Can Friedrich Merz solve Germany's problems?

Paul Diggle

Hello and welcome to Macro Bytes, the economics and politics podcast from abrdn with me, Paul Diggle.

Luke Bartholomew

And me, Luke Bartholomew.

Paul Diggle

So, the 2025 German federal elections have seen Friedrich Merz’s Christian Democrats and their Christian Social Union sister party become the largest party in the Bundestag, the German parliament. But there are now coalition talks to negotiate and most fundamentally, there are profound economic and geopolitical challenges for the new government to navigate. So, we're going to be talking about all that today. We're joined by Lizzie Galbraith, political economist here at abrdn, and Felix Feather, our European economist. Welcome, Lizzie. Welcome, Felix.

Lizzie Galbraith

Good to be back again.

Felix Feather

Hi. Good to be back.

Paul Diggle

So, Lizzie, let's start with you. Why don't you just quickly outline some of the key outcomes of this election? What would you pick out, in particular, from the results?

Lizzie Galbraith

So yes, Paul, as you mentioned, the CDU-CSU alliance has come first in the German elections. They will hold 208 seats in the Bundestag. And as a result, Friedrich Merz, the CDU leader, is very likely to become the next chancellor of Germany. However, if you look below that, we also have some incredibly interesting results among the smaller parties in Germany. The first and most obvious is that the Alternative für Deutschland party, the AfD it's often known in the UK, has become the second-largest party in the Bundestag. It has basically doubled its 2021 vote share, and it is now a kind of a major force in German politics and is looking to exert its influence over the incoming government. Now it is, of course, still on the outside of the likely coalition talks that will take place, it’s still very much in opposition, but it continues to gain ground and has done particularly in the east of Germany, where it has a very strong support base now. So that is going to loom large over German politics over the next few years, as it looks to really compound that influence going forward as well.

And the other thing to note, I think, is that all three parties in the outgoing traffic light coalition lost ground, in some cases quite a lot of ground. So, the Social Democrats that were the largest party in the previous coalition, sort of centre-left party, secured only 16% of the vote, which is their worst performance in postwar German history. The coalition partners also fared pretty badly. The Greens saw their vote share fall to under 12% of the vote, and the smallest of the three coalition partners, the Free Democrats, saw their vote collapse below the 5% threshold needed to even enter the Bundestag. So, the coalition, which had been struggling with its popularity going into the election, really was punished by voters for what was perceived to be a failure to deliver on its core goals.

And then, of course, you do finally have a bit of a surge on the left as well. So, we're really seeing a fragmentation across the German political spectrum at the moment with the centre holding in the sense that we are still going to see a relatively centrist, coalition government emerge from this election. But you are seeing increased support for parties on both the far left and the far right, which is making the environment more complex going forwards.

Luke Bartholomew

And Lizzie, can you explain why it is so significant that the Free Democrats and other small parties failed to make the 5% threshold? And the impact that has on the Bundestag and potential coalition formation?

Lizzie Galbraith

So, one thing that we were really looking for here, going into the election was, as you said, how many of these smaller parties were actually going to make it over the 5% threshold? There were three parties that were potentially going to be able to do that. So, you had Die Linke, which is a far-left party that is the successor party to what used to be the communists. You have BSW, which is effectively a splinter group from, Die Linke, which has a particular brand of populist left-wing politics that it adheres to. And then you have the FDP, which is a more liberal party that was, as I said previously, in coalition with the Greens and the SPD. And what's important about this is the more small parties that you had for falling over that 5% threshold, the more complex the parliamentary arithmetic in the Bundestag was going to become. When we were thinking about really important fundamental reforms like, the debt brake, which we'll get onto in a bit, that require a two-thirds majority for reform, it would have meant, if you had lots of those parties all in the Bundestag, that coalition management would have become very complicated. The government would be less likely to be able to reach that threshold, given a lot of the smaller parties are opposed to that brake reform. As it stands, what we think is going to happen is a coalition between the CDU and the SPD. So, a sort of a centre left and centre right, tie up, which is very common in German politics. They will hold a 50% majority in the Bundestag but fall short of the two-thirds majority that would be needed for a supermajority. And the two smaller opposition parties that have made it through, so the AfD, which holds about 20% of the vote share overall, and the, the left, Die Linke, holds a one-third blocking minority vote in the Bundestag. Although given that they are political opposites, the likelihood that they work in coordinated opposition to the government is relatively low.

Luke Bartholomew

So, as you say, the Christian Democrats and the Social Democrats, now entering into coalition talks, are likely at some point to deliver a grand coalition government. But what does history say in terms of how long those talks are likely to take? And indeed, has there been any guidance from leading members of either party about what they want to achieve, or what are likely to be the main stumbling blocks in trying to come to that arrangement?

Lizzie Galbraith

So, you would expect that coalition talks take a couple of months minimum. You'd normally see, two to three months being the sort of the norm for coalition formation talks in Germany, although they can be a bit longer than that. We know that Merz is very keen to kick that process off quite quickly, because of the need to get consensus on key issues, including a policy towards things like European common borrowing for defence. There are some really important European Council meetings coming up over the next month, and they're going to be more complicated because of the absence of settled German policy on those issues. So Merz is very keen for some progress to be made quite quickly, not least on who is going to be attending those summits on behalf of the German delegation. But that could be made more complicated by the fact that so many other parties, including the SPD, are going through a bit of a process of establishing what their post-election leadership is going to be. Olaf Scholz, the outgoing chancellor, has made it very clear that he doesn't want a role in the next government, and there is a bit of a process underway at the moment within the SPD over who will lead negotiations in this coalition-formation process, as much as who is actually going to take on the role of policy formation going forward for the SPD. So, there are a few issues that are still up in the air at the moment that will impede that process. And that's before you get on to actually some quite fundamental policy negotiations that will need to take place for any government to be formed. So it's unlikely that Merz is going to be able to announce the formation of a new government before all of the coalition partners have settled on a common agreement on how they're going to approach things like reform of the debt brake, for example, how they want to address taxation, key issues like how to balance the increased need for defence spending with social security needs, and of course, how to deal with the relatively high cost of energy, which has been a really key voter concern over the course of this election. And there are not necessarily a clear framework between the SPD and the CDU at this stage about how they would approach those in coalition. So, there are a lot of groundwork to cover in the next few months before that coalition can actually be formed, not least because we have some leadership issues to contend with first.

Paul Diggle

So, Felix let’s bring you in. As Lizzie has outlined there, the new government is going to inherit some pretty profound economic and also geopolitical challenges. Why don't you outline what some of those are.

Felix Feather

Yeah, so it's certainly true that Germany's economic model is under pressure from multiple structural headwinds. And while the root causes of these headwinds are multifaceted, many of them can be traced back to one particular issue. Namely, relatively slow capital deepening, by which we mean relatively slow rate in the expansion of the amount of capital per worker in the economy, versus in its international peers, especially the US. Now, the way to reverse this trend would be more investment, but at least in the public sector, this is not an easy thing to achieve in Germany. And the single biggest reason for this is the debt brake, a constitutional amendment restricting federal deficit spending to 0.35% of GDP. Essentially, this means the government cannot finance deficit spending on things like infrastructure without reducing the funding available to other programs. And amid upward pressure on spending on interest payments and defence, finding the best fiscal space to fund investments could get more challenging if reforms are not implemented. In addition to the investment shortfall, the government will also have to deal with things like, headaches to do with energy costs. As we've already alluded to, these were a hugely important issue in the election. Of course, the 2022 energy price shock was hugely damaging for German industry. You can still see that in the industrial production data today. In addition, the auto industry, which is so important in Germany, is facing increased international competition following the implementation of significant industrial policy measures in China and the US and more broadly, that's underlined a very weak trend in German industrial output.

Paul Diggle

I suppose alongside those economic challenges are these profound geopolitical headwinds stemming from the apparent fraying of the transatlantic alliance. I mean, looking at JD Vance's speech at the Munich Security Conference, the US administration's flirtation with AfD, the, for now, freezing out of a European role in the Russia-Ukraine negotiations, but potentially the eventual need for European security guarantees in Ukraine. There's also these big geopolitical headwinds that are going to require a large step up in defence spending, as well.

Luke Bartholomew

But not withstanding those very deep political, economic headwinds, European asset markets have actually performed very strongly this year. I think part of that is there is this sense that maybe Merz and the Christian Democrat government could introduce more growth-friendly policy in Germany. So, do you think that's likely, Felix? And, kind of, what kind of policy mix would that actually constitute?

Felix Feather

So, in terms of the structural reforms the Merz government could make, we do see some low-hanging fruit to be picked, which could push up on potential growth expectations. For example, within energy, Merz has committed himself to a policy of reducing energy costs by introducing energy abundance back to the German economy. One way you could go about that, for example, this could be controversial with coalition partners, but could be turning back on some of the nuclear reactors that were turned off by the traffic light coalition. On defence and investment, perhaps the impact on growth is a little more complicated. Because it’s hugely dependent on how this extra spending on defence and investment, if it materialises, where it comes from. So, if this extra investment and spending on defence simply draws resources away from other productive activities, then you would expect the impact on growth to be very minimal indeed. Especially given the relatively low multiplier, so the overall boost to the economy from additional fiscal expansion associated with defence spending. However, if the next government can find a way to perhaps reform the debt brake and finance investments and extra defence spending through deficit spending, well, then this story could be a bit more different. This could be a much more additive scenario for German growth prospects. All in all, we continue to feel that Germany does have some of the worse growth prospects in the Eurozone. These structural challenges are going to remain, but we will be watching this government's reform agenda closely for signs that that could be revised higher.

Paul Diggle

Yeah, two other important parts of that agenda strikes me are, that Merz and the CDU have spoken about tax cuts – possible cuts to corporation tax rate, lower energy taxes, energy grid fees could come down, perhaps in an effort to lower energy prices. And I think they're going to push a certain deregulatory agenda as well. So, a lighter touch regulatory framework. Taking a little bit of inspiration, perhaps, from across the Atlantic there as well, pursuing more business-friendly agenda. But Lizzie, obviously one of these huge debates that the new government is going to have, huge challenges they're going to face, is whether they can reform the debt brake. So, this is the constitutional constraint on the size of German deficit spending – it's limited to 0.35% of GDP on the structural deficit. That is pretty austere way to run fiscal policy. At points that seems to have played into Germany's recent economic underperformance. How would this government go about reform of the debt brake and what might be the obstacles to reform?

Lizzie Galbraith

So, there are actually quite a few obstacles to reform in that. On the face of it, at least, the parliamentary maths currently isn't there in the Bundestag to support the two-thirds majority vote that you would actually need for a constitutional reform to the debt brake. So, as things look at the moment, you have the three centrist parties broadly in favour of some sorts of debt brake reform.  So, the CDU-CSU probably supports some tweaks to support increased defence spending. Their likely coalition partners, the SPD, has previously said that they would be supportive of it for increased defence spending if it came alongside increased investment spending. So a more dual-track use of those funds that it would free up. And the Greens also broadly agree with that approach as well. They would want to see some of those funds allocated towards, as an example, renewable energy infrastructure, as well as going onto things like defence. So, there's a broad agreement on the principle of debt brake reform among those three parties, although they disagree on exactly how those funds should be used to some extent. But the problem for the incoming government is that those three parties do not, by themselves, make up a two-thirds majority. That means that they're going to have to find some votes from the other parties in opposition. And they both, for different reasons, are likely to have issues with this reform agenda. So first you have the AfD, which has been very strongly opposed to any debt brake reform, and are also largely opposed to any defence spending that goes to support Ukraine in particular. So, there are additional complexities around trying to go to the AfD for votes, before you even get to whether or not that would be a politically viable option, to break the taboo of going to the AfD for political support. And that leaves you with Die Linke, which has been previously interested in debt brake reform, but is very much opposed to debt brake reform if it funds defence. So, there are lots of complexities at play here. It is possible that you could maybe see a way to getting some limited Die Linke support if you had sufficient funding for welfare or infrastructure, for example. But that's not currently where the CDU see their preferred policy as being. So, there are lots of compromises ahead if we're likely to actually see this happen. And the additional issue here for Merz is that he's indicated he really wants to see Germany take a lead role in how Europe as a whole is going to respond to this challenge of the US withdrawing security supports from Europe. It wants to play a key role in the debate around how Europe responds. And it's going to be very difficult for Merz to retain any credibility on this issue if he's not seen to be leading from the front with increased defence spending. It's very hard for Germany to achieve that unless we actually get this debt brake reform, because of its very, very tight fiscal situation at the moment. So, there's lots at stake here for Merz and some very very complicated negotiations both in the coalition and with the opposition parties that will have to go ahead first.

Luke Bartholomew

Are there any alternative approaches or short-term temporary fixes the government could pursue, assuming it can't get full constitutional reform over the line? As you say, Merz is very committed to Germany taking on a bigger role in European defence. His credibility, his government's credibility will stand on that. So, are there other things they could do if constitutional reform just turns out to be too difficult?

Lizzie Galbraith

There've been a few things that Germany has tried in the past, so its recent increase in defence spending was actually funded by a special fund that that was effectively off balance sheets. The challenge there is that that was also something that required a two-thirds majority. So again, even more unlikely to be repeated, I think, given the current parliamentary arithmetic. It's very unlikely that you would see Die Linke or the AfD provide votes for something that was solely for defence spending, such as that. You are likely to see a renewed conversation across Europe around some sort of common borrowing to fund defence spending. That is something where maybe the domestic situation in Germany actually pushes Merz to change what has previously been a long- standing opposition to that type of common borrowing. Maybe that makes that a more attractive option for not just Germany, but many other countries across Europe as well, given the fiscal constraints that we're seeing across the bloc. And there is the option of one-year, sort of, rolling stopgap funding, which falls short of necessarily being a constitutional reform, but doesn't necessarily give you the kind of certainty that you would need for significant increases in defence procurement, for example. So, it wouldn't necessarily be a real solution to some of the defence challenges that Germany has. But this conversation around common borrowing for European defence, I think, is maybe where we're likely to see the most action over the rest of 2025, certainly at a European security level.

Luke Bartholomew

And then finally, the question that seems to me to be hanging over this whole conversation, given the deep structural challenges that we've talked about and given Alternative für Deutschland’s very strong showing in the elections. It's comfortably in the position to be the main opposition and therefore potentially well-placed to capitalise on any perceived failings of this government. Is there a sense that this is the, to coin a phrase, “last chance saloon” for mainstream German parties?

Lizzie Galbraith

I think it is definitely the case that this is a very high stakes government in that there has been a loss of faith across quite large swathes of the German electorate with the establishment parties, both incoming and outgoing, of the recent governments. And that means that you have seen particularly and then, East Germans in particular, quite a strong turn to the populist parties across the left and the right. So, there's absolutely, this growing loss of faith with the solutions that the more established parties have on offer, and certainly their faith in their ability to translate those into policy action when in government. And if that trend holds, if this coalition fails to get fundamental reform through the Bundestag and really fails to start showing genuine achievements in government, in progressing some of these agendas forward, then that does leave the door open, I think, for the AfD in particular to continue to make gains across the electorate that is clearly very dissatisfied with the current state of the German economy, and is increasingly looking at different parties that are promising radical solutions to some of these issues. So, yeah, I think it's very much a high stakes government, in that Merz has got to show that he's made good on some of the promises that he's made on the campaign trail. And the German electorate certainly doesn't feel like it's in a particularly forgiving mood, which is very much a trend that we're seeing across the developed economies at the moment. Germany’s certainly not alone in seeing these more populist parties gain some quite significant ground in elections over recent months.

Luke Bartholomew

I mean, perhaps it is just worth quickly saying that there does still exist the so-called “firewall” in German politics, right? That means the mainstream parties don't want to work with AfD, Alternative für Deutschland. That means that even if they were to win, say, the next elections they may struggle to find any coalition partners to enter into government. So, I probably should finish by asking you, Lizzy. I mean, do you see any reason for that firewall to slip any time soon, or do the German parties remain deeply committed to that?

Lizzie Galbraith

Nationally I don't think there's a reason for us to think that’s going to be the first thing that goes, I think we would have some quite early warning signals that firewall was fracturing, if that comes to pass, because you have such a devolved nature of government in Germany. So as things stand, though they're not actually involved in any of the regional governments either, despite some very strong electoral showings there, too. So, I think the first sign we would have that that firewall was starting to crack a bit would be a willingness to enter into coalition with the AfD at a regional level. And that would be a sign, I think, that you may be seeing a different approach taken to working with the AfD that would then filter nationally. But I really doubt that the first sign we would have of that would be in the Bundestag itself. So, I think we've got quite a way to go before we have a conversation, about, you know, the AfD and its role in German governments nationally.

Luke Batholomew

All right. Well, I think that is all we have time for this week. So, as ever, please do let me remind you to like and subscribe wherever you get your podcasts, if you have not already done so. And then all that remains is for me to thank Felix and Lizzy for joining us today, and to thank you all for listening. So, thanks very much and speak again soon.

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