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What Merkel's Victory Means for the Euro



One of the most politically turbulent periods in modern European history has culminated in one of Germany's most decisive electoral wins. After roiling European politics with demands on Greece and other errant countries, and stirring fears of a euro area breakdown, Chancellor Angela Merkel has coasted to an easy reelection to a third term as German leader. She may have lost her occasionally more euro-skeptic junior coalition partner—the Free Democratic Party, or FDP—in the process, but her course and policies for the future of the euro area have been endorsed by the German people.

Few would have predicted such an outcome when the European sovereign debt and banking crises erupted in 2010. The lessons are clear, though poorly understood. The handwringing and finger-pointing about Europe of the past few years, the fears of Europe dissolving into feuding factions, of Germany turning its back on its southern neighbors, of revolts and defaults and bank runs, of extremists and factions and xenophobes taking over Europe, all have proved false.

Indeed Merkel, in a low-key and reactive way, nonetheless helped to midwife an extraordinary change in the political institutional structure of Europe. Against all expectations, the common currency has been bolstered by a European taxpayer-backed quasi-fiscal agency in the €500 billion "stability mechanism." The European Central Bank (ECB) has emerged as a muscular lender-of-last-resort for euro area countries with the clout to demand conditions for its support, making it more politically powerful than the Federal Reserve Bank. The bank, with German backing, is about to take over as the main regulator of the region's largest banks, and the European Commission has teeth to enforce fiscal responsibilities on euro area countries in the form of the reformed Stability and Growth Pact. And of most critical political importance, it is now clear that conditional bailouts are acceptable to taxpayers in Europe's biggest economy and that Germany's supposed euro-skepticism is a myth.

Throughout all this tumult, the leaders of France, Britain, Spain, Italy, and Greece fell. Reelected with a record public mandate, Merkel remains Germany's most personally popular political leader. The main uncertainty now concerns her new choice of coalition partner. Whether a new grand coalition with the Social Democrats (SPD) beckons—the most likely outcome—or a new Christian Democratic Union/Christian Social Union-Green (CDU-DSU-Green) coalition comes to power in Berlin, both potential partners are generally more pro-European than the discarded FDP. As a result, German engagement with the euro area and European Union will continue. Continuity—now with a powerful public endorsement—is assured.

Germany's new single-issue protest party—Alternative for Germany (Alternative für Deutschland, known as AfD)—which advocates German withdrawal from the euro, failed narrowly. It garnered 4.7 percent of the votes, just short of the 5 percent threshold to make it into the Bundestag. The FDP—which since 2009 has occasionally endorsed more euro-skeptic policies—lost more voters to the AfD than any other party. This highlights the narrowness of public support in Germany for anti-euro views. The three mainstream German parties now represented in the Bundestag—CDU/CSU, SPD, and the Greens—have all supported the euro area measures taken to date and have been overwhelmingly returned to office with more than 75 percent of votes cast and nearly 90 percent of seats in the Bundestag.

It is not as if Germany has been compliant toward the rest of Europe, or that its behavior has not rankled countries with historic distrust of German leadership. But Merkel's leadership has been historic because it has established the principle that German taxpayers are willing to support assistance to troubled countries—if conditions are attached. Merkel has insisted that financial assistance be granted only conditionally and subject to the oversight of new European institutions and the International Monetary Fund (IMF).

This process will be well-known to IMF crises managers. But it is Merkel's insistence—with an eye to electoral politics—that the same chronology matters also in a yet politically fragmented euro area. In Merkel's political speak, recipient countries "must do their homework" first, before solidarity can be shown and financial assistance is released. We now see that this ensures public creditor country support.

To be sure, part of the process has been scary. There has been no small amount of brinkmanship and volatile financial markets. But what has been created is a new political crisis management process in the euro area, where cross-border financial rescues and more integrated economic and financial institutions for the common currency are facilitated by adopting IMF-like policy conditionality of the kind imposed by the IMF on wayward Asian and Latin American countries in the past.

Merkel's victory ensures that the use of this conditional policymaking model will expand in the coming years to include more and more of the euro area's new institutions. The ECB's Outright Monetary Transactions (OMT) program of backstop financial assistance last year adopted the functionally similar approach by providing the central bank's crucial lender-of-last-resort benefit to member states, which submit to applicable conditionality. Current banking union discussions concerning a more integrated euro area resolution finance and deposit insurance system—to be used when banks fail—will likely yield a similar outcome. Envisioned cross-border loans between national deposit insurance schemes in a crisis will provide comparable opportunities for conditionality to be introduced.

Many, including the Bundestag, will lament this spread of policy conditionality and the increased role of national parliaments in euro area institutions, seeing it as a blow to national sovereignty. And yes, a full fiscal union it is not. Naysayers, however, overlook how these mechanisms and their conditionality have enabled the euro area to forge ahead with critically required crisis mitigation, without a European treaty change that would have required a popular vote. Without the widening use of ad hoc policy conditionality, any fiscal transfer would have been impossible and the euro area crises would have been unlikely to be contained in time.

The long-term political sustainability of any national welfare system depends on the support of richer taxpayers. Similarly, cross-border euro area solidarity depends on the contribution of richer countries. Germany's election result illustrates the effectiveness of Merkel's political crisis strategy of showing solidarity with euro area reformers in neutralizing the most potent long-term political threat to the euro—the rise of a widespread euro-skepticism in Germany. Ultimately, this political result in Europe's main economic anchor is much more important for the long-term survival of the euro than the last years of economic hardship endured in the process.

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