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Political Storm Clouds over Europe

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Political Storm Clouds over Europe

August 5, 2016

At a time that on this side of the Atlantic we are obsessing about the likely outcome of our November elections, political storm clouds are gathering over Europe that could undermine the very existence of the European project. In the wake of the recent Brexit setback, over the next twelve months Europe has important elections scheduled in Italy, France, Germany, and the Netherlands. On present trends, those elections could bring further fundamental change to the European economic and political landscape that could cast a long shadow over Europe’s long-run viability.

Despite the seeming ease with which global financial markets have to date absorbed the June 23 Brexit referendum result, that referendum should be sending an urgent warning to European policymakers about the precarious state of European politics as well as about the need for early and fundamental change to the way in which policy is conducted on the continent. Since, aside from the likely damage that the referendum will have done to both the UK and European economies, the Brexit vote represented the clearest of repudiations to both the UK and international political elites that were remarkably united in cautioning voters about the grave economic risk of a Brexit.

Following the Brexit vote, the most immediate political challenge to Europe will be the Italian referendum on constitutional reform which is most likely to occur at the end of October. The importance of this referendum cannot be overstated. Prime Minister Matteo Renzi has repeatedly indicated that should he lose this referendum he would resign, which would presumably cause his government to fall. The last thing that a fragile Italian economy now needs is another period of political instability. Similarly, the last thing that a wobbly European economy needs is an economic and political crisis in a country that has more than €2 trillion ($2.2 trillion) in public debt and whose economy is simply too big for Europe to save.

Sadly, the prospects for a favorable outcome in the Italian referendum do not look good. After all, the referendum will be taking place against the backdrop of an Italian economy that is still some 7 percent below its pre-2008 peak and where unemployment still exceeds 11 percent. It will also be occurring at a time that the Italian banks are saddled with some €360 billion ($400 billion) in non-performing loans or around 18 percent of their balance sheets. The most recent polls suggest that this dismal economic backdrop is fueling support for the populist Five Star Party, which is vehemently opposed to the Euro and which has now pulled ahead of Mr. Renzi’s Democratic Party in the polls.

If Europe does manage to dodge the Italian bullet, it will next be tested by the French presidential election which is scheduled for April next year. In France also populist anger is all too much in evidence. That anger is being fueled by public displeasure about a sclerotic French economy and by an anti-immigrant political backlash. The politician most benefiting from this backlash is the National Front’s Marine Le Pen, who is hostile to France’s continued membership of the Euro. Most recent opinion electoral polls suggest that there can be little doubt that Mrs. Le Pen will make it to the second round of the presidential election and that she could benefit further from any worsening in France’s economy or in its immigration crisis.

A further major risk to the European project in the year ahead is German Chancellor Angela Merkel’s waning political fortunes. Over the past six years, Mrs. Merkel has been the dominant European political figure. She has successfully dealt with the Eurozone sovereign debt crisis and has successfully managed to keep the Euro together. Yet now, as indicated by the disturbing rise of the far-right Alternative For Germany Party and by the growing dissent within her ruling coalition government, Mrs. Merkel is now paying a heavy political price for her liberal Syrian refugee policy. This is likely to constrain Mrs. Merkel’s room for maneuver in dealing with any future European economic crisis in the run-up to the German presidential elections scheduled for September 2017.

Europe’s crowded electoral calendar in the year ahead would suggest that there can be no room for complacency about the European project’s long-run prospects for survival. Hopefully, the recent Brexit setback to Europe will galvanize European policymakers to address the fundamental causes underlying Europe’s increased signs of political fragmentation before it is too late.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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