With a fractious coalition and a shallow 12-seat parliamentary majority, German Chancellor Friedrich Merz – in office since May – never expected to enjoy a political honeymoon. But his first three months in power is turning out still more sobering than anticipated.
The US-European Union trade deal announced in Scotland on 27 July, widely regarded in Germany and across Europe as a heavy defeat for the EU negotiators, confronts the chancellor with three sets of interlinked problems.
First, it marks a fresh setback in efforts to bring back buoyancy to the German economy. The country has been close to stagnation for eight years, with industrial decision-makers slow to respond to the fiscal stimulus tied to March and April’s sharper-than-expected revision of the constitutional ‘debt brake’.
Policy-makers at the European Central Bank, who have been holding off from further interest rate cuts while awaiting the result of trade talks, are now likely to be far more open to a further quarter-point easing when the governing council meets on 10-11 September. Some governing council members see a prospective move to reduce the deposit rate to below 2% as a sign of underlying European economic weakness.
Second, the poorly received trade accord, although it averts an immediate trade war, interrupts what has been a generally positive foreign policy record for the chancellor. This is likely to further dent the poll ratings of his Christian Democratic Union/Christian Social Union grouping, in coalition since May with the Social Democrats.
CDU/CSU neck and neck with extreme right AfD
Although Merz’s never-stellar personal popularity rating seems to have improved, the CDU/CSU has been polling neck-and-neck with the main opposition party, the extreme right Alternative for Germany (AfD). Although slipping slightly in the latest poll on 29 July, the AfD may profit from a welling-up of anti-EU antagonism if criticism persists of ill-judged European Commission negotiating tactics against President Donald Trump.
Third, reaction to the deal – considerably more hostile in France than in Germany – opens potential for discord between Paris and Berlin. This could disrupt efforts by Merz and President Emmanuel Macron to patch up generally fraying Franco-German ties. The EU has agreed to spend hundreds of billions of dollars on US energy products and armaments, as well as accepting a broad 15% tariff across most exports.
Merz warned the deal would cause ‘considerable damage’ to the German economy. French Prime Minister François Bayrou went much further, calling the accord a ‘dark day’ for Europe which had ‘resigned itself to submission’. In a similar vein, Michel Barnier, his predecessor, termed the agreement an ‘admission of weakness’ resulting from ‘poor choices that ensure neither the sovereignty nor the prosperity of the continent and its states’.
Depending on how further negotiations unfold, the episode could increase resentment against Ursula von der Leyen, the contested German president of the European Commission – also a former (much criticised) CDU defence minister. Wrangling over Commission tactics could spill over into other areas, including discussion between France and Germany over nominations for key positions at the ECB, likely to be fraught in the run-up to the scheduled departure of Christine Lagarde as president in 2027.
Copious list of early difficulties
The fallout adds to Merz’s copious list of early difficulties. He has had a difficult time explaining his turnaround on the debt brake reform, with which many supporters disagree. A scheduled €500bn is earmarked for the military and related investments, with another €500bn planned for infrastructure improvements, with considerable doubt about the apportionment of ‘green’ investments.
At last week’s meeting with over 30 corporate representatives in the Berlin chancellery, the private sector vowed to invest €631bn in coming years. But there is some doubt about estimates from Deutsche Bank that gross domestic product could rise as much as 2% in 2026, up from 0.5% previously forecast.
Increased tax depreciation allowances for the next three years are designed to feed through immediately into corporate investments. However, this has not deflected criticism about a delayed reduction in corporation tax, due to a decline by 1 percentage point a year for five years from 2028 – a reduction deemed by conservative economists as ‘too little, too late’.
Lars Klingbeil, finance minister and vice chancellor of the Social Democratic Party of Germany (SPD), has been procrastinating on social benefit scheme reform. Merz and his party want to cut spending by allowing asylum seekers to apply for work and put more pressure on unemployed people to find jobs – but are facing SPD resistance.
Meanwhile Merz is facing an uphill coalition battle with the SPD over appointment of two SPD nominees for the constitutional court. This follows a row over their expression of controversial left-leaning positions on issues such as abortion and mandatory vaccinations. None of these issues seem likely to die down soon – resulting in what may prove to be a testing holiday period for Merz and his already embattled coalition.
David Marsh is Chairman of OMFIF and Andreas Meyer-Schwickerath is a Berlin-based OMFIF adviser.
Image credit: NATO North Atlantic Treaty Organization
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