The Greek exit, part II

One has to be struck by the financial market’s present equanimity about Europe’s deteriorating economic and political outlook as reflected in very low European sovereign bond yields. The reason for astonishment is not simply that all-too-many indicators suggest that a highly indebted European economy appears to be heading for a triple-dip economic recession and for a prolonged period of Japanese-style deflation. Nor is it simply that European politics continue to fragment at an alarming rate in major European countries like France, Italy and Spain. Rather, the immediate reason for surprise at the market’s equanimity is that Greece, the very country where the European sovereign debt crisis started in 2010, appears to be soon heading for another period of widespread doubt as to whether it will be capable of remaining a euro member.

Since the start of the year, in the context of ample global liquidity, markets have turned a blind eye to the marked deterioration in Europe’s economic and political fundamentals. In particular, they have shrugged off the renewed contraction of the overall European economy in the second quarter of 2014, as well as the growing indications that the German economy, which has traditionally been Europe’s economic locomotive, is now sputtering as a result of rising geopolitical tensions in Ukraine and the Middle East. Markets have also chosen to ignore the fact that the overall European economy is now on the cusp of outright deflation as unemployment remains at close to post-war record levels. Should Europe indeed succumb to a triple-dip recession and deflation, it will highly complicate efforts by the highly indebted countries of the European periphery to restore public and private sector debt sustainability.

{mosads}Markets are also choosing to ignore highly disturbing European political developments that seem to be driven by Europe’s poor economic performance and its continued high level of unemployment, especially among its youth. In France, President Francois Hollande’s popularity has now sunk to an all-time low for any president in the Fifth Republic, while the anti-European and xenophobic National Front Party of Marine Le Pen is now the country’s most popular political party. In Spain, Catalonia has gone ahead with a consultative referendum on independence in open defiance of the country’s Supreme Court, while the newly formed far-left Podemos party is now posing a real challenge to Spain’s traditional political parties. Meanwhile in Germany, the steady rise of the newly formed anti-European Alternative for Germany Party is now constraining Chancellor Angela Merkel’s room for maneuver to adopt a more supportive policy stance for the rest of the eurozone.

Against this background, it is all the more surprising that markets do not seem to be paying much attention to political developments in Greece, which could soon trigger another round of widespread doubt as to whether Greece will long remain a member of the euro. In particular, they seem to be overlooking the fact that Greece is highly likely to have general elections in the first quarter of next year as its present government fails to muster the 60 percent parliamentary majority it needs to elect a new president without having to go to the polls. They also seem to be ignoring the fact that Syriza, Greece’s far-left political party vehemently opposed to International Monetary Fund-imposed austerity and structural reform, is highly likely to win that election.

The optimists on Greece maintain that even if Syriza comes to power, it will soon buckle to the will of its German paymaster. This would seem to be highly implausible, at least in the absence of a Greek financial crisis, considering that Syriza will have just fought an election on the very platform that it will not comply with the sort of austerity policies imposed from abroad that have led to the collapse of the Greek economy and to the rise of unemployment to over 25 percent.

The optimists also believe that even if Greece is set on a collision course with its official creditors that eventually forced it out of the euro, that crisis could be contained to Greece and the rest of the eurozone’s periphery could be ring-fenced. Such wishful thinking overlooks the parlous economic and political state of the rest of the eurozone’s economic periphery and the very real risk of contagion. It also overlooks the fact that the next stage in the Greek crisis is likely to be playing out in a very much less benign global liquidity environment as the Federal Reserve readies itself for normalizing U.S. interest rates.

If there is a cautionary lesson for U.S. policymakers to draw, it is that they should not be lulled into a false sense of security by the market’s present complacency about the European economic and political outlook. Rather, U.S. policymakers would be well-advised to keep their eye keenly on Europe’s rapidly deteriorating economic and political fundamentals. And they should brace themselves for an economic shock that could very well come out of Europe as soon as the first half of next year.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.