National leaders of the 27 members of the European Union (EU) met in Brussels last week to negotiate measures to address the euro crisis. Agreement was reached early Friday morning by the leaders of 23 nations on a new "fiscal compact" that provides for a variety of measures intended to enhance European financial stability, including new requirements for fiscal austerity by the participating nations. While three of the remaining four members also appear to have acceded to the compact, the U.K. leadership clearly rejected it.
The Compact
At the core of the compact is a fiscal rule governing states that join the compact. Governments will be required to amend their constitutions to provide that structural budget deficits will be no greater than 0.5% of gross domestic product, or GDP. An unspecified "automatic correction mechanism", to be defined by each member state on the basis of principles proposed by the European Commission, will be applied to countries that violate the restrictions. The Court of Justice will have jurisdiction to verify the implimentation of this rule at the national level. Countries with deficits in excess of 3% of GDP will be subject to sanctions.
Procedural requirements will support these restrictions. Member nations will be required to submit their national budgets to the European Commission, which may request that they be revised. Advance reporting on national borrowing will also be required.
The eurozone, together with some other EU countries, will provide up to 200 billion euros to the International Monetary Fund, to be used to help troubled countries. Furthermore, as previously agreed, the EU will establish two bailout funds, the European Financial Stability Facility, or EFSF, and the European Stability Mechanism, or ESM.
The new compact will need to be ratified by each of the agreeing nations. In most cases, ratification will be by legislative action, although in some, including Ireland and the Netherlands, ratification may require national referendums.
The Eurozone
The eurozone was created by the Maastricht treaty of 1992. Maastricht's structure became operational in 1999, with the conversion of eurozone member currencies into a common currency, the euro. The members of the eurozone number 17, but importantly do not include the U.K., which continues to have its own currency.
Observers have long contended that a central weakness of the Maastricht structure is failure to include centralized fiscal decision-making. At the time the Maastricht treaty was agreed, fiscal union was not politically feasible. Some economists maintain that the failure to create central fiscal authority is a fatal flaw of the eurozone. In 1999, at the time of the euro's launch, Milton Friedman famously predicted that the eurozone would not survive its first economic crisis.
The Maastricht treaty sought to impose fiscal discipline on members by limiting fiscal deficits to 3% of gross domestic product, or GDP. However, Maastricht did not include an effective enforcement mechanism for this ban. In the event, most eurozone members, including Germany and France, violated the 3% limit. These violations were particularly pronounced in nations at the periphery of the eurozone, such as Greece, Ireland and Portugal. In some cases, national budget deficits of peripheral euro nations have risen as high as 15% of GDP.
The compact agreed on Friday is a significant step in the direction of strenghthening eurozone fiscal discipline, and reflects the significance of the current crisis in overcoming political obstacles to fiscal unification. Still, the compact falls far short of establishing the kind of centralized fiscal authority typically seen at the national level. Taxes will continue to be collected and spent at the national level, and not by a central eurozone authority.
The Periphery Nations
The periphery nations of the eurozone, including Greece, Ireland, Portugal, Spain and Italy, have been the focus of concerns about financial stability in the eurozone. The governments and banks of these nations have faced increasing difficulty issuing debt in international markets.
Some peripheral nations have received financial support from the IMF and the EU. As a condition to providing support, the IMF and the EU have required recipient nations to improve their fiscal discipline by reducing national budget deficits. However, this kind of discipline generally means reduced government spending, which in turn has adverse implications for economic growth. Economic decline in the periphery nations has led to a major political backlash, with changes in government in all five nations. Domestic political consequences could deepen, as years of fiscal austerity continue and deepen the economic malaise.
A typical response of a troubled economy seeking a return to economic growth is to devalue its currency in order to make domestically-produced goods and services more competitive in the international markets. This gambit is unavailable to the eurozone periphery nations as long as they are members.
One or more periphery nations may ultimately decide to exit the euro zone and return to the use of national currencies in order to alleviate economic difficulties. In recent weeks, some financial institutions have begun preparations for handling transactions in a Greek national currency in anticipation of the possibility that Greece might exit the euro.
Bank Funding
One of the most important facets of the financial crisis in Europe has been the difficulty European banks have faced in funding operations. Long-term markets for bank debt have dried up, and short-term unsecured funding is increasingly difficult to secure, as rates rise, terms shorten, banks increasingly find themselves unable to secure such funding at any price. Banks have resorted to depositing funds with the ECB rather than each other, and the ECB's deposit balance is higher than at any time since mid-2010.
Banks have responded to funding difficulties in various ways. As traditional sources of short-term funding have dried up, interbank deposits have increasingly come from banks in the same jurisdiction. National central banks and the ECB have provided liquidity support, lending against collateral provided by the banks. As the liquidity crisis has deepened, central banks have become increasingly liberal with respect to the kinds of collateral they are willing to accept. However, some banks have exhausted the available forms of collateral acceptable to central banks, even under liberalized standards.
Banks are also selling assets to reduce their funding needs, and to lower their risk-weighted assets counted against capital requirements. These asset sales, unfortunately, have put downward pressure on market prices for assets, with a variety of adverse knock-on effects.
The European banking sector also faces challenges in maintaining capital at required levels. In 2010 and 2011, the ECB has conducted a series of stress tests of the sector, the most recently concluded last week. The results of last week's stress test show a 155 billion euro shortfall. German banks in particular were surprised at the shortfalls identified in their capital accounts.
Negotiating the Compact
As described in a Reuters report, the compact was negotiated in the course of a single night. German Chancellor Angela Merkel, strongly supported by French President Nicolas Sarkozy, pushed the summit to its conclusion. As a Washington Post report put it, Merkel "[drove] her neighbors toward Germany’s tight-fisted spending model while giving up little in return."
UK Prime Minister David Cameron last week blocked a proposal to address the euro crisis by amending the European Union's Lisbon Treaty. Such an amendment would have required unanimous agreement of the EU members. During last week's negotiations, Cameron sought, but failed to obtain, a protocol to the compact, with provisions intended to protect the U.K.'s financial sector. French president Nicolas Sarkozy in particular vehemently resisted the U.K. position, telling Cameron, "You can't have an offshore centre taking Europe's capital." Cameron apparently thought the U.K. had support for its position of several other EU member nations, including Hungary. However, this support evaporated in the end.
The UK-proposed protocol included the following provisions:
o A requirement that certain measures would require unanimous approval of all EU member nations, including transfer of powers from national levels to EU agencies, limiting the ability of member nations to impose additional requirements on financial institutions within their own jurisdictions, and imposition of taxes and levies;
o A prohibition on EU agencies from exercising discretionary powers, which would otherwise replace discretion exercised by member nations' competent authorities;
o Precluding application of EU regulations to third-country financial institutions that operate in only one member nation and that do not seek passporting into other EU nations; and
o No discrimination within the single market for financial services on the grounds of the member states in which an institution is established.
Following the failure of the EU treaty amendment, all 26 members of the EU other than the UK appeared to agree on the new compact. In some cases, particularly EU members that do not participate in the euro, agreement was reached very late, and in a tenuous form.
One potential solution to the euro crisis that has been discussed but not agreed is referred to as "eurobonds" -- allowing each euro member nation, or a central authority, to issue euro-denominated bonds that are backed by all of the eurozone member nations. Resistance to the eurobonds idea is strong in Germany. France also opposes the eurobonds idea. Merkel has dropped hints that if other countries agree to acceptable austerity measures, she might support eurobonds. However, the eurobonds idea was not reflected in Friday's 26-nation agreement.
Private Sector Involvement
Another important agreement reached at the Brussels summit was an end to so-called private sector involvement (PSI) requirement embedded in the EU bailout fund referred to as the European Stability Mechanism (ESM). The PSI requirement, calling on sovereign debt holders to suffer reduced recoveries as part of government debt bailouts, had been enshrined in the ESM mechanism last year at the insistence of Germany. However, PSI was widely viewed as causing significant problems in the bond markets, for example driving up yields on Irish government debt.
A statement by Herman Van Rompuy, President of the European Council, reflects the abandonment of PSI as part of the ESM. "As regards the Private Sector Involvement (PSI), we have made a major change to our doctrine: from now on we will strictly adhere to the IMF principles and practices. Or to put it more bluntly: our first approach to PSI, which had a very negative effect on the debt markets, is now officially over." As one blogger puts it, "We read this as an unequivocal backstop even if the official statement is not explicit."
PSI was implemented as a principle of the Greek debt restructuring that is currently under way. A December 9 statement by the European Bank Federation says, "In terms of the private sector involvement, the decision to keep the Greek debt solution as 'unique and exceptional' is also crucial to allow confidence in the markets."
Impact of the Compact
The markets and the press generally reflect the view that the new compact does not really represent a sufficient, lasting solution to the euro crisis. In particular, the compact does not call for the kind of financial support of peripheral nations by the stronger nations that would be needed to reassure markets, enabling the peripheral nations to resume borrowing in the credit markets in needed amounts and at acceptable prices.
The compact may not have the intended effect of reasurring the financial markets. Funding difficulties may continue in the banking sector, and periphery nations may have to pay high rates of interest to finance, if they can finance at all
Many believe that notwithstanding the financial assistance contemplated by the compact, some periphery nations, including Greece and Portugal, and perhaps Ireland, will need to repudiate some of their debt. Furthermore, some observers say that the fiscal austerity promoted by Merkel and embodied in the compact will result in a recession.
The compact may not reassure markets sufficiently to preclude a deepening of the bank funding crisis, with bank failures a distinct possibility. A Telegraph columnist says, "Two weeks ago, rumours abounded that it was the near failure of a major French lender that had been the trigger for a massive co-ordinated intervention by the world's largest central banks to shore up the banking system." According to the report, "Senior analysts and traders warned of impending bank failures as a summit intended to solve the European crisis failed to deliver a solution that eased concerns over bank funding."
Germany and France
The alliance between Germany and France in promoting the compact reflects important political considerations in each of those two nations. Germany, the strongest economy in the EU, has citizenry that for decades has feared the kind of inflation experienced by the nation in the 1920s, and has placed great importance on fiscal and monetary discipline. These concerns have conditioned Merkel's approach to formulating and negotiating the compact.
France, the second-strongest economy in the eurozone, has traditionally been reluctant to surrender national autonomy, and its agreement on the compact reflects a significant step in the direction of Germany's vision of centrally-enforced eurozone fiscal discipline. However, agreement on the compact is being viewed as a major diplomatic victory for France. As an Ecomomist report puts it, "President Nicolas Sarkozy [of France] had long favoured the creation of a smaller, 'core' euro zone, without the awkward British, Scandinavians and eastern Europeans that generally pursue more liberal, market-oriented policies. And he has wanted the core run on an inter-governmental basis, ie by leaders rather than by supranational European institutions." The compact furthers both goals.
The U.K.
Prime Minister Cameron rejected the compact agreement, citing considerations of national sovereignty and the impact on the U.K.'s financial industry.
Cameron's veto of the new compact may have been inevitable in light of domestic political considerations. Deputy Prime Minister and Lord Heseltine said that the political situation in the U.K. meant it would have been impossible for Mr Cameron to have agreed to compact changes. Cameron's position in the leadership of his party depends critically upon the support of so-called euroskeptics, Conservatives who oppose the U.K.'s participation in the EU.
Cameron's objections to the compact reflect a growing U.K. concern with EU encroachment on the prosperous British financial sector, headquareted in the area of London known as the City of London. According to an Economist report, "The British government has become convinced that the European Commission, usually a bastion of liberalism in Europe, has been issuing regulations hostile to the City of London under the influence of its French single-market commissioner, Michel Barnier."
The U.K., which is a member of the EU but not of the euro group, has an important stake in the compact due in part to the significance of the London financial center to the British economy.
The consequences for the UK of not entering the new compact could be significant. While the UK will remain a member of the EU, it will not be a party to some of the most important compacts governing economic affairs in the region. Compact members could drive through the implementation of measures that inhibit UK-based financial institutions from participating fully in the EU financial sector. Cameron raised the prospect of challenging the use of EU institutions, including the European Commission and the European Court of Justice, to implement the compact. He said, "The institutions of the European Union belong to the European Union, belong to the 27 [member states]".
The U.K. is now seen as increasingly peripheral to EU politics. In the past, the U.K. generally maintained a central role in EU negotiations, despite its failure to participate in some initiatives, including the Maastricht Treaty and the Schengen Agreement. This latter is an agreement to create the Schengen area of 25 European nations that has external border controls but no border controls between member nations.
With the failure of the U.K. to agree on the new fiscal controls, the nation may be increasingly marginalized in negotiations over political and economic issues affecting Europe.
The United States
While the United States is not a member of the compact, and did not participate in the negotiations that led to it, the Obama Administration has been active in pressing European leaders to reach a solution to the euro crisis. Before agreement was reached on the compact, President Obama warned the euro nations, “There’s a short-term crisis that has to be resolved to make sure that markets have confidence that Europe stands behind the euro.” The Obama Administration is concerned that the austerity promoted by Germany and reflected in the compact will produce economic recession, a greater threat for Europe in the Administration's view than inflation.
Some observers attribute the Obama Administration's position to political considerations. With a Presidential election scheduled for November 2012, and President Obama expected to seek reelection, whether or not the U.S. economy recovers from its current slump may be the most important determinant of his success. However, a declining economy in Europe may hurt growth in the United States.
The European Central Bank
The European Central Bank (ECB) has been, and will be, an important actor in the attempt to resolve the euro crisis. The ECB is the central bank for the euro; its main task is to maintain the euro's purchasing power and price stability in the eurozone.
On Friday, ECB President Mario Draghi said that he felt the results of the compact negotiations were positive. According to a Business Week report, Draghi's opinion carries some weight, as a more active role by the ECB in reducing borrowing costs of troubled EU members is seen by many economists as the quickest relief for the eurozone's problems. Draghi has been vocal in calling for a "fiscal compact" to match the monetary compact represented by the Maastricht treaty.
Nevertheless, the ECB's role in furthering the compact's aims may be limited. In an interview with the Frankfurter Allgemeine Sonntagszeitung, Jens Weidmann, head of the Bundesbank, said he remained opposed to an expanded role for the ECB, where he sits on the governing board.
To some extent, the ECB has helped manage the crisis by purchasing bonds issued by fiscally weak members, thereby facilitating access of weaker national governments and banks to the credit markets. Some have called upon the ECB to make more purchases. However, the ECB leadership and Germany have opposed this. According to a Washington Post report, "Italy needs to borrow 157.4 billion euros by the end of April. Spain will need 63.4 billion and France, 177.8 billion. Only the ECB can come up with that much money that fast. It could give the debt-strapped countries of Southern Europe some breathing room by buying their bonds at a sustainable interest rate. But Germany is dead set against that, fearing that such measures would eliminate debtors’ incentives to reform or would trigger inflation."
According to a Reuters report, the ECB took several actions last week to help deal with the euro crisis. It cut rates to a record low of 1.0 percent, offered 3-year financing to banks and relaxed rules on the collateral it requires from banks to borrow from the ECB. However, the ECB said it would not increase its bond-buying program to ease the crisis. Barron's quotes one market commentator as saying, "What the markets want to see, as opposed to what they have seen, is for the ECB to print money and monetize debt—quantitative easing. That's not what we're seeing."