On Friday, the seventeen Eurozone countries—and the ten other nations that comprise the EU—came together to discuss the next steps in responding to the sovereign debt crisis. The pact was agreed to by 26 of the 27 present nations—the U.K. was the only holdout.
The summit addressed the short-term crisis and the long-term framework for a sustainable Eurozone in the future. Here are my thoughts on the agreement:
Will the lending facilities be sufficient?
To address the immediate crisis, the member nations agreed to deploy additional capital to stability funds. They promise to quickly use the existing €440 billion EFSF, and pledged to increase lending to the IMF by €200 billion. They also decided to accelerate the introduction of a new €500 billion facility, the European Stability Mechanism (ESM).
The timing of this is a bit unclear to me. To satisfy Germany, the combined cap of the new and old stability funds will still be €500 billion. From the Wall Street Journal:
But at Germany’s insistence they also retained a €500 billion cap on the combined size of the existing temporary fund and the new permanent fund, meaning that accelerating the new fund will have little practical impact on the amount of cash available.
Even if the €500 billion is leveraged up to €900 billion, the stability fund will not be big enough to cover Italy, which has €1.9 trillion of debt on the books. Adding to this challenge is the fact that €1.1 trillion of debt from Eurozone countries will mature in 2012, creating an imminent test for the stability funds.
The ECB’s role
Some had hoped that, once this deal was in place, the European Central Bank (ECB) would aggressively buy sovereign bonds to relieve the pressure on governments. But ECB President Mario Draghi has indicated that is not part of his strategy. Instead, the ECB will extend loans at low rates to banks, for a period of up to three years, and will broaden the acceptable collateral. This should ease the liquidity crunch at banks that are struggling to issue commercial paper or raise deposits.
Private bondholders getting protected?
Another issue is whether or not private bondholders will have to accept a haircut in the future. Previously, the rules of the stability funds have stated that any bailout must involve some burden-sharing by bondholders, which unsurprisingly makes investors skittish about investing in Spanish or Italian bonds. In this agreement, those rules have been moved from the body of the legal text to the preamble, lessening its binding effect.
In the short-run, this will be helpful—it may lower the crippling debt-service costs faced by Italy, for instance. But in the long-run, this will cause a huge moral hazard problem—bondholders would believe that in the event of a default, they would be bailed out. Therefore, they would be willing to buy sovereign bonds of countries that were not exercising fiscal discipline.
Leaders have stated that they want member states to ratify this pact by July. But some nations will have a hard time getting this agreement through their parliaments. Finland already objects to the majority-voting rule that would allow changes to the European Stability Mechanism (ESM)—previously, such changes would require unanimous support. Furthermore, Ireland has expressed concern that this agreement would force them to raise their corporate tax rate—a long-standing dispute between Ireland and the EU. If countries like Finland and Ireland drop out, this pact will have limited impact.
Fiscal responsibility and enforcement
While I react very positively to the emphasis on fiscal responsibility, I have many lingering doubts as to the implementation and enforcement of this agreement in the long-term.
I’m pleased that there is widespread acknowledgement that fiscal discipline is the key to long-term stability of the Eurozone. The agreement stipulates that nations must cap at 0.5% of GDP their structural deficit (i.e., the deficit averaged over the business cycle), and reaffirms that the deficit at any point may not be greater than 3% of GDP.
The key here is the enforcement mechanism. The agreement explicitly commands member nations to enshrine the 0.5% maximum structural deficit—and the provision for its enforcement—into their constitutions. It gives the European Court of Justice (ECJ) power to make sure that the law is written into each nation’s constitution, but it has little power to ensure that it is enforced by each state.
The pact also reaffirms the 3% maximum for deficits at any point, as written in the Stability and Growth Pact agreed to in 1997. But this “law” has had little effect on actual practice: even the major players have run deficits greater than 3% of GDP. Between 1999 and 2011, Germany and France have violated the rule five and seven times, respectively.
So this new treaty must contain more stringent enforcement mechanisms. The text of the agreement states (PDF, see page 4) that if a nation violates the 3% maximum deficit at any point, “there will be automatic consequences unless a qualified majority of euro area Member States is opposed.”
This language appears to be an improvement over the previous treaty, but it is still quite vague—it’s hard to say what those “automatic consequences” will be. As a cynical Steven Englander of Citigroup put it,
For those of us of a certain age, the fiscal language looks to be copied and pasted from the original Stability and Growth Pact with a few bells and whistles added to imply that ‘this time we mean it.’
Ultimately, Englander may be right: the enforcement mechanisms may have little practical impact. Because the U.K. rejected the agreement, it is unclear whether or not the ECJ can use its powers to enforce it. Strictly speaking, EU institutions like the ECJ cannot be used for a subset of EU nations (i.e., the 26 other EU nations) without unanimous approval from all of the EU nations (i.e., the U.K.). Yet the power of the ECJ to enforce this pact is an absolute necessity for meaningful long-term improvements of fiscal discipline.
In short, in both the short-term and long-term, this agreement moves Europe in the right direction. But there are lots of details to be decided, and officials are working against a ticking clock.