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Industrial production
Index, 100 = January 2007
110
105
Germany
100
Europe
95
90
85
Periphery
80
75
2007 2008 2009 2010 2011
Source: INE, CSO, ISTAT, NSS, Eurostat, Bundesbank, J.P. Morgan Securities LLC, J.P. Morgan Private Bank. Periphery = Portugal, Ireland, Italy, Greece, Spain.

Unemployment rates - core vs. periphery
Percent, Peripheral rates weighted by population
18%
Greece, Ireland, Spain & Portugal
16%
14%
12%
10%
8%
6%
Germany
4%
2%
0%
1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: J.P. Morgan Private Bank, Bank of Spain, Bank of Portugal, OECD, CSO, NSS, Bundesbank.

The third concern: Germany as paymaster. We are often told that Germans across both major parties are unflinching supporters of the European project, and will do whatever it takes to prevent a break-up. The objections from members of the Bundesbank are described as lonely voices of opposition that carry no weight [a]. But how large are the costs going to be? German politicians and voters may see current circumstances as exceptional, and that if they just agree to one more package, the problem will go away. However, we are starting to see analyses of how costly a permanent transfer union may be for Germany. Bernard Connolly at Hamiltonian Advisors sent me a recent paper from the Centrum fur Europaische Politik in Freiburg, which provides some clues. They see three alternatives for the deficit countries:
** massive reduction in regulations and unit labor costs to regain competitiveness
** exit from the EMU, re-introduction of national currencies
** permanent transfer union from surplus countries to deficit ones

On the last option, they estimate a "creditworthiness gap" in European deficit countries of Eur 108 billion in 2010. The gap measures how much European deficit countries rely on capital inflows to fund consumption, rather than investment (which contributes to future GDP). Germany’s share of the European surplus is around ¾, so let’s assume a pro-rata burden on Germany to maintain the transfer union. As a result, the theoretical economic cost could be 3.3% of German GDP every year, which as shown, gets close to some expensive episodes in German history. If German citizens were faced with costs this high, it could be a White Castle hamburger-throwing moment of national proportions.

Cost to German taxpayers of major events
Percent of GDP, annual
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
Peak Versailles reparations (1929)
Unification (since 1991)
Potential cost of EMU transfer union
Source: Carl-Ludwig Holtfrerich, Halle Institute for Economic Research, Zentrum fur Europaische Politik (Freiburg), J.P. Morgan Private Bank.

Europe equities, priced for the risks
Europe 10-yr trailing PE divided by US 10-yr trailing PE
1.25
1.15
1.05
0.95
0.85
0.75
0.65
1998 2000 2002 2004 2006 2008 2010
Source: Factset, MSCI.

Bottom line. At a time when European equities are trading close to 2009 lows relative to earnings and book value, this package could result in a relief rally for European equities, particularly banks. The chance of a disorderly default in 2011 has decreased markedly, and a process has been put in place to create more seamless transfers to areas (and banks) in need. But the size of the transfer union fund is not big enough to allay all concerns, particularly with Spain and Italy growing at anemic levels, and there is execution risk in Greece.

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