Merkel just failed to gain a clear center-right majority in the Bundestag, Germany's Parliament, in the fall elections and so was forced into prolonged negotiations with the center-left. She made two key concessions, each one likely to erode Germany's hard-won reputation for financial orthodoxy.
First, Merkel conceded a new national minimum wage, set at $11.68 per hour, which means a bigger wage bill, particularly in the formerly Communist-ruled eastern part of the country, where wages and productivity continue to lag.
Second, the Social Democrats also secured some weakening of the pension and retirement reforms pushed through a decade ago by Chancellor Gerhard Schroeder, himself a Social Democrat.
Schroeder's reforms, while widely credited with restoring German competitiveness and paving the way for the country's export boom, have been unpopular in his own party. He raised the retirement age; the latest coalition deal cuts it back, in some cases as low as age 63.
One of Schroeder's harshest critics from the left of his own party, Andrea Nahles, is to be minister of Labor and Social Affairs in the new government, a key position as the country tries to adapt to the costs of a rapidly aging population.
Merkel made these concessions not only to win the support of the Social Democrat leadership but to help them win the internal vote among their party's 475,000 members, who were empowered to endorse or reject the coalition deal. When the postal votes were counted Saturday the party membership voted 76 percent to 24 percent to support the coalition.
This means Merkel can be voted a third term of office as chancellor next week with a strong mandate from the center-left as well as from her own party. Her coalition will have 504 seats in the 631-member Bundestag. The real opposition in future will therefore be the Green Party and the leftist block Die Linke, many of them heirs to the old East German Communists.
The Social Democrat Party Chairman Sigmar Gabriel, who led the coalition negotiations and is to be the new vice chancellor, also takes over the ministry of the economy with special responsibility for energy policy. This means that having made big concessions on the minimum wage and retirement, Merkel will also no longer be in full control of energy, another political hot potato, even though she has said that restraining energy bills will be a top priority.
German households are up in arms about the high costs of electricity. They pay an average 35 cents a kilowatt hour, compared to 20 cents in Britain and 12 cents in the United States. Much of this, around $20 billion, goes to subsidize renewable energy supplies like wind and solar power.
Located in north central Europe, Germany isn't best-placed to benefit from solar power. The building of wind parks, particularly offshore, has run way ahead of the essential transmission lines to take the power to where it is needed.
Wind power provides either feast of famine, too little of too much. When there is too little, the power companies have to fire up gas or coal-powered stations. Where there is too much, the power stations cannot use it all but the subsidy gets paid as long as the windmills are turning.
To prevent the high costs from crippling German heavy industry, more than 2,300 cement, chemical and steel and other metal plants are currently exempt from the surcharges imposed to subsidize renewable energy. The European Commission in Brussels is questioning the fairness of this system, which had led the VIK heavy industry lobby to warn they face "billions of euros in new charges that could destroy Germany's industrial core."
How Gabriel handles his dilemma will be critical for Merkel's popularity. Foreign policy is also likely to be a sensitive issue and this has been handed to Franz-Walter Steinmeier, a former Social Democrat candidate for the chancellorship.
A staunch Atlanticist, well-liked and trusted in the United States for his role coordinating trans-Atlantic security policy after the Sept. 11, 2001, attacks, Steinmeier is unlikely to seek to embarrass the United States over the National Security Agency controversy, since he helped put in place many of the current intelligence-sharing agreements.
And with Ukraine's future looming as a major challenge for Europe and Germany, this is another key policy area that Merkel had handed to the Social Democrats.
Merkel's key ally in the new government will be her veteran Finance Minister Wolfgang Schaeuble, who presides over the current mood of modest national prosperity with growth set to accelerate from 0.5 percent this year to 1.7 percent next year. He is also the main negotiator with Germany's European partners on tackling the ongoing euro crisis, with a hard-line reputation for opposing bail-outs that would make Germany subsidize its weaker partners.
Maintaining that tough line in Europe and a pledge of no new taxes were the main concessions Merkel won from the Social Democrats during the coalition negotiations.
The concessions the Social Democrats obtained, despite winning barely one-quarter of the national vote while Merkel won nearly half of it, suggest that Merkel will have only limited executive authority in her third term over the issues most likely to define her political legacy.