A "Grand Coalition" in Germany?

The electoral deadlock in Germany may mean a "Grand Coalition" with its two major parties, the Social Democrats and the Christian Democrats.  This is the likely outcome if neither of the major parties can assemble a coalition with the minor parties; some minor/major alliances simply are not possible, for either political or ideological reasons.

Looking to public choice theory, how will a Grand Coalition operate?

Models of proportional representation typically allow for multiple equilibria, but a plausible outcome involves a trade between a major party and an allied minor party.  The minor party will promise to support the major party in forming a coalition, if the major party makes one or two key policy concessions.  The distribution of gains will depend on bargaining power.  Will the major party have other possible coalition allies?  Does the minor party crave power, or would it rather stake out a purist stance on policy, and risk being left outside the coalition?  Note that once the coalition is in place the minor party often has a difficult time defecting.  Minor party officials come to enjoy the perks of power.  Their threats to bring down the coalition often are not credible.  So the resulting government often holds power snugly and governs sluggishly.

When no minor party is available for the coalition, the terms of the bargain shift.

First, a Grand Coalition usually means that the two major parties have roughly equal electoral strength.  If the coalition collapses, and a government must re-form, and either party could come out on top in the new bargain.  Therefore the (slightly) weaker coalition member does not have a very strong incentive to hold the coalition together.

Second, the two major parties often have opposing platforms.  So the initial policy compromise might stop either party from doing much of anything.  That is one reason to expect stalemate.  It also means that the (slightly) stronger party doesn't gain much from the coalition; it cannot promote its agenda.  There is also the danger of many minor parties proliferating at the fringes, given the centrism of the joint coalition.  This lowers the returns to holding power at the center, as these minor parties will cut into your future electoral support.

The bottom line: Two parties in a Grand Coalition will reap low gains from trade.  Neither party will much mind if the Grand Coalition collapses.  Stability is "knife-edge."  But the parties therefore might be willing to take more chances.  What do they have to lose?  A Grand Coalition does not mean certain policy gridlock (in contrast to this pessimistic view). 

And let us say that both parties recognize the need for reforms, but are held back by voters.  An arrangement where accountability is low and "each party can blame the other" might be exactly what is needed.

To cite reality for just a moment, Germany had a "Grand Coalition" from 1966 to 1969, and this was no obvious disaster.  Student revolts aside, many Germans consider these years a golden age. The earlier Grand Coalition passed important economic legislation in 1967 and restricted civil liberties in a controversial manner.  Modern German politics is often slow, but in relative terms this period was not a time of gridlock.

Addendum: Here is a longish piece I once wrote on proportional representation; note Alex's contribution on referenda as well.