When Germany’s federal election takes place on September 27 the miracle of chancellor Helmut Kohl’s winning in 1994 against all predictions won’t be repeated. There are good reasons why. Germany’s economy may be picking up, but domestic demand recovery is tentative. During 1997 the rebound was export-led, and although the domestic investment cycle is turning up, household spending remains flat at best. At 10.7% unemployment is still too high and much of the recent job creation has come from government-sponsored schemes, especially in the eastern Länder where Kohl’s ruling Christian Democrats (CDU) remain deeply unpopular.
This time the opposition Social Democrats (SPD) are led by a capable personality. Gerhard Schröder is highly popular and an effective debater who handles the media well. What’s more the SPD has maintained a united front during the campaign and Schröder has set out to reassure the middle class that it has nothing to fear from his party. There have been no pre-election overtures to the communist PDS and the SPD has kept its distance from the Greens. So the odds are Kohl will be pushed out, ending 16 years of conservative rule. Indeed, the main speculation in Germany is about the kind of coalition Schröder can put together.
Germany has a complicated electoral system. It virtually ensures that no single party can have an absolute majority in parliament and, related to this, it forces the winning party to move to the centre, by co-opting coalition partners. The SPD could win the election outright were it to achieve 44% of the total vote and the smaller parties were to fail to cross the threshold for representation. But the chances of this happening are low.
Current opinion polls have the Free Democrats (FDP) hovering around the 5% threshold. The FDP usually exceeds expectations on polling day, especially when there is a backlash against the CDU. That’s because it is regarded by many “natural” centre-right voters as a safer option than the SPD to switch votes to. And although the PDS will fail to cross the 5% threshold it can qualify for representation in the Bundestag by winning a minimum of three directly elected constituency seats (as it did in 1994). At the same time, the Green party appears likely to get around 7%, most of which will be at the expense of the SPD’s natural voters.
The wild card is the extreme right-wing parties that go by various names in different German states. One, the DVU, did particularly well in local elections in Saxony-Anhalt last April. The DVU has promised to contest the federal election nationwide. Opinion polls tend to underestimate support for extreme right-wingers, if only because ordinary citizens are reluctant to admit to it publicly. Nevertheless, the smart bet is that the extreme right will still fail to enter parliament.
On balance, the most likely outcome is that the SPD will be the largest party, but it will need to form a coalition. Many argue that this will be a “grand coalition” between the CDU and the SPD. I think that’s unlikely. It is suggested that the SPD would welcome such a coalition in preference to an alliance with left-wing parties, such as the PDS or even the Greens, if the distribution of seats required it. But Germany’s last experience with grand coalition in the late 1960s proved difficult. In many policy areas it was a recipe for paralysis and, because it precluded meaningful parliamentary opposition (the two big parties dominated all proceedings), it led to the creation of a persistent urban terrorist movement. So neither the CDU nor the SPD will rush into another grand coalition.
An alternative is an SPD/FDP coalition. The FDP is currently Kohl’s coalition partner. Although it has tried to differentiate itself from the CDU during the campaign, it is still perceived as part of the centre-right. The FDP’s betrayal did result in the fall of the last SPD government in 1982, but even so the SPD and FDP may be persuaded to coalesce again. After all, Schröder, who belongs to the centrist, modernist wing of the SPD, would probably welcome FDP participation in government since this would dilute the influence of dogmatic SPD left-wingers. It would also allow him to pursue many of the structural reforms he knows he must undertake if the economy is to regain competitiveness.
Yet it is difficult to see how these two parties could come together immediately after the elections. The rank and file of the SPD continues to doubt Schröder’s socialist credentials. An attempted link-up with the FDP could backfire, as Schröder does not exert the sort of control over his party that Tony Blair does in the UK. Furthermore, it wouldn’t be straightforward for the FDP itself to line up on the left of politics after so long on the right.
A third alternative, therefore, remains most likely – an SPD/Greens coalition. Schröder has always avoided talk of this, for fear of playing into the hands of Kohl’s electoral campaign. The chancellor has frequently played on the fear of most Germans that the Greens are sandal-wearing hippies with ideas more akin to the flower-power movements of the 1960s than to the economic realities of the 1990s. But the Greens are evolving. Their parliamentary representation is becoming more organized and disciplined, and coalitions with the SPD at local level have proved surprisingly durable. The chances are that if the SPD becomes the largest party in the Bundestag, Schröder will exact a high price for such a coalition. The Greens would be kept away from defence and foreign policy – the areas where they are reckoned to be least reliable – and instead given cabinet positions dealing with the environment and the economy.
Although Schröder is likely to include the Greens initially, he won’t neglect the FDP. Once back on the opposition benches, the FDP will have to undertake serious internal reform. The current leadership will be ousted and those who take over will be eager to move to the centre, away from its close association with the rightist (by then, opposition), CDU. Schröder will have an interest in co-opting them too, partly to counterbalance the Greens and partly to limit the CDU’s chances of returning to power. The mere possibility of a SPD/FDP coalition would help subdue the Greens. Two years from now, Schröder might even ditch the Greens in favour of the FDP.
What does all this mean for Germany’s financial assets? For one thing, the new government is likely to be more stable than most expect. That’s encouraging. But less encouraging is that, at least for the first two years, it will avoid radical measures and be more concerned with internal political manoeuvring than for the creation of a new Germany. But its political complexion will be less important for German bond and equity prices than the economy. Although the participation of the Greens could push bond yields higher, by far the most important factor will be the business cycle.
Domestic final sales, particularly investment, are now driving the economy. Capacity utilization throughout core Europe is back to levels that normally stimulate fixed investment. Equally important, employment has stopped shrinking, as have real wages. With a less restrictive fiscal environment, consumers look well placed to play a leading role in sustaining growth over the next year or two. It remains to be seen whether German household demand really does live up to this billing, but consumer confidence is returning.
This encouraging cyclical outlook for Germany is tarnished only by external concerns. Export growth is weakening across all regions and the rate of growth in export orders has slowed by two-thirds since its peak last autumn. What’s more, Asia’s crisis has still to be fully reflected in the data. All this means that net exports are set to make a negative contribution to GDP growth in the coming quarters.
That’s not to say the European Central Bank will rest easy. With 87% of the Euroland economy driven by internal factors, a 3%-plus expansion of domestic demand in the core of Europe, and a 5%-plus growth rate in most of the peripheral countries means interest rates will have to go up much more than the consensus expects. That’s going to hit Bund prices.
In a world where growth is negative, slow or slowing, Europe is the best platform for corporate profit expansion. Sustained double-digit earnings growth makes equities look reasonably well supported. However, the 15% to 20% Wall Street correction that’s already under way, plus the impact of rising interest rates in Europe, will offset much of this benefit. Sure, there are lots of longer-term reasons to be bullish about German stocks, fund flows being one. But at current valuations I regard European equities as no more than defensive.
The Deutschmark is another matter. The US economy is in for a recession in growth and the Federal Reserve will move to cut, not raise, interest rates. The Asian crisis will hit the US trade account hard. In Europe, the ECB will raise interest rates sharply to control inflation risk, to establish its credibility, and to ensure a successful launch of the euro. So I expect the dollar to weaken steadily against the euro towards the equivalent of Dm1.55 to the dollar by the end of 1999.
David Roche is president of Independent Strategy, London, www.instrategy.com
