German chancellor Angela Merkel is possibly the biggest loser in Italy.

Because the election there was so close, questions have emerged about how cooperative Italy will be in the future. Not only does that threaten Merkel’s own combined, European approach to dealing with this crisis; it also makes her more vulnerable to domestic opposition as she approaches her own September election. Her personal popularity will almost surely secure her another term. But she may, as a result of these developments, face new constraints that will force her to consider German interests more narrowly than she has to date. As a consequence, Germany and Europe will lose ground.

German Resistance to Merkel and Europe

Though Merkel is well liked, the average German voter is far from entirely satisfied with her approach. Pollsters record a common concern that Merkel’s cooperation has cost Germany influence within Europe. People were particularly struck, it seems, when last year the Governing Council of the European Central Bank (ECB) simply outvoted German representatives, ignored their concerns about purchases of the sovereign debt issued by Europe’s periphery, and launched into a buying program. More serious is the vague sense within the German public that cooperation with other eurozone members has siphoned off German wealth and income. Since some 84 percent of the German people expect the crisis to get worse, they connect these losses that they believe have already occurred to a frightening and open-ended claim on their taxes, their incomes, and, they have emphasized, their pensions as well.

Few Germans, of course, connect the dots between Merkel’s cooperative approach and these fears, but no one seems to feel a need to do so either. Indeed, the sense of loss and vulnerability is that much more politically potent because it is vague. Data and economic logic would circumscribe the possibilities and render them less troubling.

When it comes to specifics, much of the German opposition seems to have focused for the time on the new arrangements for eurozone-wide bank supervision, particularly the decision to give that responsibility to the European Central Bank (ECB). Up until last June, Merkel had resisted any suggestion to recapitalize banks through the European Stability Mechanism (ESM). She insisted that such relief would have to wait until the eurozone could organize an effective and uniform system of bank supervision. All that played well with the voters.

But at the June European Union (EU) Summit, Merkel bowed to hasty arrangements for the supervisory role to go to the ECB. This did not play well in Germany. On the contrary, much of the public, the pollsters record, saw her gesture as a kind of betrayal. People pointed to her earlier vow to fight any shared liabilities in Europe, the so-called Eurobonds, for “as long as I live.”

Technically, of course, she has not contradicted herself. The Union still has not issued such bonds and has no plans to do so. They were in fact not an item at the June summit. But still, the use of pooled ESM funds for bank recapitalization does impose risk commonly across all eurozone members, much as the bonds would have. If she is technically still true to her word, the voters question the spirit of her actions.

Merkel has tried to square this circle. At a meeting during which she shared the platform with ECB President Mario Draghi, she told Germans that neither she nor the ECB would allow “eurozone-level recapitalization of banks without structural reform.” It seems to have done little to persuade. Noting the feeling at the presentation, at least one German journalist, Klaus Engele of Handelsblatt, characterized Merkel’s June summit concession as “the biggest political blunder of her illustrious career.”

The German financial and political elite seems particularly skeptical of the ECB role. Merkel’s own finance minister, Wolfgang Schäuble, has, more than once, pointed out what he refers to as an “inherent conflict of interest with the Bank’s monetary policy tools.” Peer Steinbrück, former finance minister and a challenger for the chancellor’s office, has gone so far to question the ECB’s ability to shoulder supervisory responsibilities. He points out that there are six thousand banks in Europe, and the ECB has no staff with any supervisory experience. Others in German financial circles have asked what will become of the London-based European Banking Authority when the ECB takes over bank supervision. German banks, for their own narrow purposes, have resisted the ECB in this role, as has Jens Weidmann, head of the Bundesbank, which would clearly lose authority under the new arrangements.

It seems most upsetting to these commentators that the June summiteers, including Chancellor Merkel, ignored the recommendations of the ECB’s own commission on bank supervision. This group, called the Larosière Commission (after its head, former Banque of France governor and managing director at the International Monetary Fund, Jacques de Larosière), warned on several levels against giving bank supervision to the ECB. In addition to all the complaints already voiced in Germany, the commission also worried over a politicization of the ECB, as it tried to maneuver among the different rules of the zone’s seventeen members. It even doubted whether the EU treaty permits the ECB to operate in a supervisory capacity. Though such criticisms take a technical turn, at base they question the wisdom and coherence behind the summit’s and Merkel’s decision. Summarizing that sense, Finance Minister Schäuble concluded dryly that it is hard to endorse a decision that is “anything but thought through.”

What Angela Knows

If none of this is especially flattering to Merkel, neither does it necessarily get to the nub of Germany’s interests. These, Merkel has stressed, implicitly if not explicitly, require a much broader perspective than her opponents seem to have. Germans may object to particular arrangements. But she clearly recognizes that her country can no longer simply pull back from the eurozone to protect itself and its own. Its financial markets and institutions have become too integrated into European finance for that. German industry and business have long since adjusted to the euro and would suffer horribly from its dissolution.

If Berlin, ostensibly to save its taxpayers, were to abandon rescue negotiations and leave Greece, Spain, and the others to their own devices, the German economy and German finance would find itself in a precarious situation, no doubt requiring tax resources to save both its own financial institutions and very likely many major German industrial employers as well. Germans would suffer more than they now imagine they do from the eurozone’s rescue arrangements. Merkel has proceeded with this broader threat in mind.

German banks are especially vulnerable. A recent report, compiled by the banking community itself, shows that it has about a €400 billion exposure to Greek, Spanish, Portuguese and Irish debt. This figure amounts to 260 percent of German banks’ primary capital. It is more than 16 percent of the German economy. And it does not even include holdings of Italian debt, which in all likelihood dwarf those of others. Should European support arrangements fail and these nations default or, more likely, engage in a unilateral rescheduling, confidence in German banks would almost surely collapse. A panic and recession would ensue. Even if only the smallest of those debtors were to fail, German banks would remain highly vulnerable to all, since markets, anticipating other failures, would surely mark down the value of all the periphery’s outstanding debt, destroying asset values in German banks in the process and their capital base and public confidence. Certainly a broad European solution that heads off such a panic would offer a cheaper and easier answer to Berlin.

But that is not all. Berlin also realizes that the euro serves German industry well. Because Germany joined the euro when its deutschmark stood at lows relative to both the country’s own economic fundamentals and the rates at which other nations joined, it effectively enshrined a pricing edge for German producers within the common currency. According to IMF calculations, that advantage amounts to between 10 and 25 percent opposite Greece, Spain and the rest of Europe’s periphery. The euro also gives German industry global pricing advantages it would not otherwise enjoy.

Had there never been a currency union and Germany operated separately, there can be little doubt that its Deutschmark by now would have risen so high that German industry would have found itself at a distinct price disadvantage to its world-wide competition. But because the weaker members of the eurozone keep the euro lower than a separate German currency would reach, German industry retains more competitive pricing. The nation’s industrialists no doubt have made these points clear to Berlin, reinforcing Merkel’s conviction that Germany’s fundamental interests lie within the larger union and common currency.

The Way Forward

Merkel can count on retaining her office. For all the anxiety in Germany, recent polls indicate that 42 percent of public still backs either her conservative Christian Democratic Union or its Bavarian sister, the Christian Social Union. But the opposition is gaining. Merkel’s current coalition partner, the Free Democratic Party, has seen its support fall to only 2 percent of the electorate. Since the opposition of all stripes will be able to play on voter fears, especially after the ambiguous Italian vote, Merkel may reenter the chancellor’s office much more constrained than she is now. Even now, before the election, the Bundestag has a bill before it to keep German taxpayers free of liability from older, “legacy” debt issued by periphery governments. Her current coalition, even with its comfortable majority, already shows a pointed reluctance to bring any additional bailout legislation to the Bundestag, and Germany’s constitutional court, when it established to legality of German contributions to the European Stability Mechanism, stipulated that future contributions would require more legislation.

A constrained Merkel clearly raises the risks for Europe and thus for Germany. Markets, fearing the loss of German support, could take control of the situation away from the authorities, marking down the debt of periphery governments, straining existing support mechanisms, and perhaps forcing the failures that investors and the authorities fear. Merkel’s clear political abilities may allow her to navigate around even a constrained, partisan situation and calm markets in the process.

Yet that kind of maneuver might require more of the chancellor then even she may have to offer. At the very least, Europe will face rough sledding up through the German vote this fall—and very likely for some time afterward.

Milton Ezrati is senior economist and market strategist for Lord, Abbett & Co. and an affiliate of the Center for the Study of Human Capital and Economic Growth at the State University of New York at Buffalo. He writes frequently on economics and finance. His new book, Thirty Tomorrows, linking globalization to aging demographics, is forthcoming from Thomas Dunne Books of Saint Martin’s Press.