Forecast: Europe in 2010

My conversation with colleague and friend Nouriel Roubini continues today on our political and economic expectations for key regions in the year ahead. Today, we talk about Europe.

Bremmer: We’re seeing the return of political risk to the Eurozone in a big way, as the line between developed and developing states becomes a little less distinct. Member states’ coordination on fiscal policy has been breaking down for awhile, but a sharp economic slowdown has made matters worse. Markets may be underestimating risks of default among the most vulnerable; EU support is something less than a sure thing. Even without a default, governments will respond to economic stagnation with spending meant to prop up vulnerable sectors. As in the United States and China, it’s all about jobs, jobs, jobs, and jobs.

In fact, stubbornly high unemployment is an especially serious problem in Eastern Europe, where a host of elections in 2010 could heighten tension and stoke unrest. Upcoming elections in a number of key countries materially increase the likelihood of instability. Nervous policymakers and legislators will face the temptations of channeling the frustration and anger of the unemployed with protectionist, populist, even xenophobic policy plans. Ukraine, Hungary, and Latvia are especially vulnerable, but even Poland could hit some turbulence.

Another issue to worry about: If one of the big Western European banks active in Eastern Europe finds itself in trouble, rescue efforts could become a mess.

Roubini: The recovery of the Eurozone and the rest of the advanced economies in Europe will also be anemic and below trend for several reasons: Potential growth in the Eurozone (2 percent) is lower than in the United States (closer to 3 percent). Most Eurozone economies could not do much counter-cyclical fiscal stimulus as they started — even before the crisis — with large fiscal deficits, large stocks of public debt, and financial systems that are both too big to fail and too big to save, because the sovereign does not have the resources to bail them out in case of a systemic crisis. Indeed, sovereign risk is rising in the Eurozone — currently in Greece and Ireland but soon enough in Spain and other periphery economies. The European Central Bank has followed a tighter monetary policy than the Fed and may exit from low rates and QE sooner, thus hampering the economic recovery. Financial institutions in Europe have not fully recognized the losses on their toxic assets and have large exposure to Central and Eastern Europe, where the economic and financial crisis are not yet over. Moreover, the strength of the euro is hampering the recovery of the Eurozone economies, and the Club Med economies have both a competitiveness and a public debt problem, as nominal wages rising faster than productivity have led to rising unit labor costs, real appreciation, and large external imbalances. Thus, even the viability of the European Monetary Union may be challenged over the next few years.

Ian Bremmer is president of Eurasia Group. Nouriel Roubini is a professor of economics at New York University’s Stern School of Business and chairman of RGE Monitor.