Implications of the German elections for the economy and markets

Today’s commentary

Summary: The German elections were a resounding victory for German chancellor Angela Merkel. Nevertheless, she must still broker an agreement for a coalition government and this will change the politics of Germany and Europe. Below are my thoughts on the implications for the economy and markets.

The election

Here is the situation in Germany. In terms of the ruling coalition, the CDU/CSU parties took 41.5% of the vote nationally, whereas the junior FDP partners only won 4.8% of the vote. As Germany has a 5% hurdle for parties to gain access to parliament, this puts the FDP out of the German Bundestag for the first time in the 64-year history of the Bundesrepublik. On the opposition side, The Social Democrats won 26% of the vote with the Greens taking 8.4% and the Left party taking 8.6%. The new anti-Euro party Alternativ für Deutschland (AfD) also missed the 5% hurdle at 4.7%. What this effectively means is that the present ruling coalition is history.

Merkel, despite her personal popularity, must find a coalition partner to form a government because her party is just a tad short of an absolute majority of Bundestag seats needed to rule outright, We could see this result coming for months. When I first wrote about the upcoming election in January, I mentioned this possibility, outlining the potential coalitions:

“The latest opinion polls in Germany show Angela Merkel at her most popular. But her governing coalition partner FDP will almost certainly miss the 5% hurdle in Germany’s general election, leaving the political landscape very uncertain.

“Merkel, as a political figure, has gone from strength to strength, with her personal poll numbers consistently showing widespread popularity amongst the German electorate. This has pulled her party up to its highest poll numbers since Merkel’s election as Chancellor in 2005. Right now, the CDU/CSU parties are polling at 42% for this year’s general election while the challenging SPD party is only polling at 25%. That puts Merkel in the best position to form a government after the election.

“The problem for Merkel is that her FDP coalition partner’s standing in the electorate has plummeted in recent years. Right now, they are polling at a measly 2% – and will miss the 5% hurdle that throws them out of the German Bundestag in all likelihood. That means that the Chancellor cannot reach a 50% governing coalition majority with the present governing configuration of CDU, CSU and FDP if current polls were to hold.

“There are three possibilities for the post-election German government make-up:

1. The CDU could form another grand coalition with the SPD as they did in 2005 when Merkel was first Chancellor. I see this as the most likely alternative because the centre-right CDU party is not that far from the centre-left SPD party in term of ideology. In particular, the high number of women in Merkel’s cabinet has made family and social issues more important for the CDU, aligning it with the traditional pull of the SPD.
2. The CDU could rebuff the SPD and go with the Green Party. The Greens are now considered a mainstream party in Germany after their having served in a governing coalition with the SPD under Gerhard Schroeder. Moreover, Merkel’s rejection of nuclear power has put her into a more Green-friendly light that makes this coalition at all possible despite previous contentions from the CDU/CSU parties that this coalition would never occur on a national level. The real obstacle here is the Bavarian CSU party which is the sister party of the national CDU party in Bavaria only. The CSU is more conservative than the CDU and may well balk at this governing coalition. Their preference is FDP first, SPD if necessary and Greens only as a last resort.
3. If the CDU cannot form a coalition, the SPD could form one with the Greens and Die Linke. Right now polling says that a combination of the three left wing parties would put it over the 50% majority. But because the CDU has first crack at forming a government due to its huge polling lead, this coalition can never happen unless the CDU is unable to form a government. In the unlikely event this occurs, the left wing coalition would be an easy alternative as these parties are relatively well-aligned ideologically, die Linke being the most problematic. Die Linke are a left wing party that is not considered a mainstream party in Germany and their inclusion in a governing coalition could be a problem.

Post-election

My take in January was that this likelihood would change German politics in a meaningful way. I posted on why the German EU positions will change after the German General Elections in April, noting that, “the SPD and Greens are indeed closing ranks and they are essentially campaigning as a duo. In Germany, one votes for two parties in the general election, a preferred party and a second party as well, called the second vote or Zweitstimme. The Zweitstimme is important for voting in terms of allocating seats in the Parliament, the German Bundestag. And my takeaway from the partnership electioneering here is that the SPD are trying to increase the Green/SPD seat allocation enough to clear a 50% majority of seats without having to rely on the Linke party, an amalgam of former communists and breakaway SPD politicians. What the SPD are doing is putting all their eggs into the Greens basket, even appearing at the Greens party congress. That kind of electioneering is unprecedented.

“This rules out a grand coalition as a first choice option in my view. It also rules out the CDU/CSU-Greens link up as a first choice option as well. It basically puts the Union in the position of NOT being able to form a government unless they can get the FDP well over the 5% hurdle, which I don’t think they can do.”

Merkel has been clever tactically because she saw this outcome and looked to act against it. I wrote in January that the “FDP is likely out unless they can pull out a huge turnaround from their years of decline. I believe Merkel understands this and will be positioning herself to be able to govern with the SPD, and this means a leftward turn of German politics even before the elections occur.” This is what has happened.

The first thing Merkel did was co-opt SPD positions even before the election drew near. She has cautiously moved her party to the left on a bunch of issues, with nuclear power being the most notable and largest shift, something that might make a Green party alliance possible. Second, Merkel began a campaign in the last days of the election to have Germans use their second vote for the CDU/CSU so that they could take an outright majority. Effectively, she cut the FDP lose because she was gambling that her parties could form a government without them and that they needed to do so because the FDP was so weak. I know a lot of voters who cast their vote for Merkel even though they were Green party of SPD voters. So Merkel gained at the expense of not just the FDP but also the SPD and the Greens. Third and most important: Merkel has subtly shifted the Germans away from front-loaded austerity even before the election. Only the Bundesbank is still in opposition to the new ECB policy and the back-loading of austerity we have witnessed. Angela Merkel is fully behind these positions.

The bottom line here is that since I wrote in April, the SPD and Greens’ position has weakened relative to the CDU. It didn’t help that the SP candidate Peer Steinbrück had no personality. Nevertheless, let’s give Merkel and the revived German economy full credit for this victory.

What does this mean? I think it means the SPD are no longer in pole position. We will probably see the dreaded Grand Coalition or even a CDU/CSU/Green party coalition. Now I could be wrong here and the SPD could rebuff Merkel and try and form a government with the Greens and the Left party. But I don’t see this happening because die Linke and the SPD are bitter enemies for a number of reasons. Even so, from a European perspective, the outcome is still the same one I called in April: “come September, Germany’s position on EU matters around austerity and growth is bound to change dramatically.“

Austerity lite is the new austerity

Last month, in my chronology of the euro crisis I noted the dramatic shift in Europe’s political position on austerity. Europe went from a sinking economy in May to recovery in August. While there was always likely to be some bottoming, given the depth of crisis in the periphery, a lot of this has to do with the move to backloading austerity. Front-loaded austerity had become untenable even before the German elections began. And so the shift in German economic policy toward Europe actually has already begun. The fact that Angela Merkel needs the Greens and the SPD to form a government will only entrench that shift. What this means then is that no one is going to be leading the full-on austerity charge in Europe because no one can take Germany’s role in doing so. I think this is bullish for shares and for the general economy. If the economy holds, we may even see some multiple expansion in equities, particularly in the financial sector. It helps that Greece will take over the rotating EU presidency in the upcoming period because they will lead a reform-minded, anti-front-loading agenda that I believe the Germans will sign up for.

Economically, this means austerity timetables will remain in place but remain relaxed aka backloaded austerity. The ECB will get full political support in Germany for its tacit sovereign backstop. And Germany will probably move to support a stimulus quid pro quo for German-modelled reform policies. These policies will mean internal devaluation in the periphery via wage suppression and relaxed labour laws, something that will keep down aggregate demand and keep the periphery in a state of low growth or recession.

Honestly, I think this is the best we can hope for. And while it is better than what we saw before, it is not going to be nearly good enough to remove the spectre of eurozone breakup or to vastly improve economic fortunes in the periphery. We have a long road ahead.

For now, I am upbeat about Europe and I believe the German election adds to that optimism because it signals a continuation of more growth oriented economic policy. This should arrest the debt deflationary spiral, at least over the medium term, and give some countries in the periphery enough breathing room to make it out of troble. Ireland looks to have made it through. Elsewhere, we will have to revisit these issues as time goes on.