*** Germany with Its Back Against a Wall

By George Friedman
June 29, 2016

Berlin is willing to sacrifice any part of the EU except the free trade zone.

The British establishment began eating is own this week, while at the same heaping scorn on those who had the temerity to have their own views. Prime Minister David Cameron is finished but not gone. The head of the loyal opposition, Jeremy Corbyn, was given a vote of no confidence by Labourites in Parliament, but he refused to step down immediately after the June 28 motion. The global stock markets rose, and we were assured by leading experts that this means nothing since the world is ending. And the best and brightest looked for ways to annul the will of the people, since the people were being very silly indeed. Yet the sun rose in Her Majesty’s realm, the children went to school (assuming their teachers weren’t on strike) and the financial wizards of the City continued to make money, but not always for their clients, which is as it should be, I suppose. The British survived the Battle of Britain, and they will surely survive this.

The ones who didn’t survive the Battle of Britain were the Germans. And their ability to survive this is much more uncertain than that of the British. The reasons are fairly obvious, but since everyone in the media is focused on the end of Great Britain, it is a story they haven’t noticed.

Let’s begin with a seemingly innocent statement made by German Foreign Minister Frank-Walter Steinmeier: “Let’s keep our heads up! [We have] every reason to be proud of EU integration and to continue it…Let’s be honest. We need a more flexible EU. You’re not a bad European if you want to advance at a slower pace.” On the surface, this is a reasonable and conciliatory statement.

There are of course any number of countries engaged in fairly bitter disputes with the EU. Britain is far from the only one. For example, the EU is condemning the Polish government for what it calls tampering with the judiciary. Similarly, the EU has been hostile to Hungary for interfering with the media. There was serious tension with Italy when the EU said that in a banking crisis, depositors should consider their money forfeit, and the Italians struggled with the notion of facing strict limits to aiding ailing banks. During the height of the refugee crisis the Austrians threatened to close the Brenner Pass to block refugee movement, while a number of other countries refused to follow EU dictates on the subject. The Greeks are still bitter about the devastation of EU-mandated austerity. And so on.

The image of the EU as a happy place busy fixing the minor problems that have cropped up isn’t quite true. Apart from the substantial growth of anti-EU political parties, on the left and the right, there are many EU member governments in serious disputes, many of which were initiated by the EU with regulations and mandates that the members feel they can’t live with.

Steinmeier, a powerful German politician, has conceded the need for a more flexible system. He adds that you are not a bad European if you want to advance at a slower pace. I assume that you are a bad European if you want to have nothing to do with the EU, as Britain just voted, and I suspect that was one of the messages Steinmeier wanted to deliver.

But he was also telling the other members of the EU that their membership can be flexible. He hasn’t explained how that would work, but he has basically said to the rest of Europe, “Hold on. No need to leave. We will customize membership to your needs.” What sounds like a reasonable proposal hides a desperate ploy.

The one thing that is fundamental to EU membership is free trade. The European free trade zone was the foundation upon which the EU was built. It preceded the EU and the EU is meaningless without it. The EU without the free trade zone would be like the Organization of American States, a forum for discussion and occasional condemnation of one country or another, but with no mission beyond that.

Steinmeier is not thinking about giving up the free trade zone. Other things may become optional. The euro is. Compliance with the regulation of the EU on various matters may be. Interference in the internal affairs of countries might be. The primacy of the European legal system might be. The free trade zone is not.

For Germany, the free trade zone is indispensable. The fundamental reality of Europe is that Germany derives nearly half of its GDP from exports. Europe has declined in importance as a destination for German goods, and the U.K. and U.S. have become significantly more important, but continental Europe remains an indispensable source of revenue for Germany. If the free trade zone were modified, the German economy would face an enormous crisis. A 5 percent decline in exports would mean a 2.25 percent decline in Germany’s GDP.

Germany will do anything to retain the free trade zone. It would give up the euro, which was meant to create a level playing field in the free trade zone and wound up maximizing German interests. It would give up regulations from Brussels that make entrepreneurial activity in Europe too risky to undertake. IBM was staggered by Microsoft. Google redefined the behavior of the largest corporations in the world. But Siemens has not had to face a European Google or Microsoft. It’s tough to start a business in your garage in Europe.

All of these things benefited Germany. The euro gave it an advantage on a seemingly level playing field. The regulations protected Germany’s 1950s-style corporations from 21st century challenges. And European anti-trust regulations put Google and Microsoft on the defensive. All of these were outstanding.

But with the European Union tearing itself apart over Brussels’ regulations on all things important, including immigration and Central Europe's media and judiciary, all things become vulnerable. One of the major questions never raised is whether the free trade zone benefits the members. It is not subject to discussion, like a sacred principle. Yet Germany developed its industry in the 1950s while protecting its markets from competition. It is doubtful whether Germany would have developed as it did if it had tried to industrialize in the face of American competition.

It might have been better off. During its second industrialization after World War II, Germany needed to generate capital. This meant that German industry vastly outstripped its domestic consumption to the point where today the entire German economy depends on exports. The only way Germany could have increased the share of exports in its GDP in the face of the global slowdown (in 2008 exports were about 40 percent of GDP) was to cut prices and profit margins. That and overwhelm the rest of Europe with German goods, priced in such a way that competition could not evolve.

In a market where one country is overwhelmingly powerful and highly dependent on exports, that large exporter is necessarily predatory, looking for new market niches so it can maintain cash flow. It is very difficult under these circumstances for smaller economies to develop. We have a generational crisis in southern Europe too casually ascribed to the lazy shiftlessness of Mediterranean cultures. Culture may play a role, but Germany’s tariff-free access to these markets makes recovery impossible.

The Germans' primordial fear is the loss of the European free trade zone. This is an existential issue for them. This is why, for all the German posturing, in the end the Germans made deals with the Greeks that they knew the Greeks could never comply with. The Germans put on a good show, but they never would have pushed the Greeks out of the EU. Had this happened and the Greek economy improved, it would have set the most dangerous precedent possible for the Germans.

This is the case with the U.K. Exports to Britain are critical to Germany, and the Germans may posture, but they would be cutting off their nose to spite their face by breaking trade relations with Britain. The German fear is that the British decision to leave will spread to other countries and that this might start a reconsideration of the free trade zone. Thus Steinmeier’s statement is perfectly pitched. The EU is great. We understand there is unhappiness. Everyone can proceed at their own speed. But the core assumption is that everyone is in the free trade zone, and then they can add other things. Or not. Germany will sacrifice everything to protect the free trade zone.

Germany is not a monster. Like Japan and China, it has a massive overdependence on exports because it developed in an environment where capital formation depended on that. It never suffered the setback of Japan, and now China, and therefore did not need to adjust its export dependency. When the global exports crisis hit, it had to do everything it could to maintain their exports. It cannot back off without a crisis that would require a massive shift in its economic life, with the political consequences of that inevitable and massive pain.

The Germans will put that off forever if they can. The cornerstone of their economy is unlimited access to the European free trade zone. The U.K. has not raised this issue, but it might, and so might others. Germany must retreat if it is to save what it must have. Steinmeier is being reasonable, but defending fundamental German interests. Stay in the free trade zone. Everything else is negotiable.