Europe: It's going to get a lot worse before it gets any better

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Article Highlights

  • We find the most dangerous aggregation of political troubles in Europe, which hardly bodes well for the euro.

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  • Signs of increasing political dysfunction in the larger countries in the euro area are cause for greater concern.

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  • European political developments highlight the link between poor economic performance & political dysfunction.

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Shakespeare memorably wrote that when sorrows come, they come not as single spies but as battalions. He could very well have been writing about the current spate of political troubles in Europe’s beleaguered economic periphery. For there we now find the most dangerous aggregation of political troubles, which hardly bodes well for the long run survival of the euro.

At the heart Europe’s political malaise is the very poor state of the European economy and the growing popular discontent with externally imposed policies of budget austerity and painful structural economic reform. As an extreme case, the Greek economy has now been in recession for the past five years and has seen an economic contraction exceeding 20 percent. However, even Italy and Spain have now been in economic recession these past two years with the result that their current level of output is more than 7 percent below the peak it reached in 2008.

Further feeding popular discontent is the growing realization that the European economy is going to get considerably worse before it gets any better. It is also dawning on an increasingly vocal minority across the European periphery that IMF-imposed policies are all too likely to lead these countries down a blind alley with little relief in prospect from their present economic misery.

Even the IMF is now conceding that, despite the unrelenting economic and social pain that the Greek population has already endured, the Greek economy will contract by a further 4-1/2 percent in 2013. As for Portugal, the IMF now acknowledges that the battered Portuguese economy will decline by at least 3-1/4 percent in 2013, while the IMF is projecting that GDP in an already depressed Italy and Spain will decline by more than 1-1/2 percent in 2013.

New political challenges


Against this dismal economic background, it must be of little wonder that deep political problems are manifesting themselves across the European periphery. Indeed, over the past few weeks, European political developments would suggest that the link between poor economic performance and political dysfunction is becoming all the more pronounced.

Last month, the Democratic Left, the junior coalition party in the Greek government, withdrew its support from that government over the issue of IMF-imposed public spending cuts and the associated shutdown of the national public radio station. This leaves the Greek government with the shakiest of holds on power as it has seen its parliamentary majority whittled down to barely 5 seats in a 300-member Greek parliament. One would think that it must be only a matter of time before Greece is forced again to the polls as the government loses further support for painful economic measures still being demanded by the IMF and the European Union. This could threaten to bring a populist Greek government into office that will almost certainly refuse to comply with the dictates of Greece’s foreign taskmasters.

Similarly, political developments in Portugal, which is rapidly following Greece into economic depression, have been anything but encouraging. Last week, the Portuguese government was thrown into crisis as two senior cabinet members resigned over basic disagreements on austerity policy. The resignation of these ministers now increases the probability of early elections in Portugal that would almost certainly undermine Portugal’s prospects of graduating from its IMF-EU bail-out program and returning to the capital markets by 2014 as planned.

Of even greater concern than political developments in Greece and Portugal are the recent signs of increasing political dysfunction in the larger countries in the euro area. The Spanish prime minister, whose popularity is at an all-time low for his mishandling of the economic crisis, is now embroiled in a slush fund scandal. Not to be outdone, the Italian coalition government appears to be teetering because of Silvio Berlusconi’s many legal difficulties. Meanwhile, in France President Hollande’s popularity is plumbing new lows. It does so as the star of the extreme right wing party of Marine Le Pen keeps rising as President Hollande fails to revive an ailing French economy.

More to come

Ever hopeful, the European optimists believe that once the September 2013 German elections are out of the way Germany will ride to the rescue by easing up on the austerity policies that it has been demanding of the periphery to date and by becoming more forthcoming with financial support. Little attention do the optimists seem to pay to the fact that all the major German political parties are very mindful as to how German taxpayer money might be spent. Even less attention do they seem to pay to the domestic constitutional obstacles or to the visceral opposition of the respected Bundesbank that lie in the way to less conditional and more generous German lending.

Sadly, when all is said and done, there is every prospect that European politics will further sour in the months ahead as the European economy languishes under a toxic policy mix of fiscal austerity and a credit crunch within a euro straitjacket. This could very well lead to heightened turbulence in the European financial markets well before the year is out.

American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.

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