Last year, former National Security Agency (NSA) contractor Edward Snowden revealed a plethora of documents indicating that the NSA was actively gathering information on Americans and foreigners. One of the more embarrassing episodes was that the NSA was closely monitoring allies, even to the point where German Chancellor Merkel’s cell phone was monitored. This revelation greatly unsettled relations between the U.S. and Germany and remains a sore point, especially for the German political left wing.
Relations have soured further following reports earlier this month that at least one German national, an employee with the German intelligence agency Bundesnachrichtendienst (BND), admitted to selling documents to the U.S. Central Intelligence Agency (CIA) and another may have been implicated as well. The Merkel administration took the unprecedented step of expelling the CIA station chief in Berlin. Never before has such a high-ranking official been expelled by an American ally.
Although part of the decision for expelling the station chief was to send a clear signal of displeasure to the Obama administration, it does appear that deeper underlying issues exist that are affecting U.S./German relations. These issues reflect Germany’s emergence from its post-WWII state and America’s waning superpower role.
In this report, we will reiterate the “German Problem,” the geopolitical situation that has shaped German behavior since its inception in 1870. We will delve into the recent spy scandal in more detail. From this vantage point, we will discuss the underlying issues that are affecting American/German relations and, as always, conclude with market ramifications.
The German Problem
Modern Germany sits in the center of Europe. It has few natural barriers, meaning it is nearly perfect for commerce and impossible to defend. The country was established in the wake of the Franco-Prussian War of 1870. Germany was formed by Prussian leaders coalescing together other independent regions in the area that were formally part of the Holy Roman Empire. The decision to create a nation was due in part to prevent another military power from conquering the various principalities as Napoleon did, and to take full advantage of the industrial revolution.
In short order, Germany became a rival for Britain, France and Russia, but especially to the latter two countries. Henry Kissinger described Germany as, “too big for Europe but too small for the world.” Given its favorable geography and industrious population, Germany became an industrial powerhouse; by the onset of WWI, the German economy had surpassed Britain’s. However, due to the lack of natural defenses, Germany feared it was vulnerable to attack. To act as a deterrent, Germany built a large military and allied with Italy and the Austro-Hungarian Empire.
Unfortunately, the decision to militarize raised fears of German power, leading France, Russia and Britain to expand their militaries as well, creating an arms race in the period leading up to 1914.
The rise of Germany made the European continent geopolitically unstable, and the inability to resolve the rise of Germany brought two world wars to the continent. In the aftermath of WWII, the allies divided Germany. When the Soviets isolated its sector, two separate countries were formed, East and West Germany. West Germany generally followed U.S. foreign policy and was effectively demilitarized. This process allowed Germany to focus on economic development and freed it from most geopolitical concerns. From 1945 until unification in the 1990s, Germany did not have the wherewithal to manage an independent foreign policy. Even after unification, Germany generally maintained a similar policy stance. The U.S. and the newly formed Russia were at peace and NATO had mostly demilitarized Western Europe. German foreign policy was non-interventionist and primarily pacifist.
Perhaps the best way to think about Europe is that its geography has prevented any nation from consolidating power and ruling the continent. The separation of the Nordic states by the Baltic Sea, the mountain ranges that separate the south from the north, and the existence of the British Isles all conspired to prevent control. The powerful nations of Europe controlled vast empires and were the early beneficiaries of the industrial revolution. However, the inability of any state to control Europe has left the continent vulnerable to periodic conflicts. The U.S. solved this problem by removing military power from Europe and protecting NATO members from the Soviets. However, this demilitarized condition is probably unsustainable. The recent spy scandal is perhaps a reflection of this issue.
Earlier this month, reports began to circulate that a clerk in the Operations and Foreign Relations department, which processes communication for BND agents around the world, was selling documents to the U.S. The clerk, given the code name Markus L., didn’t fit the normal profile of a spy. He is described as a short and somewhat overweight man suffering from handicaps from childhood vaccination damage. He did not finish high school and there does not appear to be any university training in his background. He seems to fit the profile of a Milton Waddams-type employee.
According to reports, Markus L. sent an e-mail to the Russian Consulate in Munich and offered his services as an informant. Markus sent a few classified documents, internal communications from the BND, as a sample of “work.” The Bundesamt fur Verfassungsschutz (BfV), Germany’s primary federal security agency, intercepted the e-mail and the BND’s internal security department pursued the case. The BND set a trap for Markus using a forged e-mail address; Markus didn’t bite. They tried to set up a clandestine meeting with a BND agent posing as a Russian handler. Again, Markus demurred. The BND, exasperated by its inability to lure Markus into a trap, sent a request for any information to the CIA. The American intelligence agency, to the surprise of the Germans, failed to respond. This raised further suspicions among the BND and led authorities to arrest Markus.
Under interrogation, Markus revealed that he was already in the employ of the CIA. The CIA managed his relationship out of the Austrian embassy. It appears that Markus gave the U.S. up to 218 documents found on a flash drive, including three that were directly related to German legislative investigations of NSA activities in Germany. In addition, Markus’s home computer was found with a software configuration consistent with that of a foreign intelligence service and Markus’s cellphone had a false weather app that would reveal encryption software if the user searched for weather in New York City. For his efforts, the U.S. evidently paid Markus €25k ($34k).
Apparently, Markus decided that he needed a new business opportunity and chose to expand his operation, which explains his offer to the Russians. According to reports, he did identify his American contacts but German authorities have not been able to apprehend them at this time.
In the documents that Markus transmitted to the CIA, there were some entries that referred to a suspected mole in the German Defense Ministry, code named Leonid K. Unlike Markus, Leonid is described as a well-educated, sophisticated and urban political advisor who reportedly is fluent in five languages. Leonid initially made contact with the U.S. during a tour as an advisor to the German military as part of the Kosovo Force. There was some evidence of continued U.S. contact with Leonid, including a €2,000 transfer from a U.S. account to Leonid. Reports indicate that Leonid was struggling to earn enough money to maintain his lifestyle. Under interrogation, Leonid argued that the money transfer was a loan that he has since repaid. However, the BfV notes that in February, contact between Leonid and the U.S. suddenly ended. It is unknown whether the U.S. ended contact on fears that Leonid was becoming unreliable or the break was simply a coincidence. However, the Germans are concerned that the U.S. discovered Leonid was being investigated from the documents Markus provided and thus decided to end their relationship with him.
Two Basic Issues
The fact that the U.S. is spying on Germany should not come as any great surprise. Even allies spy on each other. The U.S., the U.K., Canada, Australia and New Zealand have formed the “Five Eyes” group, which shares intelligence and promises not to spy on each other. Outside of that group, the U.S., as a global superpower, does and should spy on everyone else. The decision to expel the station chief in Berlin was a very strong reaction and, in fact, was clearly done to send an explicit message to the Obama administration of the degree of German anger. Beneath the surface, we believe that two key unresolved issues are being exposed by this event.
First, the German problem remains unsettled. The American solution was really a temporary one that unexpectedly lasted a long time. After unification, Germany was able to remain in this “suspended animation” because tensions between the U.S. and Russia were very low and, for the most part, the latter nation was in such dire straits that Germany didn’t face its traditional threat from Russia.
However, as time has passed, Russia has recovered. Increasing oil prices, coupled with Vladimir Putin’s strong direction, moved Russia from chaos to recovery. As the Russian situation has improved, Putin has steadily worked to expand his nation’s influence in its “near abroad,” a consistent historical pattern in Russian behavior.
Recent actions by Putin suggest Russia is trying to rebuild its buffer. The 2008 partial invasion of Georgia, this year’s annexation of the Crimea, the support of rebels in eastern Ukraine and the attempts to create a Eurasian trade area are all part of Putin’s plan to regain control of his near abroad.
The U.S. opposes Russia’s behavior. As the sole superpower, the U.S. is generally not supportive of nations trying to carve out “spheres of influence” as this implies that these areas are not accessible to the U.S. Tensions between the U.S. and Russia create problems for Germany.
Russia is an important trading partner for Germany; Russia provides raw materials and, in some cases, lower cost labor, and Germany provides investment goods and high-quality consumer goods to Russia. Germany does not want to see that trade hampered. And so, the U.S. cannot fully trust Germany to be a reliable partner in opposing Russian designs.
In other areas, Germany’s behavior suggests it is willing to “free ride” U.S. security. Germany did not assist in Libya, for example. Although it did assist NATO in Afghanistan, the Bush administration was furious with Germany for not contributing to the Iraqi War effort.
In addition, the U.S. has been less than impressed with Germany’s handling of the Eurozone economic crisis. Germany has been slow to assist its neighbors and has insisted on austerity. On several occasions, Treasury Secretary Geithner pleaded with German officials to act more aggressively to support the economies of southern Europe to no avail. Germany’s plan for the Eurozone was for the latter to adopt the export-promoting policies of Germany. As such, this puts tremendous strain on the U.S. as the provider of the reserve currency. Essentially, Germany is trying to use U.S. consumption to fix the Eurozone’s debt problem.
In effect, Germany is trying to figure out its proper role. Should it be more forceful in pushing its policies? Can Europe deal with German dominance? Will Germany side with Russia instead of the West? How will Germany deal with the decline of France? Will the U.S. tolerate a more dominant Germany?
The last question brings us to the second issue. Germany is discovering that the U.S. does not treat it as a close ally, at least in the same way America treats Britain. Germany was divided for nearly half a century and the U.S. treated the country like a parent would treat a child. The U.S. expected Germany to follow American foreign policy without question. Although some in the German left chaffed under American policy, for the most part, the center-right went along. America’s historical support of Germany, including the Berlin Airlift and the Marshall Plan, gave older, more conservative Germans a great deal of trust in and support of American policy.
Germans were seriously disturbed by the decision of George W. Bush to invade Iraq on what German policymakers believed was weak evidence and without approval of the U.N. They tended to view President Bush as erratic and unreliable; his rough exterior worried them that the U.S. was becoming dangerous.
The election of Barack Obama was welcomed by Germany. The Merkel government was hopeful that the War on Terrorism would be wound down and the new president would be supportive of European policy goals. Despite a somewhat premature awarding of the Nobel Peace Prize to President Obama in 2009, this American president has been a disappointment to Germany. Not only has Guantanamo Bay detention camp remained open, but drone strikes have actually increased under Obama compared to Bush. And, the degree of spying on Germany, as shown in the Snowden leaks and other revelations described above, suggest to Germany that the divergence in German and American aims was not a personality issue but a real difference between the two nations. German policymakers appear to be concluding that the execution of U.S. superpower policy may not always be in their best interests. Although many from the left wing of German politics held this position during the Cold War, the difference now is that Germany is in a position to conduct an independent foreign policy and appears to be heading in that very direction.
The aforementioned German problem remains unresolved. The U.S. post-WWII solution of partition and occupation postponed the resolution but since unification and the relative decline of American influence, the German problem has re-emerged. Essentially, the U.S. never really felt Germany could easily integrate itself into Europe, which is why it opted for the policy of partition and occupation. This level of discomfort is seen in the active spying that the U.S. continues to conduct on Germany; if the U.S. felt differently, it would have made Germany a “Sixth Eye” nation. Although there are reports membership has been considered, to date it has not occurred and we believe the reason is due to underlying concerns over Germany’s relations in Europe.
For Germany, the issue is that it is also trying to figure out how it will resolve its role within Europe. After three major wars (Franco-Prussian, WWI, WWII) and occupation and partition, Germany is trying again to develop its place. It is finding that it doesn’t always agree with U.S. policy and yet, due to its demilitarized nature, still needs the U.S. to defend it militarily against any major threats.
We expect Germany and the U.S. to continue to try to work out a way forward. The developing trends suggest that Germany will become increasingly independent of American policy. At a minimum, this process will raise tensions with the U.S. and Germany’s European neighbors. At worst, Europe could find itself dealing with a regional power in Germany that will dominate the region.
For investors, this steady change in German and U.S. relations will change asset patterns. Over recent decades, U.S. and European equity markets have become increasingly correlated. The process of globalization is well entrenched between America and Europe and so tightening correlation is understandable. If policy begins to drift apart, one could reasonably expect correlations to loosen over time.
Perhaps the most important issue is that it is still unknown how Germany will assert its role in Europe. Germany’s behavior during the recent debt crisis in the Eurozone suggests that it is a reluctant hegemon. Given its history, this position makes sense. However, if the U.S. is withdrawing from the superpower role, Germany will need to fill the potential vacuum in Europe or a leaderless situation could develop. If chaos were to result, it would be bearish for European assets. We view this last concern as a long-term one, and one that will bear watching in the coming years.
July 21, 2014
This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
 The red stapler-loving clerk from the movie Office Space.
 Much like the FBI in the U.S.
 It is a common tactic to use a station in a foreign nation to handle a source in another country; in this way, the local authorities probably don’t know the handler and are thus less likely to interfere. At the same time, being assigned to a foreign embassy offers the handler no diplomatic immunity in another country and if the cover is lost, the handler could be arrested.
Confluence Investment Management LLC
Confluence Investment Management LLC is an independent, SEC Registered Investment Advisor located in St. Louis, Missouri. The firm provides professional portfolio management and advisory services to institutional and individual clients. Confluence’s investment philosophy is based upon independent, fundamental research that integrates the firm’s evaluation of market cycles, macroeconomics and geopolitical analysis with a value-driven, fundamental company-specific approach. The firm’s portfolio management philosophy begins by assessing risk, and follows through by positioning client portfolios to achieve stated income and growth objectives. The Confluence team is comprised of experienced investment professionals who are dedicated to an exceptional level of client service and communication.