On May 22, 2005, Chancellor Schroeder's SPD party suffered a crushing defeat in North Rhine-Westphalia at the hands of Angela Merkel's opposition CDU party, ending the SPD's 39-year reign in Germany's most populous state and prompting Schroeder to call for early elections. After Schroeder intentionally lost a vote of confidence in the lower house of parliament on July 1, 2005, President Koehler dissolved the Bundestag and new elections were scheduled for September 18, 2005.

Given the fact that the CDU enjoyed more public support than the SPD, Schroeder's decision to force early elections was seen as a bold political move, designed to catch his opponents off-guard. Until recently, however, this plan seemed to have backfired on the chancellor. Indeed, many small business owners, whose companies account for 50% of Germany's GDP and 70% of its jobs, were elated at the prospect of a coalition between the CDU and the Free Democratic Party (FDP) as evidenced by the increased optimism found within the Ifo's expectations index, which posted its third monthly increase to reach a 6-month high in August.

The Mittelstand, as these small enterprises are known, has been the hardest hit by the economic malaise that has gripped Germany (and much of Europe, for that matter) and has been clamoring for the government to implement much-needed economic reforms. However, these reforms have failed to materialize under the stewardship of Chancellor Schroeder and his Red-Green coalition (referring to the respective colors of the SPD and the Green party). With unemployment still near historically high levels at 11.6% and the country mired in economic stagnation, it is not only small business owners that are demanding change.

Apart from his Agenda 2010 - a package of labor reforms and social security changes - Chancellor Schroeder has been unable (or, perhaps, unwilling) to further reform the German social market economy. With its solid grip on the Bundesrat, Germany's upper house of parliament, a CDU victory on Sunday in the lower house, it is widely believed, would place them in a better position to implement the many reforms they have discussed, which is seen as very positive, not only for Germany, but Europe and its common currency as well.

To reinstate or not to reinstate, that is the question

The reason the market is so enamored with the prospect of a CDU- FDP government is not simply that they will be able to push their policies through parliament, but rather the opinion that these policies will help end the anemic growth endemic of Germany for the past five years. While Chancellor Schroeder is attempting to maintain the status quo, continually praising the German social model and arguing for reforms that are implemented "in a way that include[s] an element of social justice," Ms. Merkel is looking to the Anglo-Saxon liberal economic model to help kick-start Germany's economy, by slashing bureaucratic red tape and reducing some of the burden placed on the economy by its generous welfare program..

Perhaps the most important issue of this campaign, and certainly the one that has gotten the most attention, is that of taxation. While the SPD has floated the idea of a "tax on the rich" - those making over €250,000 a year - as well as reducing the headline corporate tax rate to 19% from 25% and pushing for a more harmonized tax policy at the EU-level, much of the focus has been on the CDU's proposals and the current controversy surrounding Ms. Merkel's decision for finance minister, Paul Kirchhof, a tax expert and former constitutional judge.

Many within the CDU party are complaining that Mr. Kirchhof is straying from the party line and touting his own tax ideas, including a 25% flat income tax. This has not only caused confusion among the German electorate, but may also be the impetus for the CDU's recent decline in opinion polls [see chart below].

Mr. Kirchhof's radical tax agenda notwithstanding, Ms. Merkel and her team have proposed, among other things, raising the VAT to 18% from 16%, reducing corporate taxes to 22% from 25%, and lowering both the lower and upper limit on income tax to 12% and 39%, respectively.

Additionally, Ms. Merkel's team is looking into reinstating the capital gains tax on the sale of cross-shareholding by large companies. Although many of the other tax initiatives are grabbing the headlines (especially those by the beleaguered Mr. Kirchhof), reinstating a capital gains tax on cross-shareholding could be one of the most salient for the market because of the vast amount of cross-shareholding that exists among German corporations, especially within the banking industry.

Traditionally, many German industries have contained a large amount of cross-shareholding between large corporations and their competitors. This was originally done to help promote stability within the industry but, instead, it has had a negative impact by protecting under-performing firms from takeover bids, hampering profitability and keeping small investors out. Due to a tax on capital gains from cross-shareholding, many firms were reluctant to sell their shares, thus perpetuating the problem. However, during his first term in office, Chancellor Schroeder abolished the tax - much to the joy of the market - and paved the way for large corporations to reorganize their portfolios, which were estimated to contain $250 billion worth of cross-shareholding investments.

Although it is unknown how many of these large firms have diversified their portfolios following the abolition of the tax, a CDU decision to reinstate capital gains tax could have a negative impact on the market (and, consequently, the euro) because it would limit the willingness of firms to sell their existing shares, thus reducing the liquidity of the market, and thwart future takeovers of under-performing companies.

Go west, young (wo)man

Apart from their wide divide on tax issues, the policies of the CDU and SPD have additional consequences for corporations that differ tremendously. Under Angela Merkel's leadership, the CDU is looking westward to the shores of the US and Great Britain for inspiration when it comes to economic reforms. With Germany's economy bogged down by red tape that so often slows investment and restrictive labor laws, the CDU is proposing to loosen regulations on small business loans, allow companies to circumvent wage agreements and make the hiring and firing of employees easier for firms with less than 20 people.

The SPD, on the other hand, has not been as ambitious. Instead, it wants to maintain a more active role for government, including the pursuit of public-private partnerships and will encourage companies to raise wages to help pay for the growing cost to the Germany economy of its generous social security system.

Foreign policy is another source of glaring contention between the two sides. Again, Ms. Merkel has decided to turn her attention away from the traditional Franco-German alliance and has pledged to rebuild Germany's relationship with the US, foster closer ties with smaller EU states and push for a "privileged partnership" for Turkey instead of full EU membership. Conversely, Chancellor Schroeder has vowed to support Turkey's membership, while focusing his efforts on obtaining a permanent seat on the UN Security Council.

CDU + SPD = (Not So) Grand Coalition

Although none of the ideas proffered up by either the SPD or the CDU are especially groundbreaking, those from the CDU are certainly more business-friendly. Consequently, any sign that Ms. Merkel and her team would be swept into office have boosted both the German DAX as well as the euro. In fact, the German DAX has gained more than 12% since the announcement that the election would be moved forward.

For much of the campaign, it has appeared that the CDU and its preferred coalition partner, the FDP, would have enough support to form a majority government. However, the recent confusion over the CDU's tax proposals (as mentioned earlier), Ms. Merkel's inability to connect with voters and the rise of the recently formed Left party have taken some of the wind out of the CDU-FDP sails, dropping them below the 50% threshold, as shown in the chart below.

Despite the recent surge in Chancellor Schroeder's popularity following his debate with Ms. Merkel, there is little chance that he will be elected to his third term as German chancellor given the fact that the SPD remains more than 7 points behind the CDU.

Instead (and more worrisome from the market's perspective), there is a strong possibility that, although Ms. Merkel will become the first woman chancellor in German history, she will do so as the head of a "grand coalition" between the CDU and SPD. A black-red coalition, it is feared, will be unable to push through meaningful legislation and offer up only watered-down versions of the much needed economic reforms currently touted by CDU officials.

Of course, there is a possibility that the final outcome of the German election may not be known for weeks - thus dragging out its effect on the euro - due to the death of a candidate in Dresden, which has forced officials to delay that vote until October 2. Although this vote should not have a significant impact on the national result, if the race is truly neck-and-neck, as recent opinion polls suggest, we may not have a winner until all results (including Dresden) are available.

The euro's long and winding road

With 30% of the population still undecided, it appears that this election will go down to the wire - dragging the euro with it around each twist and turn. As the chart below illustrates, the fate of Europe's common currency has been intricately linked to Sunday's outcome. After initially declining due to the market's distaste for political uncertainty following the SPD's defeat in May, the euro has ebbed and flowed throughout the campaign - rising after the last hurdles had been cleared for the election to take place and falling when the possibility of a "grand coalition" became a distinct probability.

Although we see some upside potential for the euro tomorrow - due to the possibility that the US current account report and US Treasury's TICs data could expose the dollar's external risks - any gains made by the euro will be constrained ahead of the election results. A solid victory by the CDU- FDP coalition could see EURUSD test resistance near $1.26 next week. However, any indication that a "grand coalition" is in the works should push the euro below $1.22. A Fed rate hike two days later could prolong the slide towards the $1.2120-25 territory.