Scholz' coalition collapses. What next?

Scholz’ ‘traffic light’ coalition is over Photo by Hermes Rivera on Unsplash

Dear Reader,

Two major pieces of news in one day. 

First, the outcome of the US elections that Germany's leadership had been praying wouldn't come true: a landslide victory for Donald Trump and his Republican party. 

Then, in the evening, Olaf Scholz fired his finance minister, a move that led to the immediate collapse of his government. 

Like a car crash happening in slow motion, Scholz' 'traffic light' government had been heading for this wall for a long time. Finally, the moment of impact has come.

While the one event didn't precipitate the other, they are still intimately linked.

The German government imploded due to fundamental ideological differences over how to resuscitate the country's ailing economy.

Two of the three parties in the coalition - Scholz' Social Democrats and the Greens - wanted to copy the borrow-and-spend path taken by the US, which favours certain industries. That approach has stimulated growth but also seen public debt levels soar.

Economy Minister Robert Habeck, of the Greens, has argued that, in unstable times, Germany needs to bring critical industries back home, cost what it may. He also sees the jobs that this will create as an antidote to populism (something that the result of the US election would appear to have proven wrong.)

Habeck and Scholz have dabbled in handing multi-billion euro subsidies to chip factories and battery makers, but so far none of these bets have paid off.

The other party in the three-way coalition, the Free Democrats, whose leader Christian Lindner was finance minister, wants to cut taxes and regulation so that the economy as a whole can recover, while keeping public debt low. They also wanted to water down net zero targets.

Lindner argues that it is not the job of the government to “pick winners.” Instead, it should set the conditions for the winners to emerge from the private sector through innovation and competition.

The election of Trump, who has suggested he will impose tariffs of 20 percent on European goods, made these questions about the future direction of the country even more immediate.

The US is the largest market for German goods outside the EU, accounting for sales of €160 billion last year. Industry giants from the auto and pharma industries in particular profit from access to the American market.

If Trump were to follow through with his threat to put up tariffs, it would lead to a 15 percent drop in business in America, German economists estimate.

With BMW, VW et al already suffering collapsing sales in China - their other major non-EU market - the outlook for legacy industries looks anything but rosy.

Moritz Schularick, head of the Kiel Institute for Global Economy, went as far as to describe Trump's victory as signalling “the beginning of the most difficult economic moment in the history of the Federal Republic of Germany.”

The question is: how to deal with these seismic shifts? 

In announcing that he had sacked Lindner on Wednesday evening, Scholz made clear that he wanted to give money to the auto industry to ensure that they can keep jobs in the country.

It is thus unsurprising that the major industry lobbies have broadly backed him. The steel and chemical industries are banking on the government paying their large energy bills; the car industry wants the government to bring back incentives for people to buy their products.

On the other hand, the Mittelstand, the broad base of medium-sized companies that make up that backbone of the German economy, have supported Lindner. They are unlikely to benefit directly from subsidies and complain about “paternalistic” politicians who think they are “the better businessmen.”

In this regard, it is interesting to look at an analysis that the Kiel Institute carried out recently on the effects of a trade war between the EU and the US on overall exports.

While the study found that a trade war with reciprocal tariffs would have a crippling effect on US exports, it would have a mixed impact on the German economy.

There wouldn’t just be losers there would be winners, too. That’s because Trump’s protectionism is going to make US-made goods more expensive elsewhere in the world, something that will open opportunities for competitors.

German car manufacturing and pharmaceuticals would be hit heavily in a trade war, but manufacturers of computing and electrical goods, for example, would see their markets expand.

Presumably, that would speak in favour of a policy that doesn't use public money to prop up the car industry, something that would do little to alter the fact that there are a dwindling number of buyers for German cars.

The Kiel Institute is not alone in saying that Germany's priority should be to uphold the international trade system rather than try to appease Washington. There will be other buyers out there. Ultimately, Trump’s protectionism will hurt America more than it will hurt Germany.

Germany is now set to go to the polls in March at the latest and, despite all the other major events going on in the world, the economy will be the central issue that people will be asked to vote on.

The CDU, who are leading in polling, are very much aligned with Lindner's FDP. CDU leader Friedrich Merz even claimed that Lindner pinched many of the demands he made to Scholz on starting an "economic transformation" from legislation the CDU had proposed in parliament.

Like Lindner, Merz thinks that the priority heading into the choppy waters of a Trump presidency is to keep German debt at a manageable level and instead concentrate on improving the business environment.

Both men want to focus public spending on defence and away from welfare.

At the same time, these arguments are extremely unlikely to win a parliamentary majority.

The CDU are polling at around 33 percent and the FDP are not even certain to make it back into parliament (they're at around four percent and you need five percent to get in).

If things go well and the FDP squeezes back into the Bundestag, these parties will win around 40 percent of the vote and will still need a further coalition partner.

The SPD and Greens, meanwhile, will argue for taking on more debt to save jobs and push through the transformation to a net zero energy system. But, they are only likely to win a combined 25 percent of the vote.

Other solutions to Germany's economic woes will also be proposed. Rather than focusing on the fundamentals of how to run an economy, the AfD and the new left-wing BSW will argue that there is a silver bullet to the country’s woes: lifting sanctions on Russia gas. 

These parties are also on course to win 25 percent of the vote but, due to their reluctance to accept the Westbindung, they don't stand a chance of ending up in a future government. Their main function will be to make a lot of noise.

My own snap prediction: the arguments Lindner has made will win the election. But he won’t be the winner. Voters won’t reward him for collapsing the government (he has form here) and his party will be kicked out of the Bundestag.

Instead, it is Merz who will steer the next government in the direction of deregulation and lower taxes.

But the CDU will have to do a deal with either the SPD or the Greens - or perhaps even both. The result won’t be Lindner’s desired “economic transformation” but it will tip the balance slightly in favour of liberal economic policies.