Germany's Short Path to Instability

This month's elections could easily bring trouble to Europe's economy.

Political pundits and the financial markets are assuming seamless continuity in Berlin’s Eurozone policy after the German federal election on September 22. Conventional wisdom suggests Chancellor Angela Merkel’s Christian Democrats (CDU) will win a third term, or should the opposition Social Democrats (SPD) be included in a government coalition, little will change as their domestic and foreign-policy positions are almost identical to those of the CDU.

This consensus is too complacent.

It underestimates that incremental shifts in German election results can dramatically affect the composition of post-election government coalitions, which in turn may have a large impact on German economic policy. This election is the most critical in Germany since unification, given that all major Eurozone crisis decisions have been put on hold until the results of the election are known, tacitly acknowledging the indispensable leadership role of Germany in deciding the economic future of Europe.

Despite her personal popularity and undisputed authority, storm clouds are gathering on Merkel’s election horizon.

First, the trajectory of recent data suggests an increasing likelihood that the CDU’s business-friendly coalition with the pro-market Free Democrats (FDP) may not be returned or alternatively will be re-elected with the thinnest of majorities in the Bundestag—Germany’s Lower House of Parliament, significantly weakening the Chancellor’s authority. Merkel may suffer a further blow in the Upper House, which is composed of government representatives of Germany’s sixteen states, if the CDU/FDP coalition in the State of Hesse is defeated at a closely contested poll to be held on the same day of the Federal election.

Second, the CDU is partially crippled by new electoral rules, which minimize the advantage of a party winning more individual single-member districts than would be allotted to them under their proportion of the overall vote. In the last Federal election, held in 2009, the old rules gave the CDU twenty-four extra seats. This time round, the loss of these may be sufficient to swing the election to the opposition parties, in the event of a very tight race.

Even if Merkel survives an electoral onslaught, there is no guarantee that she will remain as Chancellor. Indeed her options are limited. If the CDU/FDP Coalition does not have the numbers to form a majority in the Bundestag, Merkel may have to look to the SPD to form a “Grand Coalition.” Here the plot thickens. Peer Steinbrück, the SPD’s candidate to head a post-election government, has stated repeatedly that he will not serve in government with the CDU if Merkel is Chancellor.

Election rhetoric is often just that, and Steinbrück may back down on this threat once post-election political haggling starts in earnest. What is likely is that the SPD will once again control the Finance Ministry, will be more assertive in its demands for higher public spending on social programs, and will likely delay and complicate German government decision-making on Eurozone bailouts, banking union and other critical economic issues.

Part of this will be due to the SPD not wanting to be seen as Merkel’s patsy, which was the impression given in the last Grand Coalition of 2005-2009. Another issue is that every compromise in government will deepen the already lethal frictions within the SPD, between centrists such as Steinbrück, and other members of the leadership who link the Federal SPD’s shift to the economic right to its decade long electoral decline.

Alternatively if the SPD does maintain its pre-election position not to enter a Grand Coalition with Merkel as Chancellor, she will have to be sacrificed for the CDU to remain in government. It is entirely unclear who would succeed her, Dr. Merkel having dispatched her internal party rivals over the years, in a quiet yet systematic manner.

In contrast, the SPD has more flexibility based on current polling, with two other realistic majority-coalition options.

The first involves the SPD forming a relatively benign three-way coalition with their traditional partners the Greens, and with Merkel’s junior partners, the FDP—but there are real questions as to whether the small-government FDP would join a coalition committed to increased regulation and higher taxes. Such a coalition may be at best volatile and short-lived.

The second, less favored option for the SPD and the Greens is a Coalition with the notoriously extremist and internally unstable Left Party—largely controlled by hardline former East German communists and disgruntled SPD socialists. The Left Party is viscerally hostile to international capital markets, Eurozone reform, free trade and, most of all, is reflexively and deeply anti-American. Steinbrück has officially ruled out such a coalition, but should the FDP not meet the electoral threshold to enter the Bundestag again, the SPD would have no other option to lead a majority government.

Either choice risks deepening the rifts between the SPD’s centrist and left-wing factions.

A third option is for the SPD to form a minority government with the Greens, variously reliant on FDP and/or Left Party votes to pass legislation—introducing unprecedented instability and uncertainty into German Federal politics.

Any of the scenarios above would result in the post-election government being in a much weaker political position than that of the current Merkel administration—including the leadership authority and domestic political capital to tackle decisively the formidable Eurozone challenges ahead.

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