Stray Reflections

John Mauldin

Nov 26, 2014

Today’s Outside the Box is special, because I’m about to give you a preview of things to come at Mauldin Economics. For months now I have been saying to my partners that we need to develop a service for the professionals who read me – the financial advisors, portfolio managers, family offices… you know who you are. And I’m excited to tell you that we are very close to making this service a reality. It will be called Mauldin Pro, and it will feature global macro and geopolitical research and analysis, portfolio recommendations, monthly interviews with some of the best talent in the business, and quarterly seminars to help you improve your game.

It will also feature a global macro analysis and investment letter that has created quite a buzz in the industry. Stray Reflections is written by Jawad Mian, a former portfolio manager who lives in the UAE. Born in Pakistan and educated in Canada, Jawad managed $250 million in proprietary funds before turning his attention to his real passion: writing about the macro themes that should be on every investor’s mind, and constructing a theme-based global macro investment portfolio. His audience includes some of the most-respected portfolio managers in the world. 

He’ll bring his fantastic letter to Mauldin Pro in the coming weeks. If you are interested in learning more and you are a professional market participant, give us your email address, and we’ll contact you when the service is ready to go.

Regardless of who you are or how you make your living, you’ll enjoy this piece from Jawad, taken from the November edition of his Stray Reflections. It deals with his view on oil, which has been the focus of the market lately. Can we say Peak Demand?

I will be braving the crowds at Central Market in a few hours, stocking up for Thanksgiving. I am normally not much of a grocery shopper and try to relegate the task to someone with more patience and time. But today, I look forward to spending the time, selecting each ingredient that I will be using with care, choosing fresh spices, chatting with the other shoppers, and just getting into the whole cooking thing, always on the lookout for something new and different.

I will be cooking banana nut cake this evening, as that was my mother’s specialty, and it just isn’t Thanksgiving without banana nut cake, at least for my family. And maybe a carrot cake if I get ambitious. Starting the soups to cook overnight, making the thick glaze for the prime, getting up very early to start the prime, as it takes almost 6 hours (and sometimes more!) to cook, since I cook on very low heat. That really helps the meat stay moist and tender. And the fried turkeys and the mushrooms!

Have a great week with your family and friends. Remember to take some time to catalog the probably long list of things you should be thankful for. High on my list will be you, whose gracious allocation of time and attention, two of the most valuable commodities in the world, makes my world even possible. I am truly grateful.

I finish this note after a long workout, trying to get ready for the Thursday marathon (although I have been told on good authority that calories do not count on Thanksgiving Day). The Beast has changed up the workout routine from lighter weights and many repetitions to “maxing out” the last few days. To my utter surprise, at the end of the workout I bench-pressed 205 pounds, 10 more than my previous max (which was 10 years ago). Who knew that 65 was such a good age for working out?

Your deep into the creativity of the kitchen analyst,

John Mauldin, Editor
Outside the Box

Stray Reflections (November 2014)

By Jawad Mian
Investment Observations
The precipitous decline in the price of oil is perhaps one of the most bearish macro developments this year. We believe we are entering a “new oil normal,” where oil prices stay lower for longer. While we highlighted the risk of a near-term decline in the oil price in our July newsletter, we failed to adjust our portfolio sufficiently to reflect such a scenario. This month we identify the major implications of our revised energy thesis.

The reason oil prices started sliding in June can be explained by record growth in US production, sputtering demand from Europe and China, and an unwind of the Middle East geopolitical risk premium. The world oil market, which consumes 92 million barrels a day, currently has one million barrels more than it needs. US pumped 8.97 million barrels a day by the end of October (the highest since 1985) thanks partly to increases in shale-oil output which accounts for 5 million barrels per day. Libya’s production has recovered from 200,000 barrels a day in April to 900,000 barrels a day, while war hasn’t stopped production in Iraq and output there has risen to an all-time high level of 3.3 million barrels per day. The IMF, meanwhile, has cut its projection for global growth in 2014 for the third time this year to 3.3%. Next year, it still expects growth to pick up again, but only slightly.

Everyone believes that the oil-price decline is temporary. It is assumed that once oil prices plummet, the process is much more likely to be self-stabilizing than destabilizing. As the theory goes, once demand drops, price follows, and leveraged high-cost producers shut production. Eventually, supply falls to match demand and price stabilizes. When demand recovers, so does price, and marginal production returns to meet rising demand. Prices then stabilize at a higher level as supply and demand become more balanced. It has been well-said that: “In theory, there is no difference between theory and practice. But, in practice, there is.” For the classic model to hold true in oil’s case, the market must correctly anticipate the equilibrating role of price in the presence of supply/demand imbalances.

By 2020, we see oil demand realistically rising to no more than 96 million barrels a day. North American oil consumption has been in a structural decline, whereas the European economy is expected to remain lacklustre. Risks to the Chinese economy are tilted to the downside and we find no reason to anticipate a positive growth surprise. This limits the potential for growth in oil demand and leads us to believe global oil prices will struggle to rebound to their previous levels. The International Energy Agency says we could soon hit “peak oil demand”, due to cheaper fuel alternatives, environmental concerns, and improving oil efficiency.

The oil market will remain well supplied, even at lower prices. We believe incremental oil demand through 2020 can be met with rising output in Libya, Iraq and Iran. We expect production in Libya to return to the level prior to the civil war, adding at least 600,000 barrels a day to world supply. Big investments in Iraq’s oil industry should pay-off too with production rising an extra 1.5-2 million barrels a day over the next five years. We also believe the American-Iranian détente is serious, and that sooner or later both parties will agree to terms and reach a definitive agreement. This will eventually lead to more oil supply coming to the market from Iran, further depressing prices in the “new oil normal”. Iranian oil production has fallen from 4 million barrels a day in 2008 to 2.8 million today, which we would expect to fully recover once international relations normalize. In sum, we see the potential for supply to increase by nearly 4 m illion barrels a day at the lowest marginal cost, which should be enough to offset output cuts from marginal players in a sluggish world economy.

Our analysis leads us to conclude that the price of oil is unlikely to average $100 again for the remaining decade. We will use an oil rebound to gradually adjust our portfolio to reflect this new reality.

From 1976 to 2000, oil consolidated in a wide price range between $12 and $40. We think the next five years will see a similar trading range develop in oil with prices oscillating between $55 and $85. If the US dollar embarks on a mega uptrend (not our central view), then we can even see oil sustain a drop below $60 eventually.

Source: Bloomberg

Normally, falling oil prices would be expected to boost global growth. Ed Morse of Citigroup estimates lower oil prices provide a stimulus of as much as $1.1 trillion to global economies by lowering the cost of fuels and other commodities. Per-capita oil consumption in the US is among the highest in the world so the fall in energy prices raises purchasing power compared to most other major economies.

The US consumer stands to benefit from cheaper heating oil and materially lower gasoline prices. It is estimated that the average household consumes 1,200 gallons of gasoline a year, which translates to annual savings of $120 for every 10-cent drop in the price of gasoline. According to Ethan Harris of Bank of America Merrill Lynch: “Consumers will likely respond quickly to the saving in energy costs. Many families live “hand to mouth”, spending whatever income is available. The Survey of Consumer Finances found that 47% of families had no savings in 20 13, up from 44% in the more healthy 2004 economy. Over time, energy costs have become a much bigger part of budgets for low income families. In 2012, families with income below $50,000 spent an average of 21.4% of their income on energy. This is almost double the share in 2001, and it is almost triple the share for families with income above $50,000.” The “new oil normal” will see a wealth transfer from Middle East sovereigns (savers) to leveraged US consumers (spenders).

The consumer windfall from lower oil prices is more than offset by the loss to oil producers in our view. Even though the price of oil has plummeted, the cost of finding it has certainly not. The oil industry has moved into a higher-cost paradigm and continues to spend significantly more money every year without any meaningful growth in total production. Global crude-only output seems to have plateaud in the mid-70 million barrels a day range. The production capacity of 75% of the world’s oilfields is declining by around 6% per year, so the industry requires up to 4 million barrels per day of new capacity just to hold production steady. This has proven to be very difficult. Analysts at consulting firm EY estimate that out of the 163 upstream megaprojects currently being bankrolled (worth a combined $1.1 trillion), a majority are over budget and behind schedule.

Large energy companies are sitting on a great deal of cash which cushions the blow from a weak pricing environment in the short-term. It is still important to keep in mind, however, that most big oil projects have been planned around the notion that oil would stay above $100, which no longer seems likely. The Economist reports that: “The industry is cutting back on some megaprojects, particularly those in the Arctic region, deepwater prospects and others that present technical challenges. Shell recently said it would again delay its Alaska exploration project, thanks to a combination of regulatory hurdles and technological challenges. The $10 billion Rosebank project in Britain’s North Sea, a joint venture between Chevron of the United States and OMV of Austria, is on hold and set to stay that way unless prices recover. And BP says it is “reviewing” its plans for Mad Dog Phase 2, a deepwater exploration projec t in the Gulf of Mexico.  Statoil’s vast Johan Castberg project in the Barents Sea is in limbo as the Norwegian firm and its partners try to rein in spiralling costs; Statoil is expected to cut up to 1,500 jobs this year. And then there is Kazakhstan’s giant Kashagan project, which thanks to huge cost overruns, lengthy delays and weak oil prices may not be viable for years.

Even before the latest fall in oil prices, Shell said its capital spending would be about 20% lower this year than last; Hess will spend about 15% less; and Exxon Mobil and Chevron are making cuts of 5-6%.”

About 1/3rd of the S&P500 capex is done by the energy sector. Based on analysis by Steven Kopits of Douglas-Westwood: “The vast majority of public oil and gas companies require oil prices of over $100 to achieve positive free cash flow under current capex and dividend programs. Nearly half of the industry needs more than $120. The 4th quartile, where most US E&Ps cluster, needs $130 or more.”

As energy companies have gotten used to Brent averaging $110 for the last three years, we believe management teams will be very slow to adjust to the “new oil normal”. They will start by cutting capital spending (the quickest and easiest decision to take), then divesting non-core assets (as access to cheap financing becomes more difficult), and eventually, be forced to take write-downs on assets and projects that are no longer feasible. The whole adjustment process could take two years or longer, and will accelerate only once CEOs stop thinking the price of oil is going to go back up. A similar phenomenon happened in North America’s natural gas market a couple of years ago.

This has vast implications for America’s shale industry. The past five years have seen the budding energy renaissance attract billions of dollars in fixed investment and generate tens of thousands of high-paying jobs. The success of shale has been a major tailwind for the US economy, and its output has been a significant contributor to the improvement in the trade deficit. We believe a sustained drop in the price of oil will slow US shale investment and production growth rates. As much as 50% of shale oil is uneconomic at current prices, and the big unknown factor is the amount of debt that has been incurred by cashflow negative companies to develop resources which will soon become unprofitable at much lower prices (or once their hedges run out). Energy bonds make up nearly 16% of the $1.3 trillion junk bond market and the total debt of the US independent E&P sector is estimated at over $200 billion.

Robert McNally, a White House adviser to former President George W. Bush and president of the Rapidan Group energy consultancy, told Reuters that Saudi Arabia "will accept a price decline necessary to sweat whatever supply cuts are needed to balance the market out of the US shale oil sector.” Even legendary oil man T. Boone Pickens believes Saudi Arabia is in a stand-off with US drillers and frackers to “see how the shale boys are going to stand up to a cheaper price.” This has happened once before. By the mid-1980’s, as oil output from Alaska’s North Slope and the North Sea came on line (combined production of around 5-6 million barrels a day), OPEC set off a price war to compete for market share. As a result, the price of oil sank from around $40 to just under $10 a barrel by 1986.

In the current cycle, though, prices will have to decline much further from current levels to curb new investment and discourage US production of shale oil. Most of the growth in shale is in lower-cost plays (Eagle Ford, Permian and the Bakken) and the breakeven point has been falling as productivity per well is improving and companies have refined their fracking techniques. The median North American shale development needs an oil price of $57 to breakeven today, compared to $70 last year according to research firm IHS

Source: WoodMackenzie, Barclays Research

While we don’t believe Saudi Arabia engineered the latest swoon in oil prices, it would be foolish not to expect them to take advantage of the new market reality. If we are entering a “new oil normal” where the oil price range may move structurally lower in the coming years, wouldn’t you want to maximise your profits today, when prices are still elevated? If, at the same time, you can drive out fringe production sources from the market, and tip the balance in MENA geopolitics (by hurting Russia and Iran), wouldn’t it be worth it? The Kingdom has a long history of using oil to meet political and economic ends.

We don’t see any signs of meaningful OPEC restraint at the group’s 166th meeting on November 27th in Vienna. The cartel has agreed to cut crude production only a handful of times in the past decade, with December 2008 being the most recent instance. Based on our assessment, the only members with enough flexibility to reduce oil output voluntarily are the United Arab Emirates, Kuwait and Saudi Arabia. OPEC countries have constructed their domestic policy based on the assumption that oil prices will remain perpetually high and most members are not in a strong enough financial position to take production offline. Once all the costs of subsidies and social programs are factored-in, most OPEC countries require oil above $100 to balance their budgets. This raises longer-run issues on the sustainability of the fiscal stance in a low-oil price environment. On the one hand, you have rising domestic oil consumption because there is no pri ce discipline, which leaves less oil for the lucrative export market, and on the other hand, you require more money now than ever before to support generous budgetary spending.

How will this be resolved?

And with a much slower rate of petrodollar accumulation, what will be the implication for global financial markets, given the non-negligible retraction in liquidity?

The current oil decline has potentially cost OPEC $250 billion of its recent earnings of $1 trillion. Thus, it is not surprising to see OPEC production – relative to its 30 million barrels a day quota – rising from virtual compliance to one where the cartel is producing above its agreed production allocation. Output rose to 30.974 million barrels per day in October, a 14-month high led by gains in Iraq, Saudi Arabia and Libya. So, it can be grasped that the lower the price of oil falls, the greater the need to compensate for lower revenues with higher production, which paradoxically pushes oil prices even lower.

We believe the “new oil normal” will alter relative economic and political fortunes of most countries, with income redistributing from oil exporters (GCC, Russia) to oil importers (India, Turkey). We therefore exited our long position in the WisdomTree Middle East Dividend Fund (GULF) at a 14.4% gain.

Those nations with abundant oil tend to suffer from the “resource curse”. With no other ready sources of income, the non-oil economy atrophies due to the extraordinary wealth produced by the oil sector. OPEC countries are some of the least diversified economies in the world.

In an article titled “When The Petrodollars Run Out”, economist Daniel Altman wrote for the Foreign Policy magazine as follows: “Twenty countries depend on petroleum for at least half of their government revenue, and another 10 are between half and a quarter. These countries are clearly vulnerable to big changes in the price and quantity of oil and gas that they might sell…So what can these countries do to bolster themselves for the future? For one thing, they might try to use their petroleum revenues to diversify their economies. Yet there's little precedent for that actually happening. In the three decades from 1983 to 2012, no country that ever got 20 percent of its GDP from oil and gas – according to the World Bank's figures – substantially reduced those resources' share of its economy. The shares typically rose and fell with prices; there were no long-term reductions.”

Source: Foreign Policy

Saudi Arabia appears to be comfortable with much lower oil prices for an extended period of time. The House of Saud is equipped with sufficient government assets to easily withstand three years at the current oil price by dipping into their $750 billion of net foreign assets. Saudi Arabia bolstered output by 100,000 barrels a day recently to 9.75 million, and cut its prices for Asian delivery for November – the fourth month in a row that it has cut official selling prices to shore up its global market share. With American imports from OPEC almost cut by half and given weak European demand, most oil-producing countries are now engaged in a price war in Asia. The Kingdom generates over 80% of its total revenue from oil sales so it may not remain immune in the “new oil normal” for long. According to HSBC research, Saudi Arabia would face a budget shortfall approaching 10% of GDP at $70 oil and at $50, the deficit could exceed 15% of GDP.

Russia and Saudi Arabia have opposing agendas in the Middle East. We believe Russia would like to see Middle East burn. This would shore up the cost of oil and keep America from geopolitically deleveraging from the region, thus allowing more room for Putin to outmaneuver his opponents in Europe. It was reported last year that the Saudis offered Russia a deal to carve up global oil and gas markets, but only if Russia stopped support of Syria’s Assad regime. No agreement was reached. It now seems the Saudis are turning to the oil market to affect an outcome.

With global energy prices at multi-year lows, Russia is facing a persistent low growth environment and an endemic outflow of capital. The $30 drop in the Brent price translates into an annual loss in crude oil revenues of over $100 billion. According to Lubomir Mitov, Russia’s financing gap has reached 3% of GDP, and they have to repay $150 billion in principal to foreign creditors over the next 12 months. Even with $400 billion in foreign currency reserves and the Russian central bank raising its official interest rate by 150 basis points to 9.5% last month, the ruble is down 38% from its June high making foreign liabilities a lot more onerous. As per Faisal Islam, political editor of Sky News, “financial markets have punished Russia far quicker than Western governments.”

“It took two years for crumbling oil prices to bring the Soviet Union to its knees in the mid-1980s, and another two years of stagnation to break the Bolshevik empire altogether…” writes Ambrose Evans-Pritchard in The Daily Telegraph. “…Russian ex-premier Yegor Gaidar famously dated the moment to September 1985, when Saudi Arabia stopped trying to defend the crude market, cranking up output instead.” It is estimated the Soviet Union lost $20 billion per year, money without which the country simply could not survive.

Could we see a repeat of events?

In the past, higher resource prices increased the occasions for military conflicts as nations would scramble to secure necessary supplies. Going forward, however, we firmly believe lower oil prices pose a greater risk of escalating current geopolitical challenges.

Putin is a determined and ambitious leader who wants to expand Russia’s power and influence. Since he rose to dominance in 1999, he advocated development of Russia’s resource sector to resurrect Russian wealth. In his doctoral thesis, he equated economic strength with geopolitical influence. Today, Russia needs an oil price in excess of $100 a barrel to support the state and preserve its national security. Consequently, there is no question Putin will try to resist lower oil prices either through outright warfare or more covert economic sabotage.

Russia is the world’s 8th-largest economy, but its military spending trails only the US and China. Putin increased the military budget 31% from 2008 to 2013, overtaking UK and Saudi Arabia, as reported by the International Institute of Strategic Studies. Russia also has plans to become the world’s largest arms exporter by more than tripling military exports by 2020 to $50 billion annually. We are convinced Putin would like to see a bull-market in international tensions. This is the biggest threat to our “new oil normal” theme.

Source: Cagle Cartoons

Turkey is a big beneficiary of lower oil prices, which provides much needed relief to the large current account deficit. As external imbalances correct and the inflation outlook gradually improves, we expect a significant shift in sentiment towards the country. Turkish stocks should do reasonably well going forward and we aim to buy the iShares MSCI Turkey ETF (TUR) on additional weakness. In our opinion, India will also continue to outperform many of its emerging market peers. Medium-term growth prospects have strenghtened due to credibility of policymakers and external windfalls from lower oil and gold prices. We will initiate a position in Indian equities once the election exuberance dissipates. The market is up 23% since Modi’s win.

Solar stocks have fallen 18% since oil peaked in June. It is assumed the fall in oil spells terrible news for the development of alternative energy sources, especially solar. We don’t agree with this conclusion as we see the world moving toward a more sustainable economy. We expect solar to gradually become more mainstream and less sensitive to fluctuations in the oil price. According to a Deutsche Bank research report, solar electricity may be as cheap or cheaper than average electricity-bill prices in 47 US states by 2016. Even if the tax credit drops to 10% (if Congress allows the federal tax credit for rooftop solar systems to expire at the end of 2016), solar will soon reach price parity with conventional electricity in well over half the nation. Solar has already reached grid parity in 10 states which are responsible for 90% of US solar electricity production. We own the Guggenheim Solar ETF (TAN) as a strategic long-term holding.

According to Nordea Research, markets are pricing in a 40% chance for an interest rate cut at the Norges Bank meeting in December. This has pushed the Norwegian kroner (NOK) nearly 7% weaker than the Norges Bank’s forecast for June of next year. We think markets have gone too far with an overreaction in NOK because of the Brent decline. The oil-sensitive Norwegian economy remains relatively more competitive with an average cash cost of $43 a barrel across the whole industry. We sold our NOK/SEK position for a 6.9% profit earlier and plan on re-buying the pair from lower levels. The cross-rate is the cheapest in two decades on a PPP basis and Sweden’s Riksbank cut its key interest rate to zero in October as it battles deflation.

In terms of other opportunities, we are also long the Mexican peso (MXN) versus the Colombian peso (COP). Mexico’s oil exports as a percent of GDP are 4% versus 8.5% in the case of Colombia. Our position is up 4.7% so far.

Jean-Claude Juncker's €315bn New Deal dismissed as a subprime gimmick

'It's unbelievable. The private sector will take governments to the cleaners,' said Professor Charles Wyplosz

By Ambrose Evans-Pritchard, International Business Editor

6:21PM GMT 25 Nov 2014

President of the Eurogroup, Luxembourg's Prime Minister Jean-Claude Juncker during a news conference at the end of an European Euro group Finance Ministers meeting at the European council headquarters in Brussels, Belgium, 16 November 2010

Jean-Claude Juncker knows that failure to kick-start a durable recovery at long last would be courting fate Photo: EPA
The European Commission has launched a €315bn “New Deal” to pull Europe out of its economic slump over the next three years, but will provide almost no new money of its own and is relying on subprime forms of financial engineering. 
The shopping list of investments and infrastructure projects will take months to sift through, and the stimulus will not reach meaningful scale until 2016. The scheme has already run into a blizzard of criticism. It depends on leverage that increases the headline figure by 15 times, leaving EU taxpayers bearing the heaviest risk while private investors are shielded from losses.
Jean-Claude Juncker, the Commision’s embattled new president, has made the plan the centrepiece of his “last chance” drive to restore popular faith in the EU project, but it risks becoming an emblem of paralysis and failure instead.
“The money is chicken feed and it won’t do anything to kick-start growth,” said Professor Charles Wyplosz, from Geneva University. “It is unbelievable they are doing this rather than real fiscal expansion. The private sector will just take governments to the cleaners.
“This is really an excuse to pretend they are they doing something while the austerity is still going on. It will take too long to work and there will be a big fight over the projects as every country tries to get a share of the cake.”

The EU’s "College" of commissioners agreed to the plan on Tuesday in Strasbourg. It will be known as the European Fund for Strategic Investment (EFSI). Further details will not be released until Wednesday but officials say privately that the package will be based on €21bn of EU money that will in theory lever almost €300bn of venture capital and private funds in a complex chemistry.
These will be used to build roads, renew railways, refine energy grids or upgrade high-speed internet, if the scheme goes according to plan. It requires the assent of EU leaders, and legislation next year. Like much of the macro-economic stimulus provided by the EU institutions, it is a fond hope rather than a hard commitment.

The projects are “higher risk” ventures that have been shunned by the European Investment Fund, jealous of its AAA rating. This places the issue of taxpayer risk squarely on the table. Governments have already sent a list of 1,800 possible projects to Brussels. These will be screened by a panel of independent experts. There will, in principle, be no national quotas.
The EU funds will mostly come from gutting the Commission’s research directorate and other parts of the existing EU budget, with €5bn in guarantees from the European Investment Bank (EIB).

Werner Hoyer, the EIB’s chief, sought to play down what he called “exuberant” expectations.
The EU bodies will suffer the “first loss” if any project defaults, a device all too like the structured finance used in the heyday of the pre-Lehman boom, when Dublin became a hub for “special investment vehicles” (SIVs) that disguised the concentration of risk. The plans entail a de facto subsidy, but of a contentious kind. Critics call it “socialised loss, private gain”.
Charles Grant, director of the pro-EU Centre for European Reform, said Mr Juncker’s valiant efforts to do something substantive have been scuppered by powerful opponents. “It is yet another sad moment in the history of mismanagement in Europe. The Germans don’t believe in the scheme and they don’t want to provide any new money for it. They simply don’t get how bad things are in Europe,” he said. Britain has also opposed a full-scale spending spree.
Markus Ferber, finance spokesman for the German Social Christians (CSU), said the plan was fundamentally misguided. “The idea of a loss-liability means the EU member states are taking on new debt,” he said.
France’s economy minister, Emmanuel Macron, said the scheme needs “at least €60bn to €80bn of fresh money” to gain traction. Paris proposed use of the EU bailout fund (ESM) to raise finance for a much bigger spending blitz. This was blocked by Berlin, ever wary of eurobonds or fiscal union by the back door.
Mario Draghi, the head of the European Central Bank, has been pleading for EU fiscal authorities to launch a recovery package, warning that monetary stimulus cannot do the job alone. Yet it is far from clear whether this EFSI plan will move the macro-economic dial.
Mr Juncker’s hands have been tied from the start. Germany, Britain and other northern states have capped EU spending near €140bn a year until 2020, forcing Brussels to resort to shadow finance.
He has been attacked by the Right for doing too much, and by the Left for doing too little. The risk is that the EFSI degenerates into a fiasco, further damaging his viability as he seeks to weather the “LuxLeaks” scandal linking Luxembourg to tax avoidance schemes on a grand scale when he was prime minister. The allegations may be unfair - since other EU states deploy such tax schemes to lure companies - but they have poisoned his relationship with the EU’s socialist bloc.
The eurozone has been in an economic depression for six years, suffering a deeper contraction than in the comparable period from 1929 to 1935. Mr Juncker knows that failure to kick-start a durable recovery at long last would be courting fate. “Either we manage to dramatically reduce unemployment, or we fail,” he said.

Sustainable Development Economics
Jeffrey D. Sachs
NOV 25, 2014

 Fields and Power Lines

PARIS – Two schools of thought tend to dominate today’s economic debates. According to free-market economists, governments should cut taxes, reduce regulations, reform labor laws, and then get out of the way to let consumers consume and producers create jobs. According to Keynesian economics, governments should boost total demand through quantitative easing and fiscal stimulus.
Yet neither approach is delivering good results. We need a new Sustainable Development Economics, with governments promoting new types of investments.
Free-market economics leads to great outcomes for the rich, but pretty miserable outcomes for everyone else. Governments in the United States and parts of Europe are cutting back on social spending, job creation, infrastructure investment, and job training because the rich bosses who pay for politicians’ election campaigns are doing very well for themselves, even as the societies around them are crumbling.
Yet Keynesian solutions – easy money and large budget deficits – have also fallen far short of their promised results. Many governments tried stimulus spending after the 2008 financial crisis. After all, most politicians love to spend money they don’t have. Yet the short-term boost failed in two big ways.
First, governments’ debt soared and their credit ratings plummeted. Even the US lost its AAA standing. Second, the private sector did not respond by increasing business investment and hiring enough new workers. Instead, companies hoarded vast cash reserves, mainly in tax-free offshore accounts.
The problem with both free-market and Keynesian economics is that they misunderstand the nature of modern investment. Both schools believe that investment is led by the private sector, either because taxes and regulations are low (in the free-market model) or because aggregate demand is high (in the Keynesian model).
Yet private-sector investment today depends on investment by the public sector. Our age is defined by this complementarity. Unless the public sector invests, and invests wisely, the private sector will continue to hoard its funds or return them to shareholders in the forms of dividends or buybacks.
The key is to reflect on six kinds of capital goods: business capital, infrastructure, human capital, intellectual capital, natural capital, and social capital. All of these are productive, but each has a distinctive role.
Business capital includes private companies’ factories, machines, transport equipment, and information systems. Infrastructure includes roads, railways, power and water systems, fiber optics, pipelines, and airports and seaports. Human capital is the education, skills, and health of the workforce. Intellectual capital includes society’s core scientific and technological know-how. Natural capital is the ecosystems and primary resources that support agriculture, health, and cities. And social capital is the communal trust that makes efficient trade, finance, and governance possible.
These six forms of capital work in a complementary way. Business investment without infrastructure and human capital cannot be profitable. Nor can financial markets work if social capital (trust) is depleted. Without natural capital (including a safe climate, productive soils, available water, and protection against flooding), the other kinds of capital are easily lost. And without universal access to public investments in human capital, societies will succumb to extreme inequalities of income and wealth.
Investment used to be a far simpler matter. The key to development was basic education, a network of roads and power, a functioning port, and access to world markets. Today, however, basic public education is no longer enough; workers need highly specialized skills that come through vocational training, advanced degrees, and apprenticeship programs that combine public and private funding.
Transport must be smarter than mere government road building; power grids must reflect the urgent need for low-carbon electricity; and governments everywhere must invest in new kinds of intellectual capital to solve unprecedented problems of public health, climate change, environmental degradation, information systems management, and more.
Yet in most countries, governments are not leading, guiding, or even sharing in the investment process. They are cutting back. Free-market ideologues claim that governments are incapable of productive investment. Nor do Keynesians think through the kinds of public investments that are needed; for them, spending is spending. The result is a public-sector vacuum and a dearth of public investments, which in turn holds back necessary private-sector investment.
Governments, in short, need long-term investment strategies and ways to pay for them. They need to understand much better how to prioritize road, rail, power, and port investments; how to make investments environmentally sustainable by moving to a low-carbon energy system; how to train young workers for decent jobs, not only low-wage service-sector employment; and how to build social capital, in an age when there is little trust and considerable corruption.
In short, governments need to learn to think ahead. This, too, runs counter to the economic mainstream. Free-market ideologues don’t want governments to think at all; and Keynesians want governments to think only about the short run, because they take to an extreme John Maynard Keynes’ famous quip, “In the long run we are all dead.”
Here’s a thought that is anathema in Washington, DC, but worthy of reflection. The world’s fastest growing economy, China, relies on five-year plans for public investment, which is managed by the National Development and Reform Commission. The US has no such institution, or indeed any agency that looks systematically at public-investment strategies. But all countries now need more than five-year plans; they need 20-year, generation-long strategies to build the skills, infrastructure, and low-carbon economy of the twenty-first century.
The G-20 recently took a small step in the right direction, by placing new emphasis on increased infrastructure investment as a shared responsibility of both the public and private sectors. We need much more of this kind of thinking in the year ahead, as governments negotiate new global agreements on financing for sustainable development (in Addis Ababa in July 2015); Sustainable Development Goals (at the United Nations in September 2015), and climate change (in Paris in December 2015).
These agreements promise to shape humanity’s future for the better. If they are to succeed, the new Age of Sustainable Development should give rise to a new Economics of Sustainable Development as well.


Nostalgia for Gold Pressures Central Banks in Europe

Swiss Vote Sunday Could Force SNB to Raise Holdings of Precious Metal

By Brian Blackstone And Jon Hilsenrath

Nov. 27, 2014 4:53 p.m. ET

The 2008 financial crisis and its aftermath have revived interest in a monetary policy instrument of a bygone era: gold.

This trend is especially pronounced in Europe, where central banks face public pressure to buy more gold or bring back home what they hold in vaults overseas.

Gold hasn’t played a significant role in global monetary policy for decades and central bankers hope it stays that way, even though some have used gold’s symbolic allure to try building trust with citizens frustrated by years of easy-money policies.

The Swiss National Bank could be forced to more than double its gold assets, and be banned from selling them, if the Alpine country’s voters on Sunday back a populist initiative the central bank vigorously opposes.

The “Save Our Swiss Gold” campaign would require the SNB to hold a fifth of its assets in gold within five years. It would also prohibit it from selling its gold and require that Swiss gold held overseas be repatriated.

Although polls suggest the initiative will fail, the referendum symbolizes the nostalgia for gold in some corners at a time when many European economies face stagnation and too-low inflation. Their central banks have responded with controversial measures loading their balance sheets with financial assets that critics, particularly in Germany but also in Switzerland, see as too risky.

Germany’s central bank made a public-relations splash with its decision last year to return home some of the country’s gold from vaults in the U.S. and Paris, which followed a campaign led by the mass-circulation Bild-Zeitung called “Bring Our Gold Back Home.”

The Bundesbank says its decision was made autonomously. Still, it has displayed gold bars to photographers and TV crews and included an exhibition of its gold at a summer festival.

The Bundesbank hasn’t conducted its own monetary policy since the 1990s when Germany joined the euro, which is governed by the European Central Bank. Bundesbank President Jens Weidmann sits on the ECB’s policy committee and has opposed many of the bank’s economic stimulus measures.

The Dutch central bank, which is also part of the ECB, followed suit recently by announcing it would repatriate gold from the U.S., even though its president said in 2012 he saw no need to do so and the gold was “absolutely safe in Manhattan.” The decision to bring some back to Dutch soil could “have a positive effect on public confidence,” the bank said last week.

“This is part of the allure for gold. Frequently it has been the asset that reflected power and might,” said Joshua Aizenman, a professor at University of Southern California. However, “if you look at pure economic return on gold it’s definitely not a conservative asset.”

Gold’s more recent volatile swings—at $1,195 an ounce Wednesday, gold was down 37% from its August 2011 peak—betray the idea that it is a stable asset. These swings have forced the ECB and SNB, at times, to mark down the value of their holdings. In the SNB’s case, it led to a $10 billion loss in 2013, forcing it to cancel dividends for the first time in more than a century.

The populist Swiss initiative “is both unnecessary and dangerous,” SNB Chairman Thomas Jordan said Sunday. “It is unnecessary because, under the current monetary order, there is no link between price stability and the share of gold in the SNB balance sheet.”

Former Federal Reserve Chairman Ben Bernanke has made similar arguments. “A lot of people hold gold as an inflation hedge, but movements of gold prices don’t predict inflation very well actually,” he said during an exchange with lawmakers in 2013. “Nobody really understands gold prices, and I don’t pretend to understand them either.”

Authorities in the U.S. and Europe experimented with varying versions of gold and silver monetary standards through much of the 19th century, imposing rules and order on the printing of paper currencies. But these standards also coincided with periods of large economic and financial volatility; financial booms and busts were common during the 1800s, in part as the physical production of gold from mining activities waxed and waned, leading to sharp expansions and contractions in bank lending.

Gold standards broke down across the developed world in the 20th century. Central banks—battling deflations, inflations, recession and war—sought flexibility to manage their own money supplies amid economic and social turmoil.

“The strength of a gold standard is its greatest weakness,” Mr. Bernanke said in 2012. “Because the money supply is determined by the supply of gold, it cannot be adjusted in response to changing economic conditions.”

Unlike many other central banks, the Fed doesn’t own gold. Among the changes imposed during the Great Depression, the Gold Reserve Act of 1934 required the Fed to transfer ownership of all of its gold to the Treasury Department.

The idea of a return to a gold standard still attracts a small but passionate following in some corners of Wall Street and Washington, but has tended to lack broad appeal among Americans.

—Neil MacLucas in Zurich and Maarten Van Tartwijk in Amsterdam contributed to this article.

Sun sets on Opec dominance in new era of lower oil prices

Flood of new oil supply coming onstream from outside Opec and weakening demand makes the group's role in energy markets less relevant, writes Andrew Critchlow

By Andrew Critchlow, Commodities editor

1:00PM GMT 22 Nov 2014

A worker of Gujarat State Petroleum Corporation checks oil flow of well PK-2 during its inauguration at Ingoli village, about 40 kilometers (25 miles) southwest of Ahmadabad, India

For how long can Opec keep on pumping? Photo: AP
It wouldn’t be the first time that a meeting of the Organisation of Petroleum Exporting Countries (Opec) has taken place in an atmosphere of deep division, bordering on outright hatred. In 1976, Saudi Arabia’s former oil minister Ahmed Zaki Yamani stormed out of the Opec gathering early when other members of the cartel wouldn’t agree to the wishes of his new master, King Khaled.

The 166th meeting of the group in Vienna next week is looking like it could end in a similarly acrimonious fashion with Saudi Arabia and several other members at loggerheads over what to do about falling oil prices.
Whatever action Opec agrees to take next week to halt the sharp decline in the value of crude, experts agree that one thing is clear: the world is entering into an era of lower oil prices that the group is almost powerless to change.
This new energy paradigm may result in oil trading at much lower levels than the $100 (£64) per barrel that consumers have grown used to paying over the last decade and reshape the entire global economy.
It could also trigger the eventual break-up of Opec, the group of mainly Middle East producers, which due to its control of 60pc of the world’s petroleum reserves has often been accused of acting like a cartel.

Even worse, some experts warn that a prolonged period of lower oil prices could reshape the entire political map of the Middle East, triggering a new wave of political uprisings in petrodollar sheikhdoms in the Persian Gulf, which depend on the income from crude to underwrite their high levels of public spending and support less wealthy client states in the Arab world.
“We are now entering a new era in world oil and we will have lower prices for some time to come,” says Daniel Yergin, the Pulitzer prize-winning author of The Quest: Energy Security and the Remaking of the Modern World. “Oil was really the last commodity in the super-cycle to remain standing.”

Mr Yergin spoke exclusively to The Sunday Telegraph ahead of what is being called the most important gathering of Opec in more than 20 years.
As oil ministers from its 12 member states prepare to fly into Vienna this week they face their biggest challenge since the depths of the financial crisis at the beginning of 2009, as bearish sentiment and oversupply grips the market. Brent crude prices have fallen by almost 30pc since reaching their high point for the year of $115 per barrel in June.

“The oil market is being redefined by two factors. Firstly, the astonishing growth in US oil production, which is real and dynamic. Secondly, the realisation that the world economy is much weaker that was previously expected so demand is being squeezed,” says Mr Yergin, who also sits on the US Secretary of Energy Advisory Board.
The fall in prices comes at a time when Opec’s domination of the world oil market is being challenged seriously for the first time in more than 30 years by the unexpected and sudden resurgence of the US as a major producer. By 2020, Citigroup estimates that America will be pumping more than 14m barrels per day (bpd) of oil and petroleum liquids, giving it the capacity to export almost 5m bpd, which will transform the energy markets.

Lifting the ban on US crude oil exports, which first came into force in the 1970s to ensure energy security, is becoming an evermore likely move by Washington as it seeks to apply pressure on Russia’s President Vladimir Putin to back down over Ukraine. According to the energy advisers IHS, such a move would further stimulate growth in domestic production and cut America’s existing import bill by $67bn, a figure not far from Britain’s total expenditure on defence.
“They recognise that the threat from North American supply is a challenge to Opec today just like the North Sea was in the 1980s,” said Mr Yergin. “Opec is going to have a very hard time adjusting to this because there isn’t agreement within the group on what to do. Everyone is happy for Saudi Arabia to cut production but the Saudis don’t want to cut and lose more market share, especially to Iran and Iraq.”

Opec nations are producing about 200,000 bpd more than their agreed quota of 30m bpd, while demand for the group’s oil is expected to fall as low as 29.2m bpd next year, as more North American supply becomes available. To balance supply with demand would suggest that Opec will have to agree on cutting up to 1m bpd from its members’ production and the responsibility for delivering this will fall mainly to Saudi Arabia.
The kingdom is the world’s biggest and cheapest exporter and because of its ability to immediately pump up to 12.5m bpd is viewed as the “swing” producer within Opec and the world. If the group is to agree cuts, that will mean Riyadh will have to make the biggest contribution to the overall reductions and surrender more market share to its rivals within the group such as Iran and Iraq.
Opec owes its existence to a period of great economic and political upheaval in the 1960s, when demand for crude oil began to surge from rapidly growing industrialised economies and producing countries in the Middle East started to emerge as newly independent states.
Created in Baghdad by five original members including Saudi, Iraq and Venezuela, the organisation offered the first real counterbalance to the so-called “seven sisters” of international oil companies such as Shell and BP, which had dominated global supply up to that time.
The group normally meets a few times every year at its headquarters in Vienna unless an “extraordinary” meeting is called for in response to events such as the Arab Spring in 2010, or the financial crisis. Some members urged such an emergency gathering in response to the current sharp drop in prices but appeals for deep cuts to production have so far been resisted by Saudi Arabia’s oil minister, Ali al-Naimi.
Saudi Arabia is the undisputed dominant force within the group, but its power is increasingly being challenged by an axis of Iran and Iraq. Since the downfall of Saddam Hussein and the exit of a major US military presence in the country, Baghdad has moved closer politically to its Shiite Muslim neighbour Iran. The country holds vast oil reserves and has plans to produce up to 9m bpd by the end of the decade, despite the threat posed by Islamic State militants in its northern provinces.
Iran, Saudi Arabia’s natural enemy in the Gulf, even before the downfall of the Shah in 1979, could also be in a position to boost its capacity significantly, if the West lifts nuclear sanctions restricting international investment in its energy sector.
Both countries need prices to remain high given the weakness of their wider economies and lack of foreign currency reserves, making it likely that they will push for a big cut in Opec production next week.
Iran’s influential oil minister Bijan Zanganeh has already called for emergency bilateral talks with Saudi Arabia in Vienna to discuss the thorny issue of how to accommodate an expected increase in production from the Islamic state.
Last week Mr Zanganeh said: “The countries in the south of the Persian Gulf are interested in keeping their market share and a decrease in market share will be difficult.”

Then there are the non-aligned countries, including Venezuela, Nigeria and Angola. These states account for a combined 6.6m bpd of Opec supply and all hold ambitious plans to boost production. Like Iran and Iraq, they are thought collectively to be pushing for deep cuts to Opec’s quota to restore oil prices back to $100 per barrel, a level required to maintain their economies.
However, Saudi Arabia and its Arab allies in the Persian Gulf appear reluctant to acquiesce to these demands. With relatively small populations and vast oil reserves these producers, which form the core of the Gulf Co-operation Council (GCC), are largely dependent on Western support for their security in an inherently unstable region.
This dependency has recently been demonstrated by the need to rely on the US and the UK to launch air strikes against the Islamic State in Iraq, amid fears that the terrorist group could also destabilise these oil-rich Gulf monarchies if allowed to spread its jihad throughout the wider Middle East.
In this context, Saudi and its allies may be more willing to allow oil prices to fall to levels around $70 per barrel to help appease the US by applying economic pressure on Russia, which also depends on crude sales for much of its foreign currency revenue.
However, these states – which account for about a fifth of the world’s oil supply combined – are also in danger of losing a greater share of the market to US shale production. That threat could be partly nullified by lower prices, which according to Deutsche Bank research would see almost 40pc of US shale oil wells become unprofitable if Brent continued to trade at its currently depressed levels for a prolonged period of time.
However, with break-even prices estimated in the range upwards of $80 per barrel in order to finance their economies these Gulf states, which include the United Arab Emirates (UAE), Qatar and Kuwait, may be reluctant to see prices remain below $100 per barrel for too long. The problem for policymakers in these countries is that Opec’s ability to influence prices has been fundamentally weakened by the rapid growth of supply outside the Middle East.
Opec has seen its share of the market fall from around half 20 years ago to just under a third today, with production from outside the group expected to exceed 63m bpd next year. The need to redress this decline makes the necessity for Opec’s biggest producers such as Saudi Arabia to cut production even more unpalatable and could signal the beginning of the end of the cartel’s global influence.
“The only thing that really unites Opec members now is that they all produce oil but if the price keeps going down then the pressure will build for some kind of action,” said Mr Yergin.
Lower oil prices will also pull at the political fabric holding together many of Opec’s members, especially in the war-torn Middle East. Persian Gulf sheikhdoms have pumped billions of pounds into supporting neighbouring Arab states whose old regimes were torn apart by the popular uprisings, which started as bread riots in Tunisia in 2010.
Saudi Arabia and the UAE have agreed to pump an additional $20bn into supporting the government of ex-Field Marshal Abdulfattah el-Sisi in Cairo, while continuing to support factions in the campaign to oust the regime of Bashar al-Assad in Syria. Falling oil prices will seriously challenge their ability to co-opt neighbouring states and undermine their own domestic economic models, which are dependent on revenue from petroleum exports.
“Riyadh has miscalculated,” says Christopher Davidson, a reader in Middle East politics at Durham University and author of After the Sheikhs: The Coming Collapse of the Gulf Monarchies.
“The Arab Spring never really ended, it was just put off. Certain regimes have been trying to keep those political forces at bay with oil so the current fall in the price will weaken the power of these governments substantially.”

Whatever action Opec takes on November 27, it is clear that its once staggering power over the global economy has been considerably weakened as a new era of lower oil prices beckons.


The Unsettling Mystery of Productivity

Since 2010 U.S. productivity has grown at a miserable rate. And no one, not even the Fed, seems to understand why.

By Alan S. Blinder

Nov. 24, 2014 6:50 p.m. ET

A cottage industry on Wall Street tries to forecast the Federal Reserve’s policy decisions. The Fed, in turn, bases its policy on how it thinks the economy will perform. The cottage industry, of course, knows that; so it is constantly engaged in forecasting the economy.

Attention nowadays is focused on the degree of slack in the U.S. labor market. The financial news is full of stories about payroll employment, the unemployment rate, labor-force participation rates, quits, initial claims for unemployment insurance, and the like. Fed staffers devote thousands of hours to combing the data for hints about how tight or loose the labor market is or might become. Investors devote millions of hours to divining what Fed Chair Janet Yellen and her colleagues think about these matters.

Meanwhile, another variable that is just as important to the forecast is being almost completely ignored. I refer to labor productivity.

Just as important? Yes, because the Fed wants to forecast the so-called GDP gap—that is, the difference between actual and potential gross domestic product. Potential GDP, in turn, depends on the number of hours of work the economy would have at full employment, which is what all the fuss is about. But it also depends on the future track of output per hour of work (labor productivity). The Fed and the markets could err in forecasting potential GDP either by getting the availability of labor wrong or by getting productivity wrong.

Yet oddly, while enormous amounts of research, energy and chatter are poured into analyzing and forecasting the labor market, hardly anyone is talking about productivity—though that may be the greater source of uncertainty.

The nearby chart displays average annual growth rates of output per hour in the U.S. over five historical periods. The left-most bar summarizes the entire available history: Over 143 years, the U.S. has averaged about 2.3% annual gains in productivity. (If you’re counting, that raised living standards more than 25-fold.) Moving rightward, we encounter the Golden Age of productivity growth, the quarter-century following demobilization from World War II, during which the U.S. averaged 2.8% per annum—probably our best performance ever for a sustained period.

Then, quite surprisingly and still somewhat mysteriously, productivity growth plummeted in the years 1973-95. The 1.4% annual average shown in the middle bar was the worst in recent history.

Fortunately, we were surprised again—this time, pleasantly—when, in the 15 years starting in 1995, productivity growth leapt back up to a rate almost as high as during the Golden Age.

You have probably noticed the puny bar at the far right, which covers only three years. That is far too short a time period to draw any conclusions. (Adding 2014, which is not over yet, will not change the picture.) But so far in this decade, productivity has grown at only half its rate during the productivity slowdown period—our previous standard of poor performance.

No one should mechanically extrapolate the recent miserable performance into the future. There is no statistical basis for doing so. My point is that, as we look out one to three years into the future—the time frame most relevant for the Fed—no one has the slightest idea how fast productivity will grow.
Over the next decade or so, we can be reasonably confident that, within a small margin of error, potential GDP will advance roughly 0.2 points faster than nonfarm labor productivity (the variable shown in the chart). So if the U.S. reverts to its 2.3% historical average, potential GDP will grow about 2.5% per annum. That could happen. But if productivity crawls along at just 0.7% a year instead, potential GDP will grow less than 1% a year. Now that’s a large potential forecasting error!

By comparison, the current debate between hawks and doves features arguments over small beer. For example, the “central tendencies” in the Federal Open Market Committee’s latest published forecasts range from 5.2% to 5.5% for the “full-employment” unemployment rate, and from 2% to 2.3% for the potential GDP trend.

In sum, here’s what we know—and do not know—about productivity growth. First, it’s been dismal for the past four years. Second, economists cannot predict swings in productivity growth. Each sharp swing shown in the chart took us by surprise. Third, while the Fed is now forecasting something near 2% productivity growth over the next several years, it really has little basis for choosing that number.

That’s not a criticism; no one else has a better basis for a different number. We are all in the dark.

So maybe some of the copious attention now being devoted to assessing labor-market slack should be redeployed to studying productivity growth. It might be more productive.

Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of “After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead” (Penguin, 2013).

11/24/2014 07:00 PM

Summit of Failure

How the EU Lost Russia over Ukraine


Photo Gallery: Ukraine's Road to War

 One year ago, negotations over a Ukraine association agreement with the European Union collapsed. The result has been a standoff with Russia and war in the Donbass. It was an historical failure, and one that German Chancellor Angela Merkel contributed to.

Only six meters separated German Chancellor Angela Merkel and Ukrainian President Viktor Yanukovych as they sat across from each other in the festively adorned knight's hall of the former Palace of the Grand Dukes of Lithuania. In truth, though, they were worlds apart.

Yanukovych had just spoken. In meandering sentences, he tried to explain why the European Union's Eastern Partnership Summit in Vilnius was more useful than it might have appeared at that moment, why it made sense to continue negotiating and how he would remain engaged in efforts towards a common future, just as he had previously been. "We need several billion euros in aid very quickly," Yanukovych said.

Then the chancellor wanted to have her say. Merkel peered into the circle of the 28 leaders of EU member states who had gathered in Vilnius that evening. What followed was a sentence dripping with disapproval and cool sarcasm aimed directly at the Ukrainian president. "I feel like I'm at a wedding where the groom has suddenly issued new, last minute stipulations."

The EU and Ukraine had spent years negotiating an association agreement. They had signed letters of intent, obtained agreement from cabinets and parliaments, completed countless diplomatic visits and exchanged objections. But in the end, on the evening of Nov. 28, 2014 in the old palace in Vilnius, it became clear that it had all been a wasted effort. It was an historical earthquake.

Everyone came to realize that efforts to deepen Ukraine's ties with the EU had failed. But no one at the time was fully aware of the consequences the failure would have: that it would lead to one of the world's biggest crises since the end of the Cold War; that it would result in the redrawing of European borders; and that it would bring the Continent to the brink of war. It was the moment Europe lost Russia.

For Ukraine, the failure in Vilnius resulted in disaster. Since its independence in 1991, Ukraine has strived to orient itself towards the EU while at the same time taking pains to ensure that those actions don't damage its relations with Moscow. The choice between West and East, which both Brussels and Moscow have forced Kiev to make, has had devastating consequences for the fragile country.

But the impact of that fateful evening in Vilnius goes far beyond Ukraine's borders. Some 25 years after the fall of the Berlin Wall and almost 70 years after the end of World War II, Europe is once again divided. The estrangement between the Russians and the Europeans is growing with Moscow and the West more inimical toward each other today than during the final phase of the Cold War. It's a reality that many in Europe have long sought to ignore.

The story of the run-up to Vilnius is one filled with errors in judgment, misunderstandings, failures and blind spots. It is a chronicle of foreign policy failure foretold -- on all sides. Russia underestimated the will of Ukrainians to steer their country toward the EU and was overly confident in its use of its political power over Kiev as a leverage.

For its part, the EU had negotiated a nearly 1,000-page treaty, but officials in Brussels hadn't paid close enough attention to the realities of those power politics. Even in Berlin, officials for too long didn't take Russian concerns -- about the encroachment of NATO and the EU into Eastern Europe -- seriously enough. The idea that Moscow might be prepared to use force to prevent a further expansion of the Western sphere of influence didn't seem to register with anyone.

With the special role it plays and the special responsibility it has for Europe, the meltdown also represented a failure for Germany. Foreign policy has long been considered one of Chancellor Angela Merkel's greatest strengths, but even she ignored the warning signs. Merkel has proven herself over the years to be a deft mediator who can defuse tensions or work out concrete solutions. But crisis management alone is not enough for good foreign policy. Missing in this crisis was a wider view and the ability to recognize a conflict taking shape on the horizon. Instead, officials in Berlin seemed to believe that because nobody wanted conflict, it wouldn't materialize.

Merkel did say at the summit that, "The EU and Germany have to talk to Russia. The Cold War is over." But the insight came too late.

Kiev, The Presidential Palace Feb. 25, 2010

Viktor Yanukovych was sworn in as president of Ukraine on Feb. 25, 2010 by the Verkhovna Rada, the country's national parliament. The first guests he would receive as president were chief European Union diplomat Catherine Ashton and European Commissioner for Enlargement and European Neighborhood Policy Stefan Füle.

Was it a sign?

During his inaugural address, Yanukovych had rejected the clear Western orientation of his predecessor Viktor Yushchenko. Instead, he said Ukraine should become a "bridge" between the East and West. He envisioned Ukraine's future as a "European bloc-free state."

But not long later, he found himself sitting together with Ashton and Füle inside Mariyinsky Palace in Kiev, the official presidential residence. The two had brought a piece of paper with them, which they used to present what they called the "matrix," Yanukovych's choices. It was their own, very bureaucratic way, of describing Ukraine's path to a European future. They handed him the matrix as if it were some kind of gift.

"We have never done this before for anybody," Füle said. Both European leaders considered the paper to be a pledge of confidence.

The "matrix" listed in detail what it would mean for Yanukovych if he engaged himself with the EU. To the left were the conditions he had to fulfill, including things like EU standards or the demands of the International Monetary Fund. On the right, the money was listed that Ukraine would receive if it went down this path toward the West.

Yanukovych was primarily interested in the right-hand column. When he needed money, he had always been in the habit of simply taking it -- from everyone: from his own people; from the Russian Federation; and, of course, also from the EU. Previously, during a stint as prime minister, he had mostly used his power to secure lucrative posts for members of his own clan.

Indeed, Yanukovych had enjoyed a dubious reputation dating back to the clan wars in his home region, the Donbass coal basin. Even if he claimed the contrary, he never cared much about Western values. But would Yanukovych really do anything for money?

The president thanked his guests for the "matrix," the "pledge of confidence" that he hadn't actually earned. He had experienced the Europeans as naive do-gooders who were constantly going on about values and human rights but who had no idea about money. He promised both guests that the first trip he would take as Ukrainian president would be to Brussels. They understood it to be a sign, but instead it was but the first of many misunderstandings to come.

Kiev Jan. 10, 2011

Enlargement Commissioner Füle traveled to Ukraine again that January to warn Yanukovych against making any serious mistakes. Füle was genuinely alarmed.

On Dec. 20, 2010, the Ukrainian Prosecutor General's Office had filed charges against Yulia Tymoshenko accusing her of misuse of state funds. It appeared as though Yanukovych was seeking to get a former political opponent out of the way.

"Don't do it," Füle implored.

Füle was then and remains now a great believer in Europe, in the grand promise of freedom. He believes in Western values, in transparency, in the rule of law and in the EU's soft power. It was inconceivable to Füle that someone who had the opportunity to become a part of Europe could possibly refuse.

"Mr. President," Füle warned. "You're walking on thin ice." The president and the commissioner were meeting alone. Füle, who is Czech, studied in the 1980s at the Moscow State Institute of International Relations, an institution for the Soviet elite and he speaks fluent Russian, obviating the need for an interpreter. He reminded Yanukovych of his promise to reform the Ukrainian justice system. The EU even had a term, "selective justice," for the arbitrariness that prevailed in the Ukrainian legal system. Füle also reminded Yanukovych that, as expansion commissioner, it was also his job to convince EU member states of why Ukraine should belong to Europe.

Was it absolutely necessary for the European public to see just how far removed Ukraine still remained from the Western idea of rule of law? Tymoshenko is one of, if not the only, Ukrainian who is recognizable to people living in the West. She was the icon of the Orange Revolution and, despite her shortcomings as prime minister, had lost little of the glamour the revolution had bestowed upon her. Now Tymoshenko, with her trademark crown braid, threatened to become a martyr.

"You have to be 100 percent sure that this will not become a politically motivated justice," Füle said at the time. Yanukovych smiled. "I promise you that our judiciary is independent," he said.

Kiev, Presidential Palace Dec. 12, 2011

Events then proceeded as Füle feared they would. In May, the Prosecutor General's Office indicted Tymoshenko a second time. At this point, she had already been in pre-trial detention for three months. It started to look as though she would get convicted. Füle asked if he could visit her in jail.

Yanukovych went over to his desk, which had a Soviet-era desktop switchboard. He pushed a button and the Ukrainian General Prosecutor quickly answered. "I have here the commissioner," Yanukovych said. "He wants to see the Lady in prison."

Kharkiv, Women's Prison Feb. 14, 2012

It was bitterly cold on the morning the gate to the Kachanivska women's prison was opened for a bus carrying German doctors. A group of protesters stood in front of the gate shouting, "Yulia, Yulia."

The group, led by neurologist Karl Max Einhäupl, the head of Berlin's Charité university hospital, then crowded into Tymoshenko's cell, a room with a small barred window beneath the ceiling. Her lawyer was also present, along with two guards. There were two doctors from Germany, three from Canada and one from Ukraine. Tymoshenko was lying on the bed. Her hair was freshly done as was her make-up. She turned to face her visitors, but the pain was so great that she could hardly move.

The EU had transformed Tymoshenko into a symbol of whether Ukraine was indeed compatible with Europe. If she were released, Kiev would be given the seal of approval for its judiciary. If she remained imprisoned, Ukraine would continue to be stigmatized as a country with an arbitrary legal system.

The doctors diagnosed a protracted slipped disc and stated that it wasn't possible to treat Tymoshenko inside the prison. The diagnosis had been a medical one, but it also served as a political verdict. "We traveled there as doctors and not politicians," Einhäupl would later say, "but that's only half the truth."

Brussels, L'Eccailler du Palais Royal Restaurant May 30, 2012, 7 p.m.

On May 30 of that year, Füle invited two acquaintances for dinner at L'Ecailler du Palais Royal, one of the better restaurants on Brussels' noble Place du Grand Sablon. The guests included former Polish president Aleksander Kwaniewski, who had just been named as the official negotiating Tymoshenko's release on behalf of the EU, as well as Ukrainian oligarch Victor Pinchuk. They sat upstairs on the second floor so they could enjoy a bit more peace and quiet. Füle ordered a nice bottle of wine for the evening so that he could toast Ukraine's future in Europe.

"To Europe," Füle said.

Two months ago, the European Union and Ukraine officially approved the Ukraine-EU Association Agreement. Brussels had begun paving the way for the "Eastern Partnership" four years ago. The partnership envisions tight political and economic ties between the EU and the six former Soviet republics in Eastern Europe and the Caucasus. The agreements had actually been envisioned as consolation prizes for countries that were unlikely to be granted EU membership at any time in the foreseeable future.

Like so many things in the EU, the Eastern Partnership is also a compromise. The Eastern Europeans, particularly the Poles, would prefer to give Ukraine full EU membership. At the very least, they want some kind of buffer placed between their countries and Moscow. But Southern and Western Europeans are not interested in an additional enlargement round. The result is a complicated situation for EU bureaucrats. Sometimes they get so caught up in policy that they fail to see the forest for the trees.

When considering the association agreement with Ukraine, EU officials clearly didn't pay enough attention to what it might mean for Russia. And that night, although Pinchuk didn't want to spoil the positive atmosphere, he also had the feeling that the commissioner was underestimating the danger that Russia might not sit back passively as Brussels sought to bring Ukraine into its sphere of influence. He warned the commissioner.

But Füle had assumed Russia wouldn't have any objections to the treaty. "Russia had never had a problem with the EU," said sources in Brussels familiar with the negotiations. After all, hadn't Putin offered his backing for closer ties back in 2004? During a visit to Spain at the time, the Russian president said, "If Ukraine wants to join the EU and if the EU accepts Ukraine as a member, Russia, I think, would welcome this."

But a lot of time had passed since then and relations had also deteriorated. It is no coincidence that the turning point was an event in Ukraine, the Orange Revolution at the end of 2004, that ensured the election of pro-European President Viktor Yushchenko. Since then, Brussels and Moscow have been both been vying to deepen ties with countries located in the region between Russia and the EU. The term used for this in the West is "competition of integration." But in Moscow, it is seen as a battle over spheres of influence.

"You will have to find a solution that is also acceptable to Putin," Pinchuk warned the commissioner.

"Things could get difficult with the Russians." But Füle believed he knew the Russians better. "It's always difficult with the Russians," he said.

Berlin, the Chancellery Spring 2012

That spring, German Chancellor Merkel was concerned about Tymoshenko, not Russia. Merkel made a phone call to the Ukrainian president in Yalta in Crimea. It was a short time before the European Cup football championships, a tournament hosted that year by both Poland and Ukraine. In April, German President Joachim Gauck had already declined his invitation to participate in a meeting of Central European heads of state in Crimea because of Tymoshenko's incarceration and now Merkel was calling in an effort to persuade Yanukovych to release her. At the beginning of the call, the Ukrainian president tried to charm Merkel.

"You speak such good Russian, let's speak without a translator," he suggested. But Merkel blocked him. She spoke with the Ukrainian president as if he were a child. "I want to help," she said, "but you have to free Yulia Tymoshenko."

Brussels, European Council headquarters Feb. 25, 2013

At the EU-Ukraine Summit on Feb. 25, 2013, Yanukovych announced his intention to work more closely with Putin's customs union. The Eurasian Economic Union was Moscow's response to Brussels' growing influence, with the aim being that of creating a single market comprised of post-Soviet states, with Ukraine at its heart.

For Putin, the Eurasion Union is the core of a foreign policy plan to defend Moscow's traditional zone of influence and with which he wants to win back lost terrain. As is always the case when it comes to Russian foreign policy, it is also a question of status. Brussels did in fact offer Moscow some of the elements of an association agreement, but Russia, a former world power, didn't want to be treated like a second-class citizen in Brussels in the same way as other countries like Moldova or Armenia. Moscow insisted on its status as a major power and demanded equal footing.

The Kremlin then proposed to Brussels that negotiations be conducted between the EU and the Eurasion Union -- directly between the two blocs of power. But European Commission President José Manuel Barroso refused to meet with the leaders of the Eurasion Union, a bloc he considered to be an EU competitor.

"One country cannot at the same time be a member of a customs union and be in a deep common free-trade area with the European Union," the commission president said on February 25. He said that Kiev had to decide which path it wanted to take. The message was clear: Kiev had to choose either Brussels or Moscow.

Kiev, Premier Palace Hotel July 27, 2013

His name wasn't anywhere on the official program and no one appeared to know that he was coming. The Russian Embassy in Kiev hadn't even been informed that Russian President Vladimir Putin would be making an appearance at a conference of his Ukrainian supporters at the Premier Palace Hotel.

"We will respect whatever choice the Ukrainian government and people make...," he said. "But there are facts that speak for themselves." The statements are far from friendly. Whereas they may have sounded like a promise to those listening in the hall, Putin's comments were both a slap in the face and a threat to the Ukrainian government.

Prior to his speech, Putin had spoken for nearly an hour with Yanukovych in the presidential palace, leaving the Ukrainian president vexed. The talk would fundamentally change Russia's position towards Kiev. Previously, officials in Moscow hadn't believed that the association agreement with Brussels could actually come to pass. The general consensus in the Russian capital had been that the EU would insist on Tymoshenko's release and that Yanukovych would never push through all the uncomfortable reforms that Brussels had demanded.

But now, Putin realized that Yanukoych actually was considering signing the agreement.

Moscow, the Interfax News Agency July 29, 2013, 9:24 a.m.

Two days later, the Kremlin-aligned news agency Interfax issued a news alert warning Russian consumers against consuming Ukrainian candies and chocolates. The article quoted Gennadiy Onishchenko, Russia's chief sanitary inspector at the time, who had just imposed a sales ban on candy by Variete, Montblanc pralines and Ukrainian milk chocolate because of alleged quality and safety problems. The sweets are made in factories that belonged to Petro Poroshenko (the oligarch and current Ukrainian president) and a television station he owned had been promoting Ukraine's pro-European policies. Shortly thereafter, Moscow imposed other measures in an escalation between Moscow and Kiev dubbed by the international media as the "chocolate war". Although the term may sound sweet, the realities were anything but nice.

By then, at the very latest, officials in Berlin should have realized that Putin was going to take off the kid gloves in the battle over Ukraine.

Berlin, the Office of the German Advisory Group Sept. 20, 2013

Berlin economists had been doing the calculations for two weeks and now they finally had the decisive figure that Yanukovych's government had been waiting for. Ricardo Giucci, the head of the German Advisory Group that monitors the reform process in Ukraine, already had several impatient emails from Ukrainian Deputy Prime Minister Serhiy Arbuzov's office when he finally hit the send button. His outgoing message included an 18-page report with the title "Impact assessment of a possible change in Russia's trade regime vis-a-vis Ukraine."

The question the report addressed is what it would cost Ukraine if Moscow were to cut its facilitation of trade with Kiev. The document included tables, bar charts and explanations about the customs union. In the end, though, only one thing interested politicians in Ukraine.

On page two, under the heading "summary," the report states that "Ukrainian exports to Russia would decrease by 17 percent or $3 billion per year." It provided a solid figure, from Germany, telling the Ukrainian government what it would have a sacrifice for the sake of closer relations with the EU. Should not Kiev be compensated for such a sacrifice?

Washington, IMF Headquarters Oct. 14, 2013

David Lipton sat down in front of Arbuzov's delegation. He had carried the title of deputy managing director at the IMF since 2011 and served as Christine Lagarde's right-hand man. The Ukrainians who had traveled to Washington found him to be friendly, at least compared to the IMF economists sitting next to Lipton with their frozen smiles exhibiting nothing but contempt for the Ukrainians.

It was the second trip Arbuzov had made to Washington within a period of only two weeks. By then, it had become clear in eyes of the Ukrainians that there could only be an agreement with the EU if Ukraine were to be granted a multi-billion-dollar loan from the IMF.

On Oct. 3, during their first visit, they had sought American support to secure better conditions for a possible IMF loan. The IMF had named conditions during the spring that Kiev considered to be unacceptable. They included a provision that the subsidized price for natural gas be raised by 40 percent and for the Ukraine's currency, the hryvnia, to be devaluated by 25 percent. For Yanukovych, who would have to face re-election in 2015, those steps would have been political suicide. But the Ukrainians also had the impression the IMF was ready to negotiate, not least because Victoria Nuland, the US assistant secretary of state for European affairs, had given her assurances that Washington backed an IMF loan for Ukraine.

Now the Ukrainians had come to present their counterproposal to Lipton, a plan that contained far less than what the IMF had demanded. In terms of negotiations over the EU agreement, the situation was becoming tenuous.
Four Thousand Deaths and an Eastern Ukraine Gripped By War
Berlin, Chancellery Oct. 16, 2013

In Germany, though, nobody seemed to be aware of the situation. One month after German parliamentary elections, Merkel spoke on the phone with the Russian president for the first time in quite a while. Vladimir Putin congratulated her on her party's election victory and they agreed to hold a joint cabinet meeting as soon as possible -- a meeting that would never be held.

In addition, the chancellor communicated her concern to the Russian president "over the arrests of the crew of the Greenpeace boat held in Russia," as it says in a press release about the call. Ukraine wasn't mentioned in it.

Merkel did refer to the issue in the phone call, but when Putin refused to take the bait, she let it go. Merkel had no telephone contact with Yanukovych at all at the time.

Brussels, Office of the Enlargement Commissioner Oct. 17, 2013

Ukraine was facing insolvency while, at the same time, Russia was busy heaping pressure on Kiev. Although Russian sanctions had long since indicated otherwise, Berlin and Brussels were not taking Ukrainian concerns, and the country's fear of Russia, seriously. The Ukrainians, they seemed to think, were simply interested in driving up the price for their ultimate signature.

Shortly after his visit to the IMF, Arbuzov headed for Brussels to present Enlargement Commissioner Füle with the numbers calculated by the German advisory group. He believed that the numbers spoke for themselves, but Füle didn't take them seriously. "Did you also request calculations," he asked smugly, "about what would happen to the Ukrainian economy in the case of a meteorite strike?"

Berlin, Foreign Ministry Oct. 17, 2013

Ukraine's ambassador in Brussels, Konstantin Yeliseyev, embarked on a "special mission" through the EU to what the Ukrainians referred to among themselves as "the problematic capitals." Given the acute situation, he wanted to persuade the Europeans to abandon their demands for Tymoshenko's release.

Yeliseyev's tour took him to The Hague, Copenhagen, Rome, Madrid, Paris and London. But his final and most challenging stop was Berlin. First, Yeliseyev met with Merkel's foreign policy advisor Christoph Heusgen before heading to the Foreign Ministry for a meeting with State Secretary Emily Haber.

Haber in particular demonstrated little enthusiasm for a compromise. When the ambassador sought to explain the Ukrainian position, Haber interrupted him saying: "Your Excellency, we are familiar with all of your arguments," adding that it was not necessary to discuss them for as long as Tymoshenko remained behind bars. Yeliseyev pleaded with Haber to abandon her focus on Tymoshenko, but to no avail.

The closer the summit approached, the greater the EU pressure became on the Germans to cease focusing so much attention on the case of Yulia Tymoshenko. The Poles in particular insisted that the issue could not be allowed to torpedo the association agreement. Behind closed doors, President Bronisaw Komorowski said: "Never again do we want to have a common border with Russia." And Germany began to revisit its position as a result, but it was much too late.

Merkel has often been praised for her pragmatism, particularly when it comes to foreign policy. The chancellor's ability to reduce a political problem to its single soluble element and then to focus all her energies on that element is considered to be one of her great strengths. But her pragmatism reached its limits in this case. Focusing too intently on the trees blinds one to the forest -- and that proved to be Merkel's decisive error. As Berlin continued to focus its efforts on Tymoshenko, it failed to recognize the real danger: The Russian Federation's power play.

Moscow, Military Airport Nov. 9, 2013

It doesn't happen often that Vladimir Putin attends a meeting at a site other than the Kremlin or his residence on the outskirts of Moscow. But on that Saturday evening in October, he unexpectedly agreed to a confidential tête-à-tête at the military airport not far from the Russian capital. His interlocutor? Viktor Yanukovych.

It was the second conversation between the two presidents within the space of just a few weeks, with the first having taken place on Oct. 27 in the Black Sea resort of Sochi.

Putin had nothing but disdain for Yanukovych, loathing the Ukrainian leader's constant wavering. In the past, he had often left Yanukovych waiting for hours like a supplicant and the Kremlin was convinced of Yanukovych's unreliability. Though the man from eastern Ukraine was much less pro-European than his successor, he had continued to stubbornly resist requests from Moscow.

Ever since Putin came to realize that Yanukovych was in fact considering signing the EU association agreement, he had been regularly sending Sergey Glazyev to Ukraine to lay out the possible Russian response. Glazyev, Putin's advisor on economic integration in the post-Soviet regions, had been born in Ukraine. But he dutifully issued Russian threats to eliminate benefits and spoke at length of the potentially negative consequences for Ukraine. "The association agreement is suicide for Ukraine," he said. In October, Glazyev visited Yanukovych three times, on one occasion bringing along a Russian translation of the thousand-page draft association agreement because the EU had only sent an English version of it to Kiev.

During Putin's meetings with Yanukovych in Sochi and Moscow, Putin promised subsidies and economic benefits worth around $12 billion annually, including discounted prices for oil and natural gas. Conversely, he also threatened to launch a trade war that would drive an already fragile Ukrainian economy to ruin. Experts in Brussels also believe that he may have told Yanukovych what Moscow knew about his dealings with the EU. In Russian, such information is known as "Kompromat," a word that comes out of KGB jargon and refers to compromising details known about a leading figure.

Following these meetings, Yanukovych's mood changed markedly. He became quieter and ceased holding the endless monologues for which he had become notorious. "Viktor, what's wrong," his Brussels partners would ask. But he evaded such questions, instead speaking in insinuations and innuendos. He proved unwilling to say much about the Russians.

Berlin, the Bundestag Federal Parliament Nov. 18, 2013

Ten days prior to her trip to Vilnius, Merkel delivered a government statement focused on the approaching summit. "The countries must decide themselves on their future direction," Merkel said, adding that she had "raised this issue many times" with Vladimir Putin. But reality looked different, with Kiev having long since ceased to be able to make decisions independently of Moscow. Merkel, though, continued to focus on the symbolism of Tymoshenko case and on "democracy, the rule of law and civil liberties."

Washington DC, IMF Headquarters Nov. 19, 2013

The IMF finally got around to composing a reply to Arbuzov, Ukraine's first deputy prime minister, in response to the Ukrainian proposal that Arbuzov had delivered a month earlier.

It was written by Reza Moghadam, a native of western Iran who had been with the IMF for 21 years. The director of IMF's European Department, Moghadam had plenty of experience with countries that believed they could engage in marketplace-style bartering with the IMF.

"Dear Mr. Arbuzov," Moghadam wrote with barely disguised condescension, "thank you for sharing with us the Ukrainian authorities' latest proposals for policies that could be supported by a possible Stand-By Arrangement with the IMF." The fund, he wrote dismissively, was pleased that the Ukrainian government had recognized the need for a change in course. But Moghadam required just a single sentence to dismantle Kiev's counterproposal. "In our view, overall the proposals still fall short of the decisive and comprehensive policy turnaround that is needed to reduce Ukraine's macroeconomic imbalances," he wrote.

Kiev, Presidential Palace Nov. 19, 2013

At Barroso's behest, Füle traveled to Kiev once again to meet with Yanukovych -- and the Ukrainian president got straight to the point. In talks with Putin, Yanukovych told Füle, the Russian president explained just how deeply the Russian and Ukrainian economies are interconnected. "I was really surprised to learn about it," Yanukovych said.

Füle couldn't believe what he was being told. "But Mr. President, you have been governor, you have been prime minister, you have been president for a number of years now. Certainly you are the last person who needs to be told about the level of cooperation, interconnection and interdependence of the Ukrainian and Russian economies. Needless to say, the association agreement does not have any negative impact on that," Füle said.

"But there are the costs that our experts have calculated," Yanukovych replied. "What experts?" Füle demanded to know. The Ukrainian president described to his bewildered guest the size of the losses allegedly threatening Ukraine should it sign the agreement with the EU.

Later, the number $160 billion found its way into the press, more than 50 times greater than the $3 billion calculated by the German advisory group. The total came from a study conducted by the Institute for Economics and Forecasting at the National Academy of Sciences of Ukraine and it was a number that Yanukovych would refer to from then on.

"Stefan, if we sign, will you help us?" Yanukovych asked. Füle was speechless. "Sorry, we aren't the IMF. Where do these numbers come from?" he finally demanded. "I am hearing them for the first time." They are secret numbers, Yanukovych replied. "Can you imagine what would happen if our people were to learn of these numbers, were they to find out what convergence with the EU would cost our country?"

Brussels, Residence of the Ukrainian Ambassador to the EU Nov. 19, 2013, 10:15 p.m.

Konstantin Yeliseyev withdrew to his residence to watch Ukraine play France in the second leg of their qualifying battle for the World Cup in Brazil. Ukraine had won the first leg 2:0 in Kiev and now it was Paris' turn to host. It was the 75th minute, just after France had scored to go up 3:0, when Yeliseyev's mobile phone rang. An enraged Füle was on the line, having just left his meeting with Yanukovych. "Listen," he said to Yeliseyev, "I now have the feeling that you aren't going to sign the association agreement in Vilnius."

Paris, Stade de France, VIP Seats Nov. 19, 2013, 10:45 p.m.

The game had come to end with a French victory, meaning Ukraine would not be heading to Brazil.

Pinchuk, the Ukrainian oligarch, was standing in the VIP section of the stadium not far from French President François Hollande when his telephone rang. It was Aleksander Kwaniewski, the former president of Poland. Kwaniewski had also just come from a meeting with Yanukovych in Kiev's presidential palace and he too was furious. "He tricked us!" Kwaniewski shouted into the phone. "Yanukovych isn't going to sign. He is a swindler, a notorious liar!"

Kiev, Deputy Prime Minister's Residence Nov. 20, 2013

Deputy Prime Minister Arbuzov and his advisors were examining the letter from the IMF, unaware for the moment that negotiations were headed toward failure. Inside the government in Kiev, Arbuzov had spent months promoting Europe against the pro-Russian faction surrounding Prime Minister Mykola Azarov and now he looked like a fool. Every sentence he read sounded like a personal indignity. The IMF European Department director hadn't even addressed Ukraine's deputy prime minister with his correct title. Arbuzov was fully aware that his opponents would jump all over him at the next cabinet meeting.

Kiev, On the Way To the Airport Nov. 21, 2013

Yanukovych was on the way to the government terminal of Kiev's Boryspil International Airport ahead of a state visit to Vienna when he finally found the time to deal with legal ordinance Nr. 905-r. The ordinance contained instructions to his government to cease working towards the association agreement with the EU for "reasons of Ukrainian national security." Andriy Klyuyev, secretary of Ukraine's national security council, was sitting next to him in the government Mercedes.

Yanukovych undertook a few minor changes to the ordinance focused on his wish to establish a trilateral commission made up of representatives from Ukraine, Russia and the EU to determine the economic damages an EU association agreement might cause. At the airport, he handed the document to Klyuyev, ordering him to hurry back to the cabinet to change the day's agenda. It would spell the end of the negotiations aimed at signing an EU association agreement in Vilnius. It would be the final rebuff of the EU.

Vienna, Presidential Suite in Hotel Sacher Nov. 21, 2013, 7:30 p.m.

Yanukovych was sitting at a Rococo table waiting for the glasses to be filled. "Mr. President," Yanukovych said, "I am grateful that you took the time. I didn't want to tell you about what happened today in passing."

The president he was speaking to was Heinz Fischer, Austria's head of state. Fischer was still reeling from an incident that had taken place a few hours earlier, when the two were sitting across from one another at lunch in the Hofburg, the president's official residence and one-time home of Austro-Hungarian royalty. They had just been served coffee with their dessert when each was simultaneously handed a slip of paper by their aides. Fischer's slip read: "Ukraine stops preparations for agreement with the EU." It was a news alert from the Austrian news agency APA.

Fischer was genuinely flabbergasted; the news invalidated everything they had been discussing up to that point. He leaned over to Yanukovych and said: "Now I really don't know what is going on anymore. Has this happened with your knowledge?"

"It was an unavoidable decision," Yanukovych said later that evening in the Sacher Hotel. The two of them were now alone with an interpreter in the best suite that the Austrian president's office had been able to book that afternoon on such short notice. It was a last, desperate effort to establish a sense of proximity that had long since vanished.

"Please understand me. I simply can't sign it now," Yanukovych said. "I had to urgently turn towards Moscow, but I want to keep the doors to Europe open. Please don't see this as a rejection of Europe."

The two presidents spoke until just before midnight, with Yanukovych doing most of the talking in the over four-hour-long meeting. An official notice on the meeting compiled later by Fischer's office mentioned the verbose explanations offered by Yanukovych: "His remarks were repeatedly complemented or interrupted by very long and elaborate comments on the historical and political developments of the last 20 years," the note read.

Vilnius, European Union Representation Nov. 28, 2013, Midday

For a brief moment, Serhiy Arbuzov thought there might still be hope. Yanukovych's negotiator had headed to Lithuania's EU representation to launch one last attempt to reach agreement with Füle and his aides. "Today, we are going to make a bold chess move," one of Füle's people said, refusing to elaborate. Were the Europeans going to offer Ukraine financial assistance after all?

Vilnius, Kempinski Hotel Nov. 28, 2013, 6:30 p.m. to 8:30 p.m.

They were all waiting for Yanukovych. It was the last chance they had to meet with the Ukrainian president to try and convince him to sign the agreement despite all that had happened. Though it was essentially a hopeless attempt, Barroso and European Council President Van Rompuy had resolved to try the impossible. Van Rompuy had brought two copies of the association agreement with him to Vilnius, ready to be signed.

After a few minutes, Yanukovych showed up with his interpreter, the Ukrainian ambassador to the EU and a handful of aides. That was unusual; in the past, Yanukovych had always conducted the most important talks on his own. The greeting was brief and the roles were reversed. This time around it was the EU that wanted something: Yanukovych's signature.

Barroso was visibly nervous. Ukraine's economy, he said, would profit considerably in the long term from closer ties with the EU. "Poland and Ukraine had roughly the same gross domestic product when the Berlin Wall fell. Now, Poland's is roughly three times as large," he said. And then came the "bold chess move" that had previously been hinted at. Barroso said that Brussels would be willing to abandon its demand that Tymoshenko be released.

Yanukovych was dumbfounded. Didn't Brussels understand that other issues had long since become more important? The talks became heated and Van Rompuy, not exactly known for his quick temper, lost his cool. "You are acting short-sightedly," he growled at Yanukovych. "Ukraine has been negotiating for seven years because it thought that it was advantageous. Why should that no longer be the case?"

Outside, the reception for the heads of state and government had long since gotten underway and EU negotiators understood that Yanukovych could no longer be budged. After two hours, Barroso said:  "We have to go." He and Van Rompuy briefly shook Yanukovych's hand and shut the door behind them.
When the German delegation, under Merkel's leadership, met with Yanukovych the next morning for one final meeting, everything had already been decided. They exchanged their well-known positions one last time, but the meeting was nothing more than a farce. In one of the most important questions facing European foreign policy, Germany had failed.

But Putin, too, had miscalculated. That same night, thousands of demonstrators collected on the Maidan (Independence Square) in Kiev. Three months later, Yanukovych would be forced to flee the country and Putin would annex the Crimean Peninsula. Thus far, the conflict has claimed the lives of 4,000 people and eastern Ukraine remains gripped by war.

In his speech in Berlin last December marking the beginning of his term as foreign minister, Frank-Walter Steinmeier said: "We should ask ourselves ... whether we have overlooked the fact that it is too much for this country to have to choose between Europe and Russia." Füle is likewise convinced that the EU confronted Ukraine with an impossible choice. "We were actually telling Ukraine …: 'You know guys, sorry for your geographic location, but you cannot go east and you cannot go west,'" he says.

More than anything, though, the Europeans underestimated Moscow and its determination to prevent a clear bond between Ukraine and the West. They either failed to take Russian concerns and Ukrainian warnings seriously or they ignored them altogether because they didn't fit into their own worldview. Berlin pursued a principles-driven foreign policy that made it a virtual taboo to speak with Russia about Ukraine. "Our ambitious and consensual policy of the eastern partnership has not been followed with ambitious and consensual policy on Russia," Füle says. "We were unable to find and agree on an appropriate engagement policy towards Russia."

Russia and Europe talked past each other and misunderstood one another. It was a clash of two different foreign policy cultures: A Western approach that focused on treaties and the precise wording of the paragraphs therein; and the Eastern approach in which status and symbols are more important.

Four months after the Vilnius summit, the political portion of the association agreement between Brussels and Kiev was finally signed with the economic section following three months after that. But the price Ukraine paid for the delay has been enormous. And this time, Russia has a voice in the matter. There are 2,370 questions that must be resolved with Moscow before the agreement can come into force. It will almost certainly take years -- and it is the last joint issue about which Moscow and the EU are still speaking.

By Christiane Hoffmann, Marc Hujer, Ralf Neukirch, Matthias Schepp, Gregor Peter Schmitz and Christoph Schult