Crisis in the Eurozone? The French election, populism, and what it means for US economic growth: A long-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 short-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.

But the centrist candidate, he had the most votes, is likely to win. Is he not a pro-European politician?

Certainly. He is very much pro-European and the second round is really going to be a fight; not between the left and the right, but between those who want to continue with globalization, those who want to continue to be part of Europe, and those who want to close France off from free trade. This is Marine Le Pen, who wants to get out of the Euro.

That is going to be a clear choice. Very likely, as I say, Macron is going to win, but it would be of concern if somebody like Marine Le Pen with those kind of views got something like 40% of the vote.

What’s also of concern, and what is a certainty, is that whoever becomes president of France is going to have to work with a parliament — parliamentary elections are in June — that is of a very different complexion from themselves. Macron, for instance. En Marche! is a very new party, it is very unlikely to win many seats in the assembly, so we’re going to have a rather weak presidency.

Even if Macron, who is a reformer who would be pro-Europe, wins, he is not very likely to achieve much in his five year presidency because he would be working with a parliament where he doesn’t have —

He’s not a representative of one of the two main parties where he would have natural allies. He’s an island of one there.

Correct. He the whole time is going to have be getting coalitions cobbled together to do particular things, so it will likely be a very unstable administration. People are already beginning to talk about how this might resemble the Fourth Republic, that it might not be characterized by too much stability in the way of government.

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.

So when we saw the headlines, Le Pen does not win, does not do particularly well, I think the short version is that the European Union has been saved. But there are more problems, that is not the case.

If you want to call it the European project, is it still in quite a lot of trouble economically? I remember a few years ago reading the Citigroup reports about the Euro collapsing, the EU dissolving, civil war — some pretty crazy stuff. How stable is the euro and the European Union at this point?

I would say that we really need to look at this in some kind of historic context. Look at where we were six years ago politically. Most European countries would have had two parties that would have been relatively stable, would have garnered 60-70% of the vote. 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.

Can it break out of the situation it’s in? And what is not the worst-case scenario, but a reasonable, bad-case scenario for Italy? How does that play out? How does it impact the EU? Do they pull out, and then what happens? What might be the chain of events you might see?

The chain of events is that if you did get an Italian government that was committed to taking Italy out of the Euro, you would have an enormous run on the Italian banks, you would have money moving out toward Germany.

Purely on that election? They wouldn’t actually have to do anything. If that kind of government took power, there would certainly be a fear factor there, right?

With the prospect of such a government coming to power in the run-up to the election Italian residents would not want to keep their deposits in Italian banks. They’d want to be shifting those deposits to Germany, to Switzerland, any place outside of Italy that is a lot more stable. That would make it really very difficult for the Germans to back-stop in Italy in the same way that they’ve been back-stopping the rest of Europe through the ECB or through their own lending.

Italy is too big to fail because if Italy fails it will take the whole of Europe with it, but it’s also too big to save in that being a large economy, Germans are going to be very reluctant to put up money for a country that isn’t on its way to reform. So this is really a very big, systemic challenge that lies ahead. Over the next year we’ll see this playing out.

So really the bad scenario would be a collapse of the euro, a collapse of the trading zone. What might happen?

What one has to bare in mind is that, if Italy were to pull out of the euro, borrowing costs in Italy would soar. Italy would then not be able to surface its debt. The only reason why Italy can surface its debt mountain right now is that interest rates on Italy are relatively low. They’re benefiting from being part of the euro.

Once Italy leaves the euro, interest rates will in Italy would soar, lenders would only provide Italy with money at very high interest rates, Italy wouldn’t be able to service its debt. If Italy can’t surface its debt then we’ll be talking about two and a half trillion dollars of default. That would ricochet right through the European banking system and, very likely, in the same way as with Lehman in September 2008, ricochet through the global financial system. The same thing would happen if we had an Italian default.

So the stakes are extraordinarily high, there would be an effort to hold Italy together, but if the Italians don’t want to be in the euro, if they vote for the populist party that wants to take them out, that is a very serious matter and one can’t dismiss this is as a very low probability event considering that the Five Star party is now ahead in the polls. They would be the majority party if the election were to be held tomorrow.

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.

This sounds like we’re potentially right back where we were in 2010, 2011. Obviously there is a lot of talk about where we are with the euro. Maybe we had a momentary breather, and now we could be right back in the thick of it.

The reason why you had that momentary breather is that in July of 2012, Mario Draghi said that he would do whatever he could to save the euro. Since then, we’ve seen a massive expansion of the European Central Bank’s balance sheet. They’ve been buying something like seventy billion dollars of bonds a month for a number of years. Their balance sheet has increased by a few trillion dollars. As long as those purchases go on, what one can do is mask the underlying problems.

What is of concern is that during this interim period, this breathing space, as you call it, was not taken advantage of by countries to improve their finances. If we just take Italy as an example, today Italy’s public debt to GDP ratio is higher than it was in 2012.

That doesn’t seem prudent to me.

It’s not at all prudent. What I’m suggesting is that Italy is very exposed now to a political shock. What it’s also exposed to is a shock from the ECB not buying bonds. As soon as the ECB begins to stop quantitative easing in the same way as it occurred in the United States, there might not be too much of a demand for Italian bonds and we’ll be seeing the pressure.

We are in a similar situation as to where we were in 2012, which should make the US administration a little concerned.

To what extent do you think US policymakers are aware of the risk in Europe? And also there are some other hot-spots around the globe which perhaps could have a contagion effect. Do we we get that? Do you speak to people in Washington who seem to understand that? Any evidence?

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.

A few listeners are probably already thinking this, but what you’re saying sounds like campaign fear of Brexit. That there’s going to be all these terrible effects if Great Britain leaves the EU, so what? They’re fine, they seem fine. Cabs are stilling running, the House of Commons is still meeting, so why should we worry that much?

The very big difference between the United Kingdom and a country like Italy is that the United Kingdom had a floating exchange rate, and that served as a shock-absorber. There certainly was a very big impact from Brexit. Brexit resulted in something like the sterling losing 15% of its value and that has helped cushion the blow from Britain leaving the EU.

It’s very different in a fixed exchange rate system. That if the euro were to break, then automatically we would have defaults on a major part of European debt and that is bound to have ramifications through the financial system. This might be a case of economists having been called wolf a couple times, but this time the wolf is really going to be at the door.

Would the Fed be overwhelmed by that kind of severity of a problem? How could it minimize damage to the US economy?

Well, that is another reason for concern with the current administration. The current administration doesn’t seem to believe in international financial cooperation or central bank intervention to prevent a crisis. If you do have a crisis and you don’t have the right kind of policy response, that crisis could be very serious. Hopefully all of this doesn’t materialize, because it doesn’t look like this administration would be very quick to respond and that is basically what was required in 2008-2009 – you really did have a lot of co-operation between global central banks. You had a lot of coordination of policy to deal what was the worst shock to the global financial system since the 1930s.

I’m afraid that Europe is such that it would constitute a financial shock on the same scale as that of Lehman if we were to have a break-down of the Euro.

What is fundamentally wrong with the global economy? What is going in that we have an inherent instability and have to be weary every 5-7 years?

That’s a complicated question, but if you’re looking for some cause of the instability, it was excessive monetary expansion that gave rise to a housing bubble in 2008. We then paid a very heavy price for that. In the case of Europe, the mistake was for them to go into a euro system without having the fundamental policies to back that up. They didn’t move in the right direction, many countries were profligate, bad lending was done. We get this kind of problem.

We see this right now. You mention that Europe is not the only source of concern. The second source of concern, maybe from a longer run point of view, is the Chinese economy and that is very reminiscent of what occurred in the run up to the 2008 bust. What we’ve seen in China over the last eight years is the largest one government credit bubble that has ever occurred. This is much larger than the bubble preceding the United States housing bust in 2008. It’s also larger than that preceding Japan’s two lost decades, what occurred in the 1980s.

What this all means is that China over the next couple years is likely to perform really badly as they deal with their credit bubble bust. I’m not suggesting that we have a housing bust like we did in the United States, because the Chinese have got control over their banks, that they can intervene, it’s a different kind of economy, but what it’s likely to mean is that China goes the way that Japan did with banks that are saddled with too much bad debt on their books, with zombie firms.

A zombie economy.

Right, a zombie economy. Instead of China growing at 8-9% for a prolonged period of time, we get a China growing at 2% or 3% a year. That will have major implications for emerging markets, for the Asian region, for the global economy. China is no longer going to be this engine of growth for this global economy. In fact, it’s likely to become a drag.

What about the effect of the United States on other economies? It’s been a fairly strong expansion, although not particularly robust, and you have the Fed raising interest rates. So what happens if we get a lot of this stimulus promised by the Trump administration and the Fed has to raise interest rates faster and higher than what they’ve spoken of? 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.

Do you think that there’s that understanding now in Washington of the precariousness of the situation and how what we do impacts that situation? 

I’m afraid that I don’t see signs of that. Rather, what I see is the entertainment of wishful thinking. That somehow the United States economy, which most economists think has got a potential rate now of 2% or less, somehow will all of a sudden begin growing by 3 or 4% so those deficits won’t materialize. There seems to be denial that this problem really is going to occur, so I don’t see a sensitivity of what might be the ramifications of this policy on the budget side for what might occur in emerging market economies, what might occur with United States trade imbalances. This seems to be something that not too much attention is being paid to.

I think there’s certainly a lot of expectation among Republicans that if they get tax policy right, however you want to define that, and get enough deregulation, that it’s going to be off to the races: 3-4% growth as far as the eye can see.

I wouldn’t share that view. I think that tax reform, deregulation, is certainly going to put the United States on a higher growth path than it otherwise would be, but it’s important that one does not oversell those kind of policies and then base their budget on expectations that aren’t going to be realized.

You can try and sell them, just don’t believe what you’re selling.

Don’t believe it. The big difference between now and the Reagan tax cuts is that the Reagan tax cuts were made in the context of the United States economy that was coming out of recession, that there was a lot of spare capacity, that you had the ability to go in for pump-priming that would then get the economy moving.

We’re not in that situation right now. Unemployment right now is down to 4.5% or so, that we’re seeing wage pressures already occurring, that the Fed is already concerned about inflation right now. There’s not much room in the way of spare capacity that is very readily going to be available, so it’s very unlikely that we grow at very much faster than 2.5%, and if we premise the budget on 3-4% growth and we’re going to grow by only 2.5%, then we’re really going to have a problem with the budget deficit.

Are you still concerned about trade and what this administration might do on trade? Is it just going to be a lot of conversation and not much is going to be done? It is going to be the occasional trade spat here and there, but it’s not going to lead anywhere?

It’s very early in the administration, but that’s one area where we’ve been positively surprised. We saw that Trump was during the campaign indicating that day one he would declare China a currency manipulator, that he’d be putting tariffs on others countries, that he’d be totally revising NAFTA. He’s walked away from that. That is really very encouraging.

What’s not encouraging is taking unilateral action against the Canadians or against the Chinese in terms of steel, stuff of that sort. That leaves question marks as to where we’re going on the trade side.

Certainly, the first three months on the trade side has been very much better than most expected. We haven’t been reversing the globalization, it looks like there’s been a shift in policy, there’s been an understanding that we really need to co-operate, that we really can’t go down this road too far. I’m not at this stage too concerned on the trade side. I’m far more concerned on where we might be headed with the budget.

What is your optimistic scenario going forward? If we get policy right in this country, if Europe stays open and together, and China muddles its way through a debt problem, and we’re sitting here in 2027, what can we say about that decade from 2017-2027? 

The concern isn’t really so much with the United States as with the rest of the world. Europe has got itself into a real mess with the euro, that we’ve got China that has a debt bubble, there’s been too much money printing all over this show, there’s been too much debt. So it’s difficult to see how we’re going to muddle through for four years.

Generally, what occurs is one really has to pay the piper at some point, and one really can’t have excess credit expansion like we’ve had globally for these past seven, eight years. We’ve seen balance sheets; the Fed’s balance sheet used to be 800 billion dollars, it’s now something like 4.5 trillion dollars. The same can be said for Europe, the same can be said for Japan, the United Kingdom. All of that eventually has to work its way out. I don’t see that holding together over the next four years.

Maybe we’re lucky, maybe we’ll muddle through the next year or two, but my view is that we will see an event either in Europe or in China within the space of this administration. This administration should really be prepared to deal with a situation that isn’t very smooth during the whole of its four-year term.