John Mauldin's Outside the Box : Stratfor, Germany

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.

Germany, Greece and Exiting the Eurozone

John Mauldin — Thu, 20 May 2010 16:29:11 GMT

The cause célèbre these days is the potential reconstitution of the eurozone: ie, Germany leaving it, or Greece getting kicked out. To look a little deeper, today I'm sending you STRATFOR's take on these two scenarios. STRATFOR explores the geography of the continent and the historical context of the EU to understand what a German exit or a Greek expulsion might mean for the rest of the region.

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John Mauldin
Editor, Outside the Box

Germany, Greece and Exiting the Eurozone

By Marko Papic, Robert Reinfrank and Peter Zeihan

Rumors of the imminent collapse of the eurozone continue to swirl despite the Europeans' best efforts to hold the currency union together. Some accounts in the financial world have even suggested that Germany's frustration with the crisis could cause Berlin to quit the eurozone - as soon as this past weekend, according to some - while at the most recent gathering of European leaders French President Nicolas Sarkozy apparently threatened to bolt the bloc if Berlin did not help Greece. Meanwhile, many in Germany - including Chancellor Angela Merkel herself at one point - have called for the creation of a mechanism by which Greece - or the eurozone's other over-indebted, uncompetitive economies - could be kicked out of the eurozone in the future should they not mend their "irresponsible" spending habits.

Rumors, hints, threats, suggestions and information "from well-placed sources" all seem to point to the hot topic in Europe at the moment, namely, the reconstitution of the eurozone whether by a German exit or a Greek expulsion. We turn to this topic with the question of whether such an option even exists.

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.

Germany: Mitteleuropa Redux

John Mauldin — Thu, 25 Mar 2010 15:34:00 GMT

With the establishment of the euro in the 1990s, speculation was abundant on how things would play out. In the last fews months we've seen that cheap credit for the Club Med countries came at a price, and now it's time to look at who will come out on top after the current economic crisis. There is a term for this type of global analysis: geopolitical intelligence. STRATFOR, a global intelligence company, uses geography, open source data, HUMINT, and a deep understanding of global affairs to produce analysis with a geopolitical perspective.

Today I'm including their take on Germany's changing role in the EU. But it is only a small sample of all they provide, so I encourage you to sign up for their free mailing list or become a member for greater access to features including Quarterly and Annual Forecasts that will put you ahead of the game.

John Mauldin
Editor, Outside the Box

Germany: Mitteleuropa Redux

March 16, 2010

By Peter Zeihan

The global system is undergoing profound change. Three powers - Germany, Iran and China - face challenges forcing them to refashion the way they interact with their regions and the world. We will explore each of these three states in detail in our next three geopolitical weeklies, highlighting how STRATFOR's assessments of these states are evolving. We will examine Germany first.

Germany's Place in Europe

European history has been the chronicle of other European powers struggling to constrain Germany, particularly since German unification in 1871. The problem has always been geopolitical. Germany lies on the North European Plain, with France to its west and Russia to its east. If both were to attack at the same time, Germany would collapse. German strategy in 1871, 1914 and 1939 called for pre-emptive strikes on France to prevent a two-front war. (The last two attempts failed disastrously, of course.)

As much as Germany's strategy engendered mistrust in Germany's neighbors, they certainly understood Germany's needs. And so European strategy after World War II involved reshaping the regional dynamic so that Germany would never face this problem again and so would never need to be a military power again. Germany's military policy was subordinated to NATO and its economic policy to the European Economic Community (the forerunner of today's European Union). NATO solved Germany's short-run problem, while the European Union was seen as solving its long-run problem. For the Europeans - including the Germans - these structures represented the best of both worlds. They harnessed German capital and economic dynamism, submerged Germany into a larger economic entity, gave the Germans what they needed economically so they didn't have to seek it militarily, and ensured that the Germans had no reason - or ability - to strike out on their own.

This system worked particularly well after the Cold War ended. Defense threats and their associated costs were reduced. There were lingering sovereignty issues, of course, but these were not critical during the good times: Such problems easily can be dealt with or deferred while the money flows. The example of a European development that represented this money-over-sovereignty paradigm was the European Monetary Union, best represented by the European common currency, the euro.

STRATFOR has always doubted the euro would last. Having the same currency and monetary policy for rich, technocratic, capital-intensive economies like Germany as for poor, agrarian/manufacturing economies like Spain always seemed like asking for problems. Countries like Germany tend to favor high interest rates to attract investment capital. They don't mind a strong currency, since what they produce is so high up on the value-added scale that they can compete regardless. Countries like Spain, however, need a cheap currency, since there isn't anything particularly value-added about most of their exports. These states must find a way to be price competitive. Their ability to grow largely depends upon getting access to cheap credit they can direct to places the market might not appreciate.

STRATFOR figured that creating a single currency system would trigger high inflation in the poorer states as they gained access to capital they couldn't qualify for on their own merits. We figured such access would generate massive debts in those states. And we figured such debts would contribute to discontent across the currency zone as the European Central Bank (ECB) catered to the needs of some economies at the expense of others.

All this and more has happened. We saw the 2008-2009 financial crisis in Central Europe as particularly instructive. Despite their shared EU membership, the Western European members were quite reluctant to bail out their eastern partners. We became even more convinced that such inconsistencies would eventually doom the currency union, and that the euro's eventual dissolution would take the European Union with it. Now, we're not so sure.

What if, instead of the euro being designed to further contain the Germans, the Germans crafted the euro to rewire the European Union for their own purposes?

Germany and the Current Crisis

The crux of the current crisis in Europe is that most EU states, but in particular the Club Med states of Greece, Portugal, Spain and Italy (in that order), have done such a poor job of keeping their budgets under control that they are flirting with debt defaults. All have grown fat and lazy off the cheap credit the euro brought them. Instead of using that credit to trigger broad sustainable economic growth, they lived off the difference between the credit they received due to the euro and the credit they qualified for on their own merits. Social programs funded by debt exploded; after all, the cost of that debt was low as the Club Med countries coasted on the bond prices of Germany. At present, interest rates set by the ECB stand at 1 percent; in the past, on its own merits, Greece's often rose to double digits. The resulting government debt load in Greece - which now exceeds annual Greek gross domestic product - will probably result in either a default (triggered by efforts to maintain such programs) or a social revolution (triggered by an effort to cut such programs). It is entirely possible that both will happen.

What made us look at this in a new light was an interview with German Finance Minister Wolfgang Schauble on March 13 in which he essentially said that if Greece, or any other eurozone member, could not right their finances, they should be ejected from the eurozone. This really got our attention. It is not so much that there is no legal way to do this. (And there is not; Greece is a full EU member, and eurozone membership issues are clearly a category where any member can veto any major decision.) Instead, what jumped out at us is that someone of Schauble's gravitas doesn't go about casually making threats, and this is not the sort of statement made by a country that is constrained, harnessed, submerged or placated. It is not even the sort of statement made by just any EU member, but rather by the decisive member. Germany now appears prepared not just to contemplate, but to publicly contemplate, the re-engineering of Europe for its own interests. It may not do it, or it may not do it now, but it has now been said, and that will change Germany's relationship to Europe.

A closer look at the euro's effects indicates why Schauble felt confident enough to take such a bold stance.

Part of being within the same currency zone means being locked into the same market. One must compete with everyone else in that market for pretty much everything. This allows Slovaks to qualify for mortgage loans at the same interest rates the Dutch enjoy, but it also means that efficient Irish workers are actively competing with inefficient Spanish workers - or more to the issue of the day, that ultraefficient German workers are competing directly with ultrainefficient Greek workers.

The chart below measures the relative cost of labor per unit of economic output produced. It all too vividly highlights what happens when workers compete. (We have included U.S. data as a benchmark.) Those who are not as productive try to paper over the problem with credit. Since the euro was introduced, all of Germany's euro partners have found themselves becoming less and less efficient relative to Germany. Germans are at the bottom of the graph, indicating that their labor costs have barely budged. Club Med dominates the top rankings, as access to cheaper credit has made them even less, not more, efficient than they already were. Back-of-the-envelope math indicates that in the past decade, Germany has gained roughly a 25 percent cost advantage over Club Med.

(click here to enlarge image)

The implications of this are difficult to overstate. If the euro is essentially gutting the European - and again to a greater extent the Club Med - economic base, then Germany is achieving by stealth what it failed to achieve in the past thousand years of intra-European struggles. In essence, European states are borrowing money (mostly from Germany) in order to purchase imported goods (mostly from Germany) because their own workers cannot compete on price (mostly because of Germany). This is not limited to states actually within the eurozone, but also includes any state affiliated with the zone; the relative labor costs for most of the

Central European states that have not even joined the euro yet have risen by even more during this same period.

It is not so much that STRATFOR now sees the euro as workable in the long run - we still don't - it's more that our assessment of the euro is shifting from the belief that it was a straightjacket for Germany to the belief that it is Germany's springboard. In the first assessment, the euro would have broken as Germany was denied the right to chart its own destiny. Now, it might well break because Germany is becoming a bit too successful at charting its own destiny. And as it dawns on one European country after another that there was more to the euro than cheap credit, the ties that bind are almost certainly going to weaken.

The paradigm that created the European Union - that Germany would be harnessed and contained - is shifting. Germany now has not only found its voice, it is beginning to express, and hold to, its own national interest. A political consensus has emerged in Germany against bailing out Greece. Moreover, a political consensus has emerged in Germany that the rules of the eurozone are Germany's to refashion. As the European Union's anchor member, Germany has a very good point. But this was not the "union" the rest of Europe signed up for - it is the Mitteleuropa that the rest of Europe will remember well.

A German Pre-Election Win and Lingering U.S. Tensions

John Mauldin — Thu, 17 Sep 2009 15:04:00 GMT

You may not think that what happens in Kabul affects the sale of GM's Opel division -- but it's recognizing the connection between seemingly unrelated global events that puts you ahead of the game in investing. This week I'm sending you a video by my friends at STRATFOR. It links cars, jobs, German elections, and the situation in Afghanistan in a way that's truly insightful and informative.

Click here to watch this enlightening video. I've probably never mentioned it, but STRATFOR's founder George Friedman also has a free weekly intelligence report. I strongly suggest you sign up to receive it -- It's just the kind of unique global insight every 'outside the box' investor needs. Click here to get a mind-blowing Friedman analysis each week in your inbox. You'll enjoy it as much as I do.

CAPTION: GM has approved the sale of its Opel division in Germany to a suitor favored by Chancellor Angela Merkel's government, saving thousands of German jobs just ahead of general elections. But the Opel sale has become a symbol of cooling relations between Washington and Berlin -- and the chilling effect has only grown worse as debate over Afghanistan heats up. In the latest STRATFOR Insights video, analyst Matt Gertken provides his analysis of the situation.

Obama's Strategy and the Summits

John Mauldin — Thu, 09 Apr 2009 16:30:00 GMT

Dear Friends:

A long-time religious land bridge between the Islamic and Western worlds, Turkey now finds itself an economic gatekeeper, a US-backed contender for the EU and the only key that could unlock Europe from dependence on Russian resources. The value of your dollar is intrinsically linked to last week’s summits—the most important multinational summits in history.

I’d like to share with you an article by my friend George Friedman at STRATFOR. It delves into the Summits (G20, NATO, bilaterals) and explores the connections between finance and geopolitics. In this case, it boils down to two string-holding puppeteers: Germany and Russia. Germany, the largest exporter in the world, is happy to up its production while the US spreads its dollar paper-thin by contributing to an IMF fund that will bail out countries who will in turn spend their money in Germany’s already tremendous export sector. Russia, the largest supplier of natural gas to Europe, too stands to benefit from US contributions to the IMF pot, as their slice of the pie gets bigger with the pan—as long as Turkey keeps her pipes closed.

The decisions made and policies enacted at the Summits trickle down to you and me. To make sense of it all, I encourage you to read STRATFOR. George has arranged a special offer for my readers: click here to take advantage of a 2-for-1 deal; you get a 2-year Membership for the 1-year price of $349. STRATFOR is the best global intelligence service in the world, and their unbiased coverage of the G20, NATO, and other extracurricular summits is unmatched by anyone else.

Yours,
John Mauldin

Obama's Strategy and the Summits

By George Friedman
April 6, 2009

The weeklong extravaganza of G-20, NATO, EU, U.S. and Turkey meetings has almost ended. The spin emerging from the meetings, echoed in most of the media, sought to portray the meetings as a success and as reflecting a re-emergence of trans-Atlantic unity.

The reality, however, is that the meetings ended in apparent unity because the United States accepted European unwillingness to compromise on key issues. U.S. President Barack Obama wanted the week to appear successful, and therefore backed off on key issues; the Europeans did the same. Moreover, Obama appears to have set a process in motion that bypasses Europe to focus on his last stop: Turkey.

Berlin, Washington and the G-20

Let's begin with the G-20 meeting, which focused on the global financial crisis. As we said last year, there were many European positions, but the United States was reacting to Germany's. Not only is Germany the largest economy in Europe, it is the largest exporter in the world. Any agreement that did not include Germany would be useless, whereas an agreement excluding the rest of Europe but including Germany would still be useful.

Two fundamental issues divided the United States and Germany. The first was whether Germany would match or come close to the U.S. stimulus package. The United States wanted Germany to stimulate its own domestic demand. Obama feared that if the United States put a stimulus plan into place, Germany would use increased demand in the U.S. market to expand its exports. The United States would wind up with massive deficits while the Germans took advantage of U.S. spending, thus letting Berlin enjoy the best of both worlds. Washington felt it had to stimulate its economy, and that this would inevitably benefit the rest of the world. But Washington wanted burden sharing. Berlin, quite rationally, did not. Even before the meetings, the United States dropped the demand — Germany was not going to cooperate.

The second issue was the financing of the bailout of the Central European banking system, heavily controlled by eurozone banks and part of the EU financial system. The Germans did not want an EU effort to bail out the banks. They wanted the International Monetary Fund (IMF) to bail out a substantial part of the EU financial system instead. The reason was simple: The IMF receives loans from the United States, as well as China and Japan, meaning the Europeans would be joined by others in underwriting the bailout. The United States has signaled it would be willing to contribute $100 billion to the IMF, of which a substantial portion would go to Central Europe. (Of the current loans given by the IMF, roughly 80 percent have gone to the struggling economies in Central Europe.) The United States therefore essentially has agreed to the German position.

Later at the NATO meeting, the Europeans — including Germany — declined to send substantial forces to Afghanistan. Instead, they designated a token force of 5,000, most of whom are scheduled to be in Afghanistan only until the August elections there, and few of whom actually would be engaged in combat operations. This is far below what Obama had been hoping for when he began his presidency.

Agreement was reached on collaboration in detecting international tax fraud and on further collaboration in managing the international crisis, however. But what that means remains extremely vague — as it was meant to be, since there was no consensus on what was to be done. In fact, the actual guidelines will still have to be hashed out at the G-20 finance ministers' meeting in Scotland in November. Intriguingly, after insisting on the creation of a global regulatory regime — and with the vague U.S. assent — the European Union failed to agree on European regulations. In a meeting in Prague on April 4, the United Kingdom rejected the regulatory regime being proposed by Germany and France, saying it would leave the British banking system at a disadvantage.

Overall, the G-20 and the NATO meetings did not produce significant breakthroughs. Rather than pushing hard on issues or trading concessions — such as accepting Germany's unwillingness to increase its stimulus package in return for more troops in Afghanistan — the United States failed to press or bargain. It preferred to appear as part of a consensus rather than appear isolated. The United States systematically avoided any appearance of disagreement.

The reason there was no bargaining was fairly simple: The Germans were not prepared to bargain. They came to the meetings with prepared positions, and the United States had no levers with which to move them. The only option was to withhold funding for the IMF, and that would have been a political disaster (not to mention economically rather unwise). The United States would have been seen as unwilling to participate in multilateral solutions rather than Germany being seen as trying to foist its economic problems on others. Obama has positioned himself as a multilateralist and can't afford the political consequences of deviating from this perception. Contributing to the IMF, in these days of trillion-dollar bailouts, was the lower-cost alternative. Thus, the Germans have the U.S. boxed in.

The political aspect of this should not be underestimated. George W. Bush had extremely bad relations with the Europeans (in large part because he was prepared to confront them). This was Obama's first major international foray, and he could not let it end in acrimony or wind up being seen as unable to move the Europeans after running a campaign based on his ability to manage the Western coalition. It was important that he come home having reached consensus with the Europeans. Backing off on key economic and military demands gave him that "consensus."

Turkey and Obama's Deeper Game

But it was not simply a matter of domestic politics. It is becoming clear that Obama is playing a deeper game. A couple of weeks before the meetings, when it had become obvious that the Europeans were not going to bend on the issues that concerned the United States, Obama scheduled a trip to Turkey. During the EU meetings in Prague, Obama vigorously supported the Turkish application for EU membership, which several members are blocking on grounds of concerns over human rights and the role of the military in Turkey. But the real reason is that full membership would open European borders to Turkish migration, and the Europeans do not want free Turkish migration. The United States directly confronted the Europeans on this matter.

During the NATO meeting, a key item on the agenda was the selection of a new alliance secretary-general. The favorite was former Danish Prime Minister Anders Fogh Rasmussen. Turkey opposed his candidacy because of his defense on grounds of free speech of cartoons depicting the Prophet Mohammed published in a Danish magazine. NATO operates on consensus, so any one member can block just about anything. The Turks backed off the veto, but won two key positions in NATO, including that of deputy secretary-general.

So while the Germans won their way at the meetings, it was the Turks who came back with the most. Not only did they boost their standing in NATO, they got Obama to come to a vigorous defense of the Turkish application for membership in the European Union, which of course the United States does not belong to. Obama then flew to Turkey for meetings and to attend a key international meeting that will allow him to further position the United States in relation to Islam.

The Russian Dimension

Let's diverge to another dimension of these talks, which still concerns Turkey, but also concerns the Russians. While atmospherics after the last week's meetings might have improved, there was certainly no fundamental shift in U.S.-Russian relations. The Russians have rejected the idea of pressuring Iran over its nuclear program in return for the United States abandoning its planned ballistic missile defense system in Poland and the Czech Republic. The United States simultaneously downplayed the importance of a Russian route to Afghanistan. Washington said there were sufficient supplies in Afghanistan and enough security on the Pakistani route such that the Russians weren't essential for supplying Western operations in Afghanistan. At the same time, the United States reached an agreement with Ukraine for the transshipment of supplies — a mostly symbolic gesture, but one guaranteed to infuriate the Russians at both the United States and Ukraine. Moreover, the NATO communique did not abandon the idea of Ukraine and Georgia being admitted to NATO, although the German position on unspecified delays to such membership was there as well. When Obama looks at the chessboard, the key emerging challenge remains Russia.

The Germans are not going to be joining the United States in blocking Russia. Between dependence on Russia for energy supplies and little appetite for confronting a Russia that Berlin sees as no real immediate threat to Germany, the Germans are not going to address the Russian question. At the same time, the United States does not want to push the Germans toward Russia, particularly in confrontations ultimately of secondary importance and on which Germany has no give anyway. Obama is aware that the German left is viscerally anti-American, while Merkel is only pragmatically anti-American — a small distinction, but significant enough for Washington not to press Berlin.

At the same time, an extremely important event between Turkey and Armenia looks to be on the horizon. Armenians had long held Turkey responsible for the mass murder of Armenians during and after World War I, a charge the Turks have denied. The U.S. Congress for several years has threatened to pass a resolution condemning Turkish genocide against Armenians. The Turks are extraordinarily sensitive to this charge, and passage would have meant a break with the United States. Last week, they publicly began to discuss an agreement with the Armenians, including diplomatic recognition, which essentially disarms the danger from any U.S. resolution on genocide. Although an actual agreement hasn't been signed just yet, anticipation is building on all sides.

The Turkish opening to Armenia has potentially significant implications for the balance of power in the Caucasus. The August 2008 Russo-Georgian war created an unstable situation in an area of vital importance to Russia. Russian troops remain deployed, and NATO has called for their withdrawal from the breakaway Georgian regions of South Ossetia and Abkhazia. There are Russian troops in Armenia, meaning Russia has Georgia surrounded. In addition, there is talk of an alternative natural gas pipeline network from Azerbaijan to Europe.

Turkey is the key to all of this. If Ankara collaborates with Russia, Georgia's position is precarious and Azerbaijan's route to Europe is blocked. If it cooperates with the United States and also manages to reach a stable treaty with Armenia under U.S. auspices, the Russian position in the Caucasus is weakened and an alternative route for natural gas to Europe opens up, decreasing Russian leverage against Europe.

From the American point of view, Europe is a lost cause since internally it cannot find a common position and its heavyweights are bound by their relationship with Russia. It cannot agree on economic policy, nor do its economic interests coincide with those of the United States, at least insofar as Germany is concerned. As far as Russia is concerned, Germany and Europe are locked in by their dependence on Russian natural gas. The U.S.-European relationship thus is torn apart not by personalities, but by fundamental economic and military realities. No amount of talking will solve that problem.

The key to sustaining the U.S.-German alliance is reducing Germany's dependence on Russian natural gas and putting Russia on the defensive rather than the offensive. The key to that now is Turkey, since it is one of the only routes energy from new sources can cross to get to Europe from the Middle East, Central Asia or the Caucasus. If Turkey — which has deep influence in the Caucasus, Central Asia, Ukraine, the Middle East and the Balkans — is prepared to ally with the United States, Russia is on the defensive and a long-term solution to Germany's energy problem can be found. On the other hand, if Turkey decides to take a defensive position and moves to cooperate with Russia instead, Russia retains the initiative and Germany is locked into Russian-controlled energy for a generation.

Therefore, having sat through fruitless meetings with the Europeans, Obama chose not to cause a pointless confrontation with a Europe that is out of options. Instead, Obama completed his trip by going to Turkey to discuss what the treaty with Armenia means and to try to convince the Turks to play for high stakes by challenging Russia in the Caucasus, rather than playing Russia's junior partner.

This is why Obama's most important speech in Europe was his last one, following Turkey's emergence as a major player in NATO's political structure. In that speech, he sided with the Turks against Europe, and extracted some minor concessions from the Europeans on the process for considering Turkey's accession to the European Union. Why Turkey wants to be an EU member is not always obvious to us, but they do want membership. Obama is trying to show the Turks that he can deliver for them. He reiterated — if not laid it on even more heavily — all of this in his speech in Ankara. Obama laid out the U.S. position as one that recognized the tough geopolitical position Turkey is in and the leader that Turkey is becoming, and also recognized the commonalities between Washington and Ankara. This was exactly what Turkey wanted to hear.

The Caucasus is far from the only area to discuss. Talks will be held about blocking Iran in Iraq, U.S. relations with Syria and Syrian talks with Israel, and Central Asia, where both countries have interests. But the most important message to the Europeans will be that Europe is where you go for photo opportunities, but Turkey is where you go to do the business of geopolitics. It is unlikely that the Germans and French will get it. Their sense of what is happening in the world is utterly Eurocentric. But the Central Europeans, on the frontier with Russia and feeling quite put out by the German position on their banks, certainly do get it.

Obama gave the Europeans a pass for political reasons, and because arguing with the Europeans simply won't yield benefits. But the key to the trip is what he gets out of Turkey — and whether in his speech to the civilizations, he can draw some of the venom out of the Islamic world by showing alignment with the largest economy among Muslim states, Turkey.

EU Summit: What is Not Being Talked About

John Mauldin — Thu, 18 Dec 2008 20:12:49 GMT

Dear Friends:

There are plenty of sources out there that are happy to tell you what's happening in the world, and much of it matters. But oftentimes, what's much more important is the dog that didn't bark. Remember Enron's undisclosed subsidiaries? Or the off-balance sheet holdings of just about every financial services firm?

Sherlock Holmes uses the dog that didn't bark to solve the mystery -- the dog had to know the intruder. My friend George Friedman's company, Stratfor, uses the dog that didn't bark to highlight issues that are equally critical to the global economy -- that aren't being discussed. Traditional sources let me mitigate known risks. Stratfor tells me about the risks and opportunities I might not even be aware of.

I'm including an example below: Stratfor's "EU Summit: What is Not Being Talked About." As this analysis demonstrates, normal reporting on what was discussed might be helpful, but it's the "missing topics" -- those that the media misses -- that you really need to think about.

George has arranged for a special offer on a Stratfor Membership just for my readers. Click here to join now, and you'll get Stratfor's 2009 Annual Forecast as part of your Membership. Plus George has a new book (and it's fascinating!) coming out in January which he'll send you as well. I highly encourage you to take advantage of this opportunity.

Your dogged by bear-markets analyst,

John Mauldin

EU Summit: What is Not Being Talked About

Summary

The European Union summit is being held Dec. 11-12. Climate change, the Lisbon Treaty and the EU response to the global economic crisis are high on the agenda for the meeting. Absent from the agenda are ideas on dealing with a resurgent Russia, the energy crisis that could start after Russia implements higher natural gas prices for most EU member states Jan. 1, and the institutional flaws underlying the economic crisis sweeping through the bloc.

Analysis

EU leaders are meeting for the last time in 2008 on Dec. 11-12. The three main issues on the agenda for the 27 heads of government meeting in Brussels are the EU stimulus package passed in response to the global economic crisis; the Lisbon Treaty, which has languished in limbo since its rejection in an Irish referendum in June; and Europe's climate package. Prior to the summit, German Chancellor Angela Merkel expressed "cautious optimism" that agreement could be reached on the climate package, initially a German proposal that has come under criticism from various quarters.

While a handful on its own, the agenda is more notable for the issues not being discussed -- namely, how to deal with a resurgent Russia; the potential energy crisis stemming from Russian natural gas price increases for most EU member states starting Jan. 1; and the institutional deficiencies underlying the economic crisis sweeping the continent.

Related Special Topic Pages

The issue of the climate change and energy package is notable, and any progress -- particularly in midst of the economic crisis -- would be impressive considering the uphill battle. Referred to as 20-20-20, the initiative aims to reduce the European Union's carbon emissions by 20 percent, increase its use of renewable fuels to 20 percent of total energy demand and reduce total EU energy demand by 20 percent, all by the year 2020. However, with the economic crisis in full swing, the emphasis on climate change is dubious. The Lisbon Treaty is also on the agenda, and the EU member states are expected to approve assurances to Ireland on neutrality, taxation, commissioner assignments among member states and controversial rules like abortion -- all key sticking points during the Irish referendum.

The leaders do plan to address the bloc's 200 billion euro (US$263 billion) stimulus package, but the plan is more of a face-lift than a real solution to the underlying institutional problems within the European Union. As it stands now, the stimulus plan is a patchwork of national stimulus packages that accounts for only 0.6 percent of the total EU gross domestic product (GDP), whereas the European Commission hopes member states will commit 1.5 percent to the plan. Some within the commission are calling for Germany, the most powerful European economy and one of the few with a balanced budget, to pick up the slack amounting to 0.9 percent of the bloc's GDP (which would be around $170 billion). That is most definitely not on Berlin's agenda.

The EU member states are discussing this plan mainly because the broader, institutional issues are impossible to agree on. Such questions include how to protect the exposed EU member states outside the eurozone (for example, the Baltics, Hungary, Romania and Bulgaria) against currency devaluation, or whether to create some sort of unified tax regime that would give the European Union an actual fund from which to draw large amounts of cash during a financial crisis. There are also issues of a continent-wide banking regulatory regime, and of expanding the European Central Bank's powers. These questions seem prescient in light of the lack of a coherent, unified EU response to the economic crisis.

The main obstacles to answering these questions are the historical lack of willingness to devolve powers to the bloc from the nation-state level, and Germany's resistance to any "economic government" plan that would rely on German economic might for financial backing. Germany therefore is comfortable with the current plan as long as it does not ask Berlin for any financing beyond its current commitment.

Next is the issue of Europe's relationship with Russia. EU member states are divided on how to talk to Russia about security. France and Germany lead the relatively appeasing line, while Poland, the Czech Republic, Sweden and the United Kingdom lead the group stressing a firm stance. The issue is clear for Poland and the Czech Republic: As they are likely targets of further Russian maneuvers, they believe the Russian resurgence must be countered. But France is much more interested in leaving all its diplomatic avenues open, while Germany does not want to antagonize its main source of energy imports and is historically open to independent accommodations with Russia.

Which brings us to the elephant that will be in the room with the 27 European heads of state at the summit: Russia's planned Jan. 1 natural gas price increases. EU member states depend on Russian imports for a quarter of their total natural gas needs. Russian natural gas behemoth Gazprom announced in July that it would raise the natural gas prices it charges EU member states from $420 per thousand cubic meters (tcm) to $720 per tcm. But many European countries have already notified Gazprom that they will not be able to pay the new price. The current financial crisis obviously makes such a drastic increase problematic, particularly for Central European economies that both depend on Russian natural gas for most of their energy supply and already are running huge trade deficits because of energy imports.

Gazprom announced Nov. 12 that it might consider scrapping its planned price increases, but any such move most likely will be used as a tool for political manipulation. The Kremlin has been known to use energy as a political tool in the past, and without a coherent, unified effort, the Europeans will be easy to pick off one by one.