Weekly Update - Elections in Germany : it will be difficult to lift the debt brake

ELECTIONS IN GERMANY : IT WILL BE DIFFICULT TO LIFT THE DEBT BRAKE
60 million Germans will vote to elect their members of parliament. According to opinion polls, the conservative CDU-CSU party (and its leader Friedrich Merz) is likely to win, with the need to form a coalition, probably with the Social Democrats of the SPD. However, parliamentary arithmetic and budgetary rules could prevent a much-needed sharp turnaround in economic policy
 
Towards a new grand coalition
With two weeks to go before the elections, voting intentions are still subject to change. What's more, the distribution of seats is difficult to predict because of the electoral system (mixed first-past-the-post and proportional representation). Nevertheless, according to polls, the CDU-CSU would come out on top with around 30% of the vote, ahead of the far-right Afd (20%), the SPD (16%) and the Greens (13%). As an agreement with the Afd seemingly out of the question, a new CDU-CSU + SPD Grand Coalition would be the most likely outcome; a CDU-CSU + Greens coalition is also possible. Nevertheless, it seems likely that a new government will be led by Merz, although it will certainly not be in place before spring at the earliest.
 
A difficult compromise
Finding a government agreement will not be an easy task, between the spending and social protection cuts promised by the CDU-CSU and the tax rises on high incomes promised by the SPD or the Greens. A government agreement could therefore include only moderate measures (a few tax cuts, a gradual increase in the minimum wage and a limited reduction in public spending).
 
Numerous economic challenges
Despite having narrowly avoided a technical recession (i.e. two consecutive quarters of falling activity), the German economy has remained sluggish since 2022, with the level of GDP remaining quasi-stable since then. This is because the German economic model - based on exports of highquality, low-cost products - has been undermined by 1) post-Covid tensions in the labour market, 2) rising energy costs following Russia's invasion of Ukraine, 3) falling demand from German companies (Chinese slowdown and energy transition) and 4) increased competition from China in the automotive sector, for example. Trump's return to the White House adds to this list the possibility of higher US customs duties and military disengagement
 
The change in the debt brake decisive
Against this backdrop, the state of public finances and the external position remain in good shape. However, restrictive budgetary rules (the debt brake) are in place, hampering the future government's ability to boost demand and revitalise the economic model. The three main governing parties appear to be in favour of reforming the debt brake, although their objectives differ. However, such a reform requires a two-thirds majority in Parliament, which is not guaranteed according to the polls - while most of the other parties (Afd and the liberals FDP in particular) are opposed to it. If an agreement is reached and passed by the new parliament, this could provide fiscal breathing space and fund public investment and military spending. It should be noted that the debate on this front could extend well beyond 2025
 

OTHER HIGHLIGHTS OF THE WEEK
 
In the highlights of the week, we chose to talk about the labor market in the United-States and the monetary policy decision of the BoE :
 
United States: a still resilient job market 
The employment report still shows a robust labour market that should support growth in the coming months. Indeed, net job creations amounted to 143 thousand while the creations for the month of December were significantly revised upwards (237K on average over the past three months). These figures are also reflected in an unemployment rate that remains low, at 4%, and wages that show a growth of 4,1% over one year. The labour market figures are expected to lead the Federal Reserve to maintain a cautious tone and its key rate at 4.50% over the coming months..
 
United Kingdom: interest rates cut by 25 basis points as expected 
As expected by the markets, the Bank of England (BoE) decided to cut its key rates by 25 basis points to 4.50%. The decision to cut rates was unanimous, but 2 out of 9 members voted for a deeper cut (of 50 bp). The disinflation cycle is well underway (2.5% in December 2024) and economic activity is slowing. Nevertheless, given the uncertainties over inflation (which could rise to 3.5% year-over-year by June due to higher utility prices) and growth (recent fall in confidence indices), the BoE insists that it will take a gradual and cautious approach - suggesting one cut per quarter. Against this backdrop, sterling has fallen by 0.7% against the dollar, and markets are expecting between 2 and 3 additional cuts in 2025.

Read full article