Originally produced on Jan. 9, 2017 for Mauldin Economics, LLC

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George Friedman and Jacob L. Shapiro

We end this series of sneak peaks at our 2017 forecast by describing what the year ahead will look like for Europe. To do that, we must keep two things in mind. First, due to limited space, this must be a high-level overview of the forecast. Many of the specifics and the argument’s logic are contained in our 2017 forecast and in our daily tracking of these issues. The goal here is to paint a picture of the major forces at play. Second, we must remember that geopolitics does not observe the Gregorian calendar the same way people do. In this sense, one year is an arbitrary period of time, and our forecast for Europe is in many respects a long-term one. Readers of The Next Hundred YearsThe Next Decade, and Flashpoints: The Emerging Crisis in Europe by Geopolitical Futures founder George Friedman will recognize elements of a process that has been underway for over a decade. 2017 will not be decisive, but it will be another chapter in the European Union’s slow unraveling.

The Italian Crisis

Our forecast for 2016 included a banking crisis in Italy. That crisis began to emerge in earnest by mid-year, and though developments have not accelerated as fast as we thought, the crisis has not gone away. It has played a prominent role in the destabilization of Italian domestic politics. The key problem is the Italian banking sector’s high rate of non-performing loans (NPLs). (Approximately 17% of all loans from Italian banks are non-performing, according to the European Banking Authority.) Italy also has poor prospects for meaningful economic growth in the near- to mid-term. The bank currently making headlines, Banca Monte dei Paschi di Siena, had 45 billion euros ($47.4 billion) worth of NPLs and other doubtful loans when its problems became apparent in 2016.

Many readers have written to us saying that even if Italy needed hundreds of billions of euros to bail out its entire banking sector, it would not be a large problem. If the only issue were the amount of money, these readers would be correct. The balance sheets of Italian banks, however, don’t exist in a vacuum. If the European Central Bank were to bail out Italy, it would mean that all of Europe effectively would be paying for it. Greece, which had austerity forced upon it, would cry foul over this special treatment. The German public would object, and Chancellor Angela Merkel’s position would be severely weakened, even if she prevails in upcoming elections later this year.

Europe is not a country, and the EU is a union in name only. The transfer of sovereignty to Brussels was never total, and member states are independent countries with independent interests.

German Exports

Italy is the bridge to 2017. The major economic issue we expect to rear its head in 2017 is declining exports in Germany. According to the latest World Bank data, Germany’s exports-to-GDP ratio is 46.8%. As those who have followed our series of articles on the subject know, we expect China’s economic woes to continue in 2017, which means there will be no prospect for increased demand from China. Russia is also in economic trouble and won’t be increasing demand. Germany has managed to survive thus far by increasing exports to the United Kingdom and the United States, but we do not view this as sustainable indefinitely. Most of the world’s major exporters have faced severe problems. Germany stands out as one of the few that has not. Yet its problems will reverberate throughout the Continent. Many Eastern European countries, for example, are part of the German supply chain.

The simple fact to remember is this: The EU is built around a massive exporter, and that exporter is Germany. That makes the EU susceptible to drops in demand for exports, and it also creates a particular kind of political relationship between Germany and the rest of the EU, especially countries that are markets for German goods and those that are in the German supply chain.

This dependency and economic architecture can, and has, worked in the past, but it now faces two key challenges. The first is the question of how to increase demand for the products in question, which is not in any single country’s control. The second is that as a result of the continued challenges emanating from the 2008 financial crisis, many of Europe’s economies are struggling. (Italy, as we described above, is the most salient example.)

The EU’s growing socio-economic problems, in turn, lead to increased nationalism. We saw this manifest in Brexit in 2016. In 2017, this dynamic already is affecting elections in France and Germany. Even if the historically internationalist candidates win, the conversation has shifted from an internationalist position to a nationalist one—even for those who historically have been most committed to the EU, Merkel being the most prominent example.

The Security Question

In addition to the economic and political reality, security will be an issue… and here, too, member states’ interests diverge. Some countries are more concerned about refugees than others, and Brussels is still unable to present a coherent and universally accepted plan for dealing with the refugee crisis. There also is the question of Eastern Europe, which faces an increasingly opportunistic and aggressive Russia, and wants its security prioritized. Western Europe is less concerned with Russia on a daily basis and more concerned about Islamic terrorism. Meanwhile, a Donald Trump administration in the US is about to shine a very bright light on the future of NATO. This will mean difficult choices for many European countries. The security issues currently are not as serious as the economic and political issues for Europe, but they loom in the background and feed the strain on the EU rather than unite member states in common cause.

When we look around Europe today, we see less of a move toward EU dissolution than the gradual ignoring of EU directives (though the prospect of other Brexit-type votes or secession votes in states like Spain is very real). Western European countries are breaking EU regulations on budget deficits, and Brussels is looking the other way. Eastern European countries are breaking similar regulations and being called out for it more consistently, but no punishments are forthcoming. Each country has its own issues with refugees and either backs or ignores EU directives on refugee quotas as it suits the individual country.

At the beginning of last year, George wrote the following, and it remains the general frame through which we view events in Europe:

The EU will survive, and one day you will be able to visit a dusty office in Brussels, much like the European Free Trade Association’s offices in Switzerland, where it still exists. [The EFTA was a British-led alternative to the European Community in the late 1950s and ’60s that is irrelevant today despite the continued existence of its offices.] I am sure the staff will be doing something, writing directives that no one will follow, or even care to object to. I once expected ‘Götterdämmerung,’ the ‘Twilight of the Gods,’ to move the EU. Today I became convinced, not that the EU couldn’t continue this way, but that it really isn’t continuing in any significant way.

Italian banks, German exports, nationalism affecting domestic elections, and divergences on security issues will be the main issues in 2017, but they are really just small parts of a much larger forecast that is slowly hulking toward fruition.

GPF Team
Geopolitical Futures is a company that charts the course of the international system. It’s an ambitious mission, maybe even foolhardy, but hear us out.