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Weak Europe Threatens to Roil Financial Markets

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Weak Europe Threatens to Roil Financial Markets

September 5, 2016

Although Americans are very much focused on the November elections, developments on the other side of the Atlantic suggest that the Eurozone could be headed for a major economic and political crisis sometime next year. In order to focus attention on how to handle such an eventuality, on September 14 the American Enterprise Institute will be hosting a public seminar in Washington DC entitled Can the European Project Survive? Click here to attend the event in person, and it will also be livestreamed on AEI’s website.

In July 2012, when Europe last faced a major economic crisis, Mario Draghi, the head of the European Central Bank (ECB), promised to “do whatever it took” to save the Euro. That ECB commitment was supposed to instill renewed confidence in the Euro’s long run viability and to put Europe on a sustained economic growth path. Yet four years later, as underlined by the recent Brexit vote, Europe’s economic and political future looks shaky, to say the least.

At the heart of Europe’s current economic and political malaise is its highly disappointing economic performance since the global economic recession in 2008-2009. At a time that the United States economy has now recovered to some 10 percent above its pre-2008 crisis peak, the overall Eurozone economy has barely recovered its 2008 level. Worse yet, key Eurozone countries like Italy and Spain find their economies still some 6-7 percent below their 2008 peak while their youth unemployment levels remain uncomfortably above 35 percent.

Sadly, the economic prospects for the European economic periphery remain grim. Despite many years of budget austerity, countries like Italy, Portugal, and Greece all have public debt to GDP ratios today that are significantly higher than they were in 2010 at the start of the Eurozone sovereign debt crisis. Similarly, despite years of belt tightening, the European economic periphery remains as uncompetitive in relation to Germany and its northern neighbors as it was at the start of the European economic crisis.

Further attempts to restore economic balance to the European periphery will produce yet more years of very weak economic growth. Since stuck within a Euro straitjacket, these countries are precluded from using exchange rate depreciation to offset the negative impact on aggregate demand of budget tightening. That is likely to keep Europe’s unemployment level above 10 percent for a few more years.

Against this dismal economic background, it is little wonder that across the Eurozone support for establishment political parties has crumbled and anti-Euro sentiment has gained traction. As an example, in Italy, the Eurozone’s third largest economy, the populist Five-Star Party, which is strongly opposed to the Euro, has now pulled even with the ruling Democratic Party. There is also strong support in Italy for a no vote in a forthcoming referendum on constitutional reform. If a no vote were to prevail in that referendum, now most likely to occur in November, Matteo Renzi’s government would almost certainly fall. Such a fall could pave the way for an anti-Euro government in Rome.

Meanwhile, in France, Marine Le Pen of the far-right National Front, which too is against the Euro, is widely expected to make it to the second round in the French Presidential elections next April and May. Similarly, in Greece, Portugal, and Spain, support for the traditional centrist political parties has collapsed, which has forced the formation of weak coalition governments in those countries.

The European periphery’s ongoing economic and political problems have to be of particular concern, coming as they do at a time that German Chancellor Angela Merkel’s political strength is being steadily eroded. Ahead of scheduled German parliamentary elections in September 2017, Mrs. Merkel’s leadership is being challenged both from within her ruling coalition party as well as by the populist far-right Alternative for Germany Party. This has to raise serious questions as to whether Mrs. Merkel will to be able to muster domestic support for future Eurozone bailout programs as she managed to do so successfully in the past.

Looking at the European economic and political landscape, one cannot discount the possibility that the new American president will be confronted with a full blown Eurozone crisis soon after assuming office in January next year. One also cannot discount the likelihood that such a full-blown Eurozone crisis would roil global financial markets, in much the same way as did the Lehman banking crisis in 2008. Among the reasons that the American Enterprise Institute is arranging a seminar on Europe at this time is to draw policymakers’ attention to that grim possibility.   

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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