How Long Until A Populist Government in Europe Renounces Sovereign Debt?

The fiscal crisis in Europe is almost certain to explode at some point within the next few years. The most frequently discussed risks are bank runs or a country defaulting on its debts. However, a third source of risk comes from the potential for a populist party to gain control of an European government and renounce the country's sovereign debt. The austerity measures being forced upon the profligate nations of Europe are being attacked by politicians on both the right and the left. A Portuguese politician has come out with an ominous threat in stating "We have an atomic bomb that we can use in the face of the Germans and the French: this atomic bomb is simply that we won't pay," stated Pedro Nuno Santos, vice-president of the Socialist Party."

Opposition to the European Union's efforts to keep the eurozone debt crisis from exploding is growing in France, Portugal, Finland, the Netherlands, Hungary and Italy. While the opposition in most of these countries  is focused upon the "reform" measures, leaders of populist parties throughout Europe have no intention of implementing the austerity measures required to eliminate budget deficits. Thus, if a populist or leftist party takes control of an European government, a default becomes practically inevitable. While the risk of a debt renouncing party taking control of a European government seems slight during 2012 due to this year's light election schedule, it is something that could happen down the road. The elections in Greece and France in the upcoming months seem likely to be won by parties that are supportive of the Euro, but the election calendar becomes much more crowded in 2013 and 2015.  (A detailed international schedule can be viewed at the IFES election guide)

In addition to all the other risks to the U.S. stock market, investors should keep an eye on the progress of European populist and leftist political parties. Even the perception of an electoral victory could hasten the explosion of the eurozone as this would likely lead to a sovereign bond auction failure. Given the exposure of many of Europe's weakest banks to sovereign debt, a bond auction failure would set off a domino effect of  bank failures.

The general consensus seems to be that the impact on the U.S. economy of Europe's troubles will only be a reduction of 1-2% in gross domestic product (GDP). As discussed extensively in previous articles on this blog, my judgement is that the contagion will be far worse. My base case is that the S & P drops to 900 in 2012.

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