the target of hundreds of threats — some from public figures — of which some of the more polite noted that “what is legal is not always legitimate.”

Countries under stress tend to pull together, and that often can mean identifying outsiders in their midst. The German economy has not performed well for 15 years. It is now in its third recession since 2001, unemployment has reached a 73-year high, and beginning in 2006, changes in social welfare laws mean that literally millions of Germans will cease to receive benefits payments. If these realities do spark some kind of social backlash, it could prove significant that Germany hosts Europe’s largest Turkish population and immigrants from a smattering of many other nationalities. There are plenty of outsiders to choose from.

 

Second, Berlin is resuscitating relations with Moscow. Germany is Russia’s largest energy and trade customer, and the Schroeder government has gone to great pains to push that relationship even further. Alone among European and NATO states, Germany has kept mum during the recent goings-on in Ukraine, and it alone is standing aside even as the rest of the West is pursuing a broad geopolitical advance throughout all of Russia’s former provinces.

 

A German-Russian alignment is not only logical in a geopolitical sense, but relations have a long way to grow before hitting any natural constraints. Though the two fought each other bitterly during World War II, it is often forgotten that they cooperated deeply until they actually bordered each other. Right now, there are a dozen countries in the zone of territory between them — broadly the same countries that were there in 1939, when Molotov and Ribbentrop decided to carve out the future.

 

After 60 years in a geopolitical coma, Germany is not just turning a page, it is beginning to write a new book. This in no way means that Germany is doomed to return to its fascist past, but neither is it a foregone conclusion that the Germany of the future will be an American ally, a British ally or especially a French ally (in fact, the past 60 years are the only period in which Paris and Berlin have seen eye-to-eye).

 

Where Germany will evolve is anyone’s guess: For all practical purposes, Berlin is only now waking up. A new balance of power must now be crafted. At present, Germany and Russia are both feeling quite unsettled, and some 21st-century version of the Treaty of Rapallo appears to be in the cards. That does not mean war is inevitable.

 

What is inevitable is change. The least likely result of a major power emerging at the heart of a continent is business as usual. And if history is any guide, Germany’s re-emergence during the next few years will slam into Europe with all the subtlety of, well, the German army.

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