EU elections portend a full-blown European crisis

The Trump administration would be making a grave mistake to gloss over the major political setbacks for the United Kingdom, Italy and Germany in last Sunday’s European parliamentary elections.

This is especially true given that the world economic recovery is threatened by worsening U.S.-China trade relations, heightened geopolitical tensions in the Persian Gulf and deepening exchange rate crises in Argentina and Turkey. A full-blown European economic crisis is the last thing that a troubled world economy now needs. 

Before the European parliamentary elections, there was already a good chance of a European economic crisis. After the dismal election results in a number of key European countries, there now has to be the real chance that we could have a full-blown European economic crisis within the next year or so.

Such a European crisis would likely be centered on systemically important countries like the United Kingdom and Italy. As such, it would be bound to have a major impact on global financial markets as well as important spillover effects to the United States economy. 

The major triumph of Nigel Farage’s Brexit Party in the recent European elections has radically upended the U.K. political scene. It has done so by handing the ruling Conservative Party its worst electoral defeat on record as well as by substantially weakening the Labour Party. 

The Brexit Party’s electoral triumph has also greatly heightened the chances that a hardline Brexiteer like Boris Johnson, Dominic Raab or Andrea Leadsom will be selected by the Conservative Party to replace Theresa May as prime minister.

As if to underline this point, Boris Johnson, who is the odds-on favorite in the leadership race, has declared unequivocally that the United Kingdom will leave Europe on Oct. 31, with or without a Brexit deal.

Despite the will of any future prime minister to the contrary, Parliament can spare the U.K. from crashing out of Europe without a deal and all of the disastrous economic consequences that would go with it.

However, to do so would involve it bringing down the government and having the country go through a period of considerable political instability. This too would pose substantial downside risks to the U.K. economy, albeit on a very much more limited scale than crashing out of Europe. 

At the same time that Nigel Farage has upended U.K. politics, Matteo Salvini has done the same in Italy. He has done so by leading his far-right League Party to a crushing victory over its supposedly senior Five-Star Movement coalition partner in Italy’s current populist government.

This now gives Salvini the upper hand in determining the government’s economic policy agenda. It also gives him every incentive to pull his party out of the coalition to force a general election that would almost certainly strengthen his party’s position in the Italian parliament. 

Salvini’s political ascendancy has to raise the risk that Europe could be headed toward another round of its sovereign debt crisis in a country like Italy, which has an economy that is around 10 times the size of that of Greece.

With its economy already in recession and with both a public debt mountain and a shaky banking system, the last thing that Italy can afford is another period of irresponsible budget policies. 

Yet if Salvini is to be taken at his word, that appears to be precisely where Italy is headed. Consistent themes in Mr. Salvini’s political discourse are his total disregard for the European Commission’s strictures about the need for budget discipline and his strong advocacy of a major tax cut in the form of the introduction of a flat tax.

This could soon put Italy on a collision course with the European Commission that could seriously undermine confidence in the Italian bond market.  

Over the past decade, German Chancellor Angela Merkel has provided critical leadership in helping to resolve Europe’s various economic crises.

After Sunday’s humiliation of both Merkel’s Christian Democratic Party and the Social Democrats in the European elections, it is doubtful whether Germany’s ruling coalition government will survive for very long or whether Germany will continue to have the political will to bailout its European partners.

This could make a hard Brexit or an Italian sovereign debt crisis even more damaging for the European economy than it otherwise would be.

Hopefully, against all odds, the European economy will avoid being hit by either a hard Brexit or a renewed Italian economic crisis. However, in the context of an already troubled global economy, it would be irresponsible for U.S. economic policymakers to premise their economic policy decisions on such a fortuitous and unlikely outcome.

Desmond 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.