Next for Germany’s Merkel: Fix Europe

September 23, 2013, 5:04 PM UTC
Angela Merkel

FORTUNE — Now that Angela Merkel has decisively secured a third term as Chancellor of Germany, it would be wise to embrace a grand coalition with her two leftist rivals in order to attain the political stability necessary for her to finally concentrate on leading Europe out of its fiscal and monetary mess. While such a grand coalition with Merkel’s party and both the SPD and the Greens would have been politically unfeasible just a few years ago, it could actually work today as Merkel has been successful in steering her party to the center of the political spectrum.

By embracing such a coalition, Merkel would have the political confidence at home to support a number of reforms to ensure a more stable eurozone. That includes not only a banking union but also a closer alignment of fiscal policy. While this would entail a loss of sovereignty, which some in the currency union would have a hard time accepting, with the full backing of Germany, almost anything can happen.

Merkel summarily crushed her opponents Sunday easily winning a third term as German Chancellor. To be more specific, her party, the CDU/CSU, crushed their opponents to secure a near majority in the lower house of the German parliament with 311 seats, thus giving the CDU/CSU party chairman, Merkel, the keys to the Chancellery.

But Merkel does not have enough seats to govern alone — she needs five more to secure a clear parliamentary majority. That means she must form a coalition with one of her rival parties. Such an arrangement is normal in German politics — its odd voting system almost forces the issue. Unfortunately, her current coalition partner, the fiscally prudent and socially liberal FDP, were slapped so hard in the face by the electorate Sunday that they didn’t achieve enough of the vote to secure the high 5% threshold necessary to garner seats in the lower house — a first for the party since its founding in 1949. It is suspected that the party lost so many votes because it failed to achieve the tax reform it campaigned on in 2009. It is also suspected that it lost votes to the anti-euro AfD party, which also failed to reach the 5% threshold, meaning it will not have any seats in the lower house, either.

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With the FDP out, Merkel has very few options to form a coalition. There is absolutely no way she would align with Linke, the East German dominated communist party, which endorses policies like Germany exiting NATO, so that means she must work with either the Greens or the SPD, which garnered 63 and 192 seats in the lower house, respectively. Both are left of center with the SPD closer to the center and the Greens being further to the left.

Merkel has governed successfully with the SPD during her first term in office so such a coalition isn’t beyond the realm of possibility. The coalition with the CDU/CSU during those years produced a government that was centrist and prudent in their policies, something Merkel has tried to instill in her party in the years after.

But a coalition with the SPD alone wouldn’t be as politically beneficial to Merkel without also including the Greens. That’s because the SPD and Greens make up the ruling coalition in the upper house of the German parliament. This is important as legislation created in the lower house can get stomped up and die in the upper house. As such, if Merkel ever wanted to pass anything, she would need complicit support from the upper house.

There are many in the SPD and in the Green party that would gasp at such a coalition, but the truth is that there is little if any real differences among the three parties, save possibly on the issue of taxes. The SPD campaigned on a plan to raise taxes on upper-income Germans, while the CDU/CSU categorically rejected that idea. But Germany’s rich could easily absorb a slight increase in their taxes, and the CDU/CSU could be persuaded to support such an initiative if they were assured that proceeds would be earmarked for debt repayment. Germany, while a pillar of economic strength, has a 2.1 trillion-euro debt load, equal to 90% of GDP, so any attempt to lower that bill would be welcome.

As for the Greens, Merkel has already demonstrated that she is on their side when it comes to the environment by embracing an extremely progressive environmental policy. She supported the shutting down of the nation’s nuclear industry and has mandated that 35% of the nation’s energy come from renewable resources by 2015. Those aren’t centrist environmental policies, so the Greens should have little to fear in joining a coalition with Merkel. If the Greens were to get the environmental cabinet post, they would consider that a true win.

It could take up to two months for Merkel to hammer out an agreement with her new coalition partner(s). Whatever she decides will be watched intently by the markets as her decision will have major consequences to that of Europe. As the eurozone’s largest economy, Germany has the ability and the responsibility to lead the eurozone, a position that Merkel has been reluctant to take up given the political situation back in Berlin. With peace finally attained at home through a grand coalition with the Greens and SPD, Merkel can take the lead on a number of initiatives to help secure the euro and bring the union closer together.

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There remains a great deal to do in order to get the eurozone back up on its feet economically. Merkel must first throw her weight behind the formation of a strong banking union. The structure for such a union was supposed to be in place by the end of the year, but discussions have stalled in Brussels, due mostly to wavering from the Germans. That’s because Germany’s banking system is largely controlled by several small savings banks, which are, understandably, afraid of a pan-European regulator. It was politically infeasible for Merkel to support a banking union during the election, as these small saving banks are influential on both a political and social level.

Now that Merkel has decisively won the election she must convince the savings banks that it is in their best interest to support the banking union. Insisting that the banking union authority would be housed in Frankfurt and not in Brussels or tiny Luxembourg would be a good first step in ensuring buy-in from the savings banks. Also having representatives from the small savings banks sit on whatever bureaucratic council that would inevitably be formed in such a union would also help smooth things out.

The banking union requires member states to give up a bit of their fiscal authority as they would lose the ability to shut down or bail out troubled banks within their borders. This is a scary proposition for many members, but it is necessary if there is ever going to be economic stability in the eurozone. If Merkel is successful in getting her eurozone partners to accept a banking union, then she would have set a precedent for relinquishing fiscal authority over to a central eurozone authority. This would then make it easier for her to push through more fiscal concessions that would eventually lead to one centralized fiscal authority.

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Such centralization of fiscal power may seem farfetched, but it will be necessary if the eurozone continues with a centralized monetary policy. Greece and Germany should not have the same interest rate if they do not have access to the same fiscal resources — plain and simple. Greece and the other peripheral nations that need higher interest rates to attract investor capital will eventually leave the eurozone, shattering the union.

The longer Europe carries on this charade, the longer it will be stuck in neutral. What it has needed all along was a leader to help galvanize and sell the idea of fiscal consolidation to the rest of Europe. Germany has been looked to as that leader, but Merkel was reluctant to take that role due to her shaky political position. Now that she has the full support of her nation, Merkel can step out of the shadows and lead. Let’s hope she does.