Germany: Code Red!

Farewell Angie, Hello Olaf! The SPD leader Olaf Scholz is in pole position to become the next Chancellor of Germany after the Phoenix-like resurrection of his party from the electoral wilderness. This is thanks to his appeal as the least worst option after the Chancellor Candidates of the other two largest parties spectacularly imploded over the course of the campaign. Firstly, the lamentable Laschet of the CDU managed to find himself caught on camera laughing whilst visiting a flooded town in July; then the Green Party’s Annalena Baerbock suffered a string of damning accusations including that she inflated her CV and plagiarised sections of her book. By comparison, the current Finance Minister looks like a safe pair of hands.

But his position as Chancellor isn’t guaranteed. Although the SPD are currently top of the polls with 25%, that’s a far cry from their historical average haul of 32% in all elections since reunification. The last time they were in power as the majority coalition partner (in 2005), they were capturing closer to 40% of the vote.

So they will certainly need a partner. In recent times that has come in the shape of the CDU/CSU, but with their vote share skidding around 20%, that is unlikely to generate enough seats to form a stable majority government.

Step forward the Greens. They’re set for their best ever result, even with the dip in form following Baerbock’s woes. At the last election they took 9% of the vote and current polls have them winning around double that. The SPD and the Greens therefore look assured for positions as the main parties in government.

So much, so left, so green. But on current polling, a third party will be needed. This is where the market will focus. Will they choose the business-friendly, budget-balancing FDP led by the charismatic Christian Lindner? Or will it be the ex-Communist Die Linke, the Left Party?

If it’s the latter, the spending spigots will be turned up to 11, and you’d expect Bund yields to soar while the Euro swoons at Communists entering the hallowed German government. If it’s the FDP, then with Lindner at the helms of the finance ministry, some fiscal rectitude will be restored, stabilising yields and the Euro.

After all, Lindner just gave a candid interview to the FT where he could not be more explicit about his priority for a balanced budget, explaining that ‘The prerequisite for us joining any coalition is that we can’t have tax increases and we respect the constitutional debt brake’. The debt brake was implemented following the bailouts from the financial crisis, writing into German law that the structural budget deficit must not exceed 0.35%.

But this law has already been suspended due to the pandemic. Germany has just clocked its largest budget deficit in thirty years. And once the spending spigots are switched on, they’re very hard to switch off. Not least when the central bank is hoovering up all that debt.

For this election, then, Germany is going left and going green. Lindner might be the only man left standing on a policy of prudence – and as such, be left out in the cold. His ideological bedfellows on the right, the CDU/CSU, have even had their wobbles over Germany’s famous “Schwarze Null” obsession (Black Zero, denoting a balanced book).

Merkel’s Chief of Staff wrote an op-ed to Handelsblatt in January this year admitting “the debt brake cannot be adhered to in the coming years”. Laschet promptly slapped him down but then cunningly created the concept of a “Germany Fund” to invest in infrastructure. Despite claiming that “we can’t allow a situation to arise where you’re circumventing the government’s debt management policy”, that’s exactly where he’s heading. The leader of his sister party, Markus Söder of the CSU, has even flirted with the idea of climate policies being ringfenced outside of the constitutional rules.

If even the pragmatic centre-right are considering extra spending on green measures, Germany’s future is clear. More spending, more deficits, more debt – and hopefully, as a result, more growth. This is a paradigm shift from Europe’s largest economy, and, as such, will change the direction of the Eurozone. Having struggled with deflationary demons, the inflationary chickens will now come home to roost. If they’re accompanied by growth, then the Eurozone might just finally shake off its sclerotic shackles and become the tiger economy for the 21st century.

There is one more hurdle it must overcome. For the Eurozone to thrive, its monetary and fiscal institutions must become more integrated. Merkel was always committed to “ever closer union”, and Laschet, as a former MEP, even more so. Olaf Scholz has gone a step further; he greeted the massive Next Generation EU fiscal stimulus as its “Hamiltonian moment”, referring to when the United States federalised the debts of individual states in 1790. The Greens are similarly on board. But Die Linke, the FDP and the AfD have reservations about the European project, or at least the need to preserve some German freedoms within it. So even if the FDP join a SPD+Greens coalition, tempering fiscal profligacy, they will raise the risk premium for German assets due to their stance on Eurozone institutions.

It is Code Red for Germany after September 26th. The end of Merkel leads to the beginning of much more risk.