Merkel’s difficulties start after election

C

hancellor Angela Merkel is at the high point of her power. But her victory – at the expense of the demise of her coalition partner of the last four years, the liberal Free Democrats – is bittersweet. Whatever the shape of the new government in Berlin, she faces a complicated time in office, with the opposition Social Democrats likely to expand further their majority in the upper house of parliament, the Bundesrat.

In coming months, the present favourable German economic picture of low inflation, low unemployment, low interest rates and reasonable economic growth is likely to give way to a less propitious environment. The present conjuncture marks Ms Merkel’s golden age. From now on, it all gets much more difficult.

One big problem is the parlous state of the debt-ridden peripheral states of Europe, led by Greece. Unsustainable debt levels will not be significantly improved by the patchy economic recovery now taking hold across Europe. Wolfgang Schäuble, the finance minister, has confirmed that Athens will need further debt relief next year.

Although he has claimed that this will not involve a formal debt write-off, further action to stretch out payments and lower interest rates on existing borrowing, as well as new loans, will be necessary.

European politicians promised such steps to the International Monetary Fund last year as part of a typically drawn-out bargain with Christine Lagarde, the IMF managing director. Under pressure from emerging market economies complaining that Europe is garnering too much IMF largesse, Ms Lagarde is more exposed over the issue than many outsiders appreciate. There are even hints that this could be a resigning matter for her.

Two-thirds of Greece’s €300bn of government debt is owed to official creditors abroad, including various European rescue funds as well as the European Central Bank. So the probable debt restructuring will for the first time require taxpayers in euro members to take losses, both directly and indirectly (through the need to compensate for the losses taken by central banks).

This would be a highly unpopular outcome in Germany, which Ms Merkel so far has made every effort to play down. The other principal European countries subject to emergency credit programmes, Portugal and Ireland, will almost certainly also require further official credits next year and may demand, too, a softening of debt conditions.

The fragmented growth picture in Europe will increase pressure on Germany to take a more activist stance. Profiting from much more diversified trade than most Emu members, Germany is doing relatively well, while peripheral countries, which since 2010 have substantially depressed demand to reduce their economic imbalances, are emerging much more gingerly from the downturn.

The lesson of recent decades is that European financial problems arise not during times of general economic stagnation, but instead coincide with periods when Germany is growing at a higher rate than its peers. This was the principal factor that caused the epochal currency crisis in 1992-93 immediately after German unification, as well as the upsets in Emu in 2010-11 as Germany led the euro bloc out of the 2009 recession.

As part of a general upturn in world interest rates caused by anticipation that the US Federal Reserve will gradually end its quantitative easing measures, German bond yields have risen substantially during the past few months. This is likely to put pressure on borrowing costs in peripheral Emu countries that have enjoyed welcome declines in their own bond yields over the past year.

German elections often have a significant impact on the continent’s financial fortunes. Unpleasant decisions affecting interest rates and currencies are often delayed until after polling day. The landmark D-Mark revaluation of 1969 took place just after an election. Chancellor Helmut Kohl’s confirmation in the March 1983 election was followed by a major realignment in the European Monetary System. Another Kohl win, in the first elections for united Germany in 1990, was followed by the spending excesses on German unification that led directly to the upsets of 1992-93.

Ms Merkel and her allies seem to be banking on US growth and, no doubt, a stronger dollar (helping European exports, as happened in the late 1990s just before the euro came into force) to help the European economy. That would be the optimistic outcome for the next two years. A more sobering assessment is that capital flowing into the euro periphery during the past 12 months will retreat back to the Germanic Emu core in coming months, similar to the way that investors have turned their backs on emerging market economies. If that happens, Ms Merkel’s crisis management qualities will be tested anew.

The writer is chairman of the Official Monetary and Financial Institutions Forum, and a former FT European Editor