Yet another European Union summit meeting has come and gone surrounded by inflated expectations of a decisive breakthrough in the euro area debt crisis. Employing the same hyperbole applied to the Congressional budget "super committee"—despite the fact that the committee comprised the same members who had gridlocked on the issues beforehand—media commentators measured the summit by unrealistic standards.
By now it is clear that some longer term political progress was achieved by EU leaders, but a short-term economic and financial turning point was not. Too much uncertainty remains over the components of what was decided in Brussels to restore confidence. This uncertainty was reinforced by the credit rating agencies' renewed threats of euro area sovereign downgrades following the summit.
Starting with the areas of "political progress," different configurations of EU leaders agreed on new measures in three main areas .
Putting the Private Sector Involvement Genie Back in the Bottle
First, the euro area agreed to address market anxieties about the prospect of future enforced write-downs or restructuring of its sovereign debt. Because of the steep debt write-downs imposed on Greece's creditors (known as Private Sector Involvement, or PSI), markets were concerned about the possibility of similar restructuring imposed on debt issued by Italy, Spain, and other countries in trouble. The new agreement calls for the permanent European Stability Mechanism (ESM) to "strictly adhere to the well established IMF [International Monetary Fund] principles and practices," which was taken to mean that euro area debt will be no more subject to that threat than any other sovereign debt in the world. In addition, the ESM, which was scheduled to take effect as a bailout entity in 2013, will be brought forward to July 2012.
The political meaning of this move was evident. Lenders to euro area sovereigns will not face legal impediments any different from those that exist in other sovereign debt markets. Even more evident was the admission implied by this step. As Herman van Rumpoy, president of the European Council, stated: "To put it more bluntly, our first approach to PSI, which had a very negative effect on debt markets, is now officially over." This was an effective acknowledgement from Brussels that it had underestimated the market contagion effects of the PSI worked out for Greece.
Euro area leaders are thus making some progress in putting the "PSI genie" back in the bottle and restoring the risk free status of euro area sovereign bonds. The latest step was a follow-up to their action at the October 26 Summit, at which they committed to "continue providing support to all countries under programs until they have regained market access, provided they fully implement those programs" (which was understood to be well beyond current IMF programs if necessary). How markets view these policy changes is likely to be affected by the ultimate agreement (or lack thereof) between Greece and its private creditors under the general terms agreed on October 26. (A nominal discount of 50 percent on notional Greek debt held by private investors is being discussed, but last minute attempts by the Greek government to extract further reductions in the net present value of loans from private creditors may not be welcomed by the rest of the euro area, even if they marginally assist Greece's efforts to restore its long-term solvency.)
A New Euro Area Rule Book, Minus the United Kingdom
The second element of progress in Brussels related to the agreement by 26 EU leaders to pursue a new "fiscal compact" for the euro area, and potentially for the nine non-euro European Union members, leaving out only the United Kingdom, which refused to go along. The rules include the following main components, directly quoting from the Summit Conclusions:
- General government budgets shall be balanced or in surplus; this principle shall be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5 percent of nominal GDP.
- Such a rule will also be introduced in Member States' national legal systems at constitutional
or equivalent level. The rule will contain an automatic correction mechanism that shall be triggered in the event of deviation. It will be defined by each Member State on the basis of principles proposed by the Commission. We recognize the jurisdiction of the Court of Justice to verify the transposition of this rule at national level.
- Member States shall converge towards their specific reference level, according to a calendar proposed by the Commission.
- Member States in Excessive Deficit Procedure shall submit to the Commission and the Council for endorsement, an economic partnership program detailing the necessary structural reforms to ensure an effectively durable correction of excessive deficits. The implementation of the program, and the yearly budgetary plans consistent with it, will be monitored by the Commission and the Council.
- A mechanism will be put in place for the ex ante reporting by Member States of their national debt issuance plans.
These rules clearly diminish the fiscal sovereignty for any participating country, in accordance with German demands for a new degree of fiscal coordination and integration in the euro area. This fiscal compact is probably close to the kind of Stability and Growth Pact (SGP) that Chancellor Helmut Kohl and Finance Minister Theo Waigel wished they had devised in 1997. It represents a sizable political victory on substance for Chancellor Angela Merkel regarding the new euro area rule book.
Some "implementation risk" lingers around this compact, however. How many countries will join, for example? Several leaders must first consult their national parliaments or get voter approval through referenda before committing. The risk of glitches is probably lower in the "non-Treaty framework" endorsed by the summit leaders than would have been the case associated with a full-blown revision of the EU Treaty, but it is still substantial, potentially prolonging the current uncertainty beyond the March 2012 deadline set by leaders.
Another "implementation risk" with the new fiscal compact derives from the institutional uncertainty over how the new rules are to be enforced in the euro area without amendment of existing EU Treaties. The refusal of British Prime Minister David Cameron to sign up to the compact means that the jurisdiction of both the European Commission and Court of Justice does not apply, for example.
The EU Treaty language about how these institutions operate is often quite flexible. Article 250 states that "the Commission shall act by a majority of its Members." Article 273 makes it clear that "the Court of Justice shall have jurisdiction in any dispute between Member States which relates to the subject matter of the Treaties if the dispute is submitted to it under a special agreement between the parties." A legal solution may be found, but the UK position has made it more difficult. The European Union (minus 1) will progress. But questions over its governance and readiness are keeping its future in political and legal limbo.
What has the British government achieved by vetoing the European Union's fiscal compact within the existing EU Treaties? Member states could probably have written new rules allowing for a UK opt out, for example by changing one of the protocols to the EU Treaty (like Protocol 12 on the Excessive Deficit Procedure or Protocol 14 on the Eurogroup).1 But Cameron refused to sign up to such an amendment, on the grounds that the other EU members did not meet his demands.
According to The Telegraph, Cameron wanted several things: veto power over future regulation of financial services, including a transfer of regulatory power to the EU level; harmonization requirements that would prevent member states from imposing additional regulatory requirements (like higher capital requirements for banks); tax issues (e.g., the financial transaction tax); and the demand to locate the new European Banking Authority in London.
But these demands would have rolled back existing provisions under the Internal Market, which operates under the Qualified Majority Voting (QMV) rule to avoid the possibility of national vetoes. This principal has been in place in the European Union since the adoption of the Single Economic Act in 1986. The precedent setting effect of giving the United Kingdom a national veto over its "vital national industry" is straightforward. But in the future other EU members would surely demand similar treatment for their own "national champions." It was hypocritical for the UK government to claim it was defending the integrity of Internal Market while wanting an exception to its key governance rule for the City of London. The other EU leaders appropriately rejected its demand.
The issue of taxation, including any financial transactions tax, is already governed by unanimity in the European Union. The United Kingdom has always been able to defend its interests in the Internal Market for the financial services sectors through alliances with other likeminded EU members. Cameron was thus invoking a strawman while claiming to stand up for British national interests and demanding new unanimity provisions. Existing political safeguards would seem quite sufficient for that purpose.
Instead, Cameron's actions look driven by his political desire to get something about financial services back from the European Union to placate euro-skeptics in his Conservative Party. In this appeasement he will undoubtedly fail. Only an actual UK withdrawal from the European Union will suffice for parts of his own party. Moreover, it is ironic that a political leader worried about the spillover effects of the euro area crisis would deepen the uncertainty about the euro area crisis solution.
A Round-Trip Role for the IMF, With Strings Attached
The third component of the progress achieved by EU leaders was their agreement to supply up to €200 billion in additional resources "to ensure that the IMF has adequate resources to deal with the crisis." The resources will likely come in the forms of loans from national central banks inside and outside of the euro area (e.g., including the Bank of England). For the countries in the euro area, this type of balance sheet expansion for national central banks, which will be part of the consolidated balance sheet of the European System of Central banks (ESCB), has a degree of "round-tripping" about it.
The ECB last week made it clear that it is opposed to lending directly to the IMF for the purposes of exclusively lending the money back to Italy and Spain especially. Now by making the decision at the national member state level (but still on the consolidated ECB balance sheet) Frankfurt can superficially outsource the political responsibility for this decision to member states. This step makes it easier for the central bank to claim that it is keeping faith with the spirit of the EU treaties and their ban on monetary financing.
Pledging more money directly to the IMF is certainly a good idea. But it must be clear to EU leaders that their expectations of "parallel contributions from the international community" must come with strings attached. Such strings should include an accelerated transfer of euro area member states' IMF quota shares to contributing countries, most obviously China. A consolidation of the euro area IMF board representation into a single seat for the euro would also make sense. Hopefully emerging-market contributors will make these demands explicit, seizing an obvious opportunity to accelerate governance reform at the IMF.
Calling for other pledges from the big emerging surplus countries also amounts to an admission that the model of a leveraged European Financial Stability Facility, an approach floated earlier this year, will not attract sufficient non-European financing. Non-euro area sovereigns will clearly find the IMF far more attractive and less risky as a lending vehicle. With official resources now likely to be raised by the IMF, the EFSF role is now limited to raising the money (mostly from private sources) to fund bailouts for the three small euro area countries on IMF programs. It could also finance help for banks falling short of the capital requirements in Europe's latest bank stress test. Pretending that the EFSF will have any meaningful role beyond these two steps is naïve.
From the perspective of utilizing European resources, it makes sense for EU leaders to try to leverage them through the IMF, where its special status can attract far more non-European resources than the EFSF. While everyone is interested in something that works, other IMF members should make sure that euro area countries pay a price in the form of new governance reforms.
Where the Summit Fell Short
As important as these achievements were, EU leaders failed to change market perceptions about the crisis. The pattern has become depressingly familiar. Once again a short-lived "summit rally" gave way to market jitters returned days after the summit concluded. This relapse is no surprise for at least two reasons.
First the EU leaders in the summit focused on longer-term political guidance for the euro area's new institutions and did nothing to address the markets' immediate financial concerns. High on the list of concerns are the large bond rollovers by Italy and Spain in early 2012. More important, the EU leaders' task was undermined by the change of signals from the ECB about its short-term role.
At the heart of the problem were the now-you-see-it, now-you-don't intentions of the ECB president Mario Draghi. Speaking the day before the summit, Draghi indicated that the central bank would step up as a forceful lender of last resort for the euro area banking sector through an unlimited 3-year liquidity provision, a reduced reserve ratio, and changed collateral rules.
But to widespread chagrin, Draghi also clarified his remarks from a week earlier before the EU parliament about how "other things might follow" from a new fiscal compact. Markets and commentators (including this one) had widely interpreted this earlier comment as suggesting that "other things" would include financial interventions to restore market calm. On December 8, however, Draghi made it clear that not only is the "other thing" not a monetary element (e.g., new ECB actions), but that "the need to respect the spirit of the Treaty should always be present in our [the ECB governing board's] minds." In other words, don't expect Frankfurt to ride to the rescue of markets anytime soon. The central bank may bail out the financial system( i.e., banks), but not stabilize the sovereign debt markets.
Draghi's words quickly reversed the market rally inspired by his earlier public remarks, especially in Italian and Spanish bonds. It is unclear why it would take a sophisticated central bank a week to correct what quickly became an erroneous market consensus about the ECB's future role. The delay suggests that events at the ECB meeting itself on December 8 caused Draghi to become more cautious and that it was not a problem of the markets inferring the wrong message. Why such a shift might have occurred is unknown. The ECB publishes no minutes of its meetings. But Draghi noted that the December 8 meeting had witnessed a "lively discussion." He denied that the Governing Board had discussed the imposition of limits on sovereign bond yields.
Thus ECB and EU leaders last week carried out a classical message of one step forward (new money for the IMF) and two steps back (dampened expectations for ECB intervention). Continued market concerns after the summit are thus hardly surprising.
The Euro Area Faces Perils but Is Not at the Brink of Collapse
In this situation it is easy to forget that longer-term political progress was achieved. The euro area's new fiscal compact brings policy coordination closer to reality. The new fiscal rules cannot be the end of the road, however. Euro area leaders correctly noted in their conclusions that "we will continue to work on how to further deepen fiscal integration so as to better reflect our degree of interdependence." With such stabilizing rules in place first, a lot more work is required on the longer-term feasibility of
eurobonds and broader fiscal surveillance. Van Rumpoy took note of that necessity at his early morning press conference, too.
Thus the medium-term outlook for such innovation does not look completely hopeless. As one thinks about the future German political situation, which could force Chancellor Merkel to turn to a new coalition partner after the next federal elections in 2013, it is worth remembering that as the Free Democratic Party (FDP) looks headed for electoral extinction, the two remaining potential partners in the Bundestag are the Social Democratic Party (SPD) and Green Party. Both support eurobonds, which Merkel has said should not be discussed until much more time has passed.
Making the enforcement of numerical debt and deficit targets more credible and automatic will not ensure the longer-term stability of the euro area. Neither Spain nor Ireland would likely have been sanctioned by these new rules, had they been in place pre-2008. The principal macro-economic weakness of these two countries was not large deficits or high debt, but a runaway housing bubble and the collapse of government revenues and fiscal sustainability when the bubble burst. To guard against private credit bubbles in the future, fiscal surveillance cannot rely on automatic debt and deficit rules alone. Instead those in charge of surveillance must be intrusive and competent enough to spot bubbles in advance, never an easy task. In other words, future EU fiscal surveillance must gain aspects of "macro-prudential regulation" (known mostly from banking regulation) to succeed. This process might well lead to a loss of fiscal sovereignty for euro area member states even greater than any loss resulting from a failure to achieve numerical debt or deficit targets.
Finally, there might be a glimmer of hope in the recent extreme bond market volatility. The rally in Italian and Spanish bonds after Draghi's initial misunderstood pledge of "other things to follow" suggests that a credible financial commitment of support for Italy and Spain is all that markets need to swing to a more positive equilibrium. The IMF might soon be able to deliver those resources.
Thus the euro area is hardly at the brink of collapse. More likely it is just one more (large) rescue package away from stabilization.
1. Note that revising protocols in the EU Treaty can be done via unanimity by the EU Members and does not, for instance, require that a time-consuming new EU Inter Governmental Conference (IGC) is called. This approach would probably have fallen short of Angela Merkel's demand for a "full Treaty revision."