The Birth of Federal Austria
The defeat of Austria at the hands of Italian and Prussian troops in the Austro-Prussian War drove the Empire into a panic of the likes it had never seen. The nation was bankrupt, its armies in shambles, and in a precarious diplomatic situation, with frayed relations both with Russia and Prussia. Imperial Chancellor Beust desired more than above all, revenge against Prussia, but it wasn't clear how to achieve this.
First, the Austro-Hungarian Compromise was rapidly concluded in negotiations with Hungarian politician Gyula Andrassy. After the pullout of French troops in Italy, Beust, seeking revenge against Prussia, quickly brokered a legitimate alliance with the French Napoleon III, who was desperate during the Luxembourg crisis to seek more allies abroad. The Hungarians under Andrassy were outraged, but as long as an actual war wasn't declared, they held their fire. In the end, Prussia backed down in the face of Italy and Austria both siding with France, which annexed Luxembourg. As Franco-Italian relations collapsed in the aftermath of the Riot of Rome, the Austro-Hungarians declared full support for the French position, with Emperor Francis Joseph I openly declaring himself the representative of the one true Pope in Avignon, further poisoning relations with the liberal secular regime in Italy, which quickly laid territorial claims on both Austro-Hungarian and French territories.
With the weight of the French support, Beust worked to defeat the warmest political sympathizers towards Prussia, namely the German liberals.[1] In the aftermath of the Luxembourg Crisis, the German-Liberals (or Constitutional Party) was entirely dismissed from office, replaced by the conservative Federalists of Count Potocki and Count von Hohenwart. Beust openly favored the Federalists and sought to permanently outflank the German liberals by promoting what became Hohenwart's radical plans for Slav accommodation within Cisleithania (in Hungary, the leading Magyar politicians vetoed any consideration of Slav accommodation). Under Beust's stipulation, the primary goal of Austrian foreign policy was to retain as much influence in the South German states as possible (using Roman Catholicism as a cudgel) while buttering up Russia to either be pro-Austrian or neutral in any future confrontation. Notably, Beust and Bismarck both viewed Russia as the most important diplomatic prize.
In 1870, the Hohenwart government pushed through radical reforms of Cisleithania. The process was begun under the Potocki cabinet, but he swapped positions with Hohenwart just because it seemed unsightly for an ethnic Pole to push policies so hostile to German interests. The original plan was to reform all of Austria-Hungary, but the Hungarians vetoed any such constitutional changes within their lands. Moravia and Silesia were immediately annexed by Bohemia (with their Diets combined with Bohemia), which split off the Sudetenland.
Legally, the Austro-Czech Compromise was extremely convoluted, as it was forced to work within the constitutional confines of the Austro-Hungarian Compromise. The Bohemian representatives to the Reichsrat promised not to take their seats, holding an alternative Parliament of the Kingdom of Bohemia instead. The Austrian Reichsrat would then pass a law permanently ratifying within Bohemia all laws passed by the Bohemian Parliament and not seating any Bohemian representatives. Bohemian Reichsrat members (constitutionally mandated) quickly became a notorious Austro-Czech joke, as their job was to literally do nothing except collect a salary.
Most outrageously, to calm many of the pan-German liberals, most of the rest of the Austrian crownlands (including the Sudetenland) were amalgamated into a new Kingdom of Germany. As a result, Cisleithania (Austria) became federally comprised of the Kingdom of Germany, Kingdom of Bohemia, Kingdom of Dalmatia, Kingdom of Galicia-Lodomeria, and the Kingdom of Bukovina (a remarkably increase in the prestige of Bukovina, which only became a Duchy in 1848). For now, Germany, Dalmatia, Galicia, and Bukovina would be governed directly by the Reichsrat, though not Bohemia. However, with the example set by Bohemia, the ground had been laid for the other kingdoms to become autonomous. In contrast, with the Kingdom of Hungary still remaining united under Magyar control, the strongest kingdom in Austria-Hungary would clearly be Hungary, which was remarkably outraged over this development in Austria. The federalization of Austria clearly put political pressure on Hungary to pressure, something that the Hungarian political class flatly refused. In addition, liberals in Austria were horrified and angry, raging that they had been permanently locked out of power by a conspiracy of elite nobles, conservatives, and ethnic minorities (Count Potocki was particularly hated as someone described as a mixture of all three).
Abroad, accommodation of the Slavs was deemed necessary in order to build good relations with Russia. In a secret meeting between Chancellor Beust, Tsar Alexander II, and Prince Milan I of Serbia, the parties began to carve up spheres of influence in the Ottoman Empire. This diplomatic breakthrough was made possible only by the Austrian willingness to compromise and take a much smaller sphere of influence than most foreign observers, including the Russians, though they would be entitled to. This was possible within Austria because of Beust's primary focus on defeating Prussia.
In a discussion with how important Austria's position as a leading Catholic power was in order to contest Prussian dominance of South Germany, the Russians agreed to clamp down on any intellectuals calling for Pan-Slavism in Catholic regions, such as Croatia, Slovenia, Slovakia, and Galicia. In exchange, Austria permanently disclaimed any sphere of influence in the Ottoman Empire, except for the Romanian United Principalities as a consolation prize. When Alexander II asked why, Beust commented that the Hohenzollern prince of Romania concerned their interests in Germany, and the Russians accepted this. The Austrians also agreed to stay neutral in any conflict between Russia and the Ottoman Empire and in any settlement between the Great Powers that they expected to result over the Ottoman Empire, support the pre-settlement status quo (which would presumably heavily favor Russia). The obvious understanding would be that Serbia would have first dibs on Bosnia. Regardless, the Russian sphere of influence in this agreement would include the rest of the Ottoman Empire, including Dobrudja (which the Russians hoped would link Russia and Constantinople together).
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[1] OTL, a detente with Germany led Beust to oppose the Fundamental Articles. ITL, the still anti-Prussian Beust supports them.