Goldman Warns Market Implications Of Europe's Populist Revolt Are "Profound"

Via Goldman Sachs,

Elections a potential driver of market volatility
Eight EU countries are due to have parliamentary elections in 2015. Several contests have the potential to drive market volatility. As a result of the high economic costs of austerity and economic adjustment, populist parties have gained at the expense of the mainstream political establishment. Should they achieve power, these populist parties are likely to challenge the policy assumptions currently underpinning the integrity of the Euro and the wider EU. Elections in Greece at the end of this month are a case in point.

Re-orientation of politics in the EU
For most of the past century, political debate in Europe has taken place along a left / right spectrum. But the importance of this distinction has declined of late. Other dimensions have assumed a greater role in defining political allegiances. Concerns about the impact of globalisation – notably via immigration, wage developments and inequality – have fuelled the rise of populist parties on both the left and the right. Given the role of the EU in opening markets and the Euro in imposing austerity and adjustment, in Europe such populism has assumed a Eurosceptic tone.

Populist rise initially met by ‘grand coalitions’ …
The initial response to the electoral threat of populist Eurosceptic parties has been the formation of ‘grand coalition’ governments spanning the mainstream pro-European establishment. This has happened in countries with a history of such arrangements (e.g., Germany) and in countries where longstanding (and deep) political rivalries have had to be overcome (e.g., Greece). Similar outcomes are likely to follow forthcoming elections elsewhere, should populist parties continue to attract substantial support. Such grand coalitions have provided a bulwark against market volatility.

… but these may serve to ossify the new political alignment
But, over time, grand coalition governments may only serve to ossify the re-orientation of political allegiances along the mainstream vs. populist dimension. If economic malaise persists to the next election, support for populist parties is likely to build, as scepticism about the adjustments required to sustain Euro area membership rises. The Greek experience points in this direction. Were this experience to extend to larger and more systemically relevant countries (such as Italy or Germany), the implications for markets would be profound.

Europe’s new politics: A populist challenge to the mainstream

2015 is a busy election year in the European Union (Exhibit 1). Eight parliamentary elections are scheduled: in Denmark, Estonia, Finland, Greece, Poland, Portugal, Spain and the UK. France, Spain and Italy face regional elections, and the Italian parliament will have to elect a new president should the incumbent resign (as expected, possibly in the coming weeks).

Admittedly, in a union of 28 member states, every year will have its fair share of elections. But 2015 promises a number of crucial contests. Fuelled by the employment cost of austerity and economic adjustment, the rise of populist parties at the expense of the mainstream political establishment (Exhibits 2 and 3) may challenge the policy assumptions currently underpinning the integrity of the Euro and the wider EU.

The Greek election on January 25 is a case in point. Opinion polls suggest there is a strong possibility of victory for the radical left-leaning Syriza party, which is committed to renegotiating the terms of the adjustment programme, upon which the financial support Greece has received from the rest of Europe (and the IMF) depends. At a minimum, any such attempt at renegotiation threatens to disrupt the Greek financial markets and economy. And should relations between a new Greek government and the ‘troika’ sour, experience has demonstrated that the wider market implications could be profound, if concerns about ‘Grexit’ re-emerge and contagion to other countries threatens.

Understanding electoral dynamics will therefore be central to understanding economic and market developments. In today’s Weekly, we discuss the evolution of Europe’s new politics. A number of conclusions emerge:

Traditional left / right political distinctions that have governed European politics for most of the past century have declined in importance of late.


Other dimensions have assumed a greater role in defining political parties and allegiances. In particular, concerns about the impact of globalisation – notably via immigration, wage developments and inequality – have fuelled the rise of populist parties on both the left and right.


In Europe, given the role played by the EU in opening markets and facilitating intra-European freedom of movement, such populism has assumed a Eurosceptic tone. And, because of concerns about the economic costs of austerity and adjustment (in the stressed economies) and fears of fiscal redistribution (in the core), within the Euro area populist parties have raised questions about the viability and desirability of monetary union, at least as it operates at present.



The resulting fragmentation of the political system has rendered it more difficult to form governments that can formulate and implement policies addressing Europe’s significant economic challenges. Electoral outcomes have become more difficult to predict.


In many cases, the initial response to such fragmentation has been to form ‘grand coalition’ governments spanning the mainstream pro-European parties. This has happened both in countries with a history of such arrangements (e.g., Germany) and in countries where longstanding (and deep) political rivalries have had to be overcome (e.g., Greece). Similar outcomes are likely to follow forthcoming elections elsewhere.


Looking forward, should the underlying economic concerns driving the rise of populism persist (as seems likely), a more fundamental re-orientation of European politics is possible, with competition between broadly pro-European mainstream parties and Eurosceptical populist parties replacing the traditional left / right divide.


In this respect, the nature of political debate surrounding the forthcoming Greek election may prove to be a harbinger of political developments in other countries (even if – as in, e.g., Spain and Ireland – they remain at an earlier stage of the process of political re-orientation, with the option of moving to a grand coalition still available).


Competing for the ‘median voter’

In characterising their ideology or orientation, political parties have traditionally been placed on a left / right spectrum. Parties to the right favour lower taxes, less public spending, the privatisation of public assets and less regulation. Parties to the left tend to favour greater public spending funded by higher taxation, more public ownership and a greater role for the state in regulating the economy.

Within this framework, the centre of the ideological spectrum constitutes the key political prize. In order to achieve a majority, parties on the left and right converge towards centrist positions in order to attract the ‘median voter’ (who will put them over the 50% plus one threshold required to govern). Periodically, activists seeking to serve the interests of the party base will pull policies away from the centre ground. But such a strategy can ultimately prove electorally unviable, forcing a return to moderation over time.

Of course, this abstract framework is a gross simplification of reality. First, the nature of the electoral system matters. Competition for the median voter is most relevant in a UK-style first-past-the-post electoral system. In the proportional systems that are more typical in continental Europe, the pressure to compete for the median voter is dissipated. Second (and more relevant for the subsequent discussion), politics is never as one-dimensional as this framework assumes. Societies are riven by other political fissures: regional (e.g., the separatist movements in Spain, Italy or the UK); denominational (e.g., in the Netherlands); or linguistic (in Belgium). Political competition occurs beyond the traditional left / right divide.

Nevertheless, for long periods in many countries, this framework has constituted a useful lens through which to view political developments. Even as changes in technology, preferences, working arrangements and demographics have shifted where the median voter lies, the convergence of policies towards that voter’s views has persisted.

Implications of the emergence of a new political dimension

Over the past decade(s), the one-dimensional characterisation of political preferences implicit in the conventional framework described above has been challenged. Globalisation has created a new societal split, distinct from the traditional left / right divide.

In advanced economies, the better educated who are plugged into the opportunities offered by the international economy have benefited from globalisation. By contrast, the (relatively) unskilled have been subject to greater competition from immigrants and the products of cheap labour in the emerging world, which has threatened the privileges (welfare, wage levels and employment security) accumulated in the middle of the 20th century.

As is well documented, median household incomes have stagnated even as aggregate incomes have risen strongly, with inequality rising as a result. Concerns about the erosion of national sovereignty stemming from globalisation magnify the more narrowly economic worries. And, more widely, there is growing disillusionment with the established ancien regime on the back of the financial crisis and its consequences.

Following from these developments, a new political fissure has opened up between:

  • On the one hand, those favouring greater economic openness (and all that it may imply in terms of inequality). For simplicity, we label parties that support this view as ‘mainstream’; and
  • On the other hand, those preferring a more protectionist approach that harks back to the greater certainties of the second half of the 20th century (and, as a consequence, are sceptical about immigration and economic integration). We label parties taking this view as ‘populist’.

Crucially, the set of populist parties encompasses both those that would be viewed as right-of-centre on the traditional left / right political spectrum (i.e., those espousing more nationalist and/or conservative views) and those that would normally be seen as left-of-centre (i.e., representing the less well-off, manufacturing and public-sector workers, etc.). It is precisely because different views on globalisation do not align closely with the traditional left / right divide that the dimensionality of the political landscape has increased.

This complicates the electoral process by leading to a greater fragmentation of the party system.

In Europe, given the role played by EU legislation in opening and liberalising markets, promoting labour market reforms that erode employment security, and facilitating intra-European free movement of capital and (crucially) labour, the populist response to concerns about globalisation has assumed a Eurosceptic tone – even where some of the main worries reflect the impact of extra-EU (rather than intra-EU) immigration.

In the Euro area, this has been further compounded by the consequences of the Euro crisis. In the stressed economies, the substantial economic cost of fiscal austerity, structural reform and macroeconomic adjustment is attributed to the Euro and the Brussels-inspired policies it implies. In the core countries (notably Germany), fears of the fiscal consequences of having to ‘bail out’ heavily-indebted stressed countries so as to maintain the integrity of the Euro area weigh. As a result, within the Euro area populist parties have raised questions about the viability and desirability of monetary union, at least as it operates at present.

Among other manifestations, the expression of populist Euroscepticism has taken concrete form in the rise of the Front National in France and the Alternative für Deutschland (AfD) in Germany (parties that would typically be seen as on the right of the traditional political spectrum); in the emergence of Podemos in Spain and Syriza in Greece (parties of the left); and the Five Star movement in Italy (a party that defies conventional left / right definitions, thereby validating the argument that a genuinely distinct political fissure has emerged). Outside the Euro area, the electoral success of UKIP, the Sweden Democrats and the Danish People’s Party – drawing on voters from both sides of the left / right spectrum – reflects the impact of the same underlying forces.

The emergence of this new dimension of political allegiance has had a powerful impact on electoral outcomes. When concerns about European issues dominate the agenda – as was the case during the Euro crisis – voters have focused on the distinction between mainstream parties, on the one hand, and populist Eurosceptic parties, on the other. Only if the relevance of European issues diminishes (e.g., if the Euro crisis recedes) and more traditional economic debates (about the role and size of the state) re-assert themselves, are we likely to see the conventional left / right divide again become the main driver of electoral dynamics.

Evolution of a new European politics

In previous work, we argued that – notwithstanding the very substantial economic and employment costs of implementing troika programmes and undertaking macroeconomic adjustment – a ‘silent majority’ existed in stressed peripheral economies that would ultimately elect a government that would accept the conditionality imposed to retain the Euro.

These countries have ageing populations. The ‘median voter’ along the mainstream / populist political dimension tends to be more concerned about the security of their retirement income (maintaining the value of what they have accumulated, through retaining the Euro) than the outlook for economic growth (which provides opportunities for the young).

When electoral decisions focus on European issues – as at the peak of the financial crisis, when membership of the Euro area was at stake in some countries – the distribution of political opinion again becomes essentially one-dimensional: left / right distinctions become second order; mainstream / populist distinction dominate. The logic of political competition discussed above leads to an electoral outcome reflecting the views of the median voter: in the end, mainstream parties gain a majority. The Euro is retained.

While this abstract story is obviously simplistic, it nevertheless provides a relevant insight. To take Greece as an example (on the basis that it is the country that came closest to exit from the Euro area in 2011-12), when push came to shove in the May 2012 general election, the longstanding and deep political enmity between the mainstream New Democracy (right) and Pasok (left) parties was overcome in order to form an (unprecedented) grand coalition sufficient to defeat the populist challenge posed by Syriza. The resulting government accepted the troika programme, membership of the Euro area was maintained and, over time, some stabilisation of the Greek economy has been achieved (even if substantial challenges clearly remain).

Using this experience as a template, populist challenges to the established order in other Euro area countries could be met with grand coalitions that serve to maintain orthodox, EU-endorsed policies and support market stability.

As we have argued elsewhere, a strong electoral showing by Podemos in Spain that brought macroeconomic adjustment into question could be addressed through a grand coalition between the Popular and Socialist Parties. Similarly, populist strength in Ireland (e.g., embodied in support for Sinn Fein) could be managed through a grand coalition between Fianna Fáil and Fine Gael, two mainstream parties. Even though opposition policies influence policy decisions between elections, the analysis presented here offers some comfort that the buffer to politically-driven market volatility may be greater than many expect, despite (say) the still extremely high levels of unemployment seen in countries like Spain.

But the Greek experience has another, less reassuring message concerning the political drivers of market stability. A grand coalition government may serve to ossify the re-orientation of political debate as a mainstream vs. populist competition. If economic malaise persists through to the next election, support for populist parties is likely to build, as scepticism about the adjustments required to sustain Euro area membership rises.

Experience suggests that voters have long memories: even in Ireland – a country generally seen as advanced in its adjustment, where growth has resumed – populist parties continue to enjoy strong support ahead of a likely 2016 election. And unless the economic outlook credibly improves, with the passage of time the preferences of the median voter along the relevant dimension will tend to shift in a more populist direction: retirees with wealth to protect will die off, while new voters will only have experience of painful austerity and adjustment.

This analysis is consistent with current opinion polls in Greece, which suggest that Syriza is in a position to beat the mainstream parties at the forthcoming election on January 25, reversing the result seen in May 2012 (Exhibit 5).

Given that Spain and Ireland have undertaken significant adjustment, serving to stabilise their economies, regain competitiveness and restore growth, there can be hope that the time bought via a grand coalition (if necessary) following their forthcoming elections will be sufficient for the economy to normalise and conventional political distinctions reassert themselves as populist Euroscepticism recedes.

Yet the recent Greek experience may be more relevant elsewhere. While national elections are not due until 2018, the experience of technocratic and broad-based mainstream governments in Italy in recent years may already have led to a political re-orientation. A Euro-friendly Renzi government seeking to implement reform is faced by opposition parties (Forza Italia, the Five Star movement, the Northern League) that all – to a greater or lesser extent – have expressed Eurosceptic tendencies. And in Germany, the mainstream parties in the grand coalition may come to face stronger challenges from the AfD and Linke parties (especially if populist opposition to any fiscal transfers to stressed economies embodied in ECB sovereign debt purchases mushrooms), even though the next federal election is still almost three years away.

Greece constitutes the immediate politically-driven threat to European market stability. But we believe that any future Greek government – including one led by Syriza – will ultimately come to some accommodation with the troika. Most major Greek parties have already publicly stated their desire to avoid a sovereign default and/or Euro exit. In this base case, the implications of the political dynamics discussed above play out in the process by which final accommodation with the troika is achieved.

But the Greek experience may be a guide to the evolution of political developments elsewhere, even if the issues at stake are different. Further political challenges may come in the future – if countries that are larger and much more systemically relevant shift decisively in a populist direction. The relevant elections may be several years away. But if the intervening period is not used to (a) restore growth and employment creation; and (b) construct credible economic governance at the Euro area-wide level, the resulting failure to neutralise the populist threat will pose significant further political challenges to the Euro.

The process we have observed in Greece suggests that grand coalitions can buy some time to arrest the influence of populists on policy decisions. But they cannot halt it altogether.