Merkel’s Walking a Tightrope… If She Falls, the EU Could Implode

By Phoenix Capital Research:

The single most important issue for Europe today remains Germany on both an economic and political front.

German Chancellor Angela Merkel has walked a tightrope over the last few years of keeping the EU together without infuriating the German populace to the point of having to abandon ship.

To do this, Merkel has maintained a firm stance of “we’ll write the check provided conditions are met” much as a parent would give a child his or her allowance provided the child performed its chores satisfactorily. In the case of German, the “chores” are required conditions of austerity measures and budgetary requirements in exchange for bailout funds.

By doing this, Merkel is able to play hardball on an economic front (having failed to meet its German-required financial targets Greece had to wait an additional six months to receive another installment of its Second bailout) without appear too hard-nosed on a political front (she continually pushes to keep the Euro together, expressing a willingness to help other nations… as long as they meet her budgetary requirements).

The policy has thus far been a success with Merkel’s approval rating soaring to its highest level since 2009 (before her re-election bid). However, the latest state election in Germany might upset this situation.

Germany’s center-left opposition won a wafer-thin victory over Chancellor Angela Merkel’s coalition in a major state election Sunday, dealing a setback as she seeks a third term at the helm of Europe’s biggest economy later this year.

The opposition Social Democrats and Greens won a single-seat majority in the state legislature in Lower Saxony, ousting the coalition of Merkel’s conservative Christian Democratic Union and the pro-market Free Democrats that has run the northwestern region for 10 years. The same parties form the national government.

The 58-year-old Merkel will seek another four-year term in a national parliamentary election expected in September. She and her party are riding high in national polls, but the opposition hoped the Lower Saxony vote would show she is vulnerable.

The outcome could boost what so far has been a sputtering campaign by Merkel’s Social Democratic challenger, Peer Steinbrueck.

“This evening gives us real tailwind for the national election,” said Katrin Goering-Eckardt, a leader of Steinbrueck’s allies, the Greens. “We can and will manage to replace the (center-right) coalition.”

However, the close outcome also underscores the possibility of a messy result in September, with no clear winner.

To understand the significance of this, you need to understand a key difference between the US and Europe. In the US, the economy often drives politics (often but not always). In Europe, politics drives everything.

You will never hear a discussion of “how involved should the Government be in the economy?” in most of Europe; it is just assumed that the Government should always be involved to a significant degree. The question is whether it should be a lot (the public sector accounts for 30% of jobs in Germany) or almost entirely (the public sector accounts for 56% of jobs in France).

With that in mind, Merkel is up for re-election in the fall of this year (likely in September). Her bid for re-election will be a major issue for the future of the EU and the Euro in 2013.

The other two candidates for the job are Peer Steinbrück, former Finance Minister to Merkel who has been extremely critical of Merkel’s handling of the EU Crisis and Rainer Brüderle who believes that Greece leaving the EU would not be a “calamity.”

Obviously whoever wins this election will change the political landscape for Europe significantly. As a result, the run up to this election will have a significant impact on the markets for 2013, much as the Obama-Romney Presidential campaigns had significant impacts on the US markets in 2012.

An important issue for this campaign will be the German economy. Germany is the second largest exporter of goods in the world behind China. And the German economy is getting slammed due to:

  1. The EU economy collapsing.
  2. The ECB’s interventions have pushed the Euro higher hurting export profits.

By most counts Europe is an economic disaster. Southern countries such as Spain and Greece have begun to resemble third world countries with commensurate poverty and malnutrition. However, even when we include stronger economies such as Germany, the EU as a whole is back in recession as of September 2012. With 71% of German exports going to the EU, this is a real problem for the German economy.

Regarding #2, every tick higher in the Euro means less profits for Germany. And the Euro has been rising dramatically since July when the ECB first hinted at providing unlimited bond buying to backstop the EU banking system.

As a result of this, the German economy is estimated to have shrunken 0.5% in the fourth quarter of 2012. If things continue to worsen here, Germany’s population will grow increasingly unhappy with the prospect of more EU bailouts. And with Merkel battling for re-election this year, this could potentially upset her high wire act of balancing German voter sentiment with a pro-EU agenda.

With that in mind, the recent state election loss is a bad omen for Merkel. True, the loss occurred by a razor thin margin. But as we mentioned before, politics is everything in Europe. The more energy Merkel has to devote to wooing German voters the less energy she will have to focus on maintaining her “we’ll backstop the EU” policy.

This will make for a very volatile year in European markets as the markets will be hinging on German officials’ statements throughout the campaign trail. With that in mind, the German economy will be an absolutely critical issue both for the German Federal elections and the solidarity of the EU as a whole in 2013.

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