Merkel’s Grand Coalition: No model for the old world edit

Germany’s government led by Angela Merkel is about to celebrate one year’s existence. In light of that anniversary many have asked: has it been worth it? For many months, Old Europe – especially Italy and France, but also much of the EU Commission – looked with anticipation to the German experiment for a sign that persistent economic and social problems could be solved by a “Grand Coalition.” In theory, there are two reasons to have a grand coalition. One is technical – no majority exists for a coalition that is dominated by a single large party. The other is the recognition that fundamental change is needed and no single-party-dominated government can survive the onslaught of lobbies and opportunistic opposition. This was the hope in Germany one year ago. To effect lasting change, so the logic goes, "everyone needs to be on board"; otherwise one side will block every effort of the other, even to the point of reversing past legislation. Because this last condition no longer seems to hold, the coalition is probably headed for the skids, possibly much sooner than the general elections election slated for 2008.

-->At the beginning things were moving fast -- especially fast for German standards. With a Social Democratic finance minister, Chancellor Merkel abolished home construction subsidies and cut commuter tax breaks, and there was a broad consensus that this was the right thing to do. It stopped short of cutting more; subsidies continue to represent about 60 billion EUR annually in cash aids, and another 50 billion in tax breaks. Similarly, the coalition was able to reform the system of "Federalism" by giving the states more autonomy in some areas, while taking away their veto rights in others. Unfortunately, the fiscal issue wasn't touched, which could have injected real responsibility into regional politics. (In fact the local Länder chiefs up getting more power in many areas). In the name of fiscal rectitude, the coalition agreed to hike the VAT by 3 percentage points – beginning in 2007. Predictably, in anticipation, this has stimulated current demand for big ticket durable goods, and has temporarily produced growth rates not seen since reunification. In the labor market, the coalition has been unwavering in keeping the Hartz-Reforms on track, and my own interpretation of recent positive news in the labor markets is that these reforms have moved the "equilibrium rate" downwards, just as the 2006 Nobel Prize Laureate Edmund Phelps would have predicted. Remarkably, the SPD has resisted temptation to backslide, even while the Federal Employment Office has slashed spending for useless active labor market programs, running a sizeable surplus of 10 billion Euros this year – of which perhaps a third is due to these cuts. Indeed, Merkel and Co. have managed to maintain the reforms proposed by her predecessor Gerhard Schröder. This alone has created a great optimism in international capital markets that reforms are not just sustainable, but irrevocable.

So much for the good news. After twelve months, the low-hanging fruit is gone. The tough items on the agenda -- health care, serious labor market reform, product market deregulation, and tax simplification are still on the table, but will require significant energy, creativity, discipline, and stamina to deal with a multitude of well-mobilized lobbies and status-quo champions. Most important, a common, agreed-upon diagnosis of the problem is necessary. The art of compromise, the pride of German politicians, will not be enough.

For evidence, consider the most significant test of the Grand Coalition to date, health care reform. The German system is difficult to explain, much less reform. It is a patchwork of government-backed insurance funds, run on wage-related contributions from employers and employees with mandatory membership for all but the best-paid. After a long public debate, the government proposed introducing competition between these health insurers by creating a common fund for contributions, pooling risks and allowing the insured to switch health care funds. As a compromise, the proposal skirts completely the issue of redistribution – should workers pay for health care according to income (SPD), or independent of it with explicit redistribution for the less well-off (CDU)? It turned out that the coalition could only agree only on the fund itself, a bureaucratic skeleton which would be needed in either case, while disagreeing on almost everything else, including cost control. Lobbyists have capitalized on the politicians’ disarray and it seems increasingly unlikely that the compromise will be enacted before 2009 – and after the next federal election. Merkel’s enemies in her own party may even use the gutted health care compromise as a dagger – and withhold crucial support for her in the last minute. Should Merkel be forced to withdraw the proposal, she will be seriously weakened. Not only has the grand coalition failed to provide a viable solution, it has been an enormous waste of time and energy, as well as public attention and patience. No wonder polls for the SPD and CDU are at the lowest level in decades.

Germany’s grand coalition is failing because the politicians still don’t agree on the correct solution to Germany’s problems. But this is not all their fault. In the end, Germany is a functioning democracy and deserves the leadership and policies it gets. Wolfgang Münchau of the Financial Times recently claimed that “Germans don’t believe in fairy tales anymore.” Far from it: Germans are still clutching desperately to the Old European fairy tale that tough reforms can be avoided by following the “third way”. More than a handful of politicians, union leaders and lobbyists are willing to tell them that they can avoid reform and restructuring seen in the US, the UK and the Netherlands as well Scandinavia. This was the message of the ambiguous election results in September 2005: Take small steps, and it will be less painful. Real reform will be even harder now that the recovery has arrived. Never mind that Germany has missed more than a decade of increases in living standards seen in leading OECD economies. No, Old Europe will not benefit from a grand coalition until the central necessary condition is fulfilled: an underlying consensus for real change in the general population as well as in the political classes. By all accounts, we are not quite there yet.