by David C. Grabbe
February 9, 2017
As Europe’s largest economy, the world’s fourth largest economy, and the instigator of World Wars I and II, Germany is a pivotal nation that shapes the course of history, particularly among Israelitish nations. In the wake of World War II, French and American strategists formulated a plan to prevent further European bloodshed and German aggression in particular. They proposed to create an economic integration so close that the resulting prosperity would overcome any desire—let alone perceived need—to go to war. An essential element of the strategy was to harness a defanged Germany’s industrial and economic power for the benefit of the rest of Europe, while keeping Germany captive through unparalleled free-trade agreements. Through a series of treaties spanning decades, the European Union (EU) was born.
While largely successful, the reasoning behind the plan contained a significant oversight: The “ever closer union” was predicated on prosperity, but what would happen if—or when—the good times ended? Would the EU still have a reason for existing if the promise of wealth was withdrawn?
In 2008, the plan began to be tested, as the U.S. sub-prime mortgage crisis spread through the world’s economies. Aggregate losses rose into the trillions of dollars, and Europe’s economies especially suffered a withering blow. Between 2008-2012, nearly thirty European banks failed, and employment throughout the EU was gutted. With no consensus among the nations on how to manage the crisis, the Eurozone entered economic stagnation and political gridlock. Managing prosperity is relatively straightforward; managing mountains of debt among highly disparate economies with a single policy can lead to madness.
Here, German vulnerability is exposed. Germany is an industrial powerhouse, producing far more than it consumes: 47% of its economy is based on exports. While its export capacity is enviable when the world economy is stable, it becomes a liability when demand decreases and markets dry up—as in times of recession. Germany’s economy is dependent on exporting the goods it produces (as is China’s). A 10% drop in exports, for instance, would result in a 5% drop in GDP.
This is not simply theoretical; it is beginning to take place. Germany’s primary export destinations—the U.S., EU, and China—are importing less as their economies struggle to regain their footing. Berlin reported that from July 2015 to July 2016, Germany’s exports declined by 10%, mainly due to decreased U.S. imports. Germany is producing, but people elsewhere are buying less.
Similarly, the European free-trade zone, intended to be a captive market for German goods, is losing its ability to consume. Southern Europe, ravaged by unemployment, is lurching from one debt crisis to the next. Italy—another major European economy—is expected to be the locus of the next financial calamity, as a massive 17% of its loans are “nonperforming” and will never be repaid. (Nearly 35% of Greece’s loans are nonperforming, but its economy is much smaller.) Greece and Portugal need regular assistance just to make the payments on their sovereign debt.
Germany is in a bind. It needs a stable Eurozone economy to buy its exports, and as the largest creditor, it has thus far loaned to the struggling nations to keep them viable—and keep them buying. But, with exports shrinking, it cannot continue to prop up weaker areas of the Eurozone indefinitely, especially with the increasing likelihood that one or more nations will default.
Two details show the seriousness of the German position: 1) Deutsche Bank currently has about $41.9 trillion worth of derivatives on its books; and 2) in January 2016, Moody’s downgraded Deutsche Bank’s long-term debt, assigning a negative outlook to both its debt and deposit ratings. So, while Germany owns contracts for a tremendous number of assets, their value is becoming less certain, decreasing its capacity to lend more. If Deutsche Bank sinks, how far will the derivative destruction go?
Berlin wields great influence in Brussels, shaping monetary policy for the EU. In the past, Germany has favored forcing austerity on countries it deems to be fiscally irresponsible, while overlooking the fact that it has shaped policy for its own benefit. However, if it takes punitive action against ailing economies, they may decide that default is preferable, and EU membership becomes negotiable.
The recent Brexit vote sets a disturbing precedent, from Germany’s point of view, as does the rise of Eurosceptic political parties, which have grown popular enough to challenge mainstream parties. Germany has prospered tremendously from the EU, but now a substantial number of EU citizens are wondering if the EU is still worth it. To them, the promise of prosperity seems to apply only to Germany. Though at the top of the heap now, Germany will be staring into the abyss if the Eurozone begins to crumble.
This drama is unfolding in front of an ominous backdrop. From the Atlantic to the Pacific, the entire Eurasian landmass—home to five billion of the earth’s seven billion people—is exhibiting economic, political, and military destabilization. The immigration crisis across Europe is becoming desperate. The world’s major powers are ensnared in Syria and the surrounding areas. The Balkans are again becoming restive. China, facing its own export crisis, is centralizing power to keep itself from fragmenting. Economically weak Russia compensates by becoming outwardly strong. Saudi Arabia, reeling from the low price of oil, sees Iran growing into a significant competitor.
Amidst all this, Germany stands at the helm of a behemoth vessel that is taking on water faster than it can be bailed out. As forecaster George Freidman notes, “The last time we saw a pattern like this was before World War II.” With such tremendous pressure in the international system right now, Germany has some grave decisions to make.