Key takeaway – The global economy is stagnating, financial markets are jittery and citizens disfranchised. Effective policy options are available, but – alas – most are not politically viable. Over the next 12 months, key elections will take place in the US, France and Germany and a constitutional referendum in Italy. Populist parties are unlikely to win, but – as politicians and policymakers deal with the rise of populism and the constraints of politics – governments will be too weak to pass meaningful reforms, with possibly severe consequences on economic fundamentals and market performance. The democratic process, especially in times of crisis, requires rethinking.
The global economy is stagnating, financial markets are jittery and citizens disfranchised … Over the next five years, in absence of structural reforms, global growth is likely to idle. Macro fundamentals will remain weak: high debt levels will deter investments and productivity gains, fiscal and monetary policy won’t support demand, stagnant salaries will keep real incomes flat and unemployment will constrain consumption and inflation. The world’s two largest economies – the United States (US) and the European Union (EU) – are likely to fall into recession. Continuous over-reliance on central banks (CBs) will lead to: 1) further financial repression, via negative policy rates; 2) competitive devaluations, buoyed by deflation fears; and 3) liquidity-driven markets and asset inflation. Inevitably, the rising disconnect between economic fundamentals and market valuations will bring about a bear market, if not a crash. Financial instability and rising inequality will spur anti-establishment feelings; citizens will not feel represented by traditional parties and xenophobia will fuel protest vote. Instability, populism and authoritarianism will rise.
… but effective policy options are available. From a technocratic point of view, there is no need to suffer all this: credible, valuable policy options are at hand. Across the globe, developed (DMs) and emerging markets (EMs) can engineer a sustained recovery – especially if they coordinate actions to: 1) stop relying on (unconventional) monetary policy alone; and 2) enact comprehensive structural reforms, such as: a) counter-cyclical fiscal policies: the US, EU and Japan should launch a five-year fiscal strategy, with near-term stimulus (i.e.: high-return investments to jump-start growth; reduce taxes – especially on labour – to encourage job creation and increase aggregate demand) and credible medium-term austerity. Most countries should increase spending in infrastructure and education via public-private-partnerships (PPP), while preserving macro stability; b) reduce rent seeking and align wages with productivity: address élite capture, improve the efficiency of the public administration and make the formal labor market more flexible, by adopting “flexicurity”; c) resolve chronic insolvencies and tolerate higher inflation: without orderly debt restructuring and mild inflation the global economy will not achieve job-generating (not just above-zero) growth. In other words, a transfer from creditors to debtors (debt restructuring) and from savers to borrowers (inflation) is the only way to clean up balance sheets whilst maintaining the integrity of the global financial system.; d) stimulate productivity growth by removing protective barriers-to-entry and diversifying the economy; e) promote the restructuring of the banking system, in order to improve its strength and reform NPLs insolvency processes; and f) reform obsolete judicial systems and simplify, harmonize settlement procedures.
Unfortunately, most policies are not politically viable. Over the next 12 months, four consultative processes will take place in key DMs (elections in the US, France and Germany; and one referendum in Italy). Populistic parties are unlikely to win, but – as politicians and policymakers will have to deal with the constraints and the realities of politics – the rise of populism is likely to impede effective policies from being implemented. In chronological order, they are:
1. US: Presidential election (November 8, 2016): The 58th presidential election will determine the 45th President and 48th Vice President of the US. The two presidential candidates are Hillary Clinton for the Democratic Party (D, social-democratic, center-left) and Donald Trump for the Republican Party (GOP, conservative, center-right).
Hillary Clinton wins (70 percent probability). With 270 electoral college votes required to win and after months of polls indicating a tight race, as of November 3, 2016 the polls attribute 226 electoral college votes (42.0 percent of the total 538 votes) to Clinton and 164 votes (30.5 percent) to Trump; 148 votes are still classified as “toss-up” (27.5 percent).
Impact on the economy: Clinton better than Trump. According to Moody’s, Clinton’s policies will outperform Trump’s. Clinton’s tax increases – mostly applied to higher-income brackets – would keep the deficit in check and have a limited impact on growth. Consumption would be fueled by: a) the proposed increase in the minimum wage; b) a strong labor-force expansion, due to additional immigration (at least an additional 250,000 immigrants per annum) and women joining the workforce, helped by early child-education programs; and c) higher access to college education, eventually increasing the purchasing power of the workforce. Private sector investment – one of the weakest areas in Clinton’s program – could benefit from short-term tax cuts and, in the long term, be stimulated by the expansion of public infrastructure. Government spending would be strong, even with an unfriendly Congress, with an expected increase (mostly in infrastructure) of around USD 1 trillion, or 25 percent of 2016 spending. Trade-wise, Clinton’s policies are expected to be neutral compared to current policies.
Impact on the markets: a Clinton victory might trigger a period of moderate “risk-on”. A clear Clinton lead in the polls in the week prior to the vote is likely to support the US, Mexican and Canadian stock markets. In the long term, however, the performance of US stocks will suffer: a) the fines imposed on US firms moving fiscal domicile to optimize their tax-burden; and b) higher taxes on short-term capital-gains. If the proposed tax on high-frequency traders is implemented, volatility in bond and stock prices might decline. In case of a Trump victory, financial markets will react negatively. A Clinton victory is likely to increase the likelihood of an interest rate hike in December by the US Federal Reserve (Fed). As a result: a) the USD will strengthen against other major currencies; and b) bonds prices will decline. Independently of who wins, the 10-year bond yield is expected to increase from current levels (less than 2 percent) to around 4 percent by 2020, as a result of higher growth in the US relative to other DMs. Commodities are unlikely to get affected by Clinton’s victory.
2. Italy’s constitutional referendum (December, 4 2016). The constitutional referendum has two objectives: a) streamline future law-making by ending the so-called “perfect bicameralism”, cause of frequent institutional gridlock (at the moment both houses of Parliament are required to vote on each law); b) provide greater government stability and minimize the risk of post-election paralysis; and c) transfer back key powers from the regions to the central government, e.g.: decision-making over infrastructure spending. According to its opponents, the constitutional change would, at the same time: a) be inadequate and ineffective; and b) make the government too powerful. Most importantly, a ‘no’ vote would not bring about political instability, market turmoil and economic damage.
Base case: the ‘no’ narrowly wins, PM Matteo Renzi does not resign (60 percent probability). Over the last few months, support for the ‘yes’ vote has weakened and the ‘no’ camp is now showing a slight edge, although the share of undecided voters remains elevated. Initially, Renzi committed to resign if the reforms were not approved, but over the last month he has backtracked, and received support to stay even in defeat.
Impact on the economy: more stagnation. If the ‘no’ vote wins, Renzi’s government will inevitably weaken and become progressively unable to: a) implement growth-enabling reforms; b) support – and bail out if needed – the banking system; and c) avoid elections. In a context of low growth, high debt, financial sector fragility and declining credit to the private sector, consumption and investment will stagnate. If the proposed 2017 budget is passed (but there are tensions with Brussels on the plan), government spending will support growth from 0.8 percent in 2016 to 1.0 in 2017. Only in case of PM’s resignation, political uncertainty will negatively impact economic performance and strengthen the anti-establishment, populist “Five Star Movement” (M5S), which is proposing a referendum to leave the euro.
Impact on the markets: uncertainty and volatility mildly up. Uncertainty will spur volatility, and stocks will continue to struggle (in the first ten months of 2016 the FTSEMIB has lost 17.3 percent); in particular, financials are likely to suffer, and might create spillovers into other markets. Yields on Italian – and other Euro-periphery – bonds are likely to increase, but the ongoing EBC QE program will prevent reaching the levels of the 2011 European debt crisis. Only the PM’s resignation would severely affect financial markets.
3. France – Presidential election (first round on April 23 and second round on May 7, 2017). The two main parties, the Republicans (LR, conservative, center-right) and the Socialists (PS, social-democratic, center-left) are being challenged by the “Front National” (FN, far-right, nationalist, populist), likely to reach the second round on May 7, 2017.
Base case: the Republican candidate – Alain Juppé or Nicolas Sarkozy – wins (75 percent probability). In the 2017 presidential race, the Republican party counts with popular potential candidates. According to the latest polls, the PS and the FN – unable to appeal to moderate audiences in spite of a rising support – are unlikely to win.
Impact on the economy: tax cuts and structural reforms, but growth to struggle. Over the 2017-2022 period, the Republican electoral program – if implemented – would: a) apply tax cuts to both higher-income citizens and businesses, reducing revenues but possibly lifting investment; b) carry out structural reforms and improve competitiveness – i.e.: by increasing the retirement age (from the current limit of 63) and abolishing the 35 hour workweek; c) reduce consumption by imposing austerity measures and immigration limits – which would decrease the purchasing power of the labor force. Historically, both republicans and socialist followed a pro-EU agenda. Conversely, a victory of the FN would increase the chances of a referendum on euro-exit and would weaken the EU, by adding centrifugal forces.
Impact on the markets: mildly positive. The elections are likely to have very limited implications on the financial markets. Stocks might react with gains to the Republicans’ victory, in anticipation of the adoption of budget cuts and business-friendly measures. Similarly, the demand for sovereign and corporate bonds is likely to increase. The euro is likely to strengthen, relieved by the defeat of anti-euro forces.
4. Germany – Federal election (between August 27 and October 22, 2017 – yet to be determined). According to recent polls, the ruling Christian Democratic Union (CDU, liberal-conservative, center-right) is on the lead with 30.0 – 33.5 percent of the vote intention, followed by the Social Democratic Party (SPD, social-democratic, center-left) with 21.0 – 24.0 percent, and Alternative für Deutschland (Alternative for Germany – AfD, far-right, nationalist, populist) with about 15 percent. Yet, CDU’s approval rate is rapidly decreasing, as populist movements attack its pro-migration policies.
Base case: the CDU candidate – very likely Chancellor Angela Merkel – gets elected (70 percent). The CDU will not obtain majority and will negotiate a grand coalition with the SPD. The upper house, the Bundesrat, will be unable to support Merkel’s pro-EU policies.
Impact on the economy: lower uncertainty, higher confidence. The continuity of the German government would reduce: a) uncertainty over the future of the euro and of the EU; and b) the likelihood of a strong increase in government spending. A coalition government led by Merkel would support investment and consumption, as it would: a) improve business confidence, not only in Germany but also in Europe; and b) implement tax cuts (as hinted by CDU representatives – electoral programs are yet to be disclosed). Upcoming restrictions to immigration flows will decrease the purchasing power of the labor force.
Impact on the markets: positive. The markets will welcome a coalition government led by Merkel, especially if her relationship with the new French president is solid. Likely reactions include increases in stocks prices in Europe and decline in yields of German bonds. The EUR will probably appreciate against the USD as investors will return to Europe.
Is democracy working in times of crisis? In the post 2008-crisis environment, traditional parties are unable to manage. Voters fail to elect capable, visionary leaders and are asked to take political responsibilities via referendums. Governments – held at ransom by strong minority interest groups – are too weak to pass meaningful reforms. Confused citizens don’t feel represented and vote “against” rather than “for”. The resulting (incongruous) coalitions lead to political impasse and paralysis, boosting far-right and national-socialist factions. Populism – by promising simple solutions to complicated problems – further undermines the political debate. In other words, electoral systems fail to aggregate individual preferences and democracy cannot build consensus.
Populism will make it hard to implement effective policies, with possibly severe consequences. In the US, Italy, France and Germany alike, the surprisingly strong performance of populist movements in recent elections is affecting the government’s behaviour. Politicians and policy makers cannot ignore populistic demands and needed structural reforms – while growth-enhancing and fiscally palatable – are put on hold. As policy decisions taken by individual countries end up shaping the global medium-term economic and political environment, the world is watching. In absence of enlightened political leadership, the implications of each consultation on economic fundamentals and market performance can be severe.
We thank Pablo Gallego Cuervo and Mert Yildiz for comments and suggestions. All errors are ours.
 Financial repression occurs when interest rates (the returns earned by savers) are held below inflation. When accompanied by inflation, it becomes a form of debt reduction. In today’s low-inflation or deflationary environment, CBs need negative policy rates to produce negative real rates. By transferring benefits from savers (the lenders) to borrowers via negative real interest rates, financial repression works as a tax on savers and bondholders, which helps liquidate the (public and private) debt overhang and eases the burden of servicing that debt. In other words, without inflation, the easier way to reduce debt is a slow process of sustained negative returns and – where possible – some orderly restructuring. A transfer from savers to borrowers (negative returns) and from creditors to debtors (debt restructuring) is the only way to clean up balance sheets whilst maintaining the integrity of the global financial system.
 “Market correction”: a fall of more than 10 percent from the 52-week high, over a single week. “Bear market”: a fall of more than 20 percent from the 52-week high, over 300 days. “Market crash”: a fall of more than 10 percent in just one day, or 40 percent from the 52-week high over 150 days.
 Over the years, access to infrastructure and a better educated labor-force will promote the circulation of goods, people and knowledge. A lack of infrastructure and an education of inadequate quality restrain growth, as they hurt SMEs and discourage entry of domestic start-ups and foreign investors.
 As private investment is constrained by a number of institutional factors that are difficult to address in the short run, schemes for more public-private risk sharing are also needed. To alleviate bottlenecks the government should both reduce the risk and increase the returns on private investment. In other words, it is necessary to stimulate risk-sharing among investors – for example, via PPP – by co-financing public works (transport and communications) and in education, by addressing under-provision of training in areas where skills are lacking. At the local level, people’s investment in skill acquisition and organizational capacity only materializes if private returns are appropriable.
 The Asian experience has shown the importance of sound economic management for job creation. Economic stability matters for employment, and maintaining it during a crisis requires strong institutional fundamentals as well as flexible macro-economic policies. When the 2008 crisis hit the Asian region, solid domestic fundamentals combined with a coordinated policy responses upheld growth. Supportive fiscal policies coupled with monetary expansion absorbed the economic and financial shocks. Importantly, large fiscal packages supported both GDP and employment: Asian countries spent on fiscal stimuli an average of 9.1 percent of 2008 GDP, far larger than the 3.4 percent of the advanced economies.
 Élite-capture occurs when local economic or political élites use their influence to capture resources (e.g. government programs aimed at distributing funds to the general public) originally destined to the larger citizenry. Some élite-self-perpetuation is unavoidable, but too often family connections matter more than individual abilities. Inherited power and wealth give access to expensive education and valuable contacts, and are powerful predictors of future success.
 The ability to balance the “flexibility” needed to adapt to economic changes with “security”, in order to maintain labor protection. In Asia, as a result of past pressures from domestic employers and foreign investors, most countries’ labor regulation is sufficiently flexible and not financially onerous for employers. In the late 1990s, Korea eliminated the guarantee of lifetime employment but provided policies to compensate. In Singapore and Malaysia employment is not secure but supported by active policies, such as skills training and self-employment promotion. Over the past decade China and Korea reduced restrictions on retrenchment but introduced unemployment insurance. In China, India (e.g.:, the National Rural Employment Guarantee Scheme) and Sri Lanka, where the informal and rural economies are large, governments often used public works, self-employment programs and skills training to reduce unemployment.
 For example, in the US, negative-equity mortgages need to be written-down. In the EU, Germany will have to forgive peripheral-debt and guarantee central government debt of core countries. It sounds indefensible, but debt forgiveness is as old as Babylonia, Solon’s Athens and Hadrian’s Rome.
 For speedier growth, and to sustain employment generation in the long-term, the economy needs a competitive diversification. Cross country comparisons show that growth accelerations are associated with the production and export of non-traditional manufacturing and services, in other words the products “in demand” in the industrialized nations. Hence, development policies should strategically promote a structural transformation toward these “more sophisticated” economic activities, by providing production incentives to new exportables. Policies should promote the manufacturing – and export – of non-traditional manufacturing and services, to foster a market-driven expansion of non-traditional products.
 If implemented – even partially, due to confrontation with Congress – by 2020 Clinton’s policies would: a) deliver an average real GDP growth of 2.4 percent per annum – slightly higher than the current 2.3 percent (i.e.: the “no policy change” scenario), and higher than the 1.5 percent achieved by Trump’s policies; and b) add 7.7 million jobs to the current employment levels, i.e.: 4.1 million jobs more than Trump (Trump’s policies would only add 3.6 million jobs). Trump proposals on: 1) immigration (the deportation of 11 million immigrants, the construction of a wall on the border with Mexico); and 2) trade (the imposition of a 45 percent tariff on products from China and 35 percent on many products from Mexico, and revisions to NAFTA agreement), would create disruptions in global trade flows and reduce national income in the US and Mexico. In 2015, Mexico run a current account deficit of USD31.7 billion with the US, its main trade partner, but a trade surplus (which does not include transfers and remittances) of USD60 billion. While Trump’s policies are unlikely to be implemented – due to: a) their elevated cost; and b) lack of support in the Congress and the Senate – his unorthodox foreign policy positions are likely weaken the EU-US alliance, NATO, and the UN – potentially resulting in a diminished role of the US in global affairs and higher global instability.
 According to Moody’s, the S&P 500 is likely to fall 1.5 percent below the level expected in the no-change scenario (compared to the – 2.4 percent in case of Trump’s victory).
 Financial markets expect a healthier international and domestic economy under Clinton. According to Brookings, a Trump victory would bring about: a) a 10-15 decline in stock prices in the US, UK and Asia; b) a reduction in oil prices by USD 4 per barrel; and c) a 25 percent slide in the Mexican peso (MXN). According to other estimates, a Trump victory would bring about a 7 percent decline in the US stock market and, on the FX front, a plunge of the MXN. In the past, global – and particularly US – equity markets reacted negatively to increases in Trump’s popularity. On Friday, October 28, 2016, financial markets fell at the FBI announcing new scrutiny on Clinton’s email use. In the 30 days running to September 16, as the candidature of Trump gained momentum, the MXN weakened steadily, and lost 9.4 percent of its value to reach 19.77, its lowest level in history against the USD.
 A ’yes’ vote in the referendum would limit the legislative powers of the Senate (the Upper House) and transform it into a body of regional representatives.
 With a ’yes’ vote, the so-called “Italicum” (the electoral law approved in May 2015 to reduce political fragmentation: it excludes from Parliament parties with less than 3 per cent of the total vote and provides a majority premium of 15 percent to the most voted party) would be applied only to the Lower House; thanks to this supermajority, the Lower House alone would be responsible for confirming the government through confidence votes.
 The economy is not expected to return to its pre-crisis (2007) real output peak until the mid-2020s. In 2015 nominal GDP was 17 percent below 2009-levels. Over 2016-21, Italy’s economy is expected to grow at around 0.8-1 percent, supported by expansionary monetary and fiscal policies.
 In 2015, the public debt rose to EUR 2.2 trillion (tn), or 132.7 percent of GDP (from 123.3 percent in 2012). The investor base is relatively stable and mostly domestic: 66.3 percent of Italian government bonds are owned by domestic investors, up from 56.7 percent in 2010, and Italian banks own about half of this amount (30.2 percent). According to the IMF, the 2007 (i.e. pre-crisis) level of public debt was EUR1.6tn, or 100 percent of GDP. According to Eurostat, the Italian government holds the second highest debt-to-GDP ratio in the eurozone after Greece (at 176.9 percent).
 In the banking system, a crisis is looming: non-performing loans (NPLs) amount to a fifth of the country’s GDP (18 percent or €360 billion, around $400 billion) and hinder the recovery and potential growth. In early-2016, NPLs totalled more than EUR300.0 bn, about 18 percent of all outstanding loans.
 Between July 2007 and December 2015 credit was constrained: new lending to SMEs fell by almost 20.0 percent and consumer credit declined, hampering banks’ profitability (profit margins are among the lowest in the EU). As credit restrictions depressed growth, a slower economic activity brought about new NPLs. The total stock of credit peaked at EUR 914 billion in November 2011, and declined to EUR 784 billion in August 2016. In 2015, total loans outstanding increased by 0.1 percent to EUR1.8tn and deposits by 3.5 percent to EUR1.4tn.
 Yet, if spending measures are not approved, growth could decline to 0.6 percent in 2017.
 In November 2011, during the Italian debt crisis (the 10-year bonds yield rose to 6.74 percent; 7 percent is the level where Italy is thought to lose market access), Prime Minister Silvio Berlusconi was forced to resign. An economist, Mario Monti, who had served as a European Commissioner from 1995 to 2004, was appointed Prime Minister of Italy, and led a government of technocrats, composed entirely of unelected professionals.
 The LR candidate will be decided on November 20-27, 2016 (most likely Alain Juppé or Nicolas Sarkozy).
 The PS candidate will be decided on January 22-29, 2017 (most likely François Hollande, the incumbent).
 The party reached the final round in the 2002 Presidential elections and is rising again: it had 11 percent of votes in 2007, 18 percent in 2012, and, according to the most recent polls, it could receive close to 30 percent in 2017. In the 2015 regional elections, France’s socialists and republicans allied at the second round to prevent the FN to control the regions where it had won in the first-round.
 The corporate-tax would be reduced from the current 33.33 to 30.00 percent.
 Over five years, government spending would be lowered by a reduction of: a) the number of civil servants; and b) the state’s pension burden via an increase in the retirement age. The reduction would total about EUR 100 billion (equivalent to 1.2 percent of total 2015 spending, every year), helping to keep the fiscal deficit – at 3.5 percent of GDP in 2015 – on track to reach the 3 percent target set for 2017. Overall, the debt-to-GDP ratio is likely to improve from its current level (96.1 percent).
 In the 2013 elections, the CDU won more than 40 percent of the votes, while AfD only won 5 percent. In the recent municipal and state elections (Mecklenburg-West Pomerania, Lower-Saxony, Berlin) the CDU results were disappointing.
 Because of the Dunning–Kruger effect, democracies rarely or never elect the best leaders. In other words, elections tend to lead to mediocre choices. The key assumption (i.e. citizens can recognize the best political candidate, or best policy idea) is erroneous, because the majority of citizens lacks those competences. In other words, unskilled individuals are inherently unable to judge the competence of other people, or the quality of those people’s ideas (e.g. on tax, pension, labour market reforms). The advantage over other forms of government is merely that democracies “effectively prevent lower-than-average candidates from becoming leaders”.
 Voters, while unhappy with the statu quo, neither want to go backward nor forward. For example, they like the euro and want to keep it. Yet, they are opposed to the further integration that is needed to make the currency union viable. Populist parties of both left and right are becoming more popular by showing hostility to globalization, free-trade, migration, religious minorities and Muslims. The EZ periphery and non-EZ EU members such as Hungary and Poland, suffer from austerity and reform fatigue, while the EZ core, led by Germany suffers from bailout fatigue.
 Acting through the democratic process, populism relies on the “tyranny of the majority” to place its interests above those of (ethnic or religious) minority groups. It also challenges the separation of powers, the independence of judicial system, the Central Bank and the press.
 In 2014, Italy appointed its third unelected Prime Minister. In the 2014 European Elections, the UK Independence Party (UKIP) received the greatest number of votes (27.49 percent) of any British party and became the largest UK political grouping in the European Parliament (EP). In the 2015 regional elections, France’s socialists and republicans allied at the second round to prevent the far-right National Front – the largest grouping from France within the EP – to control the regions where it had won in the first-round. The results of the 2015 general elections make the governability of Spain challenging. After having won the parliamentary elections in Hungary (2014) and Poland (2015), the conservative-religious right has displayed authoritarianism, illiberal attitudes and the tendency to undermine constitutional democracy. In 2015, the Danish People’s Party in Denmark became part of the governing coalition, and has set conditions including adopting a more Eurosceptic approach toward the EU, the introduction of border controls and restrictions on Denmark’s asylum policy.