The European Union (EU) has agreed to provide emergency aid to both Spain and Italy via the European Stability Mechanism (ESM), the euro area’s permanent bailout fund. The emergency provisions were agreed to under heavy pressure from Spain and Italy, and will not require additional austerity measures, which had been a major sticking point for the Germans. The aid comes without the strict oversight of the troika, which is made up of the European Commission (EC) the European Central Bank (ECB), and the International Monetary Fund. While, in principle, these are important steps that will eventually open the door to greater fiscal integration, and possibly to a fiscal union, the devil will be in the details, which are still a work in progress. Germany has made major concessions, but it is playing them down in the aftermath of the summit, as well as working hard to attach additional strings to the provisions.
The EU also agreed to further steps toward greater integration of the banking sector, the creation of a European banking supervisor under the authority of the ECB, and use of the ESM to recapitalize banks without increasing a country’s debt. This was necessary to separate the region’s moribund banking system from its debt crisis, and is expected to eventually be accompanied by a financial transactions tax that allows insurance of bank deposits to help avoid runs on the banking system, although the details of that part of the plan are still forthcoming. Furthermore, the ESM loans will not take seniority status over existing bondholders; this should relieve some of the financing pressure on Spanish banks.
The agreement came after Italian Prime Minister, Mario Monti, refused to close the meetings with a vote on Thursday night. He pushed the President of the EC to stay and keep negotiations going, which induced other members of the EC to stand behind him. The issue was that they could not adjourn without a breakthrough on whether additional austerity was required for additional help, and on an additional “growth package” for 120 billion euros. What was once considered prudent fiscal policy proved to be a vicious cycle for the worst-affected countries, as austerity measures triggered recessions so deep that there was no way they could meet their deficit targets in any meaningful way. On the opposite side, the concern is that tentative growth measures may contribute little to revamp the limping economies, and, as an unintended consequence, may weaken the countries’ resolve to address their fiscal imbalances.
The bad news is that the measures announced represent little more than a stopgap for Europe to produce a more coherent plan to capitalize and separate its banking system from the sovereign debt crisis. It also will require Europe to raise more funds to build a firewall to protect the broader banking system. This is to say nothing of the leverage it provides bailout recipients, like Greece, who would like to ease up on the austerity and oversight agreements they have already made as a result of their bailout terms.
Bottom Line: Our views are little changed, as we had expected some form of agreement to emerge, and, if anything, we are pleased that progress appears to be faster that we had anticipated. On the other hand, this will not be an easy process, and progress will be far from linear; not surprisingly, although governments found an agreement in principle, they are still negotiating on the actual details. Europe has made one leap forward on a road with miles (kilometers) to go and littered with land mines.