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).