EU Summit Seeks "Grand Bargain" on Euro: Will New Pact Convince Markets? (3/23)     Print Email

The EU summit meeting on March 24-5 has been billed for months as a crucial moment, a deadline for the European Union leaders to sign off on a long-promised grand bargain to shore up the credibility of the euro. The ambitions of the summit are twofold: to consolidate the ultimate solvency of weaker member states saddled with crushing sovereign-debt loads and also to put in place new rules aimed at preventing similar crises in future. Success depends on a central trade-off: Germany and its prosperous EU neighbors, including France, will pledge more funds for bail-out loans in exchange for eurozone-wide acceptance of measures promoting fiscal convergence and movement toward common economic governance.

In this two-part agenda, the challenge of saving stricken economies involves the immediate need to inject more funds into the current European Financial Stability Facility (EFSF) and also a longer-term requirement to set the terms for its richer successor, the European Stability Mechanism (ESM), which is due to take over in 2013 as the eurozone rescue agency. It will have more funds, but it may also impose more risks on lender banks than they have incurred until now. Alongside this bail-out mechanism, the goal of better management is being pursued in the form of new rules of the road for eurozone budget ministries. These new guidelines are being set in the form of a “pact for the euro” that will tighten up the current Growth and Stability Pact, which was born with the euro in 2001 and consisted mainly of a simple requirement for governments to keep their annual deficits below three per cent of gross domestic product. In contrast, the new rules also stipulate structural reforms to make economies more competitive, and they carry “not just the carrots of membership and cheap credit, but also some sticks in the form of fines for countries that continue to flout the rules,” according to a European official taking part in the pre-summit deliberations. The scale of these impending changes amount to what knowledgeable EU officials are calling a “silent revolution” in European fiscal integration.

“The goal here is progress in the direction of eventual economic union that is needed to underpin our monetary union in the single currency,” he said. The euro has become a core achievement of the EU, and even member states that do not use the euro – countries such as Poland and Denmark (which has a formal “opt-out” from the euro) – indicated this week that they were ready to drop earlier objections and fall in with the new discipline that the 17 member states of the eurozone are going to adopt for themselves.

At stake in the summit’s outcome is the euro’s credibility at a new juncture when major economies are emerging from the global financial meltdown, but Europe still has to deal with the debt crisis that erupted publicly at the worst of the crisis.  The degree of success or failure for the summit can be measured not only in political and media judgments of the results, but also in the reaction of international credit market -- which sets the rates that eurozone governments must pay to borrow money to continue financing their debts. More generally, the welter of issues can obscure the central issues, and so this blog post is intended to pinpoint the essentials while offering hyperlinks to articles that explore key specific aspects of the overall debate. As another practical complication for the summit meeting, its economic agenda is now bound to be colored by the international crises in Libya and Japan.

On the summit’s eve, EU officials and diplomats were optimistic.  As one of them said privately, “we’ll get less progress than some people hoped for, but more than most observers expected.”  He and others agreed on the core issues, starting with the long-run goal of better governance. On this point, a good account of the new eurozone blueprint can be read here. The plan consists mainly of “targets” aimed at producing more “competitive economies” (with higher retirement ages, no automatic indexation of wages to inflation and other reforms). This blueprint encountered stiff opposition last month when it was proposed jointly by Germany and France, working together to revive their image as the “motor” of EU progress.  But support has gradually swung behind this “pact for the euro,” partly because its terms have been watered down to change them from rules to “targets.” Instead of implementation being overseen and enforced by the European Commission in Brussels, the goals are to be pursued via the national policy mixes set by individual governments. Even in this looser format, the goals will provide benchmarks for peer pressure by eurozone governments on each other’s performances.

Much tougher challenges have erupted around the other major move in the works – the establishment of the stability mechanism as the future guarantor of eurozone countries’ solvency and as a protection against market fears that one or more of the poorer member states might default on their international debts. As part of this new mechanism, Germany (which will bankroll it) is demanding a change from the existing practice, which guaranteed that creditor banks were fully repaid for their loans while taxpayers provided the funds for the “bail-out” of their countries’ debts. Now Berlin is insisting that banks would have to “take a haircut” along with other creditors in getting only partly repaid in circumstances requiring a bail-out. This change has been in the offing since October, but international investors this week suddenly signaled a revolt against the new plan, with brokers saying they would “boycott” the bonds of weak countries such as Portugal in future because the new plan will make such loans riskier for lenders: here is a good account of the brokers’ threat. Even though the new rules could not take effect before 2013, some traders fear that bonds bought could be affected by the planned new rules. The problems of Portugal also become more acute with a domestic political crisis on the eve of the summit -- that could make Lisbon seek a Greek-style bail-out. Finland too is in a domestic political showdown that could prevent Helsinki from agreeing to shoulder part of the more generous funding for the bail-out fund, at least at the summit.

Over the longer run, the euro will gain stronger credibility now, EU officials said ahead of the summit.  “Market forces cannot have even the slightest doubt about our capacity to act even in the most stressed scenarios,” according to Olli Rehn, the European Commissioner for economic and monetary affairs. He was speaking after EU finance ministers put the finishing touches on the proposed new European Stability Mechanism, which will have more capital than the existing facility, and can lend it to countries in trouble at lower interest rates.

Other issues are caught up in the debates that have raged behind the scenes in dealings that led up to this summit. One is the difference between the eurozone countries and the other 10 EU countries, including Britain, that have not adopted the euro. London, with its strong international financial sector, wants to keep aside from many rules applied to the eurozone, but it also wants to influence those rules so that British-based banks and investors are not penalized – and has obtained a protocol that commits London only to “endeavor” to comply with new rules set for common EU fiscal practices.  This division between those who are “in” the eurozone and those who are “out” is magisterially described in this Economist column.

In a related development, the EU financial regulatory authorities are also carrying out a fresh round of “stress tests” on European banks in a bid to determine which need to be recapitalized and how much, and thus shore up credibility for that sector. Those results are due in June.

Another wrinkle is that the new system around the euro will also need approval from the European Parliament, whose powers in this regard were increased by the Lisbon treaty that took effect just over a year ago. That step may actually only involve some tweaking – provided that the EU summit produces a strong enough package to be sent to the parliament.

A major issue looming over this overhaul of the rules is the actual terms set for Greece and Ireland to repay the bail-outs they have already received. So far, the EU authorities have been reluctant about easing the price for these countries (a little for Greece, none so far for Ireland). Now the summit’s outcome will have an impact on the outlook for more flexibility on this question.

In that sense, the summit meeting (the first chaired by Hungary, which holds the rotating EU presidency) is a pivotal event. If the results are judged in the short run to be a “less-than-grand bargain,” it could trigger a new bout of market nerves.

But EU leaders contend that they are making progress, at least enough to bolster the euro’s credibility and allow the eurozone to postpone any final showdown until another day. This process is sometimes derided as “muddling through” by pundits, but politically that style is often deceptively effective. In this case, however, leaders have to contend with the reality that a key judge of the summit’s results will be the international credit markets.

By European Affairs