I find it somewhat hard to judge the merits of this past week's developments in Europe. Some positives, some negatives. On net, though, I remain a Europessimist. In my opinion, the issues of internal rebalancing remain completely ignored, and this will eventually doom the Euro if not addressed.
The European Central Bank moved forward with additional easing specifically intended to alleviate pressures in the banking system. The breakdown in the interbank lending market threatened to create a Lehman-type event sooner than later, and that threat was receded with the ECB's extension of liquidity facilities and cutting in half reserve requirements for commercial banks. The ECB also cut interest rates to 1%, with more cuts expected.
That said, the European financial system remains under pressure with continuing deleveraging and eventually more bank recapitalizations efforts needed. The result will be a worsening of the European recession, an event that is only in its infancy. And, as has been widely reported, ECB President Mario Draghi did not offer unlimited support for Eurozone sovereign debt, which was greeted with disappointment yesterday. I think it is premature to expect such a commitment; they will only play that card as a very last measure.
Overall, somewhat more aggressive than than I expected, and a clear indication that the ECB now realizes the depth of the Eurozone's financial problems. So far, so good. Yes, I would be happier with a clear statement that the ECB is the lender of last resort for European sovereign debt, but I just don't expect to hear this yet anyway.
In contrast, the Eurozone summit predictably failed to meet expectations. The UK bowed out of the agreement, guaranteeing a lack of EU wide commitment. At best you get the 17 Eurozone nations plus a few others to sign up. This opens up the possibility of more EU ruptures in the future. The seal has been broken. Second, as Felix Salmon points out, we have an agreement in principle, but ratification battles lie ahead:
It seems that German chancellor Angela Merkel is insisting on a fully-fledged treaty change — something there simply isn’t time for, and which the electorates of nearly all European countries would dismiss out of hand. Europe, whatever its other faults, is still a democracy, and it’s clear that any deal is going to be hugely unpopular among most of Europe’s population. There’s simply no chance that a new treaty will get the unanimous ratification it needs, and in the mean time the EU’s crisis-management tools are just not up to dealing with the magnitude of the current crisis.
Many opportunities for national politics to blow this agreement apart in the weeks ahead.
As far as Eurozone crisis-management tools are concerned, we are simply still where we have always been - the wealthier nations of the Eurozone - largely Germany - continue to resist putting in the necessary capital to create effective crisis funds. Moreover, the ECB appears to remain unwilling to lend the necessary money to rescue funds. In the absence of internal support, Europe continues to look toward international support. I still think this is ludicrous. How much help should Europe really expect knowing that Germany is not willing to go all-in financially to save the Euro, and now that we know the UK is making a calculated bet that the Euro is already a doomed experiment?
Let's put aside the above concerns for a minute. When all is said and done, I am still amazed that the outcome of this summit is being described as a move toward fiscal union. It is not that - it is commitment to unified fiscal austerity, nothing more. Consider just a strict enforcement of the 3% deficit ceiling in light of actual deficits in the EU. Via NPR (click to enlarge):
Just on the surface, it is tough to see any commitment to fiscal austerity as credible. Germany itself exceeded the targets in 7 out of the past 11 years. Talk about the pot calling the kettle black. France missed 6 in the past 11 years. And Italy 8 times. Thus, in addition to the periphery nations, the biggest economies in the Eurozone will all need to increase government saving to meet these targets.
Such saving will be attempted in the context of a recession in which the private sector also will be increasing savings as well. In other words, the public sector will be engaging in massive pro-cyclical fiscal policy as the recession intensifies. You have to imagine the end result is a substantial deflationary environment.
In short, I think Europe is rushing full speed to a Japanese outcome, with slow growth coupled with an appreciating currency. And it is that promise of slow growth and a strong currency will be what eventually tears the Eurozone apart. And this is truly sad given that deficits are not really the problem to begin with.
Why will the Eurozone fail? Because we still see nothing that addresses the internal imbalances between the core (largely Germany), and the periphery. That is the result of failing to commit to a real fiscal union. Such a union would include automatic internal fiscal transfers that are essential to maintaining regional economic stability. For example, economic distress in a US state results in an automatic relative transfer of resources via decreased tax revenue from and increased transfer payments to that state. Lacking such a mechanism, a slow growth, hard money regime will increasingly ratchet up the levels of economic distress in the periphery. And eventually the costs of staying in the Euro will exceed the costs of exit.
If Europe was serious about saving the Euro, they would commit to issuing more safe assets (more sovereign debt), using the ECB backstop to create such assets, and engage in direct fiscal transfers to reduce economic pain in the periphery while encouraging continuing structural and budget reforms in recipient economies. I don't think we are anywhere near such a plan - and are arguably moving in the opposite direction.
Bottom Line: I remain a Europessimist. The ECB is moving aggressively to preventing an imminent financial collapse. That should be seen as good news. But there remain unresolved deeper issues. At the core of those issues is the inability to see Europe as one large, fiscal unified economy rather than a combination of separate, fiscally austere economies. And in that remains the long-term vulnerability of the Euro experiment.