Political angst may take its toll on euro zone economies

Political angst may take its toll on euro zone economies

Spain’s Socialist leader and acting Prime Minister Pedro Sanchez attends a general election rally, in Seville. (Reuters)

Christine Lagarde on Tuesday urged Europe not to “allow self-doubt to drag us down” in her first major speech as new European Central Bank (ECB) president. Despite a big change in the economic and political leadership in Brussels this month, the challenges facing the continent will remain eerily familiar in 2020; from Brexit to economic frailty in the euro zone.

Only last month, Lagarde’s predecessor as ECB chief, Mario Draghi, warned of growing euro zone weakness concerns, with Germany again on the brink of recession. He highlighted that risks were “all to the downside,” with the ECB concerned that the 19-member currency bloc’s growth, which has slowed this year along with much of the global economy, faces “protracted weakness” as consumer and business confidence remains low and amid transatlantic trade risks from the latest US import tariffs.

This economic picture could deteriorate further due to upcoming political developments, including Sunday’s Spanish election. Next month’s UK ballot aside, Spain’s fourth poll in as many years is the most important election in Europe in the second half of 2019. With no single party expected to win nearly enough votes for an outright majority, either another period of minority government or a potentially shaky coalition will add to the political uncertainty in the euro zone’s fourth-largest economy.

According to the latest opinion surveys, the ruling Spanish Socialist Workers’ Party (PSOE) of Prime Minister Pedro Sanchez is likely to win the most seats. However, the PSOE could fall around 50 seats short of the 176 needed to win an overall majority. Sanchez’s prospects of winning more seats are being undercut, in part, by growing support for far-right parties, including the nationalist Vox.

Barring a continued period of minority government, this would open up the need for a coalition. Here, many voters favor a tie-up between PSOE, the leftist Unidas Podemos and nationalist Basque and/or Catalan parties, although attempts to form any such coalition failed after the last ballot in April.

Given the significant uncertainty over the election result, markets are worried about potential further uncertainty. In part, this is because of other mounting signs of political instability across Europe, plus weak growth in large euro zone economies like Germany, France and Italy.

Indeed, the single currency area may be on the brink of yet another downturn, hence Lagarde’s call for the continent to show greater “strength, resolve and courage.” And this comes even before the lingering possibility of a no-deal Brexit on Jan. 31, which is one of the big challenges facing new European Commission President Ursula Von der Leyen.

Sunday’s Spanish election comes when Sanchez has been the head of a minority administration for more than a year. And the political instability in Madrid is mirrored in France, where a poll indicated this month that far-right National Rally figurehead Marine Le Pen is now more popular than President Emmanuel Macron, while Chancellor Angela Merkel’s long period in power in Germany is approaching its end.

This political angst appears to be contributing to flagging European economic growth. Germany, the euro zone country most affected by the slowdown in global trade, contracted by 0.1 percent in the second quarter, while the euro zone’s overall annual growth rate continued a steady 2019 deceleration, from 1.3 percent in the first quarter to 1.2 percent in the second and 1.1 percent in the latest three months.

While Germany narrowly avoided a technical recession at the end of last year, and may do so again this year, the outlook is not strong. The latest IHS Markit’s flash composite output index for the nation’s manufacturing and services registered just 48.6, little changed from September’s near-seven-year low of 48.5, with any score below 50 signaling contraction.

The Italian economy (the euro zone’s third largest) barely grew in the third quarter and is in what has been called a multi-year “perma-recession.” This comes against the backdrop of a volatile political landscape, which saw a new coalition formed in September between the anti-establishment Five Star Movement and the center-left Democratic Party after the government that was formed last year collapsed.

The political instability in Madrid is mirrored in France, while Angela Merkel’s long period in power in Germany is approaching its end.

Andrew Hammond

It is in this context that the latest Spanish political uncertainty comes. The dominant narrative of recent ballots in Spain has been the apparent shattering of the political duopoly of the right-of-center People’s Party and the PSOE that had dominated the country since the 1970s. Several “new” parties have helped fill the political vacuum. These include Podemos and the United Left (collectively known as Unidas Podemos, which is seen as the sister grouping of the former ruling Syriza party in Greece), Vox and the centrist, business-friendly Citizens. The rise of these groups has been fueled by popular anger over political scandals and the previous fallout from the worst recession in the country for a generation, which saw a property crash and unemployment peaking at 27 percent.

In this big picture of political uncertainty, financial markets may become increasingly jittery if the election outcome does not provide even short-term stability. If political risks were to rise significantly, this would have the potential to undermine the Spanish economic recovery.

Taken overall, Spanish uncertainty is the latest manifestation of political angst in the euro zone. Instability from Italy to France and Germany may yet help drive the single currency area into a downturn in 2020, especially if a no-deal Brexit adds to its woes.

  • Andrew Hammond is an Associate at LSE IDEAS at the London School of Economics
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