Weighing Germany’s Options (via STRATFOR)

Stratfor consistently does the best analysis of international affairs. Period. From their piece on Germany’s decision regarding Greece:

And so the rest of the eurozone is watching and waiting nervously while casting occasional glances in the direction of Berlin in hopes the eurozone’s leader and economy-in-chief will do something to make it all go away. To truly understand the depth of the crisis the Europeans face, one must first understand Germany, the only country that can solve it.

via Germany’s Choice | STRATFOR.

They’re absolutely right. While others may have economies with higher current account balances with respect to GDP, make no mistake about it: Germany “moves the pile” in the Eurozone.

What follows are some discussions of things you typically won’t find in a debt rating model. That means understanding a country’s history and its geography. From the report:

The heart of Germany’s problem is that it is insecure and indefensible given its location in the middle of the North European Plain. No natural barriers separate Germany from the neighbors to its east and west, no mountains, deserts, oceans. Germany thus lacks strategic depth. The North European Plain is the Continent’s highway for commerce and conquest. Germany’s position in the center of the plain gives it plenty of commercial opportunities but also forces it to participate vigorously in conflict as both an instigator and victim.

Germany’s exposure and vulnerability thus make it an extremely active power. It is always under the gun, and so its policies reflect a certain desperate hyperactivity. In times of peace, Germany is competing with everyone economically, while in times of war it is fighting everyone. Its only hope for survival lies in brutal efficiencies, which it achieves in industry and warfare

It’s been blessed with a multitude of resources, but they’ve always engaged in conflicts on a multitude of fronts, as well. World War II is a prime example of this, with the Germans engaging the Western Europeans on the west, but wary of the Russians to the east, they attacked them as well. Also, when you look at the  annals of military history, many of the tools in modern warfare have roots that went back to platforms developed by the Germans. But as they point out, in spite of its efficiencies, Germany eventually succumbed in the end.

Fast-forward to after World War II:

Even after its disastrous defeats in the first half of the 20th century, Germany remains Europe’s largest state in terms of population and economic size; the frantic mindset that drove the Germans so hard before 1948 didn’t simply disappear. Instead of German energies being split between growth and defense, a demilitarized Germany could — indeed, it had to — focus all its power on economic development. The result was modern Germany — one of the richest, most technologically and industrially advanced states in human history.

Indeed, during the ’80s, I distinctly remember Reagan holding up Germany as a shining example of the kind of country the free world strove to be like: vital, innovative, hard-working, yet fiscally disciplined. But as they bordered the Communist bloc on the east, they couldn’t afford to be a weak country. Because if they were, it would have been too easy for the Communists – who believed in central planning and control, along with stifling freedom – to expand the number of satellite countries in their realm. I bring this up because it seems to me people have forgotten what those countries did, what they stood for, and how they operated. Having a strong Germany has always been in our interests as well as the rest of the Free World’s.

Which leads us to today:

The crisis is rooted in Europe’s greatest success: the Maastricht Treaty and the monetary union the treaty spawned epitomized by the euro. Everyone participating in the euro won by merging their currencies. Germany received full, direct and currency-risk-free access to the markets of all its euro partners. In the years since, Germany’s brutal efficiency has permitted its exports to increase steadily both as a share of total European consumption and as a share of European exports to the wider world. Conversely, the eurozone’s smaller and/or poorer members gained access to Germany’s low interest rates and high credit rating.

I’ve said this before. The dynamics behind the adoption/use of the Euro are not as symbiotic as everyone thinks. Most of the smaller countries have piggybacked off of the benefits of Germany’s monetary and fiscal policies without making changes on their own. Yes, Germany gained better access to their markets, but that benefit for Germany has been much smaller than the benefit those countries received by adopting the same currency the Germans use. Quite frankly, the smaller countries in Europe need Germany a lot more than the Germans need them.

But how did these countries behave? Keep reading:

Even though Europe’s troubled economies never actually obeyed Maastricht’s fiscal rules — Athens was even found out to have falsified statistics to qualify for euro membership — the price to these states of borrowing kept dropping. In fact, one could well argue that the reason Club Med never got its fiscal politics in order was precisely because issuing debt under the euro became cheaper. By 2002 the borrowing costs for Club Med had dropped to within a whisker of those of rock-solid Germany. Years of unmitigated credit binging followed.

Long term, this is not Euro positive and as such, has an effect on Germany. I’ll get to that later. But in the meantime, these charts were included in the Stratfor report:

You can see in historic terms, even with the spreads rising as fast they are, they’re not as wide of German bunds as they were before the Euro. One factor to consider is that before the Euro, each of these countries had their own central bank and their own monetary policy. I don’t know what interest rates were in these countries then, but I think it’s safe to say they were higher than Germany’s. The point I’m trying to make is all of these countries had different starting points relative to Germany when they adopted the Euro from a monetary policy and exchange rate perspective so the pre-Euro spreads and post-Euro spreads may not give us a good indication of the risk that is present. And either way, its Euro negative because the Euro-denominated debt these countries try to float in the market will lead to Euro weakness, which the Germans have had a strong bias against because of their experiences during the Weimar Republic.

But be that as it may, none of this really matters at the moment. The only thing that matters is whether or not the Germans decide to get involved. Or not. Stratfor makes that crystal clear. Because on the one hand, Germany can sit back and let Greece fail:

From the perspective of German finances, letting Greece fail would be the financially prudent thing to do. The shock of a Greek default undoubtedly would motivate other European states to get their acts together, budget for steeper borrowing costs and ultimately take their futures into their own hands. But Greece would not be the only default. The rest of Club Med is not all that far behind Greece, and budget deficits have exploded across the European Union. Macroeconomic indicators for France and especially Belgium are in only marginally better shape than those of Spain and Italy.

But there’s a problem with that logic, though. No matter how prudent it may seem:

The problem with that logic is that this crisis also is about the future of Europe and Germany’s place in it. Germany knows that the geopolitical writing is on the wall: As powerful as it is, as an individual country (or even partnered with France), Germany does not approach the power of the United States or China and even that of Brazil or Russia further down the line. Berlin feels its relevance on the world stage slipping, something encapsulated by U.S. President Barack Obama’s recent refusal to meet for the traditional EU-U.S. summit. And it feels its economic weight burdened by the incoherence of the eurozone’s political unity and deepening demographic problems.

The only way for Germany to matter is if Europe as a whole matters. If Germany does the economically prudent (and emotionally satisfying) thing and lets Greece fail, it could force some of the rest of the eurozone to shape up and maybe even make the eurozone better off economically in the long run. But this would come at a cost: It would scuttle the euro as a global currency and the European Union as a global player.

So the answer isn’t clear-cut regarding the best course of action to take. The fundamentals behind the Euro are negative with the continent as a whole running fiscal deficits, a relative lack of export growth and an aging population coupled with declining birth rates. These are not the traits of a region that has the secular winds to its back. Rather, these are the characteristics of a region that faces secular headwinds. The situation one must be prepared to address is a Europe with declining significance, and as a result, declining economies and investment opportunities. It’s not going to happen today, tomorrow, or next month. But you don’t want to wake up one morning ten years from now and ask why you didn’t see some of these things sooner.

But if you put everything together in a blender and see what you get, to me it’s clear the Euro is heading lower. On one hand, Greece and the other PIGS default and you have a Euro collapse. On the other hand, a bailout is agreed to, which will entail floating more debt or possibly loosening monetary policy even further and more overtly than the ECB has already done (they’ve tried to do stealth QE up to this point). But the parallels with Japan from a secular/demographic point of view are quite compelling. So compelling in fact, that in my mind, the risk of Europe going the way of Japan is significant, increasing, and may be higher than most people think. Except they’ve been living off the Euro/Yen carry trade while the Japanese have been fueling it.

But the real geopolitical problem is right over the plains of Germany and Poland. Russia and China are two countries that have economies tied to commodities and in China’s case, a huge population. There are risks there, to be sure. But the bull case is also easier to make, especially in China’s case.

But back to Germany. If Germany wants to take the mantle and lead the way forward, it will come at a price:

Taking a firmer tack would allow Germany to achieve via the pocketbook what it couldn’t achieve by the sword. But this policy has its own costs. The eurozone as a whole needs to borrow around 2.2 trillion euros in 2010, with Greece needing 53 billion euros simply to make it through the year. Not far behind Greece is Italy, which needs 393 billion euros, Belgium with needs of 89 billion euros and France with needs of yet another 454 billion euros. As such, the premium on Germany is to act — if it is going to act — fast. It needs to get Greece and most likely Portugal wrapped up before crisis of confidence spreads to the really serious countries, where even mighty German’s resources would be overwhelmed.

That is the cost of making Europe “work.” It is also the cost to Germany of leadership that doesn’t come at the end of a gun. So if Germany wants its leadership to mean something outside of Western Europe, it will be forced to pay for that leadership — deeply, repeatedly and very, very soon. But unlike in years past, this time Berlin will want to hold the reins.

The question is whether or not Paris and Brussels will go along. These are two countries that have had bad histories with Germany and tensions here have sparked conflicts before. Do I see that occurring this time around? No, but there will be a lot of disagreements over how to handle this situation.

But they’ll have to resolve whatever differences they have, and resolve them soon. Because the markets will lose patience with their dawdling.

Tick tock……

NOTE: This report is republished with permission of STRATFOR.


1 Comment

Filed under finance, government, International, macro, Markets

One response to “Weighing Germany’s Options (via STRATFOR)

  1. Hubert

    This Stratfor analysis looks like some “Pentagon thinker” reading the map of Europe.

    Germany is a post-imperial economic power. Our army is a sort of police force. We are surrounded by 10 nations – none of them has any trouble with our territory; neither do we any longer have with theirs.

    Our politics is playing the sugar-daddy of Europe in the hope that things stay quiet around us. We know what it means for millions to perish.

    Stratfors perceptions come out of the bowels of the US, the most belligerent western power, simply not understanding that Germany without Prussia was always a defensive, less-belligerent power and now is again.

    The only possible enemy, Russia, shares these demographic problem. We do not trust the Russian Regime but we have not much to fear from them either as far as we can see.

    We, in contrast to the French, are content with that and harbour – due to the horrors of Two Wars – no illusions of historic grandeur, neither do we aspire to future ones: our demograpics show us accompaning our neighbours into “le gouffre de l`histoire” (ou il y a de place pour tout le monde).

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s