Finland was the canary in the coal mine of Europe‘s state fragmentation

When Finnish voters go to the polls in the general elections on Apr. 19, the outcome might well be a government in which the euroskeptic Finns party plays a central role. This will not put the country’s euro membership at risk or make a new rescues package for Greece impossible. But striking deals in Brussels could become noisier going forward, and there is a risk of delays to market-relevant decisions.

The Finnish poll will only be the first in a series of votes in a set of small, northwest European economies this year. The Netherlands, Austria, and Switzerland will also hold elections, either on the regional or the national level. And they are facing quite similar challenges.

Northwest Europe is hardly known for political uncertainty of the kind investors fear in emerging markets–or currently in Greece. Yet the politics of these rich, still relatively egalitarian and traditionally consensual democracies are changing. The region is at risk from the growing tides of (mostly right-wing) populism and political fragmentation. As these states are euro members or at least integrated into the EU’s internal market, this may not only complicate policy-making at home, but also subject Europe to short-term bouts of volatility.

Where the populists come from…

The populist challenge is no new phenomenon. Recall: Joerg Haider’s Freedom Party (FPO) joined the Austrian federal government as a junior coalition partner already back in 1999; the euroskeptic and xenophobic Swiss People’s Party (SVP) became the strongest force in parliament in the same year; current Dutch Prime Minister Mark Rutte struck a support deal with anti-Islamic populist Geert Wilders between 2010 and 2012; and the euroskeptic True Finns–now relabeled simply as Finns–were the big winners of Finnish elections in 2011.

There is a broad debate among analysts and political scientists about the origins of the populist surge and political fragmentation. Views differ, but most experts would probably agree that growing income inequality is part of the story–even if on a level of welfare still mostly unrivalled in the rest of the world. The unresolved issue of de facto opposition to immigration in large parts of society often provides a powerful focal point for the populist discourse. And the break-down of consensus around mainstream politics provides futile grounds for both fragmentation in general and populists in particular.

…and how to deal with them

At the national level, center-right attempts to integrate the populists have usually failed quickly, as in Austria and the Netherlands in the late 90s and early 2000s, respectively: these governments soon collapsed. Mainstream parties have therefore largely reverted to a “more of the same” response: striking the grand coalition deals so typical of their political systems, tying Christian-conservative or liberal parties to social democracy or the Greens.

However, with the center-right’s lack of clarity on how to address fears of immigration, social democracy failing to close the widening income gap, and grand coalitions often further increasing dissatisfaction on the fringes, the populists have become more established. In sub-national politics, containment strategies have subsequently varied, ranging from polarization (forming center-left coalitions against the strengthened far right) to striking deals with them, either in voluntary arrangements or when left with “no way out” due to the principle of all-party government.

The populist risk does not loom in the form of landslide victories with resulting, dramatic policy changes. The traditional consensus principle holds at the core of most small states. Instead, as the populist fringes grow, governing becomes gradually more complicated. While in Finland, a potential outcome may be delays to eurozone decision-making, the result of fragmentation in the Netherlands might be a further slow-down on the domestic reform front. In Austria, the government has already felt forced to take a tough approach towards a failed lender’s bondholders. Interestingly, the medium-term political risk might be greatest in Switzerland, where integration into the EU’s single market might eventually come under strain.

Finland: difficult negotiations

After its defeat in the 2011 polls, the Center Party is likely to return as the strongest party in the general elections on 19 April. Prime Minister Alex Stubb’s National Coalition Party (Kokoomus), the Social Democrats and the euroskeptic Finns party all compete for second place. The resulting coalition arrangement might well be overly large in size and ideologically diverse in composition. Going forward, this means potentially difficult negotiations to keep all partners onboard.

Unlike after the last elections, the Finns party has signaled its appetite for a role in government. This could cause difficulties, as government involvement would force the Finns leadership to commit to a more pragmatic position vis-à-vis Europe. Regardless of the new government’s eventual composition, Finland will continue to play the role it has had so far: that of the Eurozone’s toughest creditor country, insisting much more than Germany on strict reform conditionality in program countries.

Netherlands: watered-down reforms

In the senate elections on 26 May, Prime Minister Mark Rutte’s People’s Party for Freedom and Democracy (VVD) is expected to largely retain its current seat share. However, his junior coalition partner, the Labor Party (PvdA) is likely to lose seats to the largest opposition parties, Christian Democrats (CDA), Socialists (SP), and the liberal D66.

On a positive note for the government, Geert Wilders’ populist Freedom Party (PVV) is currently polling low amid a number of internal scandals. But levels of political consolidation are unlikely not go back to where they were prior to the rise of the populists.

As Rutte depends on opposition support in the senate, these parties’ gains will make it even more difficult than before for the government to push ahead with economic reforms. The likely result is an emboldened opposition lending support but watering down proposals on health care and the housing market.

Austria: no more money for the bankers

The populist FPO is likely to perform well in each of the four regional elections in Austria this year. In Styria and Upper Austria in September, this leaves established parties with “no way out” due to the proportional system of all-party government. In contrast, the Burgenland elections on 31 May are the first polls after the local abolition of that system. Still, the formation of an alliance of the center-right Peoples’ Party (OVP), FPO and the Greens cannot be discarded: including the populists would serve as a means to oust the so far dominant Social Democrats (SPO).

In the city-state of Vienna, home to almost a quarter of Austria’s population, elections will likely be held on 11 October, and the FPO is poised to become second strongest party after the traditionally ruling SPO. In this cradle of European social democracy, polarization has been the strategy for dealing with the FPO: Major Michael Haeupl will likely continue with his center-left coalition of SPO and the Greens.

Apart from most sluggish progress on economic and tax reform, the main policy item at risk is the resolution of Heta, the bad bank managing the left-overs of Hypo Alpe Adria. The failed lender had expanded from Carinthia to the Balkans under FPO leadership before it collapsed. The recent decision by the SPO-OVP government to send Heta into resolution under new EU rules also sheds a light on populist pressures: political majorities for supporting the financial sector are simply no longer available. As a result, haircuts have been forced even on holders of bonds guaranteed by the regional state of Carinthia.

Switzerland: the risk of isolation

As in some of the Austrian regional states, the political system of Switzerland offers no way out of the populist conundrum: the at-times openly xenophobic SVP is not only the strongest force in parliament, but has also been a member of the all-party government for years.

In the general elections on 18 October, the SVP might retain its lead position, but this is not the main risk. Instead, since days of the party’s rise during the 1990s, its success has remained closely linked with the principle of direct democracy. The SVP has acted as a sponsor for populist referendum campaigns, from banning the construction of mosques to halting immigration from the EU. Last year’s majority in favor of the latter initiative has put relations with the EU under strain: Brussels is threatening to limit Swiss access to the bloc’s internal market if the Alpine republic were to clamp down on immigration from the EU.

Over the longer term, Switzerland might therefore be the country most at risk from the populist surge. In a slow but steady process of tying policy-makers’ hands in referenda, the country’s vital integration into the EU market might become at risk. Two signposts should be watched: the economic effect of the Swiss National Bank (SNB)’s surprise decision to withdraw its exchange rate ceiling to the euro; and the SVP’s political ability to cross the infamous “Roestigraben,” dividing the country’s mostly German-speaking SVP strongholds and the francophone Romandie.

Carsten and Tin first wrote a version of this report for Teneo, a global advisory firm. We welcome your comments at ideas@qz.com.

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