Title: The roadmap to a functional eurozone

Subhead: Germany’s Goalposts

While Germany is by far the most powerful country in Europe, the EU is not a German creation. It is instead a portion of the broader 1950s French vision that enhances French power on first a European, and second a global, scale. However, in the years since the Cold War ended France has lost control of the reins of Europe to a reunited and reinvigorated Germany. Germany is now working -- one piece at a time -- to rewire the European structures more to Berlin’s liking. Germany’s primary tools for asserting control are its financial acumen and strength, trading access to its wealth for agreements by other European states to reform their economies along German lines -- a design which would de facto make most of them German economic colonies.

Which brings us to the eurozone crisis, now in its 19th month. There are more plans out there to modify the euro than the zone has members, but most of them ignore one single fact: Germany’s reasons for participating in the eurozone are not purely economic. And those non-economic reasons greatly limit its options in pursuing changes in the European system.

If Stratfor had to choose a single word to describe Germany -- in any age -- it would be ‘vulnerable’. Its coastline is split by Denmark, its three navigable rivers are not naturally connected and Germany does not command the mouths of two of them, its people cling to regional rather than national identities, and most of all it faces sharp competition from both east and west. Germany has never been left alone throughout its history. When Germany is weak its neighbors shatter it into dozens of pieces, often ruling some of those pieces directly. When Germany is strong its neighbors form a coalition to break German power.

The post-Cold War, therefore, is a golden age in Germany history. It was allowed to reunify in the aftermath of the Cold War, and as of the time of this writing its neighbors have not felt sufficiently threatened to seek the breaking of German power. The institutions of the European Union -- most notably the euro itself -- have allowed the Germans to participate in Continental affairs on a field of competition on which they are eminently competitive. In any other era a coalition would have already been forming. Germany wants -- needs desperately -- to keep European competition on the field of economics as on the field of battle it simply cannot prevail against a coalition of its neighbors.

This simple fact eliminates most of the eurozone crisis solutions under discussion. Anything that would eject states from the zone who are also traditional competitors risks transforming them into their more-familiar role of rival. Ergo any reform option that would potentially end with Germany not being in the same currency zone as Austria, the Netherlands, France, Spain or Italy is a non-starter. Germany must keep these states close to prevent a core of competition from arising.

There are also restraints built of nothing more than simple math. A ‘transfer union’ as many have debated would regularly shift economic resources from Germany to Greece, the eurozone’s weakest member. The means of such allocations -- direct transfers, rolling debt restructurings, managed defaults -- are irrelevant. What is relevant is that what is done for Greece would establish precedent and be repeated for Ireland and Portugal -- and in time Italy, Belgium, Spain and France. This makes anything resembling a transfer union a dead issue. Covering all the states who would benefit from the transfers would likely cost around a trillion euro annually. Even if this were a political possibility in Germany (and it is not) it is well beyond Germany’s economic capacity.

Between the goal posts of maximized membership and fiscal union there is only a very narrow window of possibilities. What follows is the approximate roadmap that Stratfor sees the German government being forced to follow. It is not Berlin’s explicit plan per sae, but to avoid mass defaults and the dissolution of the eurozone (and likely the European Union with it) it is the only path forward.

Subhead: Cutting Greece Loose

Greece is unsalvageable. It has extremely limited capital generation capacity at home, and its rugged topography lands it with extremely high capital costs. Even in the best of times Greece cannot function as a developed, modern economy without hefty and regular injections of subsidized capital from abroad. (This is the primary reason why Greece simply did not exist between the 4th century BC and the 19th century AD, as well as the primary reason why the European Commission recommend against beginning accession negotiations with Greece back in the 1970s.)

After Greece’s modern recreation in the early 1800s, those injections came from the United Kingdom which used the newly-independent Greek state as a foil against faltering Ottoman Turkey. During the Cold War the United States was the external sponsor, wanting to keep the Soviets out of the Mediterranean. More recently Greece coasted on its membership in the EU, absorbing scads of development funds, and in the 2000s its eurozone membership allowed it to borrow huge volumes of capital at well below market rates. Unsurprisingly, during most of this period Greece boasted the highest GDP growth rates in the eurozone.

Those good times are over. No one has a geopolitical need for alliance with Greece at present, and evolutions in the eurozone have ended the cheap-euro-denominated credit gravy train. So now Greece has few capital generation possibilities while saddled with a debt closing in on 150 percent of GDP. Add in bank overindulgence and the number climbs further. This is a debt that is well beyond the ability of Greek state and society to pay.

Luckily for the Germans, Greece is not on the list of states that could potentially threaten Germany. It is disposable. And if the eurozone is going to be saved, it needs to be disposed of.

This cannot, however, be done cleanly. Greece has over 350 billion euro in outstanding government debt, of which roughly 75 percent is held outside of Greece. Were Greece cut off financially and ejected from the eurozone, it must be assumed that Athens would quickly -- perhaps even immediately -- default on its debts, particularly the foreign-held portions.

To understand how this would cripple Europe, we need to take a brief detour into the characteristics of the European banking system

European banks are not like American banks. Whereas the American financial system is all part of a single unified network, the European banking system is sequestered by nationality And whereas the general dearth of direct, constant threats to the American nation has resulted in a fairly hands-off approach to the industry, the crowded competition in Europe has often led states to expressly utilize their banks as tools of policy. There are many pros and cons to each model, but in the current eurozone financial crisis it has three critical implications.

First, because banks are regularly used to achieve national and public -- as opposed to economic and private -- goals, banks are often encouraged/forced to invest in ways that they otherwise would not. For example, during the early months of the eurozone crisis, eurozone governments leaned upon their banks to purchase prodigious volumes of Greek government debt, thinking that such demand would be sufficient to stave off a crisis. Another example: in order to better knit Spanish society together into a unified whole, Madrid forced Spanish banks to treat some one million recently naturalized citizens as having prime credit despite their utter lack of credit history, directly contributing to Spain’s current real estate and constriction crisis. Consequently, European banks have suffered more from credit binges, carry trading, and toxic assets (whether American or <home-grown subprime than their AngloAmerican counterparts.

Second, banks are far more important to growth and stability in Europe than they are in AngloAmerica. Banks -- as opposed to stockmarkets in which foreigners participate -- are seen as the trusted supporters of the national systems. As such they are the lifeblood of the European economies, on average supplying over 70 percent of funding needs for consumers and corporations (for AngloAmerica the figure is under 40 percent).

Third and most importantly, this criticality and politicization means that a sovereign debt crisis immediately becomes a banking crisis and a banking crisis immediately becomes a sovereign debt crisis. Ireland is a case in point Irish state debt was actually extremely low going into the 2008 financial crisis, but the banks’ overindulgence left the Irish government with little choice but to launch a bank bailout -- the cost of which in turn required Dublin to seek a eurozone rescue package.

And since European banks are deeply enmeshed into each others’ business via a web of cross-stock and bond holdings and the interbank market, trouble in one country’s banking sector quickly leads to cross-border contagion in both banks and sovereigns.

In the case of Greece, their 280 billion euro in sovereign debt which is held outside of Greece is mostly held within the banking sectors of Portugal, Ireland, Spain and Italy -- all states whose state and private banking sectors are already under considerable strain. A Greek default would quickly cascade into rolling bank failures across these states that would be uncontainable -- German and in particular French banks are heavily exposed to Spain and Italy. And even this scenario is somewhat optimistic, since it assumes that a Greek eurozone ejection does not damage the Greek banking sector’s 500 billion euro in assets (which is of course the single largest holder of Greek government debt).

Subhead: Making Europe Work (Without Greece)

The trick is to make a firebreak around Greece so that its failure cannot tear down the European financial and monetary structure. Sequestering all foreign held Greek sovereign debt would cost about 280 billion euro, but there is more exposure than simply that of government bonds. Greece has been in the EU since 1981. Its companies and banks are integrated into the European whole, and since joining the eurozone in 2001 that integration has been denominated wholly in euros. When Greece is ejected that will all unwind. Add the cost of mitigating that unwinding to the sovereign debt stack and -- conservatively -- the cost of aGreek firebreak rises to400 billion euro.

That, however, only deals with the immediate crisis of the Greek default and ejection. What will follow will be a long-term unwinding of Europe’s economic and financial integration with Greece (there will be few Greek banks willing to lend to European entities, and fewer European entities willing to lend to Greece) which will trigger a series of ongoing financial mini-crises. Additionally, the impact of ejecting a member state -- even one such as Greece which flat out lied about its statistics in order to qualify for eurozone membership -- is sure to rattle European markets to the core.

In August IMF chief Christine Lagardebluntly recommended an immediate 200 billion euro effort to recapitalize European banks so that they could better deal with the next phase of the European crisis. While officials across the EU immediately decried her advice, Lagarde is in a position to know: until July 5 of this year she was the French Finance Minister.

Lagarde’s 200 billion euro figure assumes that the recapitalization occursbefore any defaults and before any market panic. Under such circumstances prices tend to balloon; its easier to build a dam before the flood. Using the 2008 American financial crisis as a guide, the cost of recapitalization during an actual panic would probably be in the range of 800 billion euro.

Finally, it must also be assumed that the markets will not ‘simply’ be evaluating the banks. Governments will come under harsher scrutiny as well. There are any number of eurozone states that look less than healthy, but Italy rises to the top as concerns high debt (gross percent of GDP) and lack of political will to tackle it. Italy’s outstanding government debt is approximately 1.9 trillion euro. The formula the Europeans have used to date to determine bailout volumes has assumed that it would be necessary to cover all expected bond issuances for three years. For Italy that comes out to about 700 billion euro if one uses official Italian government statistics (and something closer to 900 billion if one uses third party estimates).

All told, Stratfor estimates that a bailout fund that can manage the fallout from a Greek ejection would need to be roughly 2 trillion euro.

Subhead: Getting from Here to 2 Trillion Euro

There is a kernel of buried in these numbers. The EU’s bailout mechanism, the European Financial Stability Facility, already exists so the Europeans are not starting from scratch. Additionally, it is not as if the Europeans have to have 2 trillion euro in the kitty the day the Greeks are ejected. Even in the worst-case scenario Italy will not be crashing within 24 hours (and even if it does it will need900 billion over three years, not all in one day). On G-Day probably “only” about 700 billion would be needed (400 billion euro to combat Greece contagion and another 300 billion euro for the banks). At least some of that -- although probably no more than 150 billion euro -- could be provided by the IMF.

The rest comes from the private bond market. The EFSF is not a traditional bailout fund that holds masses of cash and actively restructures entities it assists. Instead it is a transfer facility: it has guarantees from the eurozone member states to back a certain volume of debt issuance. It then uses those guarantees to raise money on the bond market, subsequently passing those funds along to bailout targets. In preparing for G-Day there are two things that must be changed about the EFSF.

First, there are some legal issues to resolve. In its original incarnation from 2010, the EFSF could only carry out state bailouts and it could only do so after European institutions approved them. This resulted in lengthy debates about the merits of bailout candidates, public airings of disagreements among eurozone states, and a great deal more market angst than was necessary. A July 22 eurozone summit strengthened the EFSF, streamlining the approval process, lowering the interest rates of the bailout loans, and most importantly, allowing the EFSF to engage in bank bailouts. These improvements have all been agreed to, but they must be ratified to take effect.

In this there are a couple of snags:

The German governing coalition is of mixed minds whether German resources -- even if limited to state guarantees -- should be made available to bailout other EU states The final vote in the Bundestag is supposed to occur Sept. 29. While Stratfor finds it highly unlikely that this vote will fail, the fact that a debate is even occurring is far more than a worrying footnote. After all, the German government wrote both the original EFSF agreement and its July 22 addendum.

The other snag regards smaller, solvent, eurozone states who are concerned about states’ ability to repay any bailout funds. Led by Finland and bulwarked by the Netherlands these states are demanding collateral any guarantees.

Stratfor views both of these issues as solvable. Should the Free Democrats -- the junior coalition partner in the German government -- vote down the EFSF changes, they sign their party’s death warrant. At present the FDP is so unpopular that it might not even make it into parliament in new elections. And while Germany would prefer that Finland prove more pliable, the collateral issue will at most require a slightly larger German financial commitment to the bailout program.

Which brings us to the second EFSF problem: its size. The current facility has only 440 billion euro -- a far cry from the 2 trillion euros that is required. Which means that once everyone ratifies the July 22 agreement, the 17 eurozone states have to get together (again) and modify the EFSF (again) to quintuple the size of its fund-raising capacity. Anything less ends with -- at a minimum -- the largest banking crisis in European history and most likely the euro’s dissolution. But even this road is a long shot as there are any number of events which could go wrong between now and G-Day.

  • Sufficient states -- up to and including Germany -- could balk at the potential cost, preventing the EFSF from being expanded. Its easy to see why: Increasing the EFSF to 2 trillion euro represents a potenital increase of each contributing state’s total debt load by 25 of GDP, a number that will rise to 30 of GDP should Italy need a rescue (states receiving bailouts are removed from the funding-list for the EFSF). That’s enough to push the national debts of Germany and France -- the eurozone heavyweights -- up to the neighborhood of 110 percent of GDP, in relative size more than even the United States’ current bloated volume. The politics of agreeing to this at the intra-governmental level, much less selling it to skeptical and bailout-weary parliaments and publics cannot be overstated.
  • Once Greek authorities come to the conclusion that Greece will be ejected from the eurozone anyway, they could preemptively either leave the eurozone, default or both. That would trigger an immediate sovereign and banking meltdown before the remediation system could be established.
  • An unexpected government failure could prematurely trigger a general European debt meltdown. There are two leading candidates: First, Italy. At 120 percent of GDP its national debt is the highest anywhere in the eurozone save Greece, and the political legacy of Prime Minister Silvio Berlusconi appears to be on its final legs. Berlusconi has consistently gutted his own ruling coalition of potential successors/challengers. There are now few personalities left to run cover for some of the darker sides of his colorful personality. Prosecutors have become so emboldened that now Berlusconi is scheduling meetings with top EU officials to dodge them. Belgium is also high up on the danger list. Belgium hasn’t had a government for 17 months, and its <caretaker prime minister announced his intention to quit his job Sept. 13 It hard to implement austerity -- much less negotiate a bailout package -- without a government.
  • The European banking system -- already the most damaged in the developed world -- could prove to be in far worse shape than is already believed. Anything from a careless word from government to a misplaced austerity cut to an investor scare could trigger a cascade of bank collapses.

Finally, if Europe is able to massage its system to this point, none of this solves the European Union’s structural, financial or organizational problems. “All” it does is patch up the current crisis for the period of a couple of years. The next challenge will be a German effort to get all eurozone states to hardwire debt limitations and German-run bailout provisions into their constitutions.