Angela Merkel's Moment

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How would you like to go down in history as the person who "lost Europe," "lost Germany," or simultaneously lost both? This is the question that Chancellor Angela Merkel of Germany may face sooner rather than later.

The European sovereign debt crisis was never meant to be Merkel's defining moment or her lasting legacy. Her moment was her election in 2005. As the first woman-a physicist and the daughter of a Lutheran minister-and the first politician from the former East Germany to become chancellor, Merkel herself was the message that Germany had entered a new, post-reunification political era.

Reelected in September 2009 with 33.8 percent of the vote, combined with a more closely aligned ideological coalition, Merkel's historic moment appeared to be solidified. But two months later, a Greek budget crisis began, resulting in the near collapse of the Greek financial sector in May 2010 and eliciting the first of no less than 20 European crisis summits in an attempt to solve, re-solve, or not solve at all, a deepening and widening debt crisis.

Merkel the brilliant political tactician has been on full display over the past two years, reflected in her near 70 percent popularity among the German electorate. Merkel's message has remained publicly tough, insisting that countries that run into debt and deficit difficulties must change their errant ways. This played well to an increasingly skeptical German taxpayer and her fractious coalition, providing encouragement for Merkel's reelection bid in 2013.

At the same time, Merkel supported more European integration, with the German parliament supporting three bailout packages (for Greece, Ireland, and Portugal) and two bailout funding mechanisms (the European Financial Stability Fund and the European Stability Mechanism, or ESM) to the tune, thus far, of nearly €650 billion of German taxpayer funds. Despite two German resignations from the European Central Bank (ECB) Executive Committee and growing hostility from the Bundesbank and prominent German economists, Merkel has also given her blessing to €1 trillion in ECB long-term refinancing operations and, following the September 6 ECB Governing Council meeting, unlimited bond purchases on the secondary market of distressed euro zone economies.

Merkel has had it both ways politically. But as she has juggled demands for greater austerity and bailout support, her political maneuverability has been constricted by her national constitution and the power of the German Constitutional Court based in Karlsruhe. Repeated rulings from Karlsruhe have granted more oversight power to the German parliament while allowing European-level decisions to proceed.

On September 12, the Constitutional Court will determine if the €700 billion ESM and fiscal compact treaty are consistent with the German constitution or Basic Law. Some anticipate the Constitutional Court's answer will find a way for the ESM to proceed with yet more parliamentary restrictions.

The answer could also be "yes, but." Yes, the ESM can proceed, but only if the 1949 Basic Law is changed. This will be extremely difficult to accomplish, as the only way to amend the Basic Law is by a two-thirds majority in both the lower and upper houses of the Bundestag. This is why there is growing speculation about holding a national referendum to decide the issue. The problem with asking the German people what they think about handing more sovereignty to Brussels is that the act itself is unconstitutional. Article 146 of the Basic Law only provides for the possibility of a national plebiscite to initiate the drafting of a new constitution, not changing the Basic Law itself.

Even if all of these challenges were overcome, it is unclear how quickly Germany could hold a referendum and change its constitution, but certainly it could not be responsive to today's crisis. Clearly, Merkel's tactical successes may now be her strategic undoing.

The Constitutional Court's decision will bring Chancellor Merkel's political day of reckoning closer at hand. Another parliamentary vote will be necessary to approve bailout funds for Spain and likely additional funds for Greece. For months, her own party and coalition partners have openly rebelled against her request for further bailouts, causing Merkel to rely on votes from the opposition Social Democratic Party (SPD). Eyeing 2013, the SPD has demanded that the German constitution be changed by national referendum to support a full European fiscal and banking union, as well as the creation of Eurobonds. With an opposition unwilling to continue unconditional support for the chancellor in parliament and a coalition growing increasingly nationalistic and hostile, Merkel's government may not see 2013.

What if Angela Merkel had to make a choice between saving the German economy and saving the euro? With Germany's historically low unemployment, negative borrowing costs, and a depreciating euro boosting its exports, the German economy has successfully weathered, if not prospered during, the debt crisis. However, softening German manufacturing figures and plummeting consumer confidence show that the German economy is not immune from contagion. A struggling economy, intense German hostility toward future bailouts, and next year's election make her decision clear: she must choose Germany.

But safeguarding German interests means that Germany would no longer be willing to foot nearly one-third of the total bailout bill or use its AAA credit rating (which has recently been put on negative credit watch by Moody's Investors Service) for future European bailout funds. Should the euro zone collapse and Europe return to its separate national currencies, catastrophic events would unfold for both Europe and Germany. For Germany, a return to the deutsche mark would mean its currency would appreciate substantially, causing German exports (which represent 50 percent of German GDP) to plummet. Weak German banks would collapse; others would need massive recapitalization and their liabilities redenominated. Capital controls would be imposed, and the credit market would cease to function. The European Central Bank's centralized payments system would likely collapse, leaving Germany with liabilities that could exceed one-third of its GDP. One estimate suggests that the cost of Germany's departure from the euro zone could be upwards of 25 percent of its GDP. In this scenario, Angela Merkel would be the chancellor that loses both Europe and Germany.

Today, as soft bank runs occur in southern Europe, the euro zone falls into recession, and European banks cease lending to one another, the euro zone has already begun to fray, if not unravel, with unknown consequences. Merkel's moment may have passed, her legacy already determined.

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