While most eyes are on the dramatic shifts possible for U.S. economic policy as Donald Trump is sworn in as president on January 20, similarly deep political currents are on the move in Europe. Indeed, the state of economic and political affairs there mirrors the seismic shift in the United States in many ways.
“In the U.S., the wave of populism has taken the form of the Republican Party. In Europe, it’s mostly manifested itself through the growth of extremist parties both on the left and the right,” explains Mauro Guillén, Wharton international management professor and director of The Lauder Institute.
This year, Europe’s economic growth will depend to an unusual degree on political developments, with three key elections coming up. Ground zero could turn out to be Italy. “Italy is where they were 20 years ago — they haven’t grown,” says Franklin Allen, an emeritus Wharton finance professor and executive director of the Brevan Howard Centre at Imperial College in London. Such sluggishness could have major consequences for Italian banks, whose growing trove of nonperforming loans have the potential to bring down banks all over Europe, he adds.
But one silver lining is the potential growth of European exports due to a stronger dollar, sparked by the U.S. Federal Reserve’s shift to a more hawkish stance that sees interest rates rising. Notes Guillén: “The rising value of the dollar represents an opportunity as eurozone exports become more competitive.”
The wrinkle, of course, is Trump’s unpredictability. His public comments about the U.S. dollar as being too strong compared to the Chinese yuan promptly sank the greenback, according to MarketWatch. The news site noted that Trump’s stance deviates from longstanding policies on the dollar adopted by prior administrations: “The strong dollar policy — a mantra of Democratic and Republican administrations for more than two decades — may be headed for the scrap heap.” So, growth in Europe from exports might not be a done deal.
“In the U.S. the wave of populism has taken the form of the Republican Party. In Europe, it’s mostly through the growth of extremist parties.”–Mauro Guillén
Another problem for Europe is the coming set of unknowns on the political realm. “All countries are on a bit of a cliff,” says Olivier Chatain, strategy and business policy professor at the HEC business school in Paris and an academic senior fellow at Wharton’s Mack Institute for Innovation Management. “You have a risk of self-perpetuating political instability that can result in a self-reinforcing cycle of slow economic growth.”
Major leadership elections in the Netherlands, France and Germany in 2017 could indelibly change the course of the EU as an economic entity. Last year, both the U.K. and Italy saw the resignations of their prime ministers as a result of referendums, with the U.K. voting to leave the European Union in a “Brexit” and Italy rejecting constitutional reform that would have reduced political instability and bureaucracy, according to the European Council on Foreign Relations.
While the U.S. had a surprise upset by Trump and the U.K. experienced Brexit last year, Europe was spared any dramatic economic crisis. Wharton finance professor Joao Gomes explains says that 2016 presented no big problems and “wasn’t a bad year.” Most countries showed some growth. “Germany did very well. The U.K. didn’t do very badly. Italy didn’t do very badly. Spain had no government and did very well,” he said. “It could’ve been worse.” However, despite some European countries making some big political decisions, there has been no serious focus on the economy, which needs attention, Gomes says.
One positive note from the EU point of view was that 2016 ended with “no anti-Euro governments in power,” Gomes adds. Given the major elections on tap — each with anti-European Union candidates as strong contenders — that may not be the case a year from now, he says. That includes Marine Le Pen, France’s far right candidate who has taken the lead in the polls recently in the presidential race, according to The Daily Beast.
The Shape of Brexit
Probably the biggest shock in Europe last year was the U.K. vote to leave the EU. While the Brexit vote’s immediate consequence was the weakening of the pound to a 31-year-low against the U.S. dollar, the long-term consequences remain to be seen. When the U.K. Prime Minister Theresa May invokes Article 50 of the Lisbon Treaty, which starts the process of withdrawing from the EU, formal negotiations will commence and could take two years. May pledges to pull the trigger at the end of March. However, much of the framework has yet to be decided, and trade deals between U.K. and the EU will have to be negotiated.
On Jan. 17, May drew a proverbial line in the sand by indicating that after Brexit, the U.K. aims to fully control its immigration and regulation policies. That will almost certainly result in the U.K. leaving the EU’s single market entirely with the EU itself wanting few if any remaining ties. The U.K. would have to negotiate trade deals with individual nations in Europe.
Even before May’s comments, it seemed clear that U.K. was likely headed for a tough time with the EU over Brexit. Chatain notes that other EU countries are not likely to let the U.K. exit smoothly with favorable conditions because it could tempt other members to exit, too. What is more, the U.K. has probably overestimated the willingness of governments in the EU, sore at Brexit, to keep the status quo in trade relations in some way.
“Things in Europe are changing. Before, the populist movement was growing, and now they’re winning.” –Franklin Allen
Allen also points out that the outcome of the French elections in the spring, and possibly an Italian election if it comes up in 2017, in part depending on the health of Prime Minister Paolo Gentiloni, could significantly affect the conditions for Brexit. “If the EU starts breaking up, then the other European leaders will try to introduce things that have consequences for Brexit,” says Allen.
As big a move as Brexit appears to be, however, Allen points outs that “trade agreements aren’t as important as they used to be. Services are more significant in today’s economy. Most services take place over the Internet and it’s not clear where the transactions take place.”
Italy’s Banks – the Elephant in the Room
In December 2016, the political carousel in Italy took another turn. Nearly 60% of the Italian voters rejected a referendum for constitutional reform, which would have reduced the size of its Senate and given more powers to the prime minister with the goal of reducing bureaucracy and political gridlock. Anti-establishment political parties, like the populist Five Star Movement and the far right Northern League, campaigned to defeat the referendum. For those favoring a strong EU, “The outcome in Italy was very bad,” notes Guillén. What happened in Italy reflected more of a dissatisfaction with the current government than with the reforms the government wanted to enact, explains Allen.
While the big story out of Italy recently is the country’s political upheavals, the situation in Italy’s troubled banking sector does not always get as much attention as