How Angela Merkel's political woes may be good for European stocks

For the past few years the working assumption has been that the major threat to the euro was from the peripheries.

Eventually, the Greeks, Portuguese or even the Italians would get so sick of austerity that they would either quit or finally persuade Germany to write down their debt.

The Greeks – and now the Portuguese – are at boiling point.

However, that's only half the story. The stronger countries have also played a part in creating the current situation. They want to hold the eurozone together, so they refuse to kick the likes of Greece out of the euro. But nor can they let them off the hook, for fear that their own voters will object.

No eurozone politician epitomises this paradox more than German chancellor Angela Merkel. She's always taken a tough line in negotiations, yet done just enough to keep the euro together.

But now, in the wake of the Paris attacks, her luck may be running out. Here's why – and what it means...

Angela Merkel's pragmatic stance on Greece

Angela Merkel wants to get as much money as possible from the creditor countries. If that means keeping them in a state of near-bankruptcy then so be it. But at the same time she doesn't want Greece, or any other country to quit the euro.

This is basic pragmatism. If Greece left the euro, it would almost certainly default on all its debts, which could mean that Germany (and German banks) could end up with nothing. There's also the danger that it could spark panic (becoming Europe's 'Lehman moment'). On top of that, a euro without Greece would probably be a stronger euro – depriving Germany of a key export advantage.

But there's an idealistic element too. It's also about Europe as a political project. The euro is a tool for integrating economic policy and creating a much deeper union. Over time, Merkel and others hope that the pull of the eurozone might even become so great that even those outside the single currency, such as Poland, the UK, and Sweden would eventually be forced to join.

But that vision relies on eurozone membership being a one-way street. Forcing a member state out, or allowing it to leave, throws this principle into question, potentially jeopardising the whole project.

So as far as Merkel is concerned, it can't be allowed to happen.

But there's dissension in the ranks

However, Merkel's belief isn't shared by her fellow ministers, especially those from the CDU's sister party, the CSU.

They discount Merkel's fears about the consequences of a Greek default, pointing out that Greece's small size makes the risk of contagion very small.

In contrast, they argue that the real risk lies in allowing Greece to wriggle out from under its debts. This would encourage other companies to delay austerity and demand large bailouts.

The most prominent of these is the German finance minister Wolfgang Schäuble. During the summer he made it clear that, if it were down to him, Greece would have been asked to leave the second it called a referendum. Even after Athens threw in the towel, he warned that it could still be ejected if it failed to uphold its end of the bargain.

What's more, the German population, which never really wanted to give up the deutschmark in the first place, is now closer to Schäuble than Merkel. Polling during the summer suggested that around 60% of people opposed the deal with Greece, with a majority happy for Greece to leave.

Of course, just because a policy is unpopular, it doesn't mean that it will be reversed – as the Greeks found out the hard way a few months ago. As long as her ministers are willing to put up with it, Merkel has had a relatively free hand, especially since the SPD (the other part of the 'grand coalition') is also dovish.

But that might not last. Because now she's also fighting to defend her stance on immigration policy. Merkel's decision that Germany would accept relatively large numbers of refugees made both humanitarian and economic sense (especially given Germany's ageing population). But it has also led to a firestorm of criticism that it was badly thought through – particularly in light of the numbers being much higher than expected.

There are also concerns that it has encouraged refugees to try to get into Germany via the Balkans or Eastern Europe. This has damaged relations with adjoining countries, including those that usually support Germany on issues such as austerity.

And of course, this has only got worse in the wake of the Paris attacks. In response, Merkel has tried to roll back her position, promising to beef up border security and cut benefits for refugees. The problem is that while this has made life tougher for those who are already in Germany, it has done little to stem the flows.

As a result, there are increasing rumours that many within Merkel's party are plotting to get her to resign, either now or at the CDU's conference in December. Naturally, the person being tipped to replace her is none other than Schäuble himself.

This will force Mario Draghi's hand

If Merkel is replaced with a hardliner like Schäuble, that would make Mario Draghi's job as European Central Bank boss much, much harder. That means that he has to take next month's opportunity to loosen monetary policy as much as he can before it gets harder to do so politically.

Jonathan Loynes of Capital Economics reckons that a cut in interest rates and an increase in the size of asset purchases (ie more quantitative easing) looks almost certain. Such a policy would boost eurozone stocks – probably those in the 'troubled periphery' more than most.

We have a lot more on the situation in Europe following the Paris attacks in the latest issue of MoneyWeek magazine, out today. If you're not already a subscriber, sign up now.