German Election Preview: Last Chance for the Center?

In a new Citi Research note, a team led by Deputy Chief European Economist Christian Schulz previews the February 23rd federal election, exploring the geopolitical and economic context and highlighting that the parties’ campaign positions do relatively little to address Germany’s challenges.

The Trump administration’s approach to trade and tariff policy could risk major trade tensions with both Germany and the European Union (EU). Germany is particularly dependent on the European and global rules-based order, and that order’s erosion is one factor in Germany’s economic decline over the last seven years and a looming challenge for the country’s next government. 

Key issues

The next German chancellor will have to respond to the U.S. on any number of key issues. Trump has repeatedly threatened to impose tariffs on the EU, with his goals ranging from helping balance bilateral trade and bolstering U.S. fiscal revenue to using trade issues as bargaining chips for a range of unrelated issues. The EU Commission handles trade issues for the customs union, including disputes, but member states must give guidance and cover. 

Trump’s drive to reduce U.S. energy costs could also lower energy prices in Europe and help diversify energy imports. But more fossil-fuel consumption would endanger emissions reduction targets and could provoke higher emissions prices of tariffs. How will Germany’s next government approach national, European and international energy policy?

Under Olaf Scholz, Germany became a key contributor of weapons and money to Ukraine and raised its defense spending to 2% of GDP by introducing a €100 billion military fund. But this support was often perceived as overly driven by concerns about escalation. Germany’s next government will have to try and help defend European interests while building up Europe’s defense capacity, to alleviate the burden on the U.S. but also to reduce dependence on it. A key decision: whether to build up Europe’s defense industry (which would boost Europe’s economy) or simply purchase U.S. weapons systems (which would boost the U.S. economy).

Tax cuts for U.S. companies, tariffs and fiscal expansion under the Trump administration pose complex challenges for European fiscal policy. Taxation and fiscal policy are national remits in the EU and the euro area, but the next German chancellor may have to contribute to Europe’s collective stance on the Organization for Economic Cooperation and Development (OECD) minimum-taxation project and on the implications of higher global interest rates for the level and distribution of fiscal space in the euro area.

Trump is looking to scrap regulations of financial services and artificial intelligence, while threatening to take issue with the EU’s Digital Services Act and its implications for U.S. digital platforms. Conversely, the EU may follow China in imposing restrictions on U.S. tech firms in order to gain leverage in trade negotiations. As a result, the EU risks a growing innovation gap as well as new U.S. tariffs and trade barriers.

Economic woes

German GDP has stagnated since 2018 and fallen behind all other G7 economies since the pandemic, and we see a number of reasons for this stagnation. 

Germany’s economy has been hampered by trade underperformance, generally suffering from the erosion of international trade norms, especially the 2018 trade wars between the U.S. and China. Germany has also lost labor-cost competitiveness relative to the rest of the euro area since 2010, been hurt by disrupted supply chains during both the pandemic and the Russia–Ukraine conflict, been dragged down by slowing growth in Chinese demand and become vulnerable to Chinese competition.

This trade underperformance has also led to weak investment, as have red tape, the second-highest corporate tax rate in the OECD (behind only Portugal), more favorable investment incentives elsewhere, high costs and interest rates.

Tight fiscal policy has played a role; public investment has gone backwards with fiscal rules constraining the government’s ability to respond to long-term structural changes such as mass immigration. A 2023 constitutional-court verdict further tightened Germany’s constitutional debt brake, leaving the government little room to address the long-term consequences of the pandemic and the energy crisis.

Despite the last 10 years being marked by weak growth and strong immigration, Germany’s unemployment rate remains low at 3.4%. This tight labor market has led to difficulties finding adequate staffing, which has held back investment and given labor unions bargaining power to negotiate steep wage increases. Other labor problems include a relatively low number of hours worked and extremely high and persistent sick-leave rates.

The constitutional debt brake

Many governments would try to stimulate their economies ahead of an election, and Germany’s public debt ratio, deficits and borrowing costs are all low. But Germany’s fiscal restraint is driven by its constitutional debt brake, which caps structural federal borrowing at 0.35% of GDP and structural state borrowing at 0% of GDP. This rule can be suspended in emergency situations, such as the pandemic and the energy crisis. But calls for emergencies are complicated by Germany’s hawkish constitutional court; a November 2023 constitutional-court ruling on borrowing allowances eliminated most of the fiscal reserves available to Chancellor Scholz’s coalition, and thus also took away that coalition’s policy leeway.

Germany’s new government will start in 2025 with a provisional budget, since the Bundestag didn’t pass a budget in 2024. This means the government can keep spending to comply with legal obligations and to fund programs that already received funding in 2024; it can also borrow up to 25% of the previous year’s budget. But it can’t start new programs. Provisional budgeting may start out relatively neutral fiscally, but as time passes and programs expire, policy could become more restrictive. This makes passing a 2025 budget one of the earliest priorities for the new government. 

That federal budget will be subject to two sets of constraints. The first: EU rules that limit public borrowing to 3% of GDP and aim to put government spending on a path to ensuring the structural general government deficit doesn’t exceed 1.5% of GDP and the public debt ratio falls by 1 pp per year. The second constraint is the constitutional debt brake, described above.

Based on the federal economy ministry’s potential growth estimates and our growth and GDP deflator estimates, federal borrowing excluding the military fund could rise to €41.2 billion in 2025 and €38.7 billion in 2026. But from 2028 on, fiscal policy would have to tighten substantially as the €100 billion military fund would be exhausted and the government would have to start repaying €300 billion of pandemic-era debt over 30 years. Around €30 billion in spending cuts would be necessary.

That means the EU and national constraints leave little meaningful fiscal space for Germany to stimulate its economy; in fact, both constraints require fiscal tightening of 0.5% to 0.75% of GDP toward the end of the next parliamentary term. Reforms of the debt brake seek to avoid this backloaded tightening, but wouldn’t create any near-term fiscal space. And we doubt a wholesale reform is swiftly achievable anyway, as changes to Germany’s constitution requires a two-thirds majority in both houses of parliament, which most polls show would require a coalition of at least four parties.

Potential electoral scenarios

The electoral outcomes we see as most likely depend on how three political parties fare: the center-right Christian Democratic Union (CDU), the center-left Social Democratic Party (SPD), and the Greens. We don’t see the far-right Alternative for Germany (AfD) playing a substantial role in our high-probability scenarios.

The CDU’s focus is on improving German competitiveness by bringing down labor and energy costs, with a pledge to maintain the constitutional debt brake. The SPD looks to stimulate demand in a mostly fiscally neutral but redistributive way, with tax cuts for 95% of households at the expense of the wealthiest 5%, and it’s open to reforming the debt brake. The Greens’ program has many similarities with the SPD’s.

We see the two most likely electoral outcomes as a CDU-SPD Pensioner Coalition and a CDU-Greens Geopolitical Hawks alignment. 

Given the strength of the CDU and SPD, the Pensioner Coalition remains the fallback solution in terms of political turmoil and economic crisis for Germany. While neither party commands huge majorities in today’s Bundestag, they still run almost of all Germany’s states and would be more likely to be able to assemble the majorities necessary for big changes. But the two parties’ manifestos are almost diametrically opposed, and either party would need additional fiscal space to implement some of its promises.

The Greens are the most hawkish party in Germany in terms of Russia and China, and have been more aggressive in pushing for a coalition with the CDU than the SPD has, which suggests the Greens would be more willing to compromise on their lesser priorities than the SPD would be. In considering the possibilities for the Geopolitical Hawks, we note that while the CDU and Greens are already running successful state coalitions in key industrial areas, they’ve never worked together at the national level. Despite economic and foreign-policy overlaps, we see this coalition as a less likely outcome than the Pensioner Coalition.

Our new report, Election Preview: Last Chance for the Centre?, also includes a deeper look at the major German political parties, further exploration of possible electoral outcomes, and strategic advice for investors. It’s available in full to existing Citi Research clients here.