Political reality has finally caught up with the outgoing German chancellor, Gerhard Schroeder. For more than three weeks, he stubbornly refused to acknowledge that the left-wing coalition of his Social Democratic Party, or SPD, and the Greens were voted out of office in general elections on September 18. With the opposition leader, Angela Merkel, and her Christian conservative parties, the Christian Democratic Union and Christian Social Union, poised to return to power in a “grand coalition” with the SPD, Mr. Schroeder is now clearly headed towards early retirement.

For Ms. Merkel, though, this is a bittersweet victory over Germany’s most formidable campaigner. She defeated Mr. Schroeder’s “Red-Green” coalition at the polls and the two conservative parties managed to become the biggest group in parliament, narrowly eking out the SPD. At the same time, however, the conservatives fell short of their stated goal of forming a pro-reform coalition with the free market-oriented Free Democratic Party. Furthermore, if one adds up the parliamentary seats of the SPD, Greens, and the post-communist Left Party, there now exists a leftist, antireform majority in the German Bundestag.

Ms. Merkel, despite becoming Germany’s first female chancellor, will also need to fend off potential internal challengers among her party’s powerful regional governors who are just waiting for the right opportunity to oust her. In the wake of the September 18 elections, many political analysts – speaking off-the-record – initially placed their bets on a grand coalition without either Mr. Schroeder or Ms. Merkel. The CDU chairwoman had managed to reduce a 20-percentage-point lead over the SPD in opinion polls down to 0.9 points on Election Day in less than four months. In the end, however, all these pundits seem to have ignored a golden rule in German politics: “Never underestimate Angela Merkel.”

Now that Ms. Merkel is on course to be the next German chancellor, what concrete changes and reforms can we realistically expect from her coalition? The first priority will be to cut Germany’s ballooning budget deficit – which will breach the European Union’s Growth and Stability Pact for the fourth consecutive year in 2005 – to less than 3% of gross domestic product. Faced with a sharp drop in tax revenues, the government will have no choice but to cut generous subsidies and welfare spending to achieve this ambitious goal. In contrast, failure to consolidate the budget could result in multi-billion euro fines imposed by the E.U. in Brussels.

The second major challenge will be the reform of Germany’s cumbersome federalist system to streamline the country’s political decision-making. Right now, there are 16 regional states, each with its own administrative structures. As a result, there is often considerable political gridlock between the upper chamber, controlled by the state governments, and the lower chamber, the Bundestag, especially when the two bodies are controlled by two different parties as has been the case in recent years.

Third, the coalition plans to simplify Germany’s complex income tax code by closing many of the more than 400 existing exceptions and loopholes. In addition, a Grand Coalition could potentially agree on a cut in corporate tax rates to 19% from 25%.

Fourth, the grand coalition government plans to provide more financial support for families and young parents. Given Germany’s on-going demographic decline, encouraging women to have more children by allowing them to better combine work and family life will arguably be the most fundamental challenge facing Germany and the rest of Europe’s graying continent.

Finally, the Merkel government is committed to increasing national spending on research and development to at least 3% of GDP by 2010. Achieving this goal will be an indispensable boost to Germany’s international competitiveness in the face of growing competitive pressures from Eastern Europe and Asia.

It remains to be seen how far Ms. Merkel can really go in instituting reforms and how long she will remain in power, given that the SPD, her coalition partner, remains vulnerable to defections of its left-wing legislators over economic reform measures highly unpopular among the SPD’s union base. Nonetheless, and despite its potential pitfalls, a conservative led grand coalition is Germany’s best and only chance to reverse the country’s unprecedented decline of its economic, social, and political fortunes since the outgoing Red-Green government came to power in 1998. Germany has no choice but to seize this chance for change.

Mr. Gartzke is director of the Washington Office of the Hanns-Seidel-Foundation, an affiliate of Bavaria’s Christian Social Union Party. This article reflects his personal views.