Political fragmentation is testing Europe. The protest parties are galvanised by Brexit and demanding a similar vote elsewhere. While they poll strongly, whether they have enough support remains to be seen. Politics introduces a downside skew to growth.
Is it a replay of the 2008-09 or 2011-12 crises? Neither, we think. What’s different this time is that mainstream politics and policy, which have previously sought to provide a backstop, have less support in parliaments and within the population at large. When key elections and referendums create instability, this means less structural reform and extra uncertainty, which negatively affect the economy and weigh on currencies and risk assets. Given the growing importance of the protest parties, rising fragmentation in parliaments makes government formation more difficult, achieving an absolute majority less likely and, ultimately, the political risk premium higher.
Meet the protest parties: Tapping into the frustrations of an increasing number of voters that feel disenfranchised in an era of globalisation and European integration, the protest parties promise to turn back the clock on liberalisation, deregulation and privatisation, instead of attacking Europe’s sclerotic labour and product markets. The parties on the left seem more concerned about the pressure from global markets, while those on the right more with the transfer of responsibilities to the EU level.
Political fragmentation is a hurdle to extra integration: The way the European Union will look like over the next decade will likely depend on the ability of policy-makers to deal with rising inequality and discontent, as well as two major deficiencies of the EU’s architecture: Large economic imbalances and no political union (or at least fiscal union for the eurozone countries). Even if central banks were able and willing to cushion recurring crises using their cyclical policy tools, these two structural uncertainties may well trigger bigger crises, and for quite some time.
Are particular countries at EU exit risk? It’s unlikely that other European countries will exit the EU in the near term, in our view. Yet markets may think about possible channels of contagion, also political in nature. Our scoring model compares and contrasts the EU countries across several key metrics. It suggests that Greece and Cyprus score very highly in terms of exit risks, followed by France, Austria, the Netherlands and Italy.
(Generally) a high bar for further referendums: There are a variety of referendum-like mechanisms in Europe. But only a few countries can have one triggered by the people or a minority party in parliament. These are the ones to watch, as the risk of policy accidents is high. But, generally, to pursue an exit from the EU, the protest parties will have to win an election and initiate a complex process that, formally or informally, will have to take into account the will of the people. While risks are rising, that’s still a high bar.