Two weeks to Christmas: Can the Euro summit deal hold things together?

I wrote, last Monday, of a week of reckoning that lay ahead for the Eurozone. At the end of a dramatic week, we have a remarkable resolution by 23 member countries and a potentially profound split in the European Union. Most of the ink spilt on the summit has devoted itself to the discussion of the veto by the United Kingdom of any attempt to alter the Lisbon treaty on which the EU is based; this veto subsequently led to the formation of a union-within-a-union comprising 23 countries, with three others considering support, and the firm exclusion of only the UK.

Quite what David Cameron was thinking when he took this call is a intriguing but very mysterious question, which has been dealt with in some detail in a series of posts in Bagehot, the European affairs blog of The Economist. I can do no better than to direct you there. In sum, it would seem that the UK took the dire step of brandishing a veto, while earning very little in return. In particular, by stepping out of the new resolution, the UK has diminished its political influence on any further European deliberations on economic growth, the regulation of financial services and the management of a common internal market, perhaps even at the cost of protecting its financial sector – ostensibly the reason for the veto in the first place.

Even as Britain contemplates life outside the core EU-within-the-EU, what becomes of the immediate Eurozone crisis? Before we start whining and complaining about the inadequacy of the latest Euro discussions (and we will get there, don’t worry), let’s take a minute to marvel at the scale of the change. A group of 23 European countries have agreed, in principle, to a treaty, which binds each one of them to one another in the form of a fiscal union. The union with a view to preventing fiscal profligacy will vet budgets and debt-issuance plans by individual members. Strict penalties will apply to those who fail to comply (of course, how the sanctions will actually be applied is another question). These countries will meet as often as once a month (non-members such as the UK will be excluded from these meetings). The signatories to the resolution aim to have a formal agreement in place by March.

The fiscal compact focuses on the long-term solvency of European governments and has long been considered by many commentators to be the natural counterpart of a monetary union. A decade-long error has finally been set right and should Europe survive the present crisis, the compact is surely a step towards greater European strength. Unfortunately, the agreement has little to say on the short-term resolution of the crisis.

Serious concerns remain about the solvency of both national governments as well as many European banks, particularly those with large exposure to the bonds of the peripheral European economies. The European Central Bank (ECB) has agreed to stand as lender of the resort to potentially stricken banks. This week, a raft of measures were announced to reduce financial pressures on banks; for instance, the ECB will now accept lower-quality collateral from banks in exchange for providing emergency finance. However, ECB Governor, Mario Draghi, has drawn the line at assisting governments with finance. Investors believe, and rightly so, that the solvency of banks is inextricably linked with the fate of the governments whose bonds they hold; the ECB’s ability to bail out banks will not count for much in the face of, say, Italian insolvency.

In terms of crisis funding arrangements, €200 billion has been provided to the IMF to deal with the crisis, a strengthened European Stability Mechanism should be in place by July 2012 and may even be able to borrow from the ECB.  However, any plan to issue a joint Euro bond remains a non-starter and is firmly opposed by Germany.

Matters could come to head as soon as next week if Standard and Poor’s follows through on its threat to downgrade European sovereign ratings, including France’s AAA. A downgrade of Europe might make more sense than its terribly-argued downgrade of the U.S., but S&P’s appalling timing is about as disastrous as Ricky Ponting’s right now. There’s a very good chance that this sort of report could could do just enough to push already-panicked sovereign bond markets over the edge. The ECB’s resolve may soon be tested, as will the German insistence on denying Europe a jointly issued sovereign bond.

Finally, the fiscal compact imposes a German view of government on the rest of Europe. Budgets must be balanced as far as possible and an annual structural deficit of over 0.5 per cent of GDP will not be tolerated. This is all very well for countries with higher growth prospects but implies continued austerity for the rest. There is very little substance in the summit statement on promoting growth or addressing the recession. Greece and the others remain doomed to years of pain, with severe austerity and inevitable economic stagnation.