The media spotlight has fallen on the coalition's plans to raise VAT from 16 per cent to 19 per cent and the top rate of income tax from 42 per cent to 45 per cent. These proposals have been roundly criticised as risking further damage to already sluggish consumer spending. Although German exporters have been doing well, consumers have not.
Traditionally, such fiscal austerity has at least offered the hope of an offsetting payoff from lower interest rates. But not this time. Monetary policy is in the hands of the European Central Bank, not the Bundesbank. The German Finance Minister-designate, Peer Steinbrüeck, has spotted this one. Last week he urged the ECB to leave rates "unchanged for as long as possible". He got his answer on Friday from ECB President Jean-Claude Trichet, who dropped the strongest possible hint that it is about to raise them from their "abnormally low" level of 2 per cent, perhaps in December.
Evidently, the ECB is not impressed with the fiscal tightening that is being promised. It's not hard to see why. The main tax hikes will not be implemented until 2007, and Bundesbank officials have pointed to the stimulus measures pledged for 2006. These include additional spending on items such as infrastructure and families, and a temporary increase in tax write-offs on the depreciation of machinery and equipment. Chancellor-designate Ms Merkel described these measures as "preparing the patient for a major operation".
Indeed, I have sympathy with the ECB's scepticism about whether this "major operation" will take place. Promises of fiscal tightening the year after next have been broken year after year. Conscious of this, Ms Merkel attempted to bolster the credibility of her coalition's plans last week. She rejected the idea that its budget consolidation target could be put back if growth again disappointed, commenting: "We can't keep saying for years in a row that we can't manage a budget that conforms with the constitution. That's not on".
This is all very well, but if growth disappoints again, her coalition may not survive long enough to implement its plans. Ominously, popular support for Ms Merkel's CDU/CSU parties has already fallen to 32 per cent, one point behind their SDP coalition partners. Major state elections due in March could force a change of course.
Where I part company with the ECB is in predicting that economic growth, in Germany and the eurozone, may indeed disappoint again by the second half of next year. While it is doubtful that the German fiscal austerity plans will survive in anything like their current form, the political malaise that pervades much of the eurozone is likely to continue to weigh on consumer spending. There are signs that the corporate sector is showing a greater willingness to increase capital expenditure, but it is loath to spend more on workers, whether through extra pay or jobs, so long as unemployment remains high and labour market reform proceeds at a snail's pace.
Meanwhile, a levelling out of housing market activity in the US may lead GDP growth there to slow sharply later in 2006. Thus the eurozone will be faced with a less favourable environment for its exports, particularly as this may be associated with a renewed downturn in the US dollar.
This might just dissuade the ECB from raising interest rates to the 3 per cent level currently expected by the financial markets. However, that is unlikely to be enough to salvage Ms Merkel's plans.
Mark Cliffe is chief economist, ING Financial MarketsReuse content