Germany's political and economic stagnation

Whilst the UK political class continues to eat itself over Brexit, other European countries are increasingly having to face up to significant difficulties of their own. Nowhere is this more evident than Germany where Angela Merkel’s CDU took another significant beating in regional elections in Thuringia over the weekend, pushing it into third place behind the ultra-right AfD and the ultra-left Die Linke. This has given rise to speculation the CDU may have to hold its nose and do a deal with Die Linke, whose roots stem from the former East German communist party. Although the CDU’s leadership officially continues to rule out doing a deal with either of the other two parties, it is a sign of the times that such an idea is even being publicly contemplated.

Meanwhile, the CDU’s governing coalition partners, the SPD, are in the throes of a leadership process that could see them quit the government. Party members have long been critical of its partnership with the CDU, since it has cost them widespread popular support for little apparent gain. In a vote held over the weekend, finance minister Olaf Scholz and his running mate Klara Geywitz narrowly topped the ballot of party members with 22.7% of the vote. Scholz will now face a run-off against the team that finished second in the ballot (Norbert Walter-Borjans and Saskia Esken), with the result set to be announced on 29 November. Team Scholz is committed to the SPD remaining in government. Their opponents would almost certainly want to pull out of the coalition which would make life difficult for Angela Merkel.

It is almost exactly a year since Merkel announced that she was standing down as chair of the CDU party and the European political centre which she represents now faces even stronger headwinds than it did then. Her anointed successor, Annegret Kramp-Karrenbauer (AKK) has not pulled up any trees and German media reports suggest that she has failed to stamp her authority. She certainly does not look like a Chancellor-in-waiting. To add to the political difficulties, the German economy is struggling in the backwash of the US-China trade dispute, with the Q3 GDP figures due for release in a fortnight’s time widely expected to show a second consecutive quarterly contraction. Although Germany has grown more rapidly than the UK over the period since the EU referendum in 2016, this has not been the case of late. Indeed, in the six quarters since the start of 2018, the UK economy has expanded by 1.8% in real terms versus 0.8% in Germany.

It is questionable whether a stronger economy would have much impact on the politics, since this reflects more deep-seated issues, but it is certainly not helping. As a consequence, there is mounting pressure on Germany to ease its fiscal stance. A report in the Handelsblatt newspaper ahead of the finance ministry’s latest tax revenue estimate suggested that the budget surplus this year could be in the “high-single digits”, with tax revenues expected to be around 4 billion euros higher than in the previous estimate published in May. Furthermore, the collapse in bond yields has resulted in an estimated 5 billion euros reduction in debt servicing costs. These are not big numbers in the grand scheme of things, with the budget surplus only likely to be around 0.25% of GDP, but given where we are in the economic cycle today Germany can afford to run a small deficit and still reduce the debt burden. The condition for doing so depends on the extent to which nominal GDP growth exceeds the average interest rate on federal debt. With the latter clearly in negative territory it is evident that there is a reasonable amount of fiscal headroom.

Although it did open the taps to combat the fallout from the financial crisis of 2008, the Merkel government has never given the impression that it is willing to use fiscal policy as a counter-cyclical policy instrument. It is probably expecting too much to expect a response in the near-term as political paralysis takes hold. But if Germany does not act, it is unlikely that other countries will either – despite the calls from outgoing ECB President Mario Draghi in a valedictory speech to euro zone heads of government today. Draghi is, of course, the man who promised to do “whatever it takes” to save the euro in 2012. We need someone to demonstrate the same degree of fiscal courage today.

But Germany’s economic problems are not all about fiscal policy. It is an economy which relies heavily on the export of high quality manufactured goods and as such has been a beneficiary of the globalisation process of the past 30 years. But globalisation may well have reached its limits, as evidenced by the slowdown in world trade growth and the slowdown in the KoF Globalisation index. Incidentally, this is the sort of fate that could await the UK as it seeks to find new export markets at a time when the rest of the world is more interested in turning inwards.

Finding solutions to lance the boil of populist politics will be harder. This is not just a German problem, of course, but without Germany driving from the political centre the rest of the EU caravan is unlikely to make much progress. As we edge nearer to the end of Angela Merkel’s term of office – she has made it clear that she will be gone within two years – there are big question marks over where the EU goes from here. Does it follow the Macron recipe for greater political and fiscal integration or will the current widening of political differences continue? One thing is for sure: The EU that the UK government hopes to leave is not the one it thought it was leaving in 2016.