Future German government to work on centrist program. Angela Merkel to lead a caretaker government until year-end

The result of the general elections in Germany imply continuity in a moderate financial and economic policy as a likely three-party coalition should gather around a centrist program. This should limit relative stock movements and in the Bund yield. It will take several weeks to know the composition of the new government, including the name of the new chancellor. The current Merkel-led government will be handling the necessary matters as a caretaker until a new coalition is sworn in. We expect this to happen before year-end as Germany will hold the G7 presidency in 2022.

The next chancellor has to build a majority in the Parliament

Two coalition scenarios are likely: either a SPD-led government (‘Traffic light’) under a chancellor Olaf Scholz, who improved its result by 5.2 points compared to the previous election in 2017, or a conservative CDU-led government (‘Jamaica’) under a chancellor Armin Laschet, who lost 8.9 points and registered its worst post-war result. Either one would lead a coalition including the Greens and the free-market FDP. The SPD has led a ‘social-liberal’ coalition between 1969-82 (Brandt, Schmidt) and a ‘social-ecological’ coalition between 1997-2005 (Schröder). Now, Olaf Scholz appears willing to lead a ‘social-liberal-ecological’ government and is looking forward starting coalition talks soon. A continuation of the current ‘grand coalition’ between the centre-right CDU and centre-left SPD is mathematically possible but the political willingness is clearly missing as the CDU is unlikely to accept a junior role in a Olaf Scholz (SPD) led government.

The junior partners Green and FDP have to agree on their differences … and on the chancellor

In a more fragmented Parliament where roughly three-quarters are not in the chancellor’s party, the role of the junior partners is gaining more weight. This situation is known from other European countries, such as Italy and Spain, but represents a significant evolution for Germany.

Traditionally, German coalition talks to form a federal government end in a “contract for coalition”, defining the political agenda and the ministerial responsibilities for the next four years. The next chancellor has therefore to propose compromises which allow all parties entering the coalition to rally behind him.

In the end, the smallest overlap among key policy themes is between the Green party and the FDP as they disagree on key policy themes. The most arduous bilateral talks in the next days are therefore to be expected between the two upcoming junior partners as they diverge on housing, labour market policy, fiscal rules and the European policy. And, finally, given the election outcome, the junior partners Green and FDP will pick the chancellor.

The upcoming coalition talks will tilt the political balance and set the agenda

We note that the result of the German federal elections has been in line with the most recent polls which showed that the outcome was too close to call. There is some relief that the tail risk of a participation of the Left in a coalition government hasn’t materialised.

Among the political considerations, one has to take into account that the Green Party has the biggest overlap and is likely to prefer being junior partner in a SPD-led government than in a CDU/CSU-led government, while the FDP would rather prefer the opposite.

A SPD-led coalition should push along with the Green party for higher fiscal spending and an EU Stability and growth pact reform next year towards less austerity, while the FDP is likely to remain vigilant on tight fiscal rules.

A CDU-led coalition should push along with the FDP for a smooth modernisation of the economy and the administration including the necessary digitalization, while the Green party is likely to remain vigilant on the climate transition.

Typically the party with the largest vote share starts coalition talks. This time, the junior partners will have to sort things out first, starting on 29 September. The next step is then to formally enter coalition negotiations. During this phase (likely starting during October) volatility could temporarily arise if one of the junior partners walks away from negotiations as it was the case in 2017. This would likely lead to a new grand coalition which no one really wants today.

The question of a possible German leadership in the European Union has not been answered yesterday. We expect the new government to be sworn in by the end of the year to be ready for taking over the G7 presidency in 2022 and working together with its closest neighbour during the French presidency of the EU in H1 2022. The willingness to support more leeway in the upcoming discussion on euro area fiscal reforms or not will however only be decided in the coming weeks once coalition negotiations among three parties officially start.