Scaling the summit

Europe’s sovereign-debt crisis

Once again, EU leaders have raised high hopes of a solution

SECOND marriages supposedly represent the triumph of hope over experience. Similarly, in the lead-up to every EU summit, investors become optimistic that this time—finally—leaders will manufacture a solution to the debt crisis. So it was with the latest summit on December 8th and 9th, due to take place after The Economist went to press. Beforehand, Angela Merkel, Germany’s chancellor, and Nicolas Sarkozy, the French president, had thrashed out a deal which promises future restrictions on the ability of euro-zone
countries to run large fiscal deficits.

In this section

• »Scaling the summit
• Cash for credibility
• ¡Arriba, arriba!
• Not sharing
• Double-edged deferral
• One careful owner?
• Small wonder
• Puns and punditry

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Related topics

• Europe
• European Financial Stability Facility
• Germany
• Nicolas Sarkozy
• Angela Merkel

The hope was that this would be enough to persuade the European Central Bank to open its wallet and buy more government bonds. The leaders also agreed to bring forward to next year the creation of the European Stability Mechanism (ESM), a fund designed to bail out ailing countries—reducing the risk that the likes of Italy and Spain would struggle to refinance maturing debts. The markets were also boosted by a promise that, unlike the Greek deal, future bail-outs would not require a write-off for private-sector creditors. Italian and Spanish bond yields fell sharply (see chart 1).
Standard & Poor’s, a rating agency, added to the pressure on the leaders to come up with a convincing deal by placing all euro-zone countries on negative “credit watch” with a view to reducing their ratings. The agency cited “continuing disagreements among European policymakers on how to tackle the immediate market confidence crisis and, longer term, how to ensure greater economic, financial and fiscal convergence among euro-zone members.” It also worried about the rising risk of a recession in the euro zone in 2012.
Europe’s leaders face an agonising dilemma. They needed to produce a plan to limit the region’s debt accumulation over the long run. But too great an emphasis on austerity in the short run risks sending the continent’s economy into a deep recession; the latest data on Italian industrial production showed an annual fall of 4.1% in October, even before budget cuts were introduced by the new government. In protest against the reforms, Italian trade unions called private- and public-sector national strikes.
Some feared that the outline of the Merkel-Sarkozy deal looked remarkably like the Stability and Growth Pact, which failed to control deficits over the past decade. Countries will apparently be required to keep to a deficit target of 3% of GDP, on pain of automatic sanctions (under the pact, penalties were usually waived).
“The EU has learned nothing about the shortcomings of the previous Stability and Growth Pact,” says Simon Smith, chief economist at FxPro, a foreign-exchange broker. “Investors would be correct in doubting the EU’s ability to enforce any debt or deficit rules.”
Andrew Benito of Goldman Sachs laments that “two options that would have resolved the past impasse most cleanly have been ruled out. Chancellor Merkel has ruled out the Eurobond that would have directly ‘mutualised’ excessive debt in the peripheral economies. President Sarkozy, meanwhile, has ruled out the fiscal intrusion that would have given a formal veto against national budgets.”
Back to the pact
Market optimism was tempered a little on December 7th when hopes were dashed that the ESM would be combined with the existing European Financial Stability Facility to create a much larger rescue fund. Indeed, S&P warned that the EFSF’s credit rating would be downgraded along with the countries that backstop the facility. Even a package that successfully bails out European countries in the short term would not deal with the long-term problem that has afflicted the region—that some countries have become less and less competitive, relative to Germany.
Another worry for the markets is the continued pressure on banks. The co-ordinated action of central banks on November 30th gave European banks cheaper access to much-needed dollars; they borrowed $50.7 billion from the ECB under the latest three-month deal, compared with just $395m under the previous facility, which levied an interest rate twice as high.

Nevertheless, banks remain wary of lending to each other, as is shown by the gap between their borrowing costs and official interest rates (see chart 2). Banks may respond by cutting credit to firms and households, worsening the pressure on the economy.
The danger is that the markets will repeat the pattern that followed previous summits—a rally on news of a deal that peters out once investors examine the fine print. Only a move to full fiscal union, with the northern countries subsidising the periphery, or unlimited bond purchases by the ECB, seems likely to satisfy investors. Before the summit, Jonathan Loynes of Capital Economics said that “we remain to be convinced that the proposals will bring the debt crisis to an end and ensure that the euro survives in its present form.”