German elections: Green means 'Go'

The election has marked an end to Chancellor Merkel’s era. The German political landscape has been transformed overnight, and it shifted a bit to the left. Political fragmentation has increased. Germany most likely needs a three-party coalition, as yet another Grand Coalition would simply paper over many of its structural problems. That said, the center held fairly well, and fears of yet another populist wave in the aftermath of an economic and social crisis proved unjustified.

According to the latest provisional result, the SPD wins 206 seats; the CDU/CSU 196; the Greens 118; the FDP 92; the AfD 83; The Left 39; and a Danish minority party ends up with one seat. There weren’t as many overhang seats as feared; ‘only’ 368 seats are needed for a majority. There are two dominant coalition options: the ‘Traffic light’ coalition comprising of SPD, the Greens and FDP and the ‘Jamaica’ coalition of the CDU/CSU, the Greens and the FDP. Both are centrist coalitions; one leans to the left, the other to the right, but there are no fundamental differences in their approach. If these two options fail, the SPD and the CDU/CSU may be compelled to explore a Grand Coalition, even though neither party would want this. A red-red-green coalition, a risk for Germany’s bond investors, doesn’t have a majority in the Bundestag. While a minority government is possible, it doesn’t seem to be a realistic scenario.

The SPD’s leader Scholz is in pole position for the Chancellery. He argues that the SPD’s victory provides him with the mandate to form a government, preferably with the Greens and the FDP. It is, however, not constitutionally required to include the strongest party in government. It is also not politically necessary. There will be no politician appointed to steer the formation of a coalition government (a so-called formateur) and there is no pre-set time-limit for the formation of this new government. This increases the scope for protracted negotiations, for a lot of headline-driven speculation on financial markets, for messy processes at party congresses, and for game theoretical deductions of negotiation strategies. It wouldn’t be a surprise if it takes months before the successor to Merkel is finally decided. Until then, she will stay on as Chancellor.

There will be a lot of political horse-trading, which already started in Sunday’s Elefantenrunde. Any flirtations between the Greens and the FDP should be watched closely in particular, as it is in the interest of both to structure the outlines of a coalition agreement together before entering into negotiations with a senior partner. This would increase their political clout and prevent the two larger parties from divide and rule, as they know that the Greens and the FDP have different preferences for their senior coalition partner. This collaboration is, however, easier said than done, as the Greens and the FDP are strange bedfellows which differ on a whole range of issues.

Yet if they succeed in maintaining a united front, it will probably be first up to the SPD to take an already-structured coalition package, or to leave it and risk that Mr. Laschet walks away with the Chancellery. If Scholz indeed accepts, it could be very well possible that the FDP’s Lindner becomes Federal Minister of Finance, that the Greens’ Baerbock becomes Federal Minister for Foreign Affairs and that the Greens’ Habeck takes the lead in Germany’s new green and digital investment strategy. This would tick many boxes, and is now our base case.

In this context, it also shouldn’t be dismissed that the Greens and the FDP have seen their strongest results among younger voters, who want Germany to start paying more attention to the environment (the Greens) or to its digital capacity (FDP). The two traditional Volksparteien have again failed to generate any excitement among these voters. If only for self-preservation, they should have the incentive to take the interests of the future generation into account.

Finally, the clear risk of such a strategy, is that it leaves the senior coalition partner with too little influence outside of the Chancellery. In particular in a big-tent party (i.e. SPD and CDU/CSU), a Chancellor needs to be able to provide loyalists and rivals ministerial posts to keep them satisfied. It might just take a while before we find out whether Scholz or Laschet is able to solve this puzzle.

Even though a ‘Traffic light’ coalition is our base case, it should be clear that the negotiators are going to play a multistage game with some unpredictable twists and turns. That said, there are no fundamental differences between the two main coalitions, in particular as a natural consequence of a three-party coalition is that the ambitions of the individual parties are watered down. We expect the negotiators to follow the path of least resistance and to look for common denominators. This should mean that the next German government stays away from too radical positions.

This does certainly not mean, however, that nothing will change. There is cross-party agreement that public investments in climate, digitalization and infrastructure need to be prioritised. There is also broad recognition that Europe needs Germany and that Germany needs Europe – but on whose terms? We may also see a more hawkish approach on foreign policy, in particular if the Greens enter government. We’ll discuss this in the remainder of this piece.

Fiscal discipline is strongly embedded in Germany’s institutions. It reflects a widely shared, even norm-based, concern about the sustainability of its public finances. In the German debate, the debt-to-GDP ratio is usually regarded as the key metric of fiscal sustainability. The consensus has long been that this ratio is best controlled by keeping the deficit in check rather than by pursuing policies that seek to increase productivity and GDP.

The introduction of the debt brake in 2009 formally enshrined this self-imposed austerity in Germany’s constitution. This Schuldenbremse explicitly limits the structural deficit to 0.35% of Germany’s GDP, or roughly 13 billion euros in today’s money. It essentially rules out deficit spending as a macroeconomic policy lever. However, with a large part of the sovereign curve in negative territory, and with real interest rates currently far lower, it is increasingly easy to make the argument that the effect of weak demand has a bigger impact on fiscal sustainability than any interest paid (or received!) on deficit spending.

The election result reflects an ongoing shift in attitude towards fiscal policy. The rise of the SPD and the Greens indicates there is less appetite to base fiscal policy on backward-looking rules (i.e. a focus on debt-to-GDP implies that the accumulation of past deficits guides future spending decisions), and suggests that voters want policymakers to take a cue from negative interest rates. This, after all, implies that a lack of investment rather than the financing of this investment is the bigger risk.

Even as the Schuldenbremse will remain a policy constraint, it was explicitly designed as such, a fair interpretation of Sunday’s election result is that some space will be created for a more demand-side-oriented fiscal policy. Reform of the debt brake remains unlikely. It requires a two-thirds majority in the Bundestag and goes against the grain of many conservative lawmakers.

Path of least resistance

As the political landscape is fragmented, the path of least resistance is the most likely. The Greens provide a good starting point: they want to suspend the debt brake in 2022 (and why would they stop there?), and structurally amend it so it allows for EUR 500bn in investment spending on climate, infrastructure and digitalisation over the next ten years (EUR 50bn a year, or c. 1.3% of GDP). The SPD advocates a similar rise in public investment, but Mr. Scholz has refrained from throwing his weight behind controversial reforms. He is, however, open to interpret the budgetary rules more liberally. The CDU/CSU haven’t lost their hawkish feathers, but also appear willing to finance investments through off-balance-sheet vehicles, federal investment funds, or public-private partnerships. And if the private sector, and the Mittelstand in particular, is going to be closely involved, a government-led investment push could even command the support of the FDP.

Whether this ends up in a ‘Traffic light’ or in a ‘Jamaica’ coalition: the Greens should find themselves in the position to color the investment agenda, whilst the debate will be mostly about how this agenda is financed.

If it is up to the SPD and the Greens, the government should mainly issue more debt. Tax policy is then primarily used for income redistribution. The CDU/CSU and in particular the FDP will throw up blockades, as they instead seek a combination of tax and spending cuts. This will make the fight for the Finance Ministry critical. This post is usually given to a junior coalition partner, in order to create ‘balance’ with the Chancellery. A possible compromise is that the Greens will steer the (green) investment agenda, but that the FDP will remain in control of the public purse. If this happens, we would expect to see a green investment agenda financed by off-balance sheet instruments, but also a rather swift return towards the arbitrary limits set by the Schuldenbremse.

Inflation: a clear risk to this agenda

In 1942, with the UK heavily in debt and fighting a war, John Maynard Keynes famously said: “anything we can actually do, we can afford”. He intended to convince the audience that a nation can always finance what it can produce, and that this shouldn’t be obfuscated by budgetary arithmetic. As Germany comes out of the pandemic, however, its real production capacity is already stretched. So, right now, the problem is in the doing rather than the financing. Even as progressivist supply-side policies aim to increase this capacity, Germany currently faces labor shortages, severe supply bottlenecks and, as a consequence, elevated inflation. This may water down the ambitions of a new coalition to boost the investment agenda – in particular if Germany’s heading for ‘Jamaica’. Meanwhile, the (local) government’s capacity to identify, plan and implement the right projects has also been eroded after years of underutilisation and budget cuts. This implies that any agreement on financing is just a first step, and that it may take much longer than currently expected before any money is put to work.

Our overall view is that while we may see an expansionary tilt in fiscal policy if a ‘Traffic light’ coalition is indeed agreed –in terms of increased investment spending and some redistribution of wealth/income– there are constitutional, political, and real limitations to this shift. A sea-change in the fiscal stance is therefore unlikely. This means that Germany’s domestic demand is expected to remain relatively weak, and that Germany will continue to rely on uncertain export surpluses that feed into the world’s macroeconomic imbalances. If a ‘Jamaica’ coalition is agreed, we hardly expect any improvement on this front relative to the status quo.

There is no fundamental dissent on Europe: all involved parties are deeply committed to the European Union and to the euro. This can still lead to wildly different outcomes: note that after advocating fiscal restraint and (moral) austerity during the sovereign debt crisis, Chancellor Merkel radically changed position during the Covid-19 crisis and personally spearheaded the EU’s recovery strategy. That said, stark divisions over collective European spending and debt remain: these broadly mirror the domestic debate.

It is often said that the European Union fails forward during times of crises. The pandemic indeed proved to be the main catalyst for the introduction of debt-sharing. The SPD and the Greens now want this to become a permanent feature of the EU’s budgetary architecture, whilst, crucially, the FDP sees the Next Generation EU fund as a ‘one-off’ crisis response. The CDU/CSU believes this as well. The increased influence of the Greens and the SPD should ensure that Germany increases its commitment to European integration, but to what extent this will go financially largely depends on the trade-offs that have to be made with the FDP. All things equal, we would expect a more flexible and creative approach if a ‘Traffic light’ coalition is agreed relative to a ‘Jamaica’ coalition. It should be noted that if the FDP’s Lindner indeed becomes Finance minister, he will wield his influence on the European stage.

The EU’s Stability and Growth Pact (SGP) was temporarily suspended during the pandemic, but may come back in full force in 2023. The SGP rules limit government deficits to 3% of GDP and public debt levels to 60%, but pay little attention to public investments in the green and digital transition. Moreover, the SGP’s excessive deficit procedure stipulates that EU members must reduce their debt levels by difference between their debt/GDP ratio & 60% by 1/20 every year.

The disagreement runs along familiar lines. The Greens want to reform the SGP, shifting its bias from excessive saving to investing in a greener and more digital economy. The SPD wants to be able to exploit the SGP’s flexibility when necessary, but does not advocate any changes. Most CDU/CSU members and the FDP don’t want the SGP rules to be relaxed, on the basis of arguments that are reminiscent of the core vs. periphery debate of the 2010s. Strict reapplication, as desired by the FDP, would force member states with a debt-to-GDP ratio high above 60% into sharp fiscal tightening, which amplifies an already negative fiscal impulse. That will slow the Eurozone’s economy dramatically and could even be recessionary. It would also turn any normalisation of monetary policy –another strong demand of German conservatives– into a mission impossible.

The European Commission will review the Stability and Growth Pact later this year. There is a risk that Germany is too pre-occupied with coalition talks, even though the deliberations in Brussels can only begin in earnest once a new German government is in place. Time is, however, in short supply; the window could close again in spring when France is preparing for its election.

When it comes to foreign policy, the difference between the two coalitions is probably fairly small. In both scenarios we would expect to see a subtle hawkish shift in Germany’s stance.

The greatest challenge will be the absence of Merkel’s experience and authority on the global stage; a void that is difficult to fill by either Laschet or Scholz. This is unfortunate, as it is also one of those rare occasions a crucial election takes place whilst the tectonic plates of geopolitics are visibly shifting.

German households and businesses could be in for a cold winter, as gas and electricity prices have jumped to multi-year highs; some observers argue this is because the administration in Moscow is trying to put pressure on the German government to hasten the certification of the new Nord Stream 2 gas pipeline between Russia and Germany. Meanwhile, the recent AUKUS-deal in particular has shaken the transatlantic alliance, and even has national security implications for Germany (see also here). France now tries to use this incident as proof of the need for European strategic autonomy, but Germany remains silent. If the EU really wants to be perceived as a global player in an increasingly fragmented world, it needs Germany to get fully committed to this. So far, it hasn’t been: any critique on Merkel’s legacy as a world leader therefore typically starts with her lack of strategic vision, as she preferred energy and trade deals with Russia and China over confronting the threat these regimes pose to Western democracies.

Realpolitik is a German word, but Germans remain deeply uncomfortable with its implications.

Whether Germany likes it or not, the European Union can’t take the lead on global challenges in climate, technology, energy, human rights or trade if it isn’t willing or able to project force and confidence. All too often, the EU’s external policy has been restrained by internal fragmentation on how to approach this. Even as it will help that the SPD, the Greens and the FDP are in favour of qualified majority voting in EU foreign policymaking, rather than unanimity, Germany’s own preference of commerce over politics has been a particular source of paralysis. From a strategic and long-term perspective, the EU would stand to benefit from an approach that is courageous enough to recognise when urgent actions are needed, even as these fly in the face of immediate business interests.

Any meaningful change in foreign policy won’t be driven by the CDU/CSU. Even though Laschet says to value the transatlantic relationship highly and wants Europe to become a stronger player, he is also of the view that Germany needs cordial relations with China – it’s top trading partner – and that a geopolitical ‘guarantee’ for Ukraine is sufficient for final approval of the Nord Stream 2 gas pipeline. It also isn’t likely to be driven by Scholz; after all, he has won this election by emulating Merkel, has always steered clear of moves that could provoke a strong counteraction, and most likely will seek continuity in Germany’s relationships with France, the US and the UK. The biggest risk he is expected to take, is that he is too cautious.

Again, change is expected from the Greens, and to lesser extent the FDP. Having less associations with large businesses or their unions, they can afford to be more hawkish on human rights and the rule of law. Baerbock has expressed a clear stance on Russia and China, and promises to be more assertive than Germany has been over the past two decades. The Greens have, for instance, crossed swords with the CDU/CSU on the Nord Stream 2 gas pipeline (again, this could be why Russia is said to squeeze gas supplies right now). It has also vehemently opposed the EU-China Comprehensive Agreement on Investment, which has been pushed by Merkel, as it wants Germany to take a stronger role in promoting liberal democracy and to hold China to account on human rights issues.

It’s worth noting that re-shoring of activity has its problems too, as German’s manufacturing capacity is already stretched. This raises the question as to whether the future German government would be willing to up the ante on this front; Germany is a big player in global supply chains, but bringing those ‘back to Germany’ does not seem feasible on relatively short notice. Such a shift in stance, however, would have the biggest chance of happening if the Greens were indeed be able to secure key positions on foreign and environmental policy.