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Germany’s Choice: Part 2

July 28, 2011

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

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Germany's Choice: Part 2

July 26, 2011

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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.

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Derryl Hermanutz

Aug. 16, 2011, 7:17 a.m.

Henry wrote, “For Germany to become the banker and financial backstop for Europe is neither possible nor desirable.”

No, it is not only possible.  It is necessary.  As a chronic trade surplus nation to the rest of Europe, Germany exports German goods and imports Europe’s money.  Germans don’t spend that money, they save it.  As the hoarder of savings in euros, Germany is already Europe’s creditor.  The new EFSB merely formalizes that relationship, essentially transforming Germany’s export earnings into Europe’s euro denominated reserve currency fund, managed by Germany. 

There are several things a trade surplus nation can do with the money it is stockpiling.  China ships most of its US dollars back stateside in exchange for Treasuries that allow the US to keep running fiscal deficits.  The fiscal deficits are “spent” by the government, but that spent money becomes “income” to its American recipients, who then have money to go buy stuff at Walmart.  The fiscal deficits enable the trade deficits with China (and with oil exporters).  The Bank of China converts its exporters’ US$ earnings into yuan, which increases the yuan money supply “fully backed” by Chinese holdings of the world’s reserve currency, the dollar, which supports China’s growing capitalist economy and confidence in the Chinese currency.  China has also been using those dollars to buy up commodity supplies around the world.  So China is using its trade surplus to build up its industrial economy and to “get rich”, which according to Deng (and most everyone else) is glorious. 

As Hobbes correctly stated, “money is power”.  On the one hand having money gives you power as a consumer to “command” the economy to build you a house or a car or sell you groceries or provide you with services.  Or it gives you power to command the economy as an investor, to hire people to do your bidding as workers, or build you a factory, sell you an asset, etc.  Consumers and investors exercise the power of money by “spending” it.  This power is used once and it is used up.  The money has been traded for economic goods.

But there is another kind of power that money wields, a more permanent power to command, and that is by “lending” your money.  A creditor decides who does, and who does not, get loans, and for what purposes the money will be lent.  A creditor can demand certain behaviors from borrowers.  This power does not end as soon as the money is lent, as it does with spent money.  A creditor has the right to oversee the debtor, to ensure he lives up to the terms of the loan. 

So spending money gives you some short term “economic” power; but lending money gives you long term “political” power, a long term right of command over your debtors.  This is why the question of, “Who should issue the money, bankers or governments?”, has been the central political struggle during virtually the entire history of the United States.  Andrew Jackson won in 1835.  Lincoln won when he printed his own greenbacks.  The bankers won in 1913, but now that they are all insolvent wards of the State the power balance may have shifted again, and we may see some government issued money to bail out the economy, as contrasted with more bank issued money to keep us all in debt bondage.

Henry Schedewie

Aug. 8, 2011, 4:22 a.m.

For Germany to become the banker and financial backstop for Europe is neither possible nor desirable.  Just think how any one of the United States of America would assume that role for the rest of the country!  Presently, many European Countries (incl. GB) as well as some US States are revolting against austerity measures of their own gov’ts, and it is not clear that those gov’ts will keep the upper hand.  How much more difficult would it be for outsiders (like Germany) to call in foreign debts?!

No, Germany and its taxpayers are patently unwilling lenders of last resort and do so only in order to prevent the imminent collapse of the EU and the Euro.  As pointed out above, Germany has sacrificed too much for the EU to materialize.  It does not want to throw everything to the wind now and gives it a last ditch effort to keep Europe together for mainly political reasons.  Economically and financially, Germany has done fine in the past and will likely do the same (or perhaps better?) in the future without an EU. 

For a lender to attach certain conditions to (large low interest) loans is normal and, in this particular situation, probably even essential for a chance to get the EU’s financial house in order.  Otherwise there would be no reason to change the old ways of living beyond States’ means and Billions (Trillions?) of good money would be thrown after bad.  The Maastricht Treaty with all its clear fiscal rules and penalties certainly did nothing to engender fiscal responsibility in PIIGS but Goldman Sachs made lots of money helping States pad their books. 

Something’s got to give, if Europe is to survive as a Union.  However, Germany’s assistance cannot be seen as anything but a stop gap measure which, German taxpayers hope and pray, will end sooner rather than later.  Europe’s only hope for survival is, to adopt a model similar to the United States of America with a central Treasury, Reserve Bank and IRS, that help mitigate between States of vastly different life styles and associated economic/financial prowess.  Absent such central authorities, forget about Germany, the Euro and probably the EU itself are doomed.

William Saylor

Aug. 5, 2011, 3:36 a.m.

Good article but I think tehre is a much more important and unmentioned factor behind Germany’s dominance in the Eurozone and their status in the world. Very simply it is American military might and expenditures that have allowed Germany - and all of Europe - to NOT pay anything close to their share of their defense. If you integrate the American cost of NATO, which is best visualized as a mother duck with trailing ducklings, since 1954 it almost exactly equals the American deficit. The Germans have been able to skate with less than 2% of GDP spent on their military, which is incapable of even baking bread in supprt of Afghanistan operations, while sidling up to the Russians on natural gas deals that would be unthinkable without the American shield. An exporter needs some semblance of world rule of law and that only exists because of the huge amount of American resources spent to help make that possible. You can thank America for the German economic miracle.

Walter Stolber

Aug. 1, 2011, 12:28 p.m.

Subject: Stratfor on Germany for Mr. Mauldin`s consideration.-
I am saddened by Stratfor`s repeated and now even stricter formulated assertion that ” no country in Europe has benefited more from the eurozone than Germany…. and it also made the Germans rich”. Irritated, not only because I had repudiated in vain similar blatently false statements before, but contrary to the author(s) then and here, I had made an effort to substantiate my opinion.
  Chancellor Merkel applies a similar albeit, somewhat less provocative wording in her justification to the German public of euro billions in risky support of taxpayers` money to bankrupted and corrupted governments.
What do Merkel and Stratfor authors have in common?  The need to substantiate their claims with facts; without, preferably just obmit the contentious statment.
Here,  a slightly modified repeat on the topic, sent to author a couple of weeks ago:
Stratfor`s cavalier assertion “that same German taxpayer has benefited disproportionally from the eurozoneâ??s creation” is more than dubious. In fact, it is blatently false. Remember, it was the French President Mitterand who pressured the Germans (Kohl) to give up their mighty currency for his agreeing to German re-unification. Thus, stepping out of German monetary shadow to becomng a senior partner.  As a consequence , Germany suffered from a European Central Bank interest rate policy too high for her development needs for almost a decade, which earned the country the nickname ” sick man of Europe”.
Or would Stratfor rather like to compare Germany`s economic situation say, with that of Spain when this country joined the Union and the eurozone?  Which one of the two countries benefited disproportionally from the eurozone stemming from EU membership?. No doubt, it is Spain and other poor european relatives of Germany which over night each not only gained billion of euros in lower interest payments for their accumulated and future debt, benefiting from German thrift and monetary prudence, but they also benefited from German tax money ( EU subsidies).
Stratfor may retort that it was due to the euro that Germany became the world champion in export. An economist`s reply is that such a development if it were the case, is neither structurally sound nor beneficial for the German populace, the union and beyond;  not conducive to balanced development.  However, even the argument that it was the eurozone which generated the German export monster rests on shaky grounds. Lately, trade increments with emerging countries ie. China, Russia, India, are clearly growing much faster than German trade with eurozone countries, so is trade between Germany and Switzerland,  not a EU and euro zone member, at a historical peak .
Claiming that “the Germans became rich because of the euro zone” is provocative, not conclusive.  In fact,  the opposite may be closer to the truth:  it might be much easier to support the notion that in economic terms, Germany became poorer compared to where the country would stand today without the artificial euro currency. Politically, depending on value judgements,  the outcome could also be negativ.
So Stratfor, dear Mr. Friedman, may I suggest to check the facts before repeating Merkel`s helpless mantra of German disproportional benefits, and Stratfor`s claim that German wealth derived from the eurozone: self-serving propaganda directed not only at the international clientel (Stratfor),  but also at the taxpayer at home ( Merkel) which has become sick and tired to be lied upon and being the paymaster of Europe, especially to countries like Greece.
A country having a very long history of governmental deceit, lying and incompetence dating back to the Middle Ages when German Emperors learnt their lessons in that part of Europe. More recently, members of the “Union monétaire latine” which Greece joined in 1868 learnt a similar lesson . Greece was thrown out ot that union in 1908 let us call it diplomatically, due to incorrect behavior. The Swiss ambassador to France at that time is quoted ” it was a mistake to accept Greece a member to our union”.  A precursor to what can be expected when today`s political establishment in central Europe has matured.  Germany`s choice?  History seems repeating itself . Unfortunately, however, for taxpayers this political learning process will become ever more costly with each passing day.

Mike McBride

July 30, 2011, 8:15 p.m.

I still don’t understand how this “new” EFSF, essentially guaranteed by Germany, really solves the problem of excessive debt levels that accumulated across Europe for so many years. Aren’t they just monetizing old debt with new debt? Granted, interest rates are more favorable and repayment terms are more generous, but the debt is still there, and the markets know that. Plus, what happens when/if Germany slows down or enters the next recession? Is Germany that strong to be able to service their own debt and also backstop this new EFSF debt? And, to highlight the newsletter itself, the fundamental “flaw” still exists in that there are diverging fiscal policies which are forced to operate with a common currency. If extreme austerity is employed in these countries, how will that affect things as underlying economies stagnate? Can these countries, which have been so dependent on an ever-expanding social welfare state suddenly change their history effectively? This sounds nice on paper and in theory, but I am not convinced it is the practical long term solution to place such a burden on a single country (even a supposedly strong one). I am also not convinced the financial markets will fully accept it either. Despite the reliance of 17 countries, and even the non-Euro ones, on the Euro currency, I question the harmony among them. And counting on cooperation with Russia on anything seems a bit of a stretch as well. A European banking crisis will call this new strategy into serious question. Oh, but I forgot about the “successful results” of the last European Bank Stress Test. I guess things are really OK.

Barry Rose

July 29, 2011, 3:01 p.m.

Thanks John - a superb article.  With so much media time & energy being dedicated to potential defaults among the PIIGS, it is refreshing to get a big-picture look at the EZ and Germany’s rising star.  It’s also a little discouraging, because it is a reminder that the USA has gone from being the world’s creditor to the world’s debtor.  What a difference 20 years has made, for both of our countries!

barry fay

July 29, 2011, 11:03 a.m.

What a great article! That there are no comments is probably a sign that it´s too intelligent of an analysis for most readers to get through. I live in Germany and have NOT ONCE seen the situation clearly spelled out here and have had to argue with “colleagues” about “bailing out Greece” because that is the populist version of what is going on. Thanks —I am sending this around to the “boys”!

Tom Hansen

July 29, 2011, 6:32 a.m.

Only a true Texan such as John Mauldin would understand the consequences of the EFSF. The blood of the republic still runs in your veins John.