German Chancellor Angela Merkel. REUTERS/Michaela Rehle The great British geographer Halford Mackinder invented the term “geopolitics” over 100 years ago. He painted a grand vision of international relations that revolved around one fear: dominance of what he called the “Heartland” of Eurasia. Mackinder believed the road to dominance ran through Eastern Europe. His ideas have remained influential ever since, for as long as the West has concerned itself about the impact of Eurasia on world affairs. For two decades after the end of the Cold War, the old Warsaw Pact nations rushed to link up with the European Union and NATO. Arguably the chief beneficiary of this push for Europe has been Germany.

Germany became the indispensable actor in Europe, due to its critical role both in the establishment of the eurozone and as the dominant player in the EU’s response to the Global Financial Crisis. Meanwhile, traditional Western players are looking away from Europe. America’s pivot to Asia and the United Kingdom’s upcoming ‘Brexit’ referendum have given Germany something its generals never could: hegemony on the continent.

Yet Germany is a flawed regional hegemon. A few short years ago, then-Polish foreign minister Radoslaw Sikorski surprised many by suggesting that he was more fearful of German inaction than German action. Germany’s austerity-based economic model has limited the options of policymakers in tackling the eurozone crisis. What’s the result? German policy creates surpluses in the trade and current accounts and asks its partners to run deficits. Also telling,

Finland has supplanted Greece as the European laggard in GDP growth. German Chancellor Angela Merkel may be among the most impressive leaders of our generation, but she has not delivered prosperity or safety. Since German leadership has not guaranteed prosperity in the EU, German leadership now finds itself unwelcome in Eastern Europe.

This year, geopolitics is back with a vengeance around the world. But compared to events in the Middle East or East Asia, Eastern Europe’s re-emergence as a geopolitical battleground remains underappreciated. It’s not just about Ukraine. Viktor Orban’s Hungary has traveled an illiberal path for six years. Romania and Moldova have been crippled by civic protest. Upstart populists control a third of the Czech parliament.

Warsaw, Poland iStock / scanrail The biggest prize is Poland. Poland was a key supporter of the European Union's economic and geopolitical consensus for more than a decade, and previous Polish governments have nurtured productive ties to their German counterparts. Now the new PiS government, under Prime Minister Beata Szydlo and party leader Jaroslaw Kaczynski, figures to be one of Brussels’ biggest critics, with Berlin portrayed as a prime antagonist. PiS has also halted Poland’s track to finally join the single currency.

PiS was in government almost ten years ago and, in terms of economic policy; its bark was worse than its bite. During that period (2005-2007), Polish equities and the zloty were both strong performers in EM.

This time is different. Now that EM is a threatened asset class on a global basis, the Polish government has little margin for error. Analysts have focused on the government’s plans for deficit spending and bank taxes. Investors have been quick to sell under these conditions of uncertainty, and the WIG Polish market index is already down more than 10% over the past twelve months.

These developments come five years after the nadir of the European crisis, reminding investors that politics always lags the economics. To some extent, this radicalism we see on the European periphery was just a preview of the rising eurosceptic and populist sentiments in the core eurozone economies. Geopolitical change can be the result of economics as much as its driver.

So what does the stumbling of German hegemony mean for markets? The main driver of the euro is the divergence of monetary policy between the Federal Reserve and the European Central Bank. On one side of the Atlantic, The Fed has just begun what appears to be a limited and gradual rate hike cycle that will take policy from super-accommodative to very accommodative, since the Fed funds target is unlikely to surpass core CPI (2.1% today). On the other, the ECB’s policy un-orthodoxy does not yet appear to have peaked.

In our view, Germany’s inability or unwillingness to win the hearts and minds in the Heartland of Eastern Europe warns of continued underperformance even after monetary policy eventually converges. At the very least, there will be no further adoption of the single currency in Eastern Europe for well into the next decade. Long-term investors must begin thinking about a post- Merkel Germany and a post-Draghi ECB. Neither prospect seems particularly enticing for investors.

Perhaps Germany is like a dog that chases a car. When it finally catches it, it doesn’t know what to do.

Marc Chandler is the global head of currency strategy for Brown Brothers Harriman. Matt Dabrowski is a political risk consultant and was Citigroup’s political analyst in New York.

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