07 December 2011

Douglas J Elliott: Europe tries again on Friday - expect more progress and some disappointment

Europe's fifth attempt at a comprehensive solution to the euro crisis should be announced on Friday after a summit of Europe's key leaders. Like the previous four tries, it is unlikely to provide the final answer, but it should move the continent considerably further in the right direction.

The big risk is that political constraints will so undermine the attempt that market expectations, which appear unreasonably high, will once again meet disappointment. Such disenchantment may not hit immediately, but may evolve over succeeding days and weeks as two factors sink into market participants: (a) the degree of difficulty of implementing the agreements and (b) the extent to which the key players have differing views of the situation, often rooted in long-standing political cultures that are resistant to change. It will be surprising, and highly encouraging, if the leaders fail to disappoint to some significant extent as a result of these obstacles.

The good news is that there is an increasing consensus on the outlines of the ultimate answer. This growing agreement should allow the summit to make considerable progress in establishing the framework for that solution to be achieved. It may, however, take another round or two of crisis to overcome the political and institutional obstacles to the complete solution. 

What is the solution? The eurozone needs to back the debt of its weaker members with unwavering support from its stronger members, most likely through actions by the European Central Bank (ECB). The quid pro quo for the stronger nations protecting the weaker will be greater control by European institutions over fiscal policies in each eurozone member, with the level of control much higher for members which need help or are pursuing dangerous policies.

Fears of “reform fatigue” and backsliding are why it is essential at this point to take major steps towards greater fiscal controls at the European level. Germany and the ECB must be made comfortable that there are mechanisms to ensure that recipients of eurozone support will follow through on the implementation of the necessary reforms to restore normal market access. They need to see ECB bond purchases, or the use of the EFSF, as a bridge to a longer-term market solution and not eventual defaults or perpetual support.

One of the reasons that the summit is likely to disappoint markets at some level, perhaps with a delay, is an issue of timing. European governments think in terms of months and years in dealing with such major changes. The markets, unfortunately, are very nervous now. Fiscal integration in Europe will take too long, and consequently leave too many uncertainties in the interim, to completely reassure markets on its own. Instead, there will almost certainly be a need in the relatively near future for the ECB, or coordinated efforts by the strong governments through the EFSF or other mechanism, to demonstrate that debt of the troubled countries will be supported very strongly. There are simply too many things that could go wrong across the eurozone for the markets not to be scared again if they are unsure who will ultimately provide the needed support.

Thus, it seems probable that on Friday the Euro Summit will announce some very important steps to deal with the underlying problems of the eurozone, but that they will be insufficiently precise and with too much implementation risk for the ECB to make the kind of statements, or take the kind of actions, that the markets need. I would expect the ECB to make supportive statements after the summit, and to step up their bond purchases if that seems warranted at the time, but not to go out on a limb and make a clear, massive, and long-term commitment to bond purchases.

The importance of the steps and the supportiveness of the ECB’s body language may provide considerable help in the immediate aftermath of the summit. Even if it does, though, there will be many tests in the subsequent days and there is a high likelihood that the ECB and the key national governments will fail at some point to provide the reassurance that the markets need. There is, therefore, a real possibility that another summit will need to follow in the fairly near future to take the steps necessary to allow the central bank and the leading eurozone leaders to fully commit themselves to saving the eurozone, in practice and not just in words.

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