Will the new government put the German economy back on track?

A dependence on export-led growth fuelled by cheap energy from a belligerent and unreliable partner was always going to leave Germany vulnerable to external shocks. At the same time, dogmatic adherence to rules constraining government borrowing has seen public services deteriorate and infrastructure crumble, discouraging both private investment and consumer spending.

The German economy has now been mired in recession for the past two years and is still barely larger than it was pre-pandemic. Can the new government, headed by centre-right CDU/CSU leader Friedrich Merz, put things back on track?

Germany’s new political landscape shows promise

Early signs have been promising, after Merz established a coalition agreement with Germany’s other mainstream political party, the centre-left SPD, shortly after February’s election. This shut out the more fringe voices that had undermined the previous government.

The speed also allowed him to utilise the period before the new parliament was sworn in to make constitutional changes whilst he and his coalition partners still possessed the two-thirds majority needed to do so. Their move to dilute Germany’s contentious debt brake, which had prevented previous administrations from running even the most modest of deficits, is likely to be a game-changer.

Provisions have been made to spend a massive €500bn over 12 years on infrastructure. Furthermore, borrowing can now finance a much-needed expansion in defence spending, whilst federal states will now be able to take on their own debt. This marks the biggest fiscal expansion in Germany’s post-war history.

Early proposals on how to spend this bounty include a €46bn tax cut for businesses to encourage investments and subsidise energy costs – something they have been crying out for for some time and would boost competitiveness in the current climate. Efforts to bring corporation tax down to the OECD average of 24% would also be welcome.

Merz still has a lot of convincing to do

Whilst Merz has set himself up for the best chance of success in revitalising Germany’s economy, his position is surprisingly precarious. A lack of government experience and a history of creating political enemies may limit his ability to pass further contentious reforms.

This was evident after the shock loss of the first vote to confirm his chancellorship on May 6, in what should have been a formality. This was a clear warning shot from some already disgruntled members of the coalition he has pulled together. Tackling Germany’s demographic crisis (where higher immigration is being used to offset the impact of an ageing population) has the biggest potential to pull his coalition apart, playing into the hands of the increasingly popular far-right AfD party.

Merz seems to be enjoying the unfortunate privilege of being more popular abroad than he is at home, following his full-throated support for bolstering the EU to counter an increasingly unreliable America. He will nonetheless need to convince French President Macron to eschew his protectionist instincts and slash the red tape that is stifling innovation in the EU, and seeing its tech and manufacturing industries fall behind their US and Chinese peers.

Whilst Merz has arguably taken the most important step to putting Germany back on the right track, and has the best chance at success over his predecessors, he will nonetheless remain a hostage to fortune. These efforts will be for nought if diplomacy fails and Germany ends up being buffeted on both sides in the fallout from the US/China trade war. Drives to bolster and reform the economy must also include elements of self-sufficiency to insulate it from outside forces.