Voters in Germany went to the polls on September 24 and returned Angela Merkel to the chancellorship for her fourth term. In some sense, the result was not very surprising. The German economy has been expanding steadily for the past four years, and the unemployment rate has dropped to its lowest level in the post-reunification period (Figure 1). However, the electoral results were not all positive for Chancellor Merkel. Yes, Merkel’s Christian Democratic Party (CDU) won a plurality with 33 percent of the votes cast.

However, this percentage was down sharply from the 42 percent the CDU received in 2013. Moreover, Alternative für Deutschland (AfD) garnered 13 percent of the vote, which means a farright party will be represented in the Bundestag (the lower house of German parliament) for the first time since the end of World War II.

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The center-right CDU has governed Germany in a "grand coalition" with the center-left Social Democrats (SDU) over the past four years. However, following the electoral debacle suffered by the SDU – its vote share fell to a post-WWII low of 21 percent – party leaders said they would not enter into another "grand coalition." In order to govern effectively, the CDU needs to form a coalition with other parties. The CDU has said that it will not govern with the AfD, which essentially leaves the Free Democrats (FDP) and the Greens as potential partners. However, there are big ideological differences between the economically liberal FDP and the environmentally conscious Greens. Forming a coalition will not be easy.

Reforms to the architecture of the European Monetary Union (EMU) will be one area of philosophical tension among potential coalition partners. The election in May of Emmanuel Macron as the president of France gave new hope to proponents of EMU reform. Macron has proposed that centralized fiscal authorities should have a larger budget that can be used to stabilize economic growth when shocks hit the Eurozone, and he also has called for a deeper banking union among the 19 economies of the euro area. Chancellor Merkel had expressed some interest in these reforms prior to the German election. However, the FDP is not in favor of deeper EMU integration. It may be difficult for Merkel to make a deal with Macron if the FDP is part of the governing coalition in Germany. In addition, the presence of the EMU-loathing AfD in the Bundestag will pull debate in that legislative chamber further to the right.

For now, financial markets in the euro area generally remain buoyant. Spreads on Spanish and Italian government bond yields relative to their German counterparts, which tend to widen whenever there is financial market tension, have been stable (Figure 2). The euro, which has trended higher versus most major currencies this year, has shown little signs of weakening (Figure 3). But the wide discrepancy in unemployment rates in the euro area, see Figure 4, is a stark reminder that the EMU is far from being "fixed." Financial market tension could rise anew if economic shocks buffet the euro area before the architecture of EMU is reformed. Stay tuned.

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