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The Next and More Serious Phase of the European Crisis

Monday, April 23, 2012

Two upcoming political events could usher in a new, worse phase of the European debt crisis.

While markets are again correctly obsessing over Italy and Spain’s poor economic growth prospects, as reflected in markedly higher government bond yields for those two countries, they seem to have taken their eye off two upcoming political events that could usher in a new and more serious phase of the European debt crisis. The first is the French presidential election, the first round of which was scheduled for last Sunday, and the second round for two weeks later. The second is the Greek parliamentary election on May 6, which could result in the formation of the weakest of Greek governments.

This week, the IMF revised its economic forecasts for Italy and Spain in a manner that will only heighten the market’s deep concern about those two countries’ prospects of restoring long-run fiscal sustainability. In its revised World Economic Outlook, the IMF now expects that the severe budget austerity being undertaken in both of those countries will result in their GDP declining by close to 2 percent in 2012. Worse still, the IMF is predicting that a deepening economic recession in Spain will undermine the Spanish government’s efforts to reduce its budget deficit, which the IMF expects to remain at around 6 percent of GDP in both 2012 and 2013. Similarly, the IMF believes that a weaker Italian economy will prevent that country from stabilizing its public debt-to-GDP ratio, which the IMF now forecasts to rise to 124 percent of GDP by 2013.

The IMF now expects that the severe budget austerity being undertaken in both of those countries will result in their GDP declining by close to 2 percent in 2012.

Against this gloomy economic backdrop for Europe’s third- and fourth-largest economies, the last thing that the European debt crisis now needs is destabilizing political events. Yet that is what is all too likely to occur in both France and Greece within the next few weeks. In France, the Socialist Party’s Francois Hollande is consolidating his commanding lead in the polls against the incumbent Nicolas Sarkozy in an almost certain second round run-off between those two candidates. Meanwhile in Greece, the polls are suggesting that the New Democratic Party and PASOK, which form the current ruling coalition, will be lucky to retain the slenderest of majorities in a newly elected Greek parliament. At the same time, the political parties of the hard Left will garner almost as many votes as their centrist rivals, while the number of political parties represented in the Greek parliament could rise from its present five to nine, as parties on the extreme Right and extreme Left exceed the 3 percent minimum threshold for parliamentary representation.

The significance of a Francois Hollande election in France for the course of the euro crisis should not be underestimated. This is not only because it will put him on a collision course with German Chancellor Angela Merkel due to his insistence that Europe’s economic policies should be more growth-oriented and that the recently agreed European fiscal pact should be reopened. Rather, his insistence on a 75 percent income tax for those in the highest income tax bracket and his declared war on the financial system are unlikely to be well received by the markets. In that context, Hollande might want to recall how savagely markets punished Francois Mitterand in 1981-82 for his unorthodox economic and financial policies.

The Socialist Party’s Francois Hollande's insistence on a 75 percent income tax for those in the highest income tax bracket and his declared war on the financial system are unlikely to be well received by the markets.

Likewise, a weak Greek government will have a significant effect on the debt crisis because it will only reinforce the market’s priors that Greece is simply not capable of delivering on the conditions of the second IMF-EU bailout package so recently agreed upon, especially against the backdrop of a collapsing Greek economy. In particular, markets will correctly be highly skeptical that the new Greek government will be able to deliver the 5.5 percentage points of GDP in budget cuts for 2013 and 2014 that it is supposed to have parliament approve by as soon as June. They will also strongly doubt that Greece can implement the radical and painful structural reforms on which its European partners and the IMF are insisting. And if the Greek government cannot deliver on its promises, it will only be a matter of time before Greece defaults on its official borrowing from the IMF and the ECB, which could provoke a new round of contagion to the rest of the European periphery.

All of this has to be highly disconcerting to the Obama administration, which until recently had been hoping, along with the European governments, that the strong intervention last December by the European Central Bank through its Long-Term Refinancing Operation had put the European crisis to bed. Instead, economic recessions are deepening across the European periphery and political uncertainty is growing in several important European countries, with serious systemic consequences for the global economy. President Obama is about to find out how long six months can be.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

FURTHER READING: Lachman also writes “Europe’s Financial Maginot Line,” “Time for Greece to Leave the Euro,” “Binds and Bonds: Why the EU Should Break Up,” and “Europe Can't Kick the Can Much Farther.” Alex J. Pollock provides “Sovereign Debt and Default - A History” and “Default and the Nature of the Government.”

Image by Rob Green / Bergman Group

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