RaboResearch - Economic Research

German elections: Merkel looking for a (new) deputy


  • Angela Merkel is seeking her fourth term in the national elections
  • Thanks to the strong performance of the German economy, she is full steam ahead
  • The elections may therefore appear a non-event for financial markets, but Merkel still has to form a coalition government
  • We regard a renewed Grand Coalition as the most likely, even though this goes against both parties’ preferences
  • We may then also see more progress on Eurozone integration
  • It would also be the most benign scenario for the Euro

Much ado about nothing?

Having been in power for almost twelve years as Germany’s Bundeskanzlerin, Angela Merkel is seeking her fourth term in the national elections on Sunday September 24. With three recent state election wins in a row for her Christian democratic party[1], she is full steam ahead to strengthen her appearance as a haven of stability in an unstable world. This is being welcomed by financial markets. With a contentious Brexit, an unpredictable President Trump, the two strongmen Erdogan and Putin, and two close defeats of populism in France and the Netherlands, market participants probably already have more than enough on their plate.

The brief surge in the polls that the social-democratic and pro-European SPD enjoyed after it chose Martin Schulz as its front-runner signalled that the Germans would like to see a fresh face, but not an actual change of Germany’s course. The SPD’s poll-readings have however returned to pre-Schulz levels and – barring any significant surprises – a fourth win for Merkel is widely expected.

While it may turn out to be a familiar boring race from that perspective, the outcome and the ensuing coalition formation are still of high importance to the future of the Eurozone. Just over 24 hours after his inauguration in Paris, French President Macron visited Merkel to discuss Eurozone integration and both expressed to their willingness to move further. There has already been talk of a joint finance minister who might eventually be in charge of a budget for the Eurozone. Angela Merkel gave her conditional support. If she is able to assume a fourth term, we may expect to see more progress on this front.

Based on current opinion polling, we regard a renewed Grand Coalition between CDU/CSU and SPD as the most likely. This goes against both parties’ first preferences but neither may have a choice. The FDP, which remains Merkel’s partner-of-choice, is unlikely to deliver a joint majority. A combination with the Greens, or a ‘Jamaica’-coalition with both FDP and the Greens, seems too risky from the SPD’s point of view. It can’t afford staying on the sidelines as the next coalition will have to make profound choices about the future of European integration and on how to spend Germany’s bulging fiscal surplus.

The recent strength of the Euro is at least partially based on the optimism regarding a period of closer integration. If the German-Franco axis fails in this objective the next two or three years, the Euro will no doubt pay a heavy price. For now, however, there appears to be a window of relative calm in the Eurozone political landscape. If we couple this with the spate of good news on the economic front that is showing little sign of letting up, the outlook for the common currency looks rosy. We’ll discuss these issues in the next paragraphs, starting with a closer look into the German economy.

[1] Saarland on March 26, Schleswig-Holstein on May 7 and North Rhine-Westphalia on May 14

German’s economy: robust but static

The German economy is in a healthy state and has been the Eurozone’s growth engine since the Great Financial Crisis. Even in a global comparison the economy has performed remarkably well (figure 1). The high degree of competitiveness is seen as the main driver of Germany’s growth and of its resilience. To some degree, this is true: exports make up a large share of Germany’s GDP and has been crucial in propelling the economic recovery. The cheap currency (still 10-15% undervalued against the USD on a PPP-basis) is a further boon for export growth.

Is this stellar performance really thanks to Merkel-policies? No. Wage bargaining was already decentralised to the firm-level in the 1990’s. This weakened the power of unions and allowed employers to broker the currently prevalent arrangement: restraint in wage demands in return for jobs. Furthermore, the Hartz-reforms have fundamentally increased Germany’s growth potential by increasing its work force. These reforms – which were undertaken by Merkel’s predecessor Schröder of the SPD(!) – liberalised the labour market to a high extent, mostly by severely cutting out-of-work benefits in order to increase the incentives to find work. Germany’s stronger growth rate under Merkel could therefore also be seen as a convergence to the new growth path created by previous reforms. Moreover, she did not introduce any meaningful reforms herself and even reversed some previous reforms (e.g. reversing the increase of the pension age).

But this is understating the importance of the economic stability provided by Merkel’s leadership. During her tenure she faced many crises, economic or otherwise, yet she stayed the course. This provided German businesses and consumers with the necessary confidence to continue on producing, working and – to some extent – consuming. She can therefore politically take credit for the transformation of Germany’s economy from the ‘Sick man of Europe’ with one of the highest unemployment rates of the Eurozone to the economic powerhouse it is today, nearing full employment (figure 2).

Figure 1: The German economy performed well under Merkel's tenure
Figure 1: The German economy performed well under Merkel's tenureNote: Index of real GDP, 2006Q1 = 100
Source: Macrobond, Rabobank calculations
Figure 2: From the highest to the lowest unemployment of the Eurozone
Figure 2: From the highest to the lowest unemployment of the EurozoneNote: ILO definition
Source: Macrobond

This makes it difficult for her political opponents to attack Merkel on the economy. Firstly, most Germans are simply content with a stable job in a turbulent world. Secondly, the SPD has governed with Merkel for two of her three terms. As a consequence, serious disgruntlement about economic issues is pushed to the fringes of the political spectrum, partly explaining the rise of the Alternative für Deutschland (AfD). Despite the general improvement in workers’ real wages, a substantial amount of Germans feel left out as they struggle to get by. According to the Ministry of Economic Affairs, the bottom 40% of workers are on lower wages than they were twenty years ago. This is a side-effect of the Hartz-reforms: workers are pressed to take any job over (very low) benefits. More recently, there has also be a large increase in ‘mini jobs’, part-time jobs that are meant as a transition to a full-time job but may also lead to nowhere.

Wealth inequality is also high. The bottom 40% of Germans barely own anything, sometimes not even a savings account. Wealth is concentrated in the families who own the capital of Germany’s Mittelstand firms. Significant tax breaks on inheritances mean they can pass this on to their offspring, which inhibits economic mobility. There is a lingering sentiment and backlash against these developments in German society, which perfectly fit within the ongoing asset-rich income-poor debate, but this is currently not fully exploited by any major political party.

More structurally, the German economy faces more or less the same issues as it did in 2006. The economy needs higher private and public investment. While there was an argument in earlier years for firms and households to engage in (precautionary) savings in anticipation of an aging society, it does not really hold up anymore (figure 5). In the public realm, the government is also running a fiscal surplus for a few years now, while it is difficult to argue no productive means for that money can be found within Germany. Infrastructure and schools badly need renovation, whereas investment in education could increase economic mobility. Regarding the digitalisation of the economy, Germany significantly lags most of its peers, according to a study by the EC (figure 4). In the domestic services sector, many professions and industries remain protected, leading to low productivity growth there (figure 3).

Figure 3: Productivity growth in services is very low
Figure 3: Productivity growth in services is very lowNote: Index, 1997=100
Source: OECD productivity database
Figure 4: The not-so digital economy of Germany is lagging most of its peers
Figure 4: The not-so digital economy of Germany is lagging most of its peersNote: Digital Economy and Society Index for 2016
Source: European Commission

Internationally, there is criticism on Germany’s persistent current account surplus. In absolute terms it is the highest in the world, even topping the Chinese surplus. During the two crises, the persistency of the German surplus was actively inhibiting the internal devaluation of the peripheral countries. More recently, the surplus was being driven by demand from outside the Eurozone (figure 6), yet the last two years the surplus vis-à-vis the rest of the Eurozone is increasing again.

We don’t see why Germany should be blamed for being competitive. Nor can it be punished for Chinese preferences to drive in German cars. The surplus is however a reflection of the imbalances within the German economy. If Germany uses its savings to boost private and public investment, it would increase its future growth potential. There may also be room in certain sectors to raise wages. This would increase consumption and furthers Germany’s transition to a more domestically-driven economy, and it helps other parts of the Eurozone in the process. Merkel is unlikely to deliver on any of these potential reforms. She thereby risks presiding over an economy that’s stable now, but not ready for the future.

Figure 5: All sectors of the German economy are saving
Figure 5: All sectors of the German economy are savingNote: National accounts data, may not entirely be consistent with BoP data
Source: OECD
Figure 6: Germany's current account surplus to the rest of the Eurozone is increasing again
Figure 6: Germany's current account surplus to the rest of the Eurozone is increasing againNote: Current account balance by region
Source: Bundesbank, Rabobank calculations

Elections in Germany: the mechanics

Let’s get back to the elections. Since the early 1990s there have only been five parties in the Bundestag. The two centrist parties – the centre-right combination of CDU/CSU and the centre-left SPD – call the shots as they generally win 80 to 85% of the seats. The pro-business FDP, the progressive Greens and the socialist The Left compete for the remainder of the votes. The Greens and FDP are mainstream parties who have been in government before on the federal, regional and local level. The Left, originating from East Germany’s former communist party, is considered somewhat of a ‘pariah’, although they strive to purge themselves of this status. Despite that, they’re not likely to be regarded as a feasible coalition partner. The AfD is a populist right-wing nationalist party that may make it to the Bundestag but has no chance to be in government.

Figure 8 shows the current composition of the 18th Bundestag. The CDU/CSU just fell short of an absolute majority whereas the preferred junior partner-to-go FDP didn’t make the electoral threshold. So Merkel had to engage in a Grand Coalition with her centre-left rivals. This is not the preferred coalition for either the CDU/CSU or the SPD, but it happened before in 1965 and in 2005.

Figure 7: History of the (west-)German Bundestag
Figure 7: History of the (west-)German BundestagSource: Macrobond
Figure 8: Composition of the current 18th Bundestag
Figure 8: Composition of the current 18th BundestagSource: Macrobond

It’s worth elaborating a bit on the German electoral system, as it has some peculiarities. The used arrangement is called a mixed-member proportional voting system. This requires voters to mark two crosses on their voting ballots.

The first vote is directly for a candidate in one of Germany’s 299 constituencies. The winner in each constituency then goes to the Reichstag in Berlin directly. This “winner takes all”-approach ensures that the Bundestag has sufficient regional representation. In this sense it is broadly similar to the first-past-the-post system in the UK.

The second vote is for the other 299 seats. This vote is cast for the party list in one of Germany’s sixteen Länder (so a vote for the SPD list in Bavaria or the CDU list in Baden-Württemberg) and used to determine how the seats in the Bundestag are distributed. This is based on a system of proportional representation per Land, meaning that the seats in each Land are allocated to the party lists in that Land.

So far so good, but there are a few complications.

Firstly, there is a threshold. If a party fails to win three constituencies in the first vote or to win 5% of the second vote, it is not entitled to any seats. This happened to the liberal FDP and the anti-euro AfD in the 2013 elections when both narrowly failed to meet this 5%-threshold.

Secondly, there could be a mismatch between the two ballots. There’s an incentive to vote strategically on the first ballot (e.g. a vote for the AfD is a ‘wasted’ vote if CDU/CSU and SPD are neck and neck in that constituency), but this tendency largely disappears on the second ballot. This is also reflected in the data of the 2013 elections. The CDU/CSU and SPD scored significantly better in the first vote than in the second vote (see Table 1).

In practice it is necessary to increase the size of the Bundestag to make sure that each party receives the number of seats it is entitled to. That is, for each party the minimum number of seats is determined by taking the highest of the number of seats won in the first vote and the second vote.

The resulting effects can be quite extensive when a party wins more seats in the first vote than it is entitled to by the results of the second vote, often the consequence of strategic voting. The extra seats that are then “added” are called overhang seats. Under a recent amendment of the electoral law “balance seats” are then also added to other parties in order to ensure complete proportionality of the share of votes for all parties on the federal level. 

Table 1: 2013 elections result: percentages and seats
Table 1: 2013 elections result: percentages and seatsSource: Rabobank

Schulz-effect was short-lived

There are many different pollsters, but they all ask the same “Sonntagsfrage”. It is formulated as follows: “If you were up to vote for the Bundestag next Sunday, for which party would you vote?”. The results are fairly consistent and grasp the same trend. If we look at the average of the past few weeks, the CDU/CSU combination could count on roughly 38% of the votes. The SPD is coming in in second place at 24%. The party experienced rising support in the polls after the nomination of Martin Schulz (former president of the European Parliament), but this effect has almost completely evaporated. The convergence between the CDU/CSU and the SPD turned out to be not much more than a short-lived mirage.

Figure 9: Opinion polling for the 2017 German elections
Figure 9: Opinion polling for the 2017 German electionsSource: Bloomberg, Rabobank

The four parties that are competing for third place are The Left, The Greens, the FDP and the AfD. If the polls are accurate and strategic voting will be minimal, it will be the first time that the eurosceptic AfD will make it to the Bundestag, clearing the 5% threshold.

If we compare the polls with the results of the 2013 “second vote” (see again table 1), we can conclude that the differences are fairly small. Admittedly, the Union is performing slightly worse (41.5% vs 38%), but support for the SPD is basically unchanged. The AfD and FDP are doing somewhat better – probably at the expense of the Union’s support – but it matters for just 2-3 percentage points. 

But beware of surprises!

The consistency in the polls and the minor shift compared to four years ago, falsely suggests that the elections will be a political non-event. A poll published in the Frankfurter Allgemeine last Wednesday indicated that 46% of voters is still undecided. This is higher than in previous elections and perhaps also being reflected in increasing support for the AfD and FDP. It is also a signal that the Bundestag might become significantly more fragmented.

Even though both CDU/CSU and SPD are expected to end up with a roughly similar share of the vote as four years ago, there are now four other parties that can make the 5% threshold. This changes the dynamics; it matters a lot whether there are four or six parties in the Bundestag. If we look at the 2013 results, the votes the AfD and the FDP received combined were actually worth around sixty Bundestag seats, which eventually were redistributed to the four other parties. Increased fragmentation is also likely to yield in much more overhang seats. The size of the Bundestag will definitely increase if the eventual outcome corresponds with current polls.

It is impossible to accurately predict how vote percentages translate into Bundestag seats without making assumptions on strategic voting and the number of overhang seats. Fortunately, there are some projects devoted to this. We use the website Mandatsrechner.de to calculate the seat outcomes for a number of scenarios. These are displayed in the table below. A coalition agreement looks to be inevitable, unless half of the AfD and FDP voters rally behind Merkel. 

Table 2: Scenarios: percentages and seats
Table 2: Scenarios: percentages and seatsSource: Mandatsrechner

Looking for a partner

As we mention above, it is impossible to exactly predict the election outcome, especially with the complicated German parliamentary seat arithmetic. We can however describe the most likely scenarios given the current poll figures.

The most likely option, in our view, is a renewed Grand Coalition with CDU/CSU and SPD. While both parties have implicitly and explicitly said this is not their preference, the seat count may imply that they do not have much of a choice. Moreover, in government the SPD can work on some of its policy priorities while remaining visible and claim some successes while the CDU will look for a successor to Merkel. In terms of policy, the SPD wants to redistribute the fiscal surplus and invest more in infrastructure. Merkel prefers using the surplus for tax cuts. In practice, a combination of the two will probably take place. On Europe, Schulz will flex his muscles but he will be reluctant on breaking points as otherwise the FDP may explicitly ask the CDU to block these. The CDU wants to reach full employment through tax reductions but plans to leave public investment at its current level, which is below the long run average.

A second, slightly less likely scenario is a coalition of CDU/CSU, FDP and the Greens, the so-called ‘Jamaica’-coalition. The CDU prefers the FDP as a coalition party and – when short of a majority – may ask the Greens to join in. The Greens could then extract concessions to show these to their centre-left constituents. This scenario would therefore be a nightmare to the SPD, which would find it very hard to be a credible opposition. Policy wise, there would still be a focus on reducing income taxes (as CDU and FDP want) but more likely in an egalitarian manner.

The third scenario would be an outright majority for CDU/CSU and FDP. While Merkel is not explicitly in favour of this, she may be pushed by her party to go for this option if possible. We would then expect a focus on tax reduction and an increase in military spending to 2% of GDP (which the SPD vehemently opposes).

Implications for Europe

After Macron’s victory, markets turned more optimistic on the Eurozone as political risks abated. His focus on further European integration also means the German elections became more relevant. And while these elections were always going to be less risky in terms of populism, the resulting coalition can still have profound consequences for the future of European integration. We will discuss the implications of the different coalitions on the future of the EU, using the ‘four scenarios’-framework described here.

Another Grand Coalition would likely result in further integration steps. The SPD has actually rewritten its election manifesto to align it with Macron’s plans. It wants a European budget minister and to reform the Stability and Growth Pact (SGP). The CDU is also willing to take some steps towards deeper integration. The Union is in favour of a European Monetary Fund, though it stops short of pooling debt or mutualise risks and does not want to alter the SGP. Altogether this would still move us towards the scenario of deeper integration.

The policies on Europe of the Jamaica coalition are harder to predict. The FDP wants to formalise an exit-procedure for euro countries such as Greece. The Greens are on the other end of the spectrum and actually want to grant Greece debt relief and mutualise some of its debt. The CDU would be the tiebreaker, but it would also be hesitant for deep integration. So this may result in further muddling through or perhaps a two-speed approach if Macron recasts himself.

A CDU/CSU and FDP coalition would be reluctant to take any steps towards further integration. Especially the FDP is openly hostile towards Europe. Some small steps may be possible but this scenario would likely result in the muddling through scenario. There is a tail break up risk if any calamities come up during this coalition’s tenure.

In any case, the window for European reform is small and would have to take place in the next two or three years.

Implications for financial markets

The German elections, including the TV debates and the ensuing coalition formation, are likely to coincide with market repricing of ECB QE (meetings on September 7 and October 26). This will be a much more dominant theme, which will make it difficult to disentangle the financial market impact of the German elections.

If the outcome broadly corresponds with the opinion polls as we now know, we don’t expect to see a major market reaction on the day after the elections. A CDU/CSU win is fully priced in and the risk of a populist victory is extremely small. Of course, polls may be wrong. A bigger-than-expected win for the AfD may cause some short-term disturbances, but even then the centrist parties should be able to form a coalition without the fringe parties.

This process will take time. The SPD may only be willing to join a Grand Coalition as a junior partner when the new government carries out policies that redistribute the public surplus, whereas the CDU/CSU is focusing on tax cuts. Where there's a will, there's a way, however. We’ve seen that in 2013 when it took the two parties a little more than two months to hammer out an agreement. The economic situation is now much more benign.

We regard a Grand Coalition with a positive stance towards further Eurozone integration as the most favorable scenario for the Euro. To some extent, the market has already placed its bets on such an outcome. If the Franco-German axis fails in this agenda, we could see some negatives for the Euro. This is more likely when the FDP is part of the coalition, given its tough stance on dossiers as Greece and its hostility towards Europe.  

Daniel van Schoot
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 30381
Stefan Koopman
Rabobank KEO

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