A Body Blow To Schroder

Will losses in local elections help him get his party in line?

Peter Muller led his victory entourage like a conga line through the cobbled streets of Saarbrucken's bar district. "Peter! Peter!" they chanted. Hoots. High fives. Fists in the air as about 50 people snaked between outdoor tables crowded with diners enjoying a warm late-summer night. The exuberance was understandable: Muller had just led the center-right Christian Democratic Union party to statewide victory in the German state of Saarland for the first time in 15 years.

The CDU's return to power in Saarland, a region of dying coal mines and shuttered steel mills that is normally a Socialist fortress, is a grim omen for German Chancellor Gerhard Schroder. It came on the same day that support for his center-left Social Democratic Party (SPD) plunged in elections in the eastern German state of Brandenburg. The elections signaled grave voter disappointment with Schroder and his lurching attempts to remake the economy. Polls show more bad news is in store as Schroder faces a battery of local elections in coming months. The Saarland loss further weakens the party in the Parliament's upper house, which must approve bills that affect state finances.

GOOD OMEN. But the vote wasn't an outcry against economic reform. It may have even marked a kind of progress in Germany's stumble toward an economy that can compete more effectively with the U.S. and Britain. In fact, Schroder could use the election results to discipline his own unruly coalition and hammer out a compromise with the opposition.

With economic growth picking up, skittish voters might be more willing to accept a little short-term pain in return for long-term economic well-being. "The next two months are dramatically important for [Schroder's] political future and authority," says Michel Friedman, a leader of Germany's Jewish community who serves as an adviser to Muller.

When it comes to reforming Germany's economy, Schroder and the CDU agree on what needs to be done--budget cuts, lower taxes, and measures to prevent the collapse of the pension system as Germany's population ages. But they differ on who should benefit and who should pay. Besides finding middle ground with the opposition, Schroder needs to win the support of the SPD's left wing, which resists any change that seems to benefit the wealthy or that trims social welfare. Schroder also needs to sell his plan to the public.

By choosing Muller, Saarland's voters signaled that they are open to change. The 43-year-old judge, who will become Saarland state prime minister, belongs to the CDU's progressive faction. In a state where an antique coal cart decorates the back lawn of the Parliament building, Muller says he will let coal mining fade away and focus instead on modernizing the Saar economy. Although he's vague on specifics, Muller had made it clear that he won't lead Saarland back to a bygone age of big subsidies and jobs for life.

COMPROMISE. Muller's policies and campaign contrasted sharply with those of his SPD rival, Reinhard Klimmt, the incumbent Saar prime minister. Klimmt succeeded and was the protege of "Red" Oskar Lafontaine--former SPD national chairman, hero of the party's left wing, and Finance Minister in Schroder's government until he left after clashes with the more moderate Chancellor. On the hustings, Klimmt vowed to continue propping up the coal industry with subsidies. And he attacked Schroder's plan to cut $16.3 billion from the national budget. He even called for restoration of the wealth tax. In the Sept. 5 elections, Klimmt's party scored 44.4% of the vote. Muller's CDU edged him out with 45.5%.

Schroder is trying to turn the debacle to his advantage. It's easier now for him to argue that the SPD must work with the CDU, since the opposition can block major legislation in the upper house of Parliament. "All the parties recognize that reform is needed," says Ulrich Beckmann, Deutsche Bank's co-head of euro-zone research. "I'm optimistic."

Still, the next few weeks are fraught with risk as Schroder faces state or local elections in states including Thuringia, North Rhine-Westphalia, and Saxony. He has to convince German voters that his reforms are consistent with their values. If not, his "New Middle" will be a lonely place.

Before it's here, it's on the Bloomberg Terminal.