Germany’s recent federal election has unveiled a complex political landscape, bringing forth significant implications for the nation’s economy. Friedrich Merz’s center-right Christian Democratic Union/Christian Social Union (CDU/CSU) emerged as the largest party, capturing 28.5% of the vote. However, this victory is underscored by a fragmented political environment and the likely resurgence of the ‘Grand Coalition’ in partnership with Olaf Scholz’s weakened Social Democratic Party (SPD). As coalition talks intensify, both investors and economists are closely monitoring the prospects for economic reforms under this new government.
Following an exhaustive election night on February 23, the political center in Germany held its ground—but just barely. The CDU/CSU secured 208 seats in the Bundestag, outperforming the far-right Alternative für Deutschland (AfD), which claimed 152 seats. In contrast, the SPD, governing under Scholz since 2021, faced substantial losses, falling to 120 seats. The Greens, previously part of the coalition, also recorded declines, while the far-left Die Linke made modest gains. The Free Democratic Party (FDP) was notably affected, losing all 91 of its seats after failing to meet the 5% threshold for parliamentary entry, resulting in the resignation of its leader, Christian Lindner.
The fragmentation of Germany’s political scene is evident, as Carsten Brzeski, global head of macro at ING, remarked, “The German political landscape has become more fragmented than ever.” While the CDU/CSU emerged as the largest party, their performance was still disheartening—being the second weakest in the party’s history—leading them to open coalition discussions with the SPD. The CDU’s Bavarian sister party, the CSU, has already dismissed the possibility of collaboration with the Greens, reinforcing the likelihood of a renewed ‘Grand Coalition’ as the only feasible option.
Historically, the CDU/CSU and SPD have co-governed multiple times: in 1966–1969, 2005–2009, 2013–2018, and 2018–2021. These coalitions have often led to significant policy shifts, but whether this current coalition can navigate the fiscal challenges ahead remains uncertain.
One of the principal hurdles facing the emerging government is the reform of Germany’s constitutional debt brake, a mechanism that strictly limits government borrowing. Goldman Sachs outlines the predicament posed by the combined 216 seats held by the AfD and Die Linke, granting them veto power over any constitutional amendments. The AfD is staunchly against reforming the debt brake, while Die Linke opposes increased defense spending, which complicates the negotiations even further.
Despite these hurdles, there are potential avenues for increasing fiscal space. One approach might involve utilizing joint European funding for military spending, as EU-issued debt does not tally against Germany’s debt brake. Alternatively, the government could consider reforming the debt brake, which Die Linke may support if tied to increased investment expenditures. Lastly, invoking the escape clause in response to an external crisis could temporarily allow for greater borrowing, creating necessary fiscal space in the fiscal year when the escape clause is activated.
Philip Bokeloh, a senior economist at ABN Amro, expresses a more optimistic outlook on potential debt brake reform, noting a “high chance” for such changes in a renewed ‘Grand Coalition.’ He suggests that alleviating the constraints of the debt brake could facilitate the government’s ability to implement recommendations from the Draghi report, which advocates for enhanced European integration and greater investments in areas such as energy transition, innovation, and defense.
However, despite these possibilities, there remains skepticism among economists regarding the likelihood of significant structural reforms under a CDU/CSU-SPD government. Analysts suggest that the longing for stability among Germans and Europeans will persist, and it is challenging to envision the next government delivering beyond temporary economic boosts, such as tax cuts and limited investment.
Additionally, the prospects for pension system reform appear bleak, which may create disappointment in equity markets. According to DWS, the implications of the new government’s policies will be more consequential in the medium term than the immediate results of the elections. In the face of political uncertainty, a sense of urgency has emerged among mainstream policymakers—a response sharpened by international pressures—potentially allowing for a smoother coalition formation that could offer positive surprises for the markets.
On the day following the election, Germany’s DAX index rose by 1.6%, as market reactions began to solidify. Notable gains were seen in companies like Vonovia SE and Rheinmetall AG, which rose by 4.1% and 3.9%, respectively, indicating a cautious market optimism amidst the evolving political climate.
In summary, Germany’s return to a ‘Grand Coalition’ is poised to navigate a challenging economic landscape fraught with debates over fiscal policies, reform potential, and international cooperation. While the CDU/CSU’s leadership marks a familiar political scenario, the pressures for genuine reform and adaptation to both domestic and global economic challenges will be critical points of scrutiny for investors and citizens alike. As coalition talks unfold, the economic direction prompted by this coalition could shape not just Germany, but also the wider European economic landscape in the years to come.
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