The meeting in Brussels on Sunday will not resolve the matter of the now almost certain extension of the European discussions over the debt crisis. What's required is an accord between France and Germany. And for that, with such political opposition in both countries, some rather fancy dancing is needed.
German Chancellor Angela Merkel is facing something just short of a full rebellion within the ranks of her ruling coalition. The problem is so bad, she delayed meetings in Frankfurt in advance of the Brussels summit to attend a closed-door budget meeting with her own party.
In an action that lifted eyebrows on both sides of the Atlantic, the German government, on short notice, canceled Friday's statement on the E.U. summit – a sure signal that the disagreements continue to run deep.
Meanwhile, in Paris, French President Nicolas Sarkozy is fending off his own political problems, including the undercapitalized French banks, with toxic assets still on their books and a continuing reticence to lend money. At stake is the future of the Eurozone – a future that will largely be decided by Merkel and Sarkozy.
Proposed Bailout is Not Enough
The current proposal on the table – a bailout package of some €440 billion (the European Financial Stability Facility, or EFSF) – is clearly insufficient. Without leveraging that amount through issuing securities, the plan falls flat on its face.
Yet this is one of the major points of disagreement. The positioning of the European Central Bank (ECB) in the leveraging that's required is a significant flashpoint. Without the ECB imprimatur, the essential paper will not succeed.
So which gets thrown under the bus – sovereign debt in periphery E.U. countries, or the banks?
Now, there is an obvious way out: using the existing apparatus that allows the European Investment Bank (EIB) to issue paper. But whether leveraging the EFSF to the trillions of euros required is even possible remains an open question. It is also the issue over which France and Germany remain bitterly opposed.
At stake for Germany is additional debt encumbrance, as its own economy – Europe's leading economy – begins to slow down. For France, its AAA rating is in jeopardy, as the weakness of its commercial banking sector is exposed. But even so…
The Brussels Meeting is Mere Window Dressing
Those who are expecting a resolution from the meeting Sunday will be disappointed. In a joint declaration late Thursday, Merkel and Sarkozy even said a second summit will be necessary later in the week.
However, two important developments have taken place.
First, facing an unraveling social order in Athens, the Greek government has now lined up sufficient support in Parliament to pass the next package of austerity measures. This will hit hard those in government service. The package will cut public sector jobs (a significant portion of the nation's overall employment), thrusting civil servants out into the streets to join the hundreds of thousands already there.
Greece still faces a fiscal mechanism that has never worked, along with a broken system of taxation, but the passage of the new austerity measures will probably be enough to secure another tranche of assistance and stave off default. (At least for now.)
Second, in the joint statement from the German Chancellor and the French President was a very significant guarantee that a resolution would be found, possibly by Wednesday. The wording was quite clear. If it does not happen, both leaders are in political limbo, and the situation will deteriorate fast.
There is a G20 meeting in France November 3 and 4. The last thing Sarkozy wants is to host a meeting at which the Greek debt crisis upstages French wine.
So who's going to take what haircut, buy which kinds of bonds, and write off whose debt?
Here's How It Will Play Out
Leaders will leverage EFSF – because leverage they must – using a provision from the 1957 Treaty of Rome. And the paper will come through the EIB, not the ECB (at least not directly).
The haircut will be greater, with banks having to write off a greater percentage of bad debts than the EFSF currently allows. (Remember, you can't short European banks at the moment, so this write-down will be less costly than if it took place over here, at least in the short term.)
Under this format, selective default of sovereign debt (without triggering cross default provisions) will be followed by an application of Brady Bond clones. This will cancel some debt. The remaining debt will be refinanced.
The approach parallels the bailout of emerging countries (mainly Latin American) in the 1980s from a wave of debt defaults. The task facing Brussels amounts to the political equivalent of herding cats. And for that, Merkel and Sarkozy will need to exercise some decisive leadership.
Meanwhile, the rest of us sit and watch. And hope.