Europe Express: a shot in the arm for Merz

Welcome back. With the German economy stalled and the far right leading opinion polls, Chancellor Friedrich Merz is in dire need of a political boost. He got one this week when his coalition government endorsed a groundbreaking package of reforms to make the country’s pension system more affordable.

The proposed overhaul is probably the boldest move by Merz’s government so far — the momentous decision to relax strict debt rules and invest massively in infrastructure and defence having been made before they took office in May last year. 

Since then, the coalition has largely fallen short of the sky-high expectations Merz himself created, held back by infighting between the chancellor’s Christian Democrats and their Social Democrat partners. Could this be a turning point?

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Age-old problem

As my colleague Anne-Sylvaine Chassany has explained, Germany’s terrible demographics make the problem stark.

Its pay-as-you-go pension system is notionally funded by employee and employer contributions. But in 2024 it needed a top-up of €118bn from the federal government, eating up a quarter of the budget. That bill will only grow, with millions more baby boomers retiring over the next decade than new workers joining the workforce.

According to the OECD, Germany’s working-age population is set to drop by 23 per cent over the next 40 years, a much steeper decline than the OECD average of 13 per cent.

To address the problem, the government appointed a pension commission made up of 13 experts, economists and MPs chosen by the coalition parties. In just six months it produced a bold but surprising report (you can read it here, in German). Merz and Bärbel Bas, the centre-left social affairs minister, both pledged to implement it in full. Merz said it was a “big step” while Bas called it a “complete work of art” not to be tinkered with.

I’ll spare you too many details on a Saturday, but the reform package of 33 measures has four main elements.

1) a new compulsory personal pension invested in capital markets, modelled on Sweden’s scheme, funded by a 2 per cent salary contribution split between employee and employer.

2) a very gradual rise in the pension age beyond 67 — roughly six months every ten years — in line with life expectancy.

3) restrictions on the right to early retirement for people who have already notched up 45 years of contributions

4) slower rises in pension payments under Germany’s main scheme after 2031

Risk takers

The reforms are bold because they shift more of the burden to the individual. There have been several pension reforms over the past two decades and they have mostly expanded individual benefits and costs for the state. This does the opposite.

It also directs more savings into equities, with higher potential returns, and away from low-risk, low-return savings products. This can only be good for Europe’s ambitions to develop deeper and ultimately more integrated capital markets.

The reforms are not perfect. They have been criticised by business groups and trade unions. The biggest problem is increased costs for employers at a time when they are being squeezed by tax pressures, high energy costs and foreign competition. These higher costs will be partly offset by the planned savings in the reforms, but only partly.

Curbs on early retirement risk penalising people who started working at a younger age. However, the commission found that it is mostly higher-paid professionals who benefit from early retirement (with those on lower incomes disproportionately paying for it). The unions and the left wing of the SPD have complained that retirement at 70 would be socially regressive. Manuela Schwesig, state premier of Mecklenburg-Vorpommern, has described the reforms as “unfair”.

The economist Marcel Fratzscher argues, on the other hand, in this piece (in German) for Die Zeit that a later pension age is a prerequisite for stabilising the system and for ensuring better pensions for the low paid. He argues in this thread (in German) on Bluesky that the reforms are too timid and gradual, thereby penalising the young.

Spread the pain

The strength of the proposed reforms is that they share the burden of reform. Older workers will have to wait longer to retire, younger workers will have to pay a bit more into their new compulsory private pension but should benefit from higher returns. The taxpayer will also have to shoulder some of the transitional costs (it is not yet clear where that money will come from).

This spread-the-pain approach probably explains the rare consensus within a normally fractious government. A row over shorter-term pension measures last autumn brought the coalition to the brink of collapse. On this occasion, Berlin is showing the advantages of coalition decision-making. It shines an unfavourable light on France, where politicians have been woefully incapable of agreeing how to make the country’s pension system sustainable. 

Germany’s plan, assuming it is not derailed, should improve mutual confidence between Christian Democrats and Social Democrats. It could embolden the coalition to be more ambitious in other areas. 

The pension overhaul is just one element of a larger programme of reforms in health, long-term care and the tax system. But these reforms, especially proposed changes to income tax, are likely to be more contentious inside the coalition because there are more obvious losers. 

With pension reform, Merz’s coalition is showing it can fix Germany’s problems. But it will take a lot more compromises to prove it can sustain that momentum.

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