The critical event was the vote that took place yesterday (Sunday) in Germany:
[where the party of Angela Merkel] suffered a crushing defeat on Sunday in an election in Germany’s most populous state, a result which could embolden the left opposition to step up its criticism of her European austerity policies.
The election in North Rhine-Westphalia (NRW), a western German state with a bigger population than the Netherlands and an economy the size of Turkey, was held 18 months before a national election in which Merkel is expected to fight for a third term. (Reuters)
So why should you care?
Up to this point Chancellor Merkel has been the bulwark in Europe against the forces of irresponsible economic policies. She has been insisting that other countries get their houses in order and refused to commit Germany to paying off the debts of others. Her steadfast position played an important role in reassuring international creditors and buying time for the Euro.
Despite doubts about the political will of leaders in Greece, Italy, Spain and Portugal, Merkel was (and is) seen as an anchor that would keep the European Union from drifting into the economic shoals of unrestrained spending and mounting deficits.
Now Merkel’s political future and her commitment to holding firm on austerity measures will be in question.
This does not mean that she will cave or alter her policy position. But, the election in Germany now puts the question of “confidence” back on the table. Until Sunday’s vote there was the assumption among most economic observers that Europe would somehow muddle thru and the Euro would remain intact. Merkel’s political setback now has the potential to change all of that and the change will not be positive for the world economic outlook.
Greece is a trainwreck. There is no other way to slice it. Greece is now firmly on the road to abandoning the Euro and embracing political extremism. The odds are slim and growing slimmer that the Greeks will opt for a middle of the road, fiscally-responsible solution to their debt crisis. Instead, it is highly likely that they will stiff all of their creditors and will return to the drachma. While others in Europe will try to prevent this, the political realities inside Greece make sticking with the Euro increasingly unlikely. Merkel’s political rebuff in Germany, ironically, is likely to resonate in Greece and fuel those pressing to walk away from Greece’s prior commitments to pay creditors something.
What does this mean for the United States and its economy? A crisis of confidence in the international markets is likely to send more panicked investors seeking safe haven our way. But that kind of demand could have an inflationary pressure on our economy, which is the last thing we need in the midst of a failing recovery.
The turmoil in Europe will last through the summer and will roil the international currency and financial markets. The ramifications extend beyond Europe and will adversely affect Asia. When Asia catches an economic flu, you can be certain that the infection will make its way to our shores.
I wish I had better news for you, but it is what it is.