Is the Euro Zone at the Beginning of the End of Muddling Through?
This week’s series of high-level meetings in Europe is being billed as make or break for the euro. The good news is that European politicians finally seem to realize the extreme seriousness of the current situation. But any agreement at this Friday’s summit of all 27 euro-area countries is likely to stop short of anything resembling a full fiscal union, in my view.
Monday’s meeting between Germany and France unveiled the broad outlines of the “fiscal compact” likely to be agreed at the EU summit. This should help impose more budgetary discipline on the euro area’s constituent countries.
However, the compact is very much a compromise made necessary by the huge gulf that still exists between France and Germany on the nature of fiscal union itself. France is reluctant to surrender too much fiscal sovereignty to Brussels, while Germany is reluctant to pool national borrowing powers through joint issuance of eurobonds without pooling fiscal sovereignty as well.
At some point this impasse is likely to be broken, perhaps after a further escalation of the crisis. However, we are not there yet.
Meanwhile, proposed changes to the European Stability Mechanism (ESM) suggest that Germany now realizes that decisions it has forced on the rest of the euro area have contributed to the escalation of the crisis. Most important in this respect have been its insistence on private sector involvement in the ESM framework and, even more so, on imposing “voluntary” losses on Greek bondholders. These actions undermined the very foundations of sovereign debt in the euro area.
In the latest bilateral agreement, the explicit reference to private sector involvement has been dropped. Private sector involvement may still be possible in cases where a future adjustment program runs off course, as has happened in Greece. But both France and Germany made clear that Greece should be seen as the exception, rather than the rule.
In my view, Germany is trying to put the genie back in the bottle. This will not be easy, given the damage that has already been done.
So where does this leave us? In the near term, the key question is how the European Central Bank (ECB) will respond to Friday’s summit. Not surprisingly, considerable attention has been paid to Mario Draghi’s speech to the European Parliament last week, in which he highlighted the importance of agreeing on a fiscal compact. This appears to hold out the prospect of additional ECB support as a quid pro quo for an agreement at this week’s summit.
The extent to which the ECB will be willing to intervene in sovereign-debt markets (or support markets indirectly via loans to the International Monetary Fund) is likely to depend on the nature of the fiscal compact. The ECB would probably respond more positively to a decisive step toward true fiscal union (involving pooled fiscal sovereignty and pooled borrowing) than to a simple tightening of the rules governing fiscal discipline in the euro area.
But unless something dramatic changes in the next two days, euro-area leaders are likely to agree on a fiscal compact that falls into the latter category. The ECB is still likely to respond positively. And together with additional measures to support the banks, this could reduce some of the tension in sovereign-debt markets. But massive, proactive, bond purchases are unlikely at this stage.
In summary, a cautious approach to the (ever widening) periphery is still warranted.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Darren Williams is Senior European Economist at AllianceBernstein.