Will the EU Fiddle While Eastern Europe Burns?

| About: SPDR S&P (GUR)

"We should not allow that a new Iron Curtain should be set up and divide Europe."
– Ferenc Gyurcsany, Prime Minister of Hungary

Will Germany prove content to fiddle as Eastern Europe burns? The risk seems real.

Angela Merkel, Germany’s chancellor, knows her party will be facing a tough series of elections this fall. She also knows Deutschland is struggling... and writing a huge check to bail out a clutch of flailing non-German nations would be a deeply unpopular act.

So when Ferenc Gyurcsany, the prime minister of Hungary, proposed a lump-sum Eastern Europe bailout package to the tune of $241 billion, the EU’s richer members spat out their croissants.

In a moment of quiet political panic, Chancellor Merkel stalled. “Saying that the situation is the same for all Central and Eastern European states, I don’t see that,” she said.

Political Will (And Lack Thereof)

This lack of political will helps explain why the U.S. dollar is strong and the euro is in the tank.

The European Union has 27 client states, 16 of which have adopted the euro. The USA has fifty states, all of which use the greenback.

The difference is that, if Washington decides the state of California needs emergency funds, South Carolina can’t fold its arms and say “Yeah, right” (much as it might like to). America’s fifty states are bound together under a unified political system, which makes large fiscal transfers a workable option. The 27 client states of the European Union, on the other hand, do not have the same ties that bind.

This throws a huge monkey wrench into Europe’s flow of funds, as we are seeing now with Germany’s hesitation to do what might be needed. Ms. Merkel does not want to commit political suicide at home for the sake of helping out her poor neighbors. These “political roadblocks” will be thrown up again and again as the EU nations see their broader fortunes diverge.

Iceland Redux?

The thing is, Germany, France, and the other “rich” EU members may ultimately have no choice in the matter. A bailout of Eastern Europe might wind up being a necessity in order to save Western Europe’s banks.

An estimated $1.7 trillion worth of loans (if not more) has poured into Eastern Europe. Out of that fairly large sum, a huge chunk has gone toward foreign-currency-denominated mortgages. Western European banks have done most of this lending, some of them on a staggering scale. According to various reports, one Austrian bank alone has lent sums to Poland, Romania and Ukraine totaling 70% of Austria’s GDP.

This is the same type of mistake made by Iceland’s now-belly-up banks: loading up the boat with exotic mortgages, then sailing forth blithely between the Scylla and Charybdis of repayment risk and forex risk.

And thus, if Eastern Europe goes down the tubes, in all likelihood so do Western Europe’s banks. And if that happens, you can probably kiss the Euro goodbye... and with that, the free movement of people, goods and capital between European borders... and in that scenario Europe on the whole is pretty much toast.

So I hate to break it to you, Chancellor Merkel, but you should think pretty seriously about writing your neighbors that bailout check. (Unless, of course, you’re willing to deal with the political consequences embedded in a potential full-on collapse of the European banking system.)