Friedrich Merz, the designated German chancellor, admits he has only two years to find success in his likely new job before critical tests emerge in 2027. Merz faces the mammoth tasks of holding the European Union together, stabilising the bruised relationship with the US, building Germany’s defence efforts against a threatening Russia and resuscitating a stagnating economy.
The chairman of the Christian Democratic Union, which won the 23 February election, is due be sworn into office on 6 May at the helm of another ‘grand coalition’. This will be the fourth, and potentially the most problematic, in 20 years between the CDU, its Bavarian Christian Social Union sister party and the Social Democrats (SPD) of defeated Chancellor Olaf Scholz.
Merz will not enjoy even the briefest of honeymoons. One of the biggest questions facing financial markets is whether the planned surge in German spending and borrowing can be accommodated without triggering a rise in bond market spreads in economic and monetary union. This could possibly force fresh bond-raising intervention by the European Central Bank. Merz will face eight big tests.
- Merz has little time to rebuild frayed credibility
He retreated from pre-election budgetary caution as a price for agreement from his future SPD partners on a multi-year overall spending package of up to €1tn on defence and infrastructure. His weakened status among stability-conscious conservative voters has been one of the reasons for a decline in CDU/CSU support to 24% to 25% of the electorate, around the same as the far-right Alternative for Germany (AfD), according to latest opinion polls. The AfD is now the second biggest party in the German parliament following the doubling of its score in the election.
- A slower than expected timetable for lowering corporate taxation will not help the economy
An expected investment boost from much enhanced depreciation allowances will provide compensation for a two-year delay in lowering headline corporate taxes. Merz admitted the two-year deadline for enhancing German growth in an hour-long broadcast with Germany’s ARD public sector TV channel on 13 April. He has set a target to raise potential annual economic growth to 2% from the present 0.4%. This will be very difficult to achieve without major improvements in productivity.
- Reforms have to make an impact in the first two years of the 2025-29 legislature period
The AfD has promised a campaign for early elections in two years if Germany does not achieve turnaround in the crucial issues of immigration and the economy. Another reason for the importance of 2027 is the French electoral timetable. President Emmanuel Macron’s two-term mandate ends with the April 2027 election. France will place maximum pressure on Merz to produce results-enhancing reforms to ensure that France avoids a far-Right incumbent in the Élysée Palace. Many high-spending European growth measures favoured by France and Italy will be anathema to Merz’s conservative supporters already distressed by his pull-back from economic orthodoxy over the so-called ‘debt brake’.
- Merz’s most intractable domestic problem is the near impossibility of combining CDU/CSU and SPD approaches on sustaining growth
The SPD is highly leveraged. In its disastrous showing on 23 February, the party recorded its lowest ever share of the vote at 16.4% (12 points behind the CDU/CSU). But it is gaining key ministries in the new government. These include the finance ministry, expected to come under the control of Lars Klingbeil, the ambitious SPD co-chairman. Merz confirmed on 13 April that coalition negotiations almost broke down over the SPD’s wish for new tax increases, which Merz succeeded in rejecting in the light of threats to global growth from US tariff increases.
With understanding between the CDU/CSU and SPD strained by a testing month of coalition negotiations, SPD parliamentarians may not be inclined to back Merz during near-inevitable showdowns over social spending, industry support and immigration. This could raise the likelihood of early elections if the SPD feels its chances are enhanced by severing links with the CDU/CSU and restarting an alliance with the Greens.
- Merz will be confronted with great difficulties in brokering compromises on immigration
This was the most toxic issue during the election campaign, exacerbated by a spate of individual murderous attacks in urban centres over the past year. In finding solutions over rejecting asylum-seekers at borders or repatriating family members, Merz will have to find a balance between adhering to European laws and regulations, satisfying SPD humanitarian concerns and winning general consensus from the German population, where the AfD has been stoking concerns about links between criminality and illegal entry.
- On Europe, Merz will be a key player in guiding the reaction to changes in the relationship with US and China
He will need to reopen the door to special measures for more dynamic European growth without sparking German grassroots anxieties over imbalanced growth and higher inflation. This will include efforts to win some support for the recommendations of former Italian prime ministers Mario Draghi and Enrico Letta in official Brussels reports over the past two years, which have been largely neglected on the German political scene.
- Merz must tread a fine line over defending Ukraine and enhancing Germany’s security
He wants to support domestic industry with planned extra defence spending, satisfy US wishes to ‘buy American’ and bring in a Europe-wide dimension, including non-EU countries. On 13 April, Merz spontaneously mentioned the UK’s 50m population adding to the weight of the EU’s 450m. He expressly called for coordination with Germany’s Nato and European partners over supplying Ukraine with German-Swedish Taurus medium-range cruise missiles, which he said he supports to help buttress Ukraine’s defence against the bombardment of population centres.
- Merz will need to give weight to building the euro as a genuine alternative to the dollar on world financial markets
This includes promoting Europe-wide borrowing vehicles to enhance European prowess in issuing ‘safe assets’. Merz may be constrained to give reluctant backing to European mechanisms for additional borrowing for common defence projects and systems – involving extending the Next Generation EU fund beyond 2026, with a different name. Organising higher German borrowing for infrastructure and defence without disrupting other European capital markets will be a major task. Intriguingly, this could involve imaginative solutions bringing the UK into plans for a genuine pan-European capital markets union – which would necessarily have to involve other currencies as well as the euro.
David Marsh is Chairman of OMFIF. Andreas Meyer-Schwickerath is a Berlin-based OMFIF adviser.
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