What does America do if France and Italy spark a financial crisis in the Eurozone? A short-read Q&A with Desmond Lachman

The last round of the French presidential election is this Sunday, and may be the last act in a play featuring Part I: the Brexit referendum and Part II: the US election. Forces acting against a globalized status quo seem to have played a big role in I and II. Regardless of the outcomes of Brexit and the US election, the French election will have major implications for the future of the Eurozone and world economy, and may add fuel to other fires across the Eurozone – Italy in particular. What do we need to know? What sorts of ripple effects will this economic and political uncertainty have in the US and for the Trump administration?

I recently spoke to Desmond Lachman about this, which you can listen to in full over at Ricochet. You can also check out the long-read version of this post here.

PETHOKOUKIS: We just had the first round of the French presidential elections on April 23. The next round is this Sunday, May 7. Were the results encouraging if you value free trade and global markets, and at least a certain kind of liberalism? Were they encouraging?

LACHMAN: They were encouraging in that we had set the ball pretty low, that the fear was that we might have two candidates: one on the extreme right and one on the extreme left, so that in the run-off we could either have a candidate on the extreme right or extreme left become president of France and that was a very scary prospect.

Fortunately, that did not occur. The candidate on the extreme left, Mélenchon, lost and Marine Le Pen went ahead, but we’ve got somebody like Macron who would be a center-right party reformer who would be very likely to become president. In that sense, it’s encouraging.

What was discouraging is the real collapse of the traditional center parties on the left and the right in that election. That has to give cause for concern that such a large percentage of the French electorate already voted against Europe. That really does not bode well for Europe’s long run future.

Sometimes in American politics you’ll hear the phrase “gridlock is good,” that when Congress doesn’t act that is actually best for the economy because if they do anything it will probably be the wrong thing. That’s not the case with France, is it? For a country that’s so important, a country of slow growth and very high unemployment – they need big change.

You’re absolutely correct that France’s economy has really under-performed Germany’s for many years. It’s characterized by public spending level that’s something like 57% of France’s GDP, extraordinarily high. It’s got labor laws that are archaic, there’s a 35 hour work week, many reasons why business don’t want to invest in France, many reasons why French people prefer to work in London.

One would hope that Macron would change this. It looks like he’s going to have difficulty in parliament to move things through, so to answer your question: Gridlock is the last thing that France needs. France really needs to have real reform to put it on a real growth path so that it can compete as an equal partner to Germany. That would also be very important for Europe. We don’t want Germany to become the hegemon of Europe again if we want balance. Particularly now with the UK out of Europe, we really need a French counterweight. If France doesn’t perform economically, Germany’s really going to dominate Europe, which is not healthy for either Germany or for Europe.

Why not?

We don’t really want to have one country dictating what the policies are, what the vision is of Europe. We really want to have equal partners.

I’ve been told that Germany is the last bastion of free market liberalism now that the US is a more nationalist, protectionist leader. If that’s the best we have, if that’s the place where we find more open economic policies, is that as bad as them being the leader in Europe?

What we really wanted is a France that was more forward-minded, more in Germany’s mold, that was an equal partner and that could provide some kind of impetus to Europe.

There’s a lot of resentment, particularly in Southern Europe, about Germany dictating policies that are simply in Germany’s interest. One really wants to get some kind of balance in the European Union.

We are now having places like France that are severely fracturing, where you are having four main candidates more or less getting that same amount of votes. You’re getting the same sort of thing in places like Greece, in Spain, in Italy. We’re really getting a lot of political fragmentation.

That is one reason that calls for concern. That if we don’t get growth really growing, if we don’t get unemployment coming down, a sense of prosperity, this kind of political trend I would expect to continue.

The second reason that I’d have concern for, and I think what we saw this weekend was Europe dodging a bullet, is that there’s an even larger bullet on the horizon and that is Italy.

Tell me a bit more about that.

We’ve got an Italian economy that is categorized by extremely high public debt. Their public debt level is now something like 132% of GDP, they’ve got a banking system that is bust, that banks have something like 18% of their loans non-performing, that is a huge amount, the economy is completely sclerotic, that the level of Italian GDP today is pretty much the same as it was some fifteen years ago. There’s been practically no growth, declining living standards, and now we’ve got political fragmentation.

Look, what we’re seeing right now is we’re seeing the Democratic party begin to splinter and we’ve seen in the polls the Five Star party that is really wanting to take –

That’s the populist party?

Absolutely. That’s the populist party led Beppe Grillo, a former comedian, and he’s wanting to take Italy out of the Euro, presumingly wanting to take them out of Europe too, and he stands a real chance of winning the next election and that election has to take place before the spring of 2018. While we might have dodged the French bullet, we’ve now got to deal with the Italian one, which looks to be in a much worse situation that France was.

What also makes Italy very important from a global point of view is that we’re now not talking about a small country like Greece which doesn’t have that much systemic significance. We’re talking about the third largest country in the Eurozone. We’re talking about a country that has the world’s third largest sovereign bond market with something like two and a half trillion dollars of debt.

If we do get an event in Italy, it is very difficult to see how the Euro in its present form can survive. That’s why the focus of markets, the focus of European governments, I’ve got very little doubt will soon be shifting to Italy and seeing how Italy can break out of its really very dismal past.

How well do you feel like you understand, or anyone understands, the international financial linkages between what would happen in the European economy if we had Italy leave the EU, and the rest of the world?

It would be presumptuous to say that we fully understand the linkages and all the events that would occur if there were to be an event in Italy, but what we do know is that this would be a major event for the global financial system. What would occur is that banks that have lent money to Italy would be in difficulty, we would then get this cascading through the system in the same way as it did with a small bank in the United States, Lehman. If you asked anyone beforehand what would happen if Lehman went bust, people would say it wouldn’t be that big a deal. But then we found out that people who had been exposed to Lehman then went bust and then you got a chain reaction through the financial system. What I’m suggesting is that the Italian bond market is so large and that the French and the German bank exposure to Italy is so large that you’d have major events.

The other thing that one’s got to worry about with Italy is that were Italy to fail, the focus of the markets would then shift to other weak countries in the Eurozone: the Greeces, the Portugals, the Irelands, the Spains — all those countries would then come under pressure. It wouldn’t just be Italy, as large as it is on own. You would then get other dominoes in the Eurozone falling.

To what extent do you think US policymakers are aware of the risk in Europe? 

I’m concerned that there are important figures in the Trump administration who seem to be cheerleading Europe to fail. They’re asking which is the next country that is going to fail.

In anticipation.

This is not something that the United States should be encouraging, the failure of Europe, because that, aside from geopolitical considerations, that would have a direct bearing on the United States economy. That would be a major event for global financial markets and the United States is very much part of those global financial markets, so we should be really trying to encourage them to do the right thing, to make this work, even though this may have been an ill-advised project from the start. It’s coming apart will certainly have very big implications.

What are the international ramifications of a lot of Fed rate hikes?

The international ramifications are not good because with that scenario you’re painting, not only would the Fed have to raise interest rates a lot to prevent inflation from materializing, that you would be having fiscal expansion at the time you have full employment, the Fed would have to be raising interest rates, but were the Fed were to have to raise interest rates you would also have a strong appreciation of the US dollar.

But that’s good, because we always want a stronger US dollar because that symbolizes American economic strength. So that’s good!

Not if your policy objective, your international policy objective, is to reduce the United States current account deficit. If you’ve got a very large budget deficit that is reducing the United States saving rate, you’ve got a large deficit that is making United States exporters less competitive through a strong dollar, you’re not going to achieve the reduction of the United States current account deficit. On the contrary, what you will see is the United States current account deficit rising.

The international ramification of that is really very bad for emerging market economies that have borrowed too much in dollars. We have the Bank for International Settlements telling us that over the past eight years or so, the corporate sector in emerging market economies like Brazil, Turkey, Mexico, Chile and so on, they’ve increased their borrowing by as much as three and a half trillion dollars in dollar-denominated terms.

If you get a strong dollar, you get high interest rates. Those corporations aren’t going to be able to service that debt, so we will have a lot of defaults in the emerging market economies. We’ve been to this movie a number of times; this is not a good outcome. Hopefully the US Congress will put a break on the tendency towards deficit spending in the United States.