Massive losses for Germany’s former catch-all parties (CDU/CSU and SPD) and record gains for the far-right Alternative for Germany (AfD) have caused turmoil in Germany’s political landscape. The tumbling leaders Angela Merkel and Martin Schulz keep affirming that good policies were simply not explained sufficiently. They blame globalization and refugees to be at the roots of growing political discontent. Meanwhile, a rightward shift in Austria and the Czech Republic has occurred, albeit the number of refugees in the Czech Republic is low and growth is high. Everywhere in Europe far-right parties flourish independently from the level of income and the number of welcomed refugees. What is the common driving factor?
We see the European Central Bank (ECB) and other central banks around the world as the main culprits because they have issued immense amounts of liquidity, which had all over Europe adverse growth and redistribution effects. The Figure shows an interest rate index, which represents both ECB interest rate cuts towards zero and extensive government bond purchases (translated into negative shadow interest rates). The index reveals a common trend in productivity growth and our IWP Political Polarization Index for Europe, which represents the share of votes in parliamentary elections for parties challenging the political status quo.[i] The three developments are strongly intertwined for two reasons.
Figure 1: Shadow Policy Rate, Productivity Growth, and Support for Established Parties
Source: OECD, Institute for Economic Policy. Support for established Parties = 1 – support for left and right extreme parties (EU28 averages). Productivity growth equals smoothed arithmetic averages of Germany, France, Italy, Spain and the United Kingdom.
Firstly, the gradual monetary expansion since the early 1990s has paralyzed growth dynamics in Europe. For a long time, productivity growth was high, which allowed real wages to rise. The established parties could redistribute parts of the productivity gains via increasingly generous social security systems. This made European citizens happy and loyal to their political leaders.
The problem is, however, that the central banks’ liquidity glut has undermined the so-called allocation function of interest rates, which separates good investment projects from the ones with low returns. In the past, at an interest of—say—8%, only investment projects with an expected return of more than that were financed. Companies had to make great efforts to achieve efficiency gains. As the financing costs have fallen sharply, an increasing amount of low-yield investment projects has been launched. Unproductive firms—so-called zombies—are kept alive by cheap liquidity—in particular in southern Europe. The upshot is that productivity growth in Europe’s largest economies has fallen.
Since productivity growth is the prerequisite for real wage increases, the source for higher wages and social security for everybody is lost. If some privileged groups still have wage increases and secure jobs—e.g. Lufthansa pilots or French public servants—the wage level and job security of others—e.g. Ryanair pilots and an increasing number of people working in the low-wage sectors all over Europe—must fall. Since the mid-1980s, the wages and pension entitlements of young job-seekers and reintegrates in the labor market in Europe have been gradually reduced.
Secondly, the unprecedented monetary expansion has painful redistribution effects via financial markets. As cheap liquidity of the ECB (and other large central banks) drives up real estate and stock prices, elder and wealthy people—who mostly hold these assets—become richer. In contrast, interest earnings on the bank deposits of the middle class are depressed towards zero. Young people, who want to buy or rent a home for their families have to spend a much larger share of their income compared to former generations. Without the assistance of parents, the acquisition of wealth has become merely impossible. The resulting inequality and social immobility are widely regarded as unjust.
Given growing frustration, without thinking about the reasons for growing inequality, more and more people turn towards political alternatives that challenge the status quo, which translates into higher support for parties at the far-left or far-right of the political spectrum. On the one hand, the far-left attracts voters by the call for even more redistribution. On the other hand, as globalization is blamed for being the main culprit for the growing wage pressure in the public debate, the sympathy for economic and thereby political nationalism is growing (as in the case of the Brexit). As a consequence, parties at the far-right are expanding faster than parties at the far-left.
Europe is caught in a vicious circle. As the established former catch-all parties try to cure the growing inequality by more regulation and redistribution they further undermine market forces and productivity growth. This creates additional pressure on central banks to buy government bonds—with the described consequences for inequality. In short: By aiming to stabilize Europe, the ECB is driving big wedges into the old continent! If the political elites in Europe do not understand soon that their traditional redistribution reflexes have reached their limits, the political polarization process in Europe will continue. As the pattern of political polarization is reminiscent of the 1930s, let’s hope that European leaders will wake up soon!
Schnabl, Gunther / Müller, Sebastian (2017): Die Zukunft der Europäischen Union aus ordnungspolitischer Perspektive, Universität Leipzig Wirtschaftswissenschaftliche Fakultät Working Paper 150.
[i] A declining value implies a declining support for the established parties. For the construction of the indices see Schnabl und Müller (2017).