Why does Angela Merkel’s Germany still dominate Europe?

The German elections on 22 September are being watched across Europe, with many of Berlin’s partners hoping it will produce a easing of the austerity-first approach Chancellor Merkel has promoted since the eurozone debt crisis broke out nearly four years ago.

But the prospect of major shifts in her euro policy are slim, even if she is forced into a “grand coalition” with the Social Democrats (SPD), whose candidate Peer Steinbrueck has criticised the chancellor for choking off growth in southern members of the currency bloc by insisting on spending cuts and painful reforms.

“Germany remains committed to eurozone membership, but public opinion and institutional constraints… limit the scope for any German government to drastically alter course towards more generous support policies,” analysts at Citi Research said in a research note.

That makes the election in Europe’s largest economy too close to call.

Economy

Germany is Europe’s biggest economy. Its 2.7tr euro GDP accounts for nearly 30 per cent of euro zone output.

The economy is picking up, its DAX stock index is at a record high, and the euro has recovered from the doubts over its very future just over a year ago.

Chancellor Merkel’s Christian Democrats and their Bavarian sister party would prefer four more years in coalition with the business-friendly Free Democrats (FDP).

However, recent polls show her junior partner only just above the 5 per cent threshold for staying in parliament.

Should the FDP stumble, Chancellor Merkel may be forced back into a “grand coalition” with the Social Democrats (SPD), like her first government of 2005-2009.

Coalition talks with the Social Democrats, with whom the conservatives have greater ideological differences, could take weeks, said William De Vijlder, Chief Investment Officer at BNP Paribas, although markets would be hurt only modestly.

Such uncertainty would affect weaker economies on the euro zone’s “periphery”, pushing up yields on the likes of Spanish and Italian debt relative to Germany’s, the euro zone benchmark.

Europe

Markets will be relieved just to have Germany emerge from months of political vacuum when many of the eurozone’s problems have been put on hold, as Chancellor Merkel avoided endorsing any steps that would go down badly with her voters before the election.

Issues that have been put on hold include a third bailout for Greece – whose collapse in 2010 opened the eurozone crisis – and more aid for Portugal.

Most urgent of all is the need for banking union, which aims to restore confidence in the financial system after a series of taxpayer-funded bailouts.

Germany, the biggest contributor to the bailouts, fears it will also become liable for problems at other countries’ banks.

However, eurozone officials say Berlin is now considering a plan that could reinvigorate the project, albeit on a less ambitious scale.

So far the Social Democrats and their Green allies have supported Chancellor Merkel in parliament on all eurozone crisis votes, clearing the way for bailouts for Greece, Portugal and Ireland.

In coalition negotiations, the SPD would probably push for more measures to boost economic growth and for faster, deeper European integration than a coalition of the conservatives and the FDP would want.

Employment

Germany’s unemployment rate is the second lowest in Europe. There are currently 41.8m people in employment.

However in August joblessness rose by some 7,000 to 2.943, in seasonally adjusted terms in August, the first month-on-month increase since May.

A bastion of strength in the early stages of the eurozone’s debt crisis, the German economy only narrowly avoided recession at the start of the year as a worsening global outlook diminished appetite for its products and willingness to invest.

But it grew at its strongest rate in more than a year in the second quarter and business sentiment hit its highest level in 16 months in August, adding to evidence that it is bouncing back from the brief slowdown.

The non-adjusted number of people out of a job, a politically important figure in Germany, remained below 3m for the fourth month in a row.

Exports

Germany ranks third in the world for exports, behind the US and China. About 69 per cent of exports of goods “made in Germany” were shipped to European countries.

Exports fell unexpectedly in July but imports rose, underscoring that the domestic economy will be key for growth in Germany this year as a weak global environment makes selling goods abroad hard.

Seasonally adjusted exports dropped by 1.1 per cent on the month, data from the Federal Statistics Office showed.

Imports, forecast to gain 0.9 per cent, rose by a less-than-expected 0.5 per cent but an originally reported 0.8 per cent fall in June was revised to a deeper 1.0 per cent drop.