- Date:
- Author:
- GianLuigi Mandruzzato
The recent burst of inflation in the US and in many other countries has led investors to wonder whether the entire inflation environment has changed.
The snap election on 23 February offers Germany a chance to reinvigorate its economy. In this Macro Flash Note, Senior Economist GianLuigi Mandruzzato looks at the reasons behind the government crisis and the key issues that the new government must address.
On 7 November, the German coalition government, which has been in office since 2021, collapsed.1 The crisis follows months of disputes over the 2025 budget and the recipe for relaunching the economy.
Causes of the government collapse
Despite Germany’s debt-to-GDP ratio being among the lowest in the eurozone (see Chart 1), Free Democratic Party (FDP) leader and Finance Minister Lindner opposed the Social Democratic Party (SPD) and Greens’ proposal for a higher deficit in 2025. The resources would have been used to cut energy prices, support the ailing car industry, incentivise fixed investments, and increase military spending to support Ukraine. In contrast, the FDP has proposed cutting social welfare payments and reducing climate protection measures to fund tax cuts for companies, while keeping the budget deficit within the limits given by the debt brake.
Source: IMF and LSEG Data & Analytics. Data as at 19 November 2024.
The debt brake, enshrined in German Basic Law since 2009, prescribes that the structural cyclically adjusted public deficit cannot exceed 0.35% of GDP at the federal level and that the budgets of the Federal states are not in deficit. In exceptional circumstances, the rule can be suspended with a simple majority vote of the Bundestag, Germany’s lower house of Parliament, as happened between 2022 and 2023, to deal with the effects of Covid and the war in Ukraine.
Following the recession in 2023, the projected decline in 2024 GDP, and the downside risks to growth in 2025 highlighted by worsening business sentiment (see Chart 2), the SPD and the Greens wanted to suspend the debt brake again in order to stimulate the economy. FDP disagreement instead led to the collapse of the government coalition.
Source: IFO, LSEG Data & Analytics and EFGAM calculations. Data as at 19 November 2024.
What happens next?
According to the German Constitution, the chancellor must now ask the Bundestag for a vote of confidence. If, as expected, a majority of the Bundestag does not support him, the chancellor will propose to the President of the Republic that the Bundestag should be dissolved. If a new government does not win a vote of confidence within 21 days, the President will dissolve it and call new elections within 60 days.
The main German parties have agreed on an institutional calendar that allows for early elections on 23 February 2025.
The centre-right Christian Democratic Union (CDU) party is ahead in the polls and its leader Friedrich Merz is the favourite to become the next chancellor. However, if the polls are indicative of the outcome of the February election, the CDU will need a junior partner to have a majority in the Bundestag (see Chart 3). Another grand coalition with the SPD seems likely as the CDU ruled out any co-operation at the Federal level with the far-right Alternative for Deutschland (AfD) party.
Source: EFGAM calculations based on various polling firms. Data as at 19 November 2024.
Germany’s economic challenges
A priority for the new government will be to address issues that are hampering the German economy. The International Monetary Fund has highlighted that Germany’s low GDP growth reflects low labour productivity, poor public infrastructure, the low female participation rate in the labour market, the aging population, and excessive bureaucracy.2
Merz, a pro-European, supports a reduction in business tax rates and market deregulation to boost private investment and increase the competitiveness of German companies. He also advocates the need to reduce bureaucracy, increase public investment and improve the efficiency of the public administration, for example by broadening the provision of online services. In addition, the CDU leader favours boosting military spending in line with the 2% of GDP NATO target and using nuclear energy to lower energy costs for German businesses and households.
In contrast, Merz was critical of the increases in social spending approved by the outgoing government and of the EU decision to focus entirely on electric mobility by imposing a ban on the production of internal combustion engine vehicles by 2035 instead of examining other technologies to reduce emissions.
Some of Merz's positions, particularly on social spending, tax cuts and nuclear energy, contrast with the policies implemented by the SPD-led government. It is therefore likely that negotiations to form a new government coalition will be lengthy and that the CDU will have to soften some of its positions.
Furthermore, it is desirable that the new government considers a reform of the debt brake to allow greater fiscal flexibility. In the past, Merz has supported a strict implementation of the debt brake. However, he has recently indicated that he is open to reforming it contingent on the additional resources financing pro-growth programs and social welfare spending remaining under control. According to IMF estimates, a change to the debt brake that increases the federal deficit limit by one percentage point of GDP would keep the German debt/GDP ratio on a decreasing trajectory.3
Reforming the debt brake rule implies changing an article of German Basic Law. This requires a qualified majority of two-thirds in both the Bundestag and the Bundesrat, Germany’s upper house of Parliament. According to polls, this threshold can be reached with an agreement between the CDU, the SPD and the Greens. Although it is not necessary for the Greens to join the government coalition, negotiating a debt brake reform would make it more likely that some of their demands will influence the new government’s policies, thereby further softening Merz’s stance.
Conclusions
The collapse of the coalition between the SPD, Greens and FDP will likely lead to a change of government after the snap elections on 23 February. The leader of the centre-right CDU party Friedrich Merz is the favourite to become the next chancellor and aims to implement a pro-growth and pro-business agenda including lower taxes, deregulation, less bureaucracy, and more infrastructure investments. Even though a new government coalition, most likely with the SPD, will be needed to gain the Bundestag's confidence, it seems likely that during the next legislature German fiscal policy will be more expansionary than it has historically been.
1 The German government coalition was led by the Social Democratic Party (SPD) and included the Greens party, and the liberals of the Free Democratic Party (FDP).
2 See IMF, https://www.imf.org/en/News/Articles/2024/03/27/germanys-real-challenges-are-aging-underinvestment-and-too-much-red-tape
3 See IMF, https://www.imf.org/en/Publications/selected-issues-papers/Issues/2024/08/01/Options-for-Creating-Fiscal-Room-for-Investment-and-Other-Spending-Needs-Germany-552871
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