Germany's ‘Grand Coalition' takes shape: What it means for the economy

Yahoo

24-02-2025

Friedrich Merz's centre-right CDU/CSU has won Germany's federal election, but with only 28.5% of the vote, the party faces a fragmented political landscape and is set to revive the so-called 'Grand Coalition' with Olaf Scholz's weakened SPD.
As coalition talks begin, investors are watching closely for signals on Germany's fiscal path, with economists divided on whether the new government will be able to deliver meaningful economic reforms.
After a long election night on 23 February, Germany's political centre held, but just barely. Merz's CDU/CSU secured 208 seats, making it the largest party in the Bundestag, followed by the far-right Alternative für Deutschland (AfD) with 152 seats.
The SPD, which has governed under Scholz since 2021, suffered heavy losses, dropping to 120 seats. The Greens, which were part of the outgoing coalition, also saw declines, while far-left Die Linke made small gains.
The Free Democratic Party (FDP) suffered a stunning collapse, losing all 91 seats won in the 2021 election after failing to meet the 5% threshold for parliamentary entry. Its leader and former Finance Minister, Christian Lindner, resigned.
'The German political landscape has become more fragmented than ever,' said Carsten Brzeski, global head of macro at ING.
'While Christian Democrats came in first, they fell well short of the sweeping mandate to reform Germany that their chancellor candidate Friedrich Merz had hoped for,' DWS said in a note Monday.
Despite Merz's victory, the CDU/CSU's performance was far from overwhelming—the second weakest in its history - forcing the party into coalition talks with the SPD.
Markus Söder, the leader of the CSU, the CDU's Bavarian sister party, has already ruled out working with the Greens, leaving a renewed 'Grand Coalition' as the only viable option.
The CDU/CSU and SPD have governed together multiple times, forming 'Grand Coalitions' in 1966–1969, 2005–2009, 2013–2018, and 2018–2021.
One of the biggest challenges facing the next government is whether it can reform Germany's constitutional debt brake, which strictly limits government borrowing.
Goldman Sachs notes that the challenge lies in AfD and Die Linke holding a combined 216 seats—over a third of the Bundestag—granting them the ability to veto any constitutional amendments.
'The AfD is against a reform of the debt brake. The Linke is against an increase in defence spending, even though they might support a debt brake reform to increase investment,' said Niklas Garnadt, an economist at Goldman Sachs.
Despite these obstacles, there are alternative ways to increase fiscal space.
One approach could be using joint European funding for military spending, as EU-issued debt would not count against Germany's debt brake.
Another possibility is a debt brake reform, which Die Linke might back if tied to higher investment spending.
Lastly, the government could invoke the escape clause in response to an external crisis, temporarily easing borrowing limits. 'This would create some fiscal space beyond the debt brake limits in the fiscal year in which the escape clause is triggered,' Garnadt said.
Philip Bokeloh, senior economist at ABN Amro, is more optimistic about debt brake reform, saying there is a high chance of it in a renewed 'Grand Coalition.'
'Easing the debt brake also opens the door to implementing proposals from the Draghi report, which calls for further European integration and higher investments in energy transition, innovation, and defence,' Bokeloh said.
Beyond the debt brake, economists are sceptical that a CDU/CSU-SPD government will push through major structural reforms.
'The longing of many Germans and Europeans for German political and economic stability will not end today, and it's hard to see the next government being able to deliver much more for the economy than a short-lived positive impact from some tax cuts, small reforms and a bit more investment,' ING's Brzeski said.
'A reform of the pension system looks highly unlikely,' he added.
According to DWS this will be 'slightly disappointing for equity markets in the short term. However, in the medium term, the actual policy implications will matter more than the election results.'
Despite political uncertainty, there is now 'a tangible sense of urgency among mainstream policymakers, not least in the face of international pressure,' DWS analysts noted. 'This could pave the way for a relatively smooth coalition formation, which might come as a modestly positive surprise for markets.'
On Monday, Germany's DAX index climbed 1.6% by 11 a.m. CET following the election results, on track for its best session since mid-January. Vonovia SE and Rheinmetall AG led gains, up 4.1% and 3.9%, respectively.