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European Debt Crisis

Wildcard Weekend

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Americans usually associate wildcard weekend with December playoffs, but in Europe, this Sunday will be the day that market spectators will be watching with both eagerness and dismay.  On May 6th, the people of France and Greece go to the polls to vote for their respective leaders, and the outcome of both elections have the potential to shake the foundations of the European Union and the world economy.

La Grande Nation

Most eyes will be on France, Europe’s second largest economy and the key legitimizing piece of the Franco-German leadership team. The incumbent, Nicolas Sarkozy, has been running a come-from-behind campaign against his main socialist rival, François Hollande. Mr. Sarkozy has been laboring against the general animosity of the French electorate, who have never taken to Mr. Sarkozy personally, as well as the “curse of the crisis”: since the financial crisis began, no European incumbent has been returned to office.

 

Indeed, during the first round of voting, Mr. Sarkozy came a close second behind Mr. Hollande’s Socialists. Since French elections cannot be decided by a plurality, Mr. Sarkozy and Mr. Hollande moved on to the second round.

Complicating matters were the challenges from the extreme right and left. Mr. Mélenchon’s Left Party was never a serious challenger and his threat to draw off votes from Mr. Hollande was exaggerated. Furthermore, his voters can be counted on to solidly back the Socialist candidate against a President they despise.

The real wild card was the strong performance of Marine Le Pen, the charismatic daughter of Jean-Marie Le Pen. She inherited her father’s Front National and ran a strong campaign aimed at middle-class, disaffected voters. Her platform of “national preference”, the dual threats to France of competition from immigrant labor and of non-assimilating Islam, the debilities of the single currency and the patrician ways of Mr. Sarkozy resonated strongly and won her 17% of the vote. This was not enough to secure her a place in the second round, as her father once achieved, but it leaves her as a potential kingmaker for Mr. Sarkozy.

Common Sense has written before about Mrs. Le Pen and the growing threat of right-wing extremism in Europe. It should be of great concern to everyone that nearly a fifth of the French electorate voted for so blatantly anti-democratic a candidate.

Too Close To Call

Although Mr. Hollande has an advantage, Sunday’s election remains too close to call[1]. A victory by either candidate is fraught with peril.

A second term for Mr. Sarkozy would preserve the “special relationship” with Germany, which has been the core of European integration for 50 years. The current leaders of both countries have taken the relationship to a new level, so much so that they share a (pejorative) name – “Merkozy”. More Merkozy means more of the same policies that have brought on a deep recession and are threatening the stability and economic life of the periphery nations.

A win for Mr. Hollande will be a clear repudiation of Mrs. Merkel’s policies. Optimists hope that France will be able to push the agenda towards growth, rather than austerity. Pessimists believe that it will merely create new and more dangerous fault lines in Europe.

Common Sense inclines to the latter view.

Mr. Hollande will not wish to drive a wedge between France and Germany, but his policies will inevitably do so. He cannot go back on his campaign promises of keeping the retirement age at 60, imposing a 75% marginal tax rate on French millionaires, and increasing social spending. Implementing these promises will but enormous pressure on Mrs. Merkel’s increasingly fragile domestic coalition. Germans will ask themselves why they continue to bailout countries who are so obviously unwilling to make the same sacrifices that they themselves have been making for over a decade, and on top of that list will be France.

Mr. Hollande’s policies are likely to prove bittersweet medicine for the French economy as well. If France’s credit rating is already teetering on the brink, a Socialist victory is almost sure to bring further downgrades in short order. That will not only increase the cost of French debt, as well as that of Spain, Italy and Portugal; it will increase doubts about the European bailout funds, to which France is the second largest contributor.  S&P is fresh from the dual slaughter of the Spanish sovereign and  banks[2], while Moody’s is preparing an early May list of Italian banks to downgrade. There is no doubt that all three agencies will view a Socialist “return to profligacy” in the most negative terms possible.

Even if Mr. Hollande does lead a revolt against austerity in Europe, what is the likelihood of victory? Mrs. Merkel is unlikely to concede anywhere near as much as people in Spain, Italy and Portugal are hoping for. Certainly not Eurobonds, serious relaxation of deficit targets or further runs of the ECB printing presses. And even if she did, she would be risking both a collapse of her government as her coalition fractured and electoral slaughter at the hands of her outraged voters. Not even Mr. Hollande wants to see Mrs. Merkel replaced by a Euro-skeptic in Berlin.

Tales from Cassandra

Overshadowed by the flashier election in France, the elections in Greece may nevertheless have an even more immediate impact on Europe. Greeks will be going to the urns with the economy entering its fifth year of recession and a level of despair, hatred and vitriol not seen on the continent since the Yugoslav civil wars. The main centrist parties, which have together run the country since the end of the Second World War, are predicted to suffer a bloodbath as frenzied voters vent their spleen those candidates who are blamed for accepting the austerity diktat.

Europe is hoping that New Democracy (center-right) and PASOK (socialists) secure enough votes to form a coalition government, which will be committed to continuing the current program of reform, fiscal retrenchment and wage devaluation[3].

Should they fail to do so, one of two things may happen:

  • If they are strong enough, they will negotiate with a third, or even fourth, minority party to attempt to form a broader coalition. This may be difficult since almost all the minority parties are campaigning on a rejection of the IMF-led program. Any accommodation will probably include a revision of the agreements which can only lead to increased instability and market fears;
  • If they are not strong enough, the strongest minority parties might attempt to form a “rejectionist” government. This seems far-fetched and European pundits point to the fact that the rejectionist parties include such extremes as a “hard” communist party and a national socialist party – but politics makes strange bedfellows and the pundits should remember the complacency of the British and French just before the Molotov-Ribbentrop Pact was signed.

A rejectionist government would be the worst outcome. It is hard to see further tranches of funding being approved for such a government, which would only deepen the crisis and the contagion effects. Such a government might even call for a withdrawal of Greece from the euro. Common Sense doesn’t believe the EU could survive a unilateral Greek exit.

Even a multi-party coalition with PASOK, New Democracy and one or more minority parties would only be staving off the reckoning. It would be so unstable that it is hard to believe that the coalition could long survive; and a fragmentation would lead to new elections and a new crisis.

“Some damned silly thing in the Balkans”[4]

It seems that the fate of Europe again hangs on a Balkans question. So too, for that matter, does Mr. Obama’s reelection. The American presidential race will likely be decided by the economy and unemployment rate: a European implosion will damage both, and bring Mr. Romney that much closer to victory.



Sources and Notes:

[1] Deen, Mark, “Hollande Poll Lead Narrows with Sarkozy Closing in as Race Ends,” Bloomberg, 05 May 2012
[2] Penty, Charles, “Santander and BBVA Among 11 Spanish Banks Downgraded by S&P,” Bloomberg, 30 April 2012
[3] Petrakis, Maria and Bensasson, Marcus, “Greece Votes in Elections with Euro Future at Stake,” Bloomberg, 05 May 2012
[4] Otto von Bismarck

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