This article was first published on the Stratfor website.

Europe is on the cusp of change. A European Union
heads-of-state summit on December 16 launched a process aimed to save the
common European currency. If successful, this process would be the most
significant step toward creating a singular European power since the creation
of the European Union itself in 1992
— that is, if it doesn’t
destroy the euro first.

Envisioned by the EU Treaty on Monetary Union, the common currency,
the euro, has suffered from two core problems during its decade-long
existence: the lack of a parallel political union and the issue of debt.
Many in the financial world believe that what is required for a viable
currency is a fiscal union that has taxation power — and that is indeed
needed. But that misses the larger point of who would be in charge of
the fiscal union. Taxation and appropriation — who pays how much to whom
— are essentially political acts. One cannot have a centralized fiscal
authority without first having a centralized political/military
authority capable of imposing and enforcing its will. Greeks are not
going to implement a German-designed tax and appropriations system
simply because Berlin thinks it’s a good idea. As much as financiers
might like to believe, the checkbook is not the ultimate power in the
galaxy. The ultimate power comes from the law backed by a gun.

Europe’s Disparate Parts

This isn’t a revolutionary concept — in fact, it is one most people
know well at some level. Americans fought the bloodiest war in their
history from 1861 to 1865 over the issue of central power versus local
power. What emerged was a state capable of functioning at the
international level. It took three similar European wars — also in the
19th century — for the dozens of German principalities finally to merge
into what we now know as Germany.

Europe simply isn’t to the point of willing conglomeration just yet,
and we do not use the American Civil War or German unification wars as
comparisons lightly. STRATFOR sees the peacetime creation of a unified
European political authority as impossible, since Europe’s component
parts are far more varied than those of mid-19th century America or

Northern Europe is composed of advanced technocratic economies, made
possible by the capital-generating capacity of the well-watered North
European Plain and its many navigable rivers (it is much cheaper to move
goods via water than land, and this advantage grants nations situated
on such waterways a steady supply of surplus capital). As a rule,
northern Europe prefers a strong currency in order to attract investment
to underwrite the high costs of advanced education, first-world
infrastructure and a highly technical industrial plant. Thus, northern
European exports
— heavily value added — are not inhibited greatly
by a strong currency. One of the many outcomes of this development
pattern is a people that identifies with its brethren throughout the
river valleys and in other areas linked by what is typically omnipresent
infrastructure. This crafts a firm identity at the national level
rather than local level and assists with mass-mobilization strategies.
Consequently, size is everything.

Southern Europe, in comparison, suffers from an arid, rugged
topography and lack of navigable rivers. This lack of rivers does more
than deny them a local capital base, it also inhibits political
unification; lacking clear core regions, most of these states face the
political problems of the European Union in microcosm. Here, identity is
more localized; southern Europeans tend to be more concerned with
family and town than nation, since they do not benefit from easy
transport options or the regular contact that northern Europeans take
for granted. Their economies reflect this, with integration occurring
only locally (there is but one southern European equivalent of the great
northern industrial mega-regions such as the Rhine, Italy’s Po Valley).
Bereft of economies of scale, southern European economies are highly
dependent upon a weak currency to make their exports competitive abroad
and to make every incoming investment dollar or deutschemark work to
maximum effect.

Central Europe — largely former Soviet territories — have yet
different rules of behavior. Some countries, like Poland, fit in well
with the northern Europeans, but they require outside defense support in
order to maintain their positions. The frigid weather of the Baltics
limits population sizes, demoting these countries to being, at best, the
economic satellites of larger powers (they’re hoping for Sweden while
fearing it will be Russia). Bulgaria and Romania are a mix of north and
south, sitting astride Europe’s longest navigable river yet being so far
removed from the European core that their successful development may
depend upon events in Turkey,
a state that is not even an EU member. While states of this grouping
often plan together for EU summits, in reality the only thing they have
in common is a half-century of lost ground to recover, and they need as
much capital as can be made available. As such variation might suggest,
some of these states are in the eurozone, while others are unlikely to
join within the next decade.

And that doesn’t even begin to include the EU states that have
actively chosen to refuse the euro — Denmark, Sweden and the United
Kingdom — or consider the fact that the European Union is now made up of
27 different nationalities that jealously
guard their political (and in most cases, fiscal) autonomy

The point is this: With Europe having such varied geographies,
economies and political systems, any political and fiscal union would be
fraught with complications and policy mis-prescriptions from the start.
In short, this is a defect of the euro that is not going to be
corrected, and to be blunt, it isn’t one that the Europeans are trying
to fix right now.

The Debt Problem

If anything, they are attempting to craft a work-around by addressing
the second problem: debt. Monetary union means that all participating
states are subject to the dictates of a single central bank, in this
case the European Central Bank (ECB) headquartered in Frankfurt. The
ECB’s primary (and only partially stated) mission is to foster long-term
stable growth in the eurozone’s largest economy — Germany — working
from the theory that what is good for the continent’s economic engine is
good for Europe.

One impact of this commitment is that Germany’s low interest rates
are applied throughout the currency zone, even to states with mediocre
income levels, lower educational standards, poorer infrastructure and
little prospect for long-term growth. Following their entry into the
eurozone, capital-starved southern Europeans used to interest rates in
the 10-15 percent range found themselves in an environment of rates in
the 2-5 percent range (currently it is 1.0 percent). To translate that
into a readily identifiable benefit, that equates to a reduction in
monthly payments for a standard 30-year mortgage of more than 60

As the theory goes, the lower costs of capital will stimulate
development in the peripheral states and allow them to catch up to
Germany. But these countries traditionally suffer from higher interest
rates for good reasons. Smaller, poorer economies are more volatile,
since even tiny changes in the international environment can send them
through either the floor or the roof. Higher risks and volatility mean
higher capital costs. Their regionalization also engenders high
government spending as the central government attempts to curb the
propensity of the regions to spin away from the center (essentially, the
center bribes the regions to remain in the state).

This means that when the eurozone spread to these places, theory went
out the window. In practice, growth in the periphery did accelerate,
but that growth was neither smooth nor sustainable. The unification of
capital costs has proved more akin to giving an American Express black
card to a college freshman: Traditionally capital poor states (and
citizens) have a propensity to overspend in situations where borrowing
costs are low, due to a lack of a relevant frame of reference. The
result has been massive credit binging by corporations, consumers and
governments alike, inevitably leading to bubbles in a variety of
sectors. And just as these states soared high in the first decade after
the euro was introduced, they have crashed low in the past year. The
debt crises of 2010 — so far precipitating government debt bailouts for
Ireland and Greece and an unprecedented
bank bailout in Ireland
— can be laid at the feet of this
euro-instigated over-exuberance.

It is this second, debt-driven shortcoming that European leaders
discussed Dec. 16. None of them want to do away with the euro at this
point, and it is easy to see why. While the common currency remains a
popular whipping boy in domestic politics, its benefits — mainly lower
transaction costs, higher purchasing power, unfettered market access and
cheaper and more abundant capital — are deeply valued by all
participating governments. The question is not “whither the euro” but
how to provide a safety net for the euro’s less desirable, debt-related
aftereffects. The agreed-upon path is to create a mechanism that can
manage a bailout even for the eurozone’s larger economies when their
debt mountains become too imposing. In theory, this would contain the
contradictory pressures the euro has created while still providing to
the entire zone the euro’s many benefits.

Obstacles to the Safety Net

Three complications exist, however. First, when a bailout is
required, it is clearly because something has gone terribly wrong. In Greece’s
, it was out-of-control government spending with no thought to
the future; in essence, Athens took that black card and leapt straight
into the economic abyss. In Ireland’s case, it was private-sector
overindulgence, which bubbled the size of the financial sector to more
than four times the entire country’s gross domestic product. In both
cases, recovery was flat-out impossible without the countries’ eurozone
partners stepping in and declaring some sort of debt holiday, and the
result was a complete funding of all Greek and Irish deficit spending
for three years while they get their houses in order.

“Houses in order” are the key words here. When the not-so-desperate
eurozone states step in with a few billion euros — 223 billion euros so
far, to be exact — they want not only their money back but also some
assurance that such overindulgences will not happen again. The result is
a deep series of policy requirements that must be adopted if the
bailout money is to be made available. Broadly known as austerity
measures, these requirements result in deep cuts to social services,
retirement benefits and salaries. They are not pleasant. Put simply:
Germany is attempting to trade financial benefits for the right to make
policy adjustments that normally would be handed by a political union.

It’s a pretty slick plan, but it is not happening in a vacuum.
Remember, there are two more complications. The second is that the Dec.
16 agreement is only an agreement in principle. Before any Champagne
corks are popped, one should consider that the “details” of the
agreement raise a more than “simply” trillion-euro question. STRATFOR
guesses that to deliver on its promises, the permanent bailout fund
(right now there is a temporary
with a “mere” 750 billion euros) probably would need upwards
of three trillion euros. Why so much? The debt bailouts for Greece and
Ireland were designed to completely sequester those states from debt
markets by providing those governments with all of the cash they would
need to fund their budgets for three years. This wise move has helped
keep the contagion from spreading to the rest of the eurozone. Making
any fund credible means applying that precedent to all the eurozone
states facing high debt pressures, and using the most current data
available, that puts the price tag at just under 2.2 trillion euros. Add
in enough extra so that the eurozone has sufficient ammo left to fight
any contagion and we’re looking at a cool 3 trillion euros. Anti-crisis
measures to this point have enjoyed the assistance of both the ECB and
the International Monetary Fund, but so far, the headline figures have
been rather restrained when compared to future needs. Needless to say,
the process of coming up with funds of that magnitude when it is
becoming obvious to the rest of Europe that this is, at its heart, a
German power play is apt to be contentious at best.

The third complication is that the bailout mechanism is actually only
half the plan. The other half is to allow states to at least partially
default on their debt (in EU diplomatic parlance, this is called the
“inclusion of private interests in funding the bailouts”). When the
investors who fund eurozone sovereign debt markets hear this, they
understandably shudder, since it means the European Union plans to
codify giving states permission to walk away from their debts — sticking
investors with the losses. This too is more than simply a trillion-euro
question. Private investors collectively own nearly all of the
eurozone’s 7.5 trillion euros in outstanding sovereign debt. And in the
case of Italy, Austria, Belgium, Portugal and Greece, debt volumes worth
half or more of GDP for each individual state are held by foreigners.

Assuming investors decide it is worth the risk to keep purchasing
government debt, they have but one way to mitigate this risk: charge
higher premiums. The result will be higher debt financing costs for all,
doubly so for the eurozone’s more spendthrift and/or weaker economies.

For most of the euro’s era, the interest rates on government bonds
have been the same throughout the eurozone, based on the inaccurate
belief that eurozone states would all be as fiscally conservative and
economically sound as Germany. That belief has now been shattered, and
the rate on Greek and Irish debt has now risen from 4.5 percent in early
2008 to this week’s 11.9 percent and 8.6 percent, respectively. With a
formal default policy in the making, those rates are going to go higher
yet. In the era before monetary union became the Europeans’ goal, Greek
and Irish government debt regularly went for 20 percent and 10 percent,
respectively. Continued euro membership may well put a bit of downward
pressure on these rates, but that will be more than overwhelmed by the
fact that both countries are, in essence, in financial conservatorship.

That is not just a problem for the post-2013 world, however. Because
investors now know the European Union intends to stick them with at
least part of the bill, they are going to demand higher returns as
details of the default plan are made known, both on any new debt and on
any pre-existing debt that comes up for refinancing. This means that
states that just squeaked by in 2010 must run a more difficult gauntlet
in 2011 — particularly if they depend heavily on foreign investors for
funding their budget deficits. All will face higher financing and
refinancing costs as investors react to the coming European disclosures
on just how much the private sector will be expected to contribute.

Leaving out the two states that have already received bailouts
(Greece and Ireland), the four eurozone states STRATFOR figures face the
most trouble — Portugal,
Belgium, Spain and Austria
, in that order — plan to raise or
refinance a quarter trillion euros in 2011 alone. Italy and France, two
heavyweights not that far from the danger zone, plan to raise another
half-trillion euros between them. If the past is any guide, the weaker
members of this quartet could face financing costs of double what
they’ve faced as recently as early 2008. For some of these states, such
higher costs could be enough to push them into the bailout bin even if
there is no additional investor skittishness.

The existing bailout mechanism probably can handle the first four
states (just barely, and assuming it works as advertised), but beyond
that, the rest of the eurozone will have to come up with a
multitrillion-euro fund in an environment in which private investors are
likely to balk. Undoubtedly, the euro needs a new mechanism to survive.
But by coming up with one that scares those who make government
deficit-spending possible, the Europeans have all but guaranteed that
Europe’s financial crisis will get much worse before it begins to

But let’s assume for a moment that this all works out, that the euro
survives to the day that the new mechanism will be in place to support
it. Consider what such a 2013 eurozone would look like if the rough
design agreed to Dec. 16 becomes a reality. All of the states flirting
with bailouts as 2010 draws to a close expect to have even higher debt
loads two years from now. Hence, investors will have imposed punishing
financing costs on all of them. Alone among the major eurozone countries
not facing such costs will be Germany, the country that wrote the
bailout rules and is indirectly responsible for managing the bailouts
enacted to this point. Berlin will command the purse strings and the
financial rules, yet be unfettered by those rules or the higher
financing costs that go with them. Such control isn’t quite a political
union, but so long as the rest of the eurozone is willing to trade
financial sovereignty for the benefits of the euro, it is certainly the
next best thing.