Europe, Unemployment and Instability [Friedman]

Guest post by George Friedman, Founder and Chairman, Stratfor Research

The global financial crisis of 2008 has slowly yielded to a global unemployment crisis. This unemployment crisis will, fairly quickly, give way to a political crisis. The crisis involves all three of the major pillars of the global system -- Europe, China and the United States. The level of intensity differs, the political response differs and the relationship to the financial crisis differs. But there is a common element, which is that unemployment is increasingly replacing finance as the central problem of the financial system.

Europe is the focal point of this crisis. Last week Italy held elections, and the party that won the most votes -- with about a quarter of the total -- was a brand-new group called the Five Star Movement that is led by a professional comedian. Two things are of interest about this movement. First, one of its central pillars is the call for defaulting on a part of Italy's debt as the lesser of evils. The second is that Italy, with 11.2 percent unemployment, is far from the worst case of unemployment in the European Union. Nevertheless, Italy is breeding radical parties deeply opposed to the austerity policies currently in place.

The core debate in Europe has been how to solve the sovereign debt crisis and the resulting threat to Europe's banks. The issue was who would bear the burden of stabilizing the system. The argument that won the day, particularly among Europe's elites, was that what Europe needed was austerity, that government spending had to be dramatically restrained so that sovereign debt -- however restructured it might be -- would not default.

One of the consequences of austerity is recession. The economies of many European countries, especially those in the eurozone, are now contracting, since austerity obviously means that less money will be available to purchase goods and services. If the primary goal is to stabilize the financial system, it makes sense. But whether financial stability can remain the primary goal depends on a consensus involving broad sectors of society. When unemployment emerges, that consensus shifts and the focus shifts with it. When unemployment becomes intense, then the entire political system can shift. From my point of view, the Italian election was the first, but expected, tremor.

A Pattern Emerges in Europe

Consider the geography of unemployment. Only four countries in Europe are at or below 6 percent unemployment: the geographically contiguous countries of Germany, Austria, the Netherlands and Luxembourg. The immediate periphery has much higher unemployment; Denmark at 7.4 percent, the United Kingdom at 7.7 percent, France at 10.6 percent and Poland at 10.6 percent. In the far periphery, Italy is at 11.7 percent, Lithuania is at 13.3 percent, Ireland is at 14.7 percent, Portugal is at 17.6 percent, Spain is at 26.2 percent and Greece is at 27 percent.

Germany, the world's fourth-largest economy, is at the center of gravity of Europe. Exports of goods and services are the equivalent of 51 percent of Germany's gross domestic product, and more than half of Germany's exports go to other European countries. Germany sees the European Union's free trade zone as essential for its survival. Without free access to these markets, its exports would contract dramatically and unemployment would soar. The euro is a tool that Germany, with its outsized influence, uses to manage its trade relations -- and this management puts other members of the eurozone at a disadvantage. Countries with relatively low wages ought to have a competitive advantage over German exports. However, many have negative balances of trade. Thus, when the financial crisis hit, their ability to manage was insufficient and led to sovereign debt crises, which in turn further undermined their position via austerity, especially as their membership in the eurozone doesn't allow them to apply their own monetary policies.

This doesn't mean that they were not profligate in their social spending, but the underlying cause of their failure was much more complex. Ultimately it was rooted in the rare case of a free trade zone being built around a massive economy that depended on exports. (Germany is the third-largest exporter in the world, ranking after China and the United States.) The North American Free Trade Agreement is built around a net importer. Britain was a net importer from the Empire. German power unbalances the entire system. Comparing the unemployment rate of the German bloc with that of Southern Europe, it is difficult to imagine these countries are members of the same trade group.

Even France, which has a relatively low unemployment rate, has a more complex story. Unemployment in France is concentrated in two major poles in the north and the south, with the southeast of France being the largest of them. Thus, if you look at the map, the southern tier of Europe has been hit extraordinarily hard with unemployment, and Eastern Europe not quite as badly, but Germany, Austria, the Netherlands and Luxembourg have been left relatively unscathed. How long this will last, given the recession in Germany, is another matter, but the contrast tells us a great deal about the emerging geopolitics of the region.

Portugal, Spain and Greece are in a depression. Their unemployment rate is roughly that of the United States in the midst of the Great Depression. A rule I use is that for each person unemployed, three others are affected, whether spouses, children or whomever. That means that when you hit 25 percent unemployment virtually everyone is affected. At 11 percent unemployment about 44 percent are affected.

It can be argued that the numbers are not quite as bad as they seem since people are working in the informal economy. That may be true, but in Greece, for example, pharmaceuticals are now in short supply since cash for importing goods has dried up. Spain's local governments are about to lay off more employees. These countries have reached a tipping point from which it is difficult to imagine recovering. In the rest of Europe's periphery, the unemployment crisis is intensifying. The precise numbers matter far less than the visible impact of societies that are tottering.

The Political Consequences of High Unemployment

It is important to understand the consequences of this kind of unemployment. There is the long-term unemployment of the underclass. This wave of unemployment has hit middle and upper-middle class workers. Consider an architect I know in Spain who lost his job. Married with children, he has been unemployed for so long that he has plunged into a totally different and unexpected lifestyle. Poverty is hard enough to manage, but when it is also linked to loss of status, the pain is compounded and a politically potent power arises.

The idea that the Germany-mandated austerity regime will be able to survive politically is difficult to imagine. In Italy, with "only" 11.7 percent unemployment, the success of the Five Star Movement represents an inevitable response to the crisis. Until recently, default was the primary fear of Europeans, at least of the financial, political and journalistic elite. They have come a long way toward solving the banking problem. But they have done it by generating a massive social crisis. That social crisis generates a political backlash that will prevent the German strategy from being carried out. For Southern Europe, where the social crisis is settling in for the long term, as well as for Eastern Europe, it is not clear how paying off their debt benefits them. They may be frozen out of the capital markets, but the cost of remaining in it is shared so unequally that the political base in favor of austerity is dissolving.

This is compounded by deepening hostility to Germany. Germany sees itself as virtuous for its frugality. Others see it as rapacious in its aggressive exporting, with the most important export now being unemployment. Which one is right is immaterial. The fact that we are seeing growing differentiation between the German bloc and the rest of Europe is one of the most significant developments since the crisis began.

The growing tension between France and Germany is particularly important. Franco-German relations were not only one of the founding principles of the European Union but one of the reasons the union exists. After the two world wars, it was understood that the peace of Europe depended on unity between France and Germany. The relationship is far from shattered, but it is strained. Germany wants to see the European Central Bank continue its policy of focusing on controlling inflation. This is in Germany's interest. France, with close to 11 percent unemployment, needs the European Central Bank to stimulate the European economy in order to reduce unemployment. This is not an arcane debate. It is a debate over who controls the European Central Bank, what the priorities of Europe are and, ultimately, how Europe can exist with such vast differences in unemployment.

One answer may be that Germany's unemployment rate will surge. That might mitigate anti-German feeling, but it won't solve the problem. Unemployment at the levels many countries are reaching and appear to be remaining at undermines the political power of the governments to pursue policies needed to manage the financial system. The Five Star Movement's argument in favor of default is not coming from a marginal party. The elite may hold the movement in contempt, but it won 25 percent of the vote. And recall that the hero of the Europhiles, Mario Monti, barely won 10 percent of the vote just a year after Europe celebrated him.

Fascism had its roots in Europe in massive economic failures in which the financial elites failed to recognize the political consequences of unemployment. They laughed at parties led by men who had been vagabonds selling post cards on the street and promising economic miracles if only those responsible for the misery of the country were purged. Men and women, plunged from the comfortable life of the petite bourgeoisie, did not laugh, but responded eagerly to that hope. The result was governments who enclosed their economies from the world and managed their performance through directive and manipulation.

This is what happened after World War I. It did not happen after World War II because Europe was occupied. But when we look at the unemployment rates today, the differentials between regions, the fact that there is no promise of improvement and that the middle class is being hurled into the ranks of the dispossessed, we can see the patterns forming.

History does not repeat itself so neatly. Fascism in the 1920s and 1930s sense is dead. But the emergence of new political parties speaking for the unemployed and the newly poor is something that is hard to imagine not occurring. Whether it is the Golden Dawn party in Greece or the Catalan independence movements, the growth of parties wanting to redefine the system that has tilted so far against the middle class is inevitable. Italy was simply, once again, the first to try it out.

It is difficult to see not only how this is contained within countries, but also how another financial crisis can be avoided, since the political will to endure austerity is broken. It is even difficult to see how the free trade zone will survive in the face of the urgent German need to export as much as it can to sustain itself. The divergence between German interests and those of Southern and Eastern Europe has been profound and has increased the more it appeared that a compromise was possible to save the banks. That is because the compromise had the unintended consequence of triggering the very force that would undermine it: unemployment.

It is difficult to imagine a common European policy at this point. There still is one, in a sense, but how a country with 5.2 percent unemployment creates a common economic policy with one that has 11 or 14 or 27 percent unemployment is hard to see. In addition, with unemployment comes lowered demand for goods and less appetite for German exports. How Germany deals with that is also a mystery.

The crisis of unemployment is a political crisis, and that political crisis will undermine all of the institutions Europe has worked so hard to craft. For 17 years Europe thrived, but that was during one of the most prosperous times in history. It has not encountered one of the nightmares of all countries and an old and deep European nightmare: unemployment on a massive scale. The test of Europe is not sovereign debt. It is whether it can avoid old and bad habits rooted in unemployment.

Europe, Unemployment and Instability is republished with permission of Stratfor.