John Mauldin's Outside the Box : Mauldin, financial

Dynamic Economic Decision Making

John Mauldin — Tue, 23 Aug 2011 02:23:00 GMT

This week’s Outside the Box is from my good friend John Silvia, the Chief Economist at Wells Fargo and fishing buddy in Maine. He has written a powerhouse book called Dynamic Economic Decision Making: Strategies for Financial Risk, Capital Markets, and Monetary Policy.

Combining three intellectual disciplines – economics, business, and decision making– that have traditionally been taught separately, Dynamic Economic Decision Making forges a new path that redefines how we view business choices. And that is the main point of the book. So many business leaders and investors make decisions based on static factors, historical patterns, or straight-line assumptions that it is no wonder that all too many bad decisions are made. And worse, we train our MBAs to approach decision making with outmoded tools that have proved themselves worthless in the real world.

Jim McTague of Barron’swrote:

“For the price of a book you receive the equivalent of a three-credit course from a top MBA program. Silvia, one of the nation's most astute economists, has written a comprehensive, accessible masterpiece on applied economics. The author is an able teacher: Anyone, novice or expert, will profit from this well-written book.”

I agree. Even though John sent me this book for review, I will download it to my iPad for $40! (note to my editor at Wiley, who published this book: Why can Silvia get $39 for Kindle and I get $12?) I get a lot of reading done as I travel, and this is one I want to get through.

I asked John to write a short piece to give us a flavor of his main points, and I don’t think you’ll be disappointed. You can get the book on Amazon at http://www.amazon.com/Dynamic-Economic-Decision-Making-Strategies (37% off).

Have a great week, and learn to enjoy volatility. And please get the fact that Silvia (and I) keep noting: We are not going back to the old days. We are in a brand new world and we need to deal with it.

Your actually looking forward to the future analyst,

John Mauldin, Editor
Outside the Box

Dynamic Economic Decision Making

The Great Recession of 2008-10 demonstrated the power that macroeconomic and financial forces have to alter the risks and rewards that frame choices for both private and public sector decision makers. Moreover, these forces completely overwhelmed the complex, micro mathematical strategies that were the rage of many investors. Yet many approaches to decision-making in finance and economics are more like cookbooks—they tell you how to prepare a specific meal, step-by-step, but not the fine art of being the gracious host that leads the guests through a wonderful evening. Too much focus is exclusively on the fine techniques of micro management, while ignoring the reality of the broader set of macro scenarios faced by actual decision-makers involving the many changes in economic growth, finance, and globalization that are ongoing. Is it any wonder that failure and surprise accompany the economic shocks of the day? Our finest financial engineers fail in the face of real world change.

Dealing With Cyclical & Structural Change

“You can’t argue with a hundred years of success.”

--William I. Walsh(The Rise and Decline of the Great Atlantic & Pacific Tea Company, Lyle Stuart, New Jersey, 1986)

Actually you can when the environment changes around you—not knowing that the economic world is changing and the world is always changing. In the early 1950s, A&P, which was then the leading grocery chain in America, ranked only behind General Motors in annual sales. Americans tastes changed. They wanted choices, not the limited availability associated with the Great Depression and World War II periods of thrift. A&P stores did not provide the level of variety, nor cleanliness, expected by the new, growing middle class suburban households that began to emerge after the war. America’s tastes had changed and the offering of A&P did not. (See Jim Collins, Good to Great, Harper Business, 2001, pp. 65-69.)

Three forces interact to drive economic success. First, economic activity provides the overall flow of information and sets the character of surprises and our decision-framework. Yet, in practice, decision makers conduct stress tests, risk assessments and simulations that do not deal with the cyclical nature of economic behavior. This would appear for two reasons.

Second, most business and public policy decision-makers are not trained to deal with or think in terms of the business cycle. Forecasting for most consists of straight-line projections from a spread sheet.

Third, dealing with the business cycle demands a set of assumptions and the interaction of those assumptions that can require scenario building. The results of these scenarios on the outlook for growth, inflation and interest rates, for example, can be more complex than decision-makers have the time or willingness to engage.

Many decision-makers feel more comfortable on focusing on the business, where they feel comfortable, and not of forecasting. Even more misleading, over time the model of the economy does not fundamentally change and, thus retaining its original framework. In addition, many simulations are defined in terms of allowing one factor, for example economic growth, to fluctuate. This is done to simplify the analysis but with the knowledge that other key variables are likely to change at the same time.

There is a tradeoff here between simplicity and reality. Often, the comfort of simplicity leads to a misrepresentation of the outlook. Better to deal with the complexity and get a sense of the issues than fall back on simplicity and misrepresent the future outlook. These simulations and ignore the reality that other drivers, such as inflation, interest rates, profits and exchange rates, also move along with changes in growth. Over the last fifty years, the economy does has not ever returned to its prior “normal” but a new framework has always emerged with each business cycle, always different than previous frameworks, sometimes in significant ways. The original equilibrium was never restored. Creating economic models as if it did will not make it so.

Decision-traps limit the leader’s ability to deal with cyclical but especially longer-term changes. Decision-makers tend to anchor their expectations about the future in the past and to think in terms of their historical investments in their career and in their firm. Their career is their memory of events and decisions tend to be framed in terms of our experience. Decisions about the future of the firm tend to reflect the firm’s existing structure. Seldom do firms break out of character and set a new course. This causes them not to examine the marginal costs and benefits of moving to a new future. In addition, public policy makers are slow to recognize the changing character of competitiveness in industries (autos, textiles, and consumer electronics) and thereby subsidize such industries for far too long. This is not only a U.S. tendency but very much the general case as evidenced by the United Kingdom in the post-World War II period until Prime Minister Margaret Thatcher took office in 1980 and introduced a market-driven approach regarding subsidization of industries.

Finally, decisions on the future of the institution reflect the influence of past decisions (path dependent) and which sets the parameters for success regarding future decisions. In some cases, decisions today cut off options tomorrow while other decisions today open up options for the future. A student who decides to go to one college cuts off the opportunity to go to another college. An athlete decides to play baseball and give up playing soccer. A business firm decides to pursue project A and set aside project B. Once we decide on one path, generally we cut off other options and decisions today will reflect our decisions in the past. Business decisions also have this tendency for path dependence as will be shown in several cases in this chapter.

Four Biases in Decision-making

(For a great read on decision-making biases see Michael Roberto, Know What You Don’t Know: How Great Leaders Prevent Problems before They Happen.)

Two aspects of successful decision-making in a changing economic world are evident so far. First, a strategy is needed that recognizes the reality of fluctuations in economic growth as well as in the four other economic drivers. Second, this strategy should prevent economic shocks or change from causing business failures. If they use the three techniques to identify change, decision makers now have observations that suggest the future direction of economic change. But what mental barriers prevent decision makers from accepting such change?

Normalization of Deviance

Our first decision-making challenge is the normalization of deviance. In this situation we normalize, learn to live with, small deviations in the normal run of affairs. We learn to live with a dripping faucet, a toilet that runs a bit longer, a door that sticks. Diane Vaughan, sociology professor at Columbia, made a study of the Challenger space shuttle disaster of 1986. (The Challenger Launch Decision: Risky Technology, Culture and Deviance at NASA.Chicago: University of Chicago Press, 1996.) Vaughan’s study focused on the gradual development of a set of beliefs that small deviations from the norm in the behavior of the O-rings under cold temperatures were acceptable since no major problems had occurred. Since most flights had occurred with temperatures in a normal range the overwhelming evidence was that there was no problem. The small amount of erosion that did occur in some flights was considered an anomaly. Over time, these anomalies became the accepted course, much like the sticky door, and so they were taken for granted as the normal course of action. Deviations from the normal became accepted as part of the acceptable risks of any flight. At the time of the flight in 1986 the temperatures at launch were much colder than normal and disaster soon followed.

In business, normalization of deviance was apparent in the credit standards involved in subprime lending yet borrowers continued to pay, or enough of them paid, so that the entire enterprise was profitable, at least in the short run. The rise in housing prices over the last twenty years provided the underlying rational of the housing mortgage market. Credit standards were continually eased, often for political purposes, by government-supported enterprises such as Fannie Mae and Freddie Mac. At the same time, capital gains taxes were lowered on housing taxes on income in general were rising and interest rate deductions were eliminated for consumer credit and auto loans. Thus, to meet their desire for consumption, households increasingly took equity from their homes through home equity loans, which reduced the capital cushion of ownership. Easier credit standards, meanwhile, meant that the purchaser of the home had “less skin in the game,” that is the buyer of the home has less invested in the home and therefore less interest in paying off the mortgage if events turned bad (which they did as house prices fell) and therefore the real credit risk in lending was rising. This ultimately proved to be the undoing of the market. Lower credit standards meant more buyers could qualify. Rising demand for housing initially drove up prices. Eventually, supply caught up. Housing prices slowed and the carrying costs of the mortgage could not be justified. Many buyers, walked away now.

In recent years, the normalization of deviance was evident in the housing market bust of 2008-2009 and the deterioration of credit standards that came to be accepted. Mortgage standards eased by 2005 and 2006 such that 60 day plus delinquencies were rising earlier in the life of adjustable rate mortgages (ARMs) suggesting that the risk profile of the borrowers had risen and likely this rise was faster than investors in these loans had expected. The rapid rise of delinquencies in 2006 suggested that indeed the housing problem was much greater than many had expected. In short the mortgage market framework changed and many failed to notice. The fact that home prices were rising justified the increasing deviance of lending standards—until home prices no longer could rise and started to fall dramatically. In fact, in the history of markets, it often takes a substantial change in prices to reveal the underlying deviance of traded prices from their fundamentals. Success was defined in terms of rising home ownership even though the underlying credit quality of the borrower and the appraisal/market value of the house were increasingly suspect. The markets normalized the deviance in credit standards as long as home ownership rates went up.

Change as a process not an event

A second barrier to effective decision-making is the failure to recognize change as a process and not an event. Decision-makers want to identify one event as the “cause” of a significant change. Yet, the lessons of the pre-World War I period is that an entire sequence of decisions lead to the outbreak of the conflagration and not a single cause such as the shooting of Archduke Ferdinand. (Barbara Tuchman, The Guns of August, Ballantine Book, 1962.) Since 1956, three firms have dropped out of the Dow Jones index, Bethlehem Steel, General Motors and Woolworth. Yet there is not a single event in each of these company histories that caused the companies’ relative decline. Instead, changes in the overall economy led to an increasing disconnect between the economy and the framework of decision-making in each company. (Jim Collins,Good to Great, provides an interesting view on Bethlehem Steel. James O'Toole, in Leading Change, provides a view on the decline of General Motors.) Catastrophic failures such as Johns Manville (Asbestos litigation led to bankruptcy filing in 1982.) and Enron (irregular accounting concerns led to bankruptcy in 2001) can be attributed to singular failures over a short period of time.

For business firms the trend growth in the globalization of trade signifies the process of rising competition that characterizes the economic framework today. Recent years have also produced a trend of lower inflation and lower interest rates. Lower inflation, on average, suggests a reduction in pricing power with products and services increasingly being perceived by customers as commodities—perfect substitutes in a perfectly competitive market place. The challenge for businesses is to create the impression, if not the reality, of product differentiation—imperfect substitutes in a monopolistically competitive environment. For example, in financial services, are the services offered significantly different to justify a pricing for service model or are all the benefits of a financial service firm generated at the back-end by reducing back office recordkeeping costs?

The Illusory Correlation

A third decision-making stumbling block is the illusory correlation. This idea, which is particularly popular when many decision-makers are scrambling for simplistic explanations in a very complex environment, is the leap from observing one economic trend and then using that trend as an explanation of another trend without any intervening theory. Certainly odd events happen and there is a tendency to ascribe cause-effect to situations where no real link exists. This illusion is particularly prevalent among financial commentators.

It is also true among decision makers at firms or in state governments who ascribe changes to individual decisions. In fact national or global trends are the real culprits. U.S. presidents and corporate head are credited or blamed for every advance or decline on their watch while trends occur totally outside their control.

In the early years of the post World War II period, some analysts asserted that the economic success of the Soviet Union validated their economic model. In fact, the correlation of economic growth and with the Soviet model was purely coincidence. The Soviet Union was living off the resource transfers from other nations and countries that it had conquered with little regard to the long run consequences. It had the incentives within its economic framework that would insure continued success over the long run. In economic studies, the appearance of success in the short-run may hide underlying problems and those countries, states and companies may be living off past success with little provision for the future. Flash-in-the pan success in the short-run, may give the appearance of a new economic model but often that success is illusory unless supported by long-run oriented policies.

In economic or business comparisons, Americans are hampered by their anchoring bias dating back to the early post-World War II period. Japan and Germany had been destroyed by war. China, India, and Russia were not trading partners. Brazil and Mexico were run by military juntas. The U.S. had a largely closed economy and little global competition. Yet current public policy makers continue to speak in terms of America’s leadership in many industries—textiles, furniture and consumer electronics—that have become global. In fact, the post-World War II period was an exception in economic leadership with one country—America—holding such a dominant position. The reality is that change is constant and memories of the past are a prescription to failure in most cases.

Sunk Costs

Finally, decision makers’ability to react to cyclical and structural change is hampered by their attachment to sunk costs, which are the costs already put into a project that are past and irreversible and are not altered by the decision to continue ahead or to stop the project. Richard Brealey (Professor at the London Business School) and Stewart Myers (professor at MIT) point out the decision in 1971 whether to continue with Lockheed’s development of the TriStar airplane after $1 billion had already been spent. Lockheed had already spent one billion dollars and was not recoverable whether Lockheed went ahead or not with the project. (Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance, third edition, McGraw-Hill, 1988, p. 95.) In 1981 Lockheed announced it would stop production of its money-losing L-1011 jetliner. Eventually Lockheed dropped out entirely from commercial airline production. (John Greenwald, Jerry Hannifin/Washington, Joseph J. Kane/Burbank, Catch a Falling TriStar, Time magazine, December 21, 1981.) Overly committed to certain activities, decision makers stick with investments that are quickly losing their value. They are unable to let go of the past and move on to new opportunities. As a result, these investments lose value. Cyclical and secular change, by its nature, means that old investments become sunk costs, and barriers to innovation.

In fact, in many cases decision makers escalate their commitment believing that just a bit more investment will allow them to achieve their goal. (For a real-world example of the sunk cost effect with tragic consequences see Krakauer, J. Into Thin Air: A Personal Account of the Mount Everest Disaster. New York: Anchor Books, 1997.) In public policy, this can be seen in the commitment to retain the scale of many industries through protectionism and subsidies beyond any economic justification. While many U.S. firms in the textile, furniture, steel, auto and consumer electronics industries are globally competitive, government subsidizes these industries on a scale that allows weak companies to persist. They then can sell products at low prices and thereby hamper the ability of competitive firms to earn a profit and reinvest so as to remain globally competitive. Policy focuses on preserving jobs with little regard to workers and their skills. As a result, there are too many workers in old technology fields when these workers must to move into fields where they have a competitive future.

Example abound for both private and public policy decision-makers today. Credit standards are an obvious example of the normalization of deviance whereby credit standards that were questionable in the past now serve as good credit today. As for the illusory correlation, every investor can recite numerous examples of one-time wonders in forecasting the future of stock prices. Sunk costs are exemplified in both the public and private sectors by those continuously failing projects that continue to somehow get financing without ever becoming successful.

As for the current cycle/structural evolution of the economy, each of these decision biases is well represented. For successful investors, the challenge is to recognize our own biases and to better adapt to the constant evolution of the economy. Change in the economy is a process, not an event, and the bias to recognize the old blinds us to what is new.

Germany's Choice: Part 2

John Mauldin — Thu, 28 Jul 2011 04:13:00 GMT

For today's special-edition OTB, let's turn our fiscal eye across the pond to all that's going haywire in Europe. But not the continent's banking crisis, per se. Today's piece takes a broad look at who's really running the show. I'll give you a hint: they've done it before, and it wasn't too long ago. The folks at STRATFOR (a global intelligence publication) have spent the better part of two years saying that Germany will run Europe. The newly redesigned EFSF (European Financial Security Facility) can be considered concrete evidence of such.

From Berlin's point of view, the Eurozone is its sphere of influence, and its preservation is in Germany's national security interest. It's a new Europe, where Germany is not just the checkbook anymore, but holds some reins.

I'm sure you'll find this piece as thought-provoking as I did. Investors are always talking about geopolitical risk (but you and I talked about it first here); and if you're looking for geopolitical analysis and forecasting, I highly recommend you check out STRATFOR. OTB readers can get a hefty discount on a STRATFOR subscription, plus a free copy of (warning: more self-promotion) my book Endgame.

Your now craving schnitzel analyst,

John Mauldin, Editor
Outside the Box

Germany's Choice: Part 2

July 26, 2011

Related Link

By Peter Zeihan and Marko Papic

Seventeen months ago, STRATFOR described how the future of Europe was bound to the decision-making processes in Germany. Throughout the post-World War II era, other European countries treated Germany as a feeding trough, bleeding the country for resources (primarily financial) in order to smooth over the rougher portions of their systems. Considering the carnage wrought in World War II, most Europeans — and even many Germans — considered this perfectly reasonable right up to the current decade. Germany dutifully followed the orders of the others, most notably the French, and wrote check after check to underwrite European solidarity.

However, with the end of the Cold War and German reunification, the Germans began to stand up for themselves once again. Europe’s contemporary financial crisis can be as complicated as one wants to make it, but strip away all the talk of bonds, defaults and credit-default swaps and the core of the matter consists of these three points:

Europe cannot function as a unified entity unless someone is in control.
At present, Germany is the only country with a large enough economy and population to achieve that control.
Being in control comes with a cost: It requires deep and ongoing financial support for the European Union’s weaker members.

What happened since STRATFOR published Germany’s Choice was a debate within Germany about how central the European Union was to German interests and how much the Germans were willing to pay to keep it intact. With their July 22 approval of a new bailout mechanism — from which the Greeks immediately received another 109 billion euros ($155 billion) — the Germans made clear their answers to those questions, and with that decision, Europe enters a new era.

The Origins of the Eurozone

The foundations of the European Union were laid in the early post-World War II years, but the critical event happened in 1992 with the signing of the Maastricht Treaty on Monetary Union. In that treaty, the Europeans committed themselves to a common currency and monetary system while scrupulously maintaining national control of fiscal policy, finance and banking. They would share capital but not banks, interest rates but not tax policy. They would also share a currency but none of the political mechanisms required to manage an economy. One of the many inevitable consequences of this was that governments and investors alike assumed that Germany’s support for the new common currency was total, that the Germans would back any government that participated fully in Maastricht. As a result, the ability of weaker eurozone members to borrow was drastically improved. In Greece in particular, the rate on government bonds dropped from an 18 percentage-point premium over German bonds to less than 1 percentage point in less than a decade. To put that into context, borrowers of $200,000 mortgages would see their monthly payments drop by $2,500.

Faced with unprecedentedly low capital costs, parts of Europe that had not been economically dynamic in centuries — in some cases, millennia — sprang to life. Ireland, Greece, Iberia and southern Italy all experienced the strongest growth they had known in generations. But they were not borrowing money generated locally — they were not even borrowing against their own income potential. Such borrowing was not simply a government affair. Local banks that normally faced steep financing costs could now access capital as if they were headquartered in Frankfurt and servicing Germans. The cheap credit flooded every corner of the eurozone. It was a subprime mortgage frenzy on a multinational scale, and the party couldn’t last forever. The 2008 global financial crisis forced a reckoning all over the world, and in the traditionally poorer parts of Europe the process unearthed the political-financial disconnects of Maastricht.

The investment community has been driving the issue ever since. Once investors perceived that there was no direct link between the German government and Greek debt, they started to again think of Greece on its own merits. The rate charged for Greece to borrow started creeping up again, breaking 16 percent at its height. To extend the mortgage comparison, the Greek “house” now cost an extra $2,000 a month to maintain compared to the mid-2000s. A default was not just inevitable but imminent, and all eyes turned to the Germans.

A Temporary Solution

It is easy to see why the Germans did not simply immediately write a check. Doing that for the Greeks (and others) would have merely sent more money into the same system that generated the crisis in the first place. That said, the Germans couldn’t simply let the Greeks sink. Despite its flaws, the system that currently manages Europe has granted Germany economic wealth of global reach without costing a single German life. Given the horrors of World War II, this was not something to be breezily discarded. No country in Europe has benefited more from the eurozone than Germany. For the German elite, the eurozone was an easy means of making Germany matter on a global stage without the sort of military revitalization that would have spawned panic across Europe and the former Soviet Union. And it also made the Germans rich.

But this was not obvious to the average German voter. From this voter’s point of view, Germany had already picked up the tab for Europe three times: first in paying for European institutions throughout the history of the union, second in paying for all of the costs of German reunification and third in accepting a mismatched deutschemark-euro conversion rate when the euro was launched while most other EU states hardwired in a currency advantage. To compensate for those sacrifices, the Germans have been forced to partially dismantle their much-loved welfare state while the Greeks (and others) have taken advantage of German credit to expand theirs.

Germany’s choice was not a pleasant one: Either let the structures of the past two generations fall apart and write off the possibility of Europe becoming a great power or salvage the eurozone by underwriting 2 trillion euros of debt issued by eurozone governments every year.

Beset with such a weighty decision, the Germans dealt with the immediate Greek problem of early 2010 by dithering. Even the bailout fund known as the European Financial Security Facility (EFSF) was at best a temporary patch. The German leadership had to balance messages and plans while they decided what they really wanted. That meant reassuring the other eurozone states that Berlin still cared while assuaging investor fears and pandering to a large and angry anti-bailout constituency at home. With so many audiences to speak to, it is not at all surprising that Berlin chose a solution that was sub-optimal throughout the crisis.

That sub-optimal solution is the EFSF, a bailout mechanism whose bonds enjoyed full government guarantees from the healthy eurozone states, most notably Germany. Because of those guarantees, the EFSF was able to raise funds on the bond market and then funnel that capital to the distressed states in exchange for austerity programs. Unlike previous EU institutions (which the Germans strongly influence), the EFSF takes its orders from the Germans. The mechanism is not enshrined in EU treaties; it is instead a private bank, the director of which is German. The EFSF worked as a patch but eventually proved insufficient. All the EFSF bailouts did was buy a little time until investors could do the math and realize that even with bailouts the distressed states would never be able to grow out of their mountains of debt. These states had engorged themselves on cheap credit so much during the euro’s first decade that even 273 billion euros of bailouts was insufficient. This issue came to a boil over the past few weeks in Greece. Faced with the futility of yet another stopgap solution to the eurozone’s financial woes, the Germans finally made a tough decision.

The New EFSF

The result was an EFSF redesign. Under the new system the distressed states can now access — with German permission — all the capital they need from the fund without having to go back repeatedly to the EU Council of Ministers. The maturity on all such EFSF credit has been increased from 7.5 years to as much as 40 years, while the cost of that credit has been slashed to whatever the market charges the EFSF itself to raise it (right now that’s about 3.5 percent, far lower than what the peripheral — and even some not-so-peripheral — countries could access on the international bond markets). All outstanding debts, including the previous EFSF programs, can be reworked under the new rules. The EFSF has been granted the ability to participate directly in the bond market by buying the government debt of states that cannot find anyone else interested, or even act pre-emptively should future crises threaten, without needing to first negotiate a bailout program. The EFSF can even extend credit to states that were considering internal bailouts of their banking systems. It is a massive debt consolidation program for both private and public sectors. In order to get the money, distressed states merely have to do whatever Germany — the manager of the fund — wants. The decision-making occurs within the fund, not at the EU institutional level.

In practical terms, these changes cause two major things to happen. First, they essentially remove any potential cap on the amount of money that the EFSF can raise, eliminating concerns that the fund is insufficiently stocked. Technically, the fund is still operating with a 440 billion-euro ceiling, but now that the Germans have fully committed themselves, that number is a mere technicality (it was German reticence before that kept the EFSF’s funding limit so “low”).

Second, all of the distressed states’ outstanding bonds will be refinanced at lower rates over longer maturities, so there will no longer be very many “Greek” or “Portuguese” bonds. Under the EFSF all of this debt will in essence be a sort of “eurobond,” a new class of bond in Europe upon which the weak states utterly depend and which the Germans utterly control. For states that experience problems, almost all of their financial existence will now be wrapped up in the EFSF structure. Accepting EFSF assistance means accepting a surrender of financial autonomy to the German commanders of the EFSF. For now, that means accepting German-designed austerity programs, but there is nothing that forces the Germans to limit their conditions to the purely financial/fiscal.

For all practical purposes, the next chapter of history has now opened in Europe. Regardless of intentions, Germany has just experienced an important development in its ability to influence fellow EU member states — particularly those experiencing financial troubles. It can now easily usurp huge amounts of national sovereignty. Rather than constraining Germany’s geopolitical potential, the European Union now enhances it; Germany is on the verge of once again becoming a great power. This hardly means that a regeneration of the Wehrmacht is imminent, but Germany’s re-emergence does force a radical rethinking of the European and Eurasian architectures.

Reactions to the New Europe

Every state will react to this new world differently. The French are both thrilled and terrified — thrilled that the Germans have finally agreed to commit the resources required to make the European Union work and terrified that Berlin has found a way to do it that preserves German control of those resources. The French realize that they are losing control of Europe, and fast. France designed the European Union to explicitly contain German power so it could never be harmed again while harnessing that power to fuel a French rise to greatness. The French nightmare scenario of an unrestrained Germany is now possible.

The British are feeling extremely thoughtful. They have always been the outsiders in the European Union, joining primarily so that they can put up obstacles from time to time. With the Germans now asserting financial control outside of EU structures, the all-important British veto is now largely useless. Just as the Germans are in need of a national debate about their role in the world, the British are in need of a national debate about their role in Europe. The Europe that was a cage for Germany is no more, which means that the United Kingdom is now a member of a different sort of organization that may or may not serve its purposes.

The Russians are feeling opportunistic. They have always been distrustful of the European Union, since it, like NATO, is an organization formed in part to keep them out. In recent years the union has farmed out its foreign policy to whatever state was most affected by the issue in question, and in many cases these states has been former Soviet satellites in Central Europe, all of which have an ax to grind. With Germany rising to leadership, the Russians have just one decision-maker to deal with. Between Germany’s need for natural gas and Russia’s ample export capacity, a German-Russian partnership is blooming. It is not that the Russians are unconcerned about the possibilities of strong German power — the memories of the Great Patriotic War burn far too hot and bright for that — but now there is a belt of 12 countries between the two powers. The Russo-German bilateral relationship will not be perfect, but there is another chapter of history to be written before the Germans and Russians need to worry seriously about each other.

Those 12 countries are trapped between rising German and consolidating Russian power. For all practical purposes, Belarus, Ukraine and Moldova have already been reintegrated into the Russian sphere. Estonia, Latvia, Lithuania, Poland, the Czech Republic, Slovakia, Hungary, Romania and Bulgaria are finding themselves under ever-stronger German influence but are fighting to retain their independence. As much as the nine distrust the Russians and Germans, however, they have no alternative at present.

The obvious solution for these “Intermarium” states — as well as for the French — is sponsorship by the United States. But the Americans are distracted and contemplating a new period of isolationism, forcing the nine to consider other, less palatable, options. These include everything from a local Intermarium alliance that would be questionable at best to picking either the Russians or Germans and suing for terms. France’s nightmare scenario is on the horizon, but for these nine states — which labored under the Soviet lash only 22 years ago — it is front and center.