First things first, the Euro is alive! Doomsday scenarios have not materialized. Having stubbornly flirted with disaster for almost two years, the seventeen members of the Eurozone have at last made some important decisions. So far, markets like what they see.
The devil, as always, is in the details, and the details have yet to be worked out. Does the package amount to the bazooka that many have invoked to fight the crisis? As of yet, all we have is a road map. But this broad plan does, at least, finally address all the open questions− from the sovereign debt crisis to the banking crisis. Even the structural weaknesses of some member countries, notably Italy, have been recognized. There are a lot of moving parts on Europe’s narrow path to recovery. If they do not move in sync, things could go south once again.
Writing down the Greek debt is certainly the most visible component of this week’s package, as well as its boldest. A voluntary 50% haircut on bonds, which is called for under the deal, is a courageous move under any circumstances. The debt write-down should give Greece some breathing room to overhaul a country mired in a deep structural crisis. Only a year ago, talk of such a drastic haircut would have been seen by most partners as too harsh a punishment for Greece, and one that risked jeopardizing the entire Euro area. Now the debt write-down has become a lifeline.
A second crucial component of the deal is the recapitalization of European banks. Here, Europeans have chosen a softer approach. Eurozone leaders asked their financial institutions to come up with 106 billion Euros in additional capital, much less than what the IMF estimated as necessary just a month ago (about 200 billion). They wanted to avoid placing an excessive burden on the banks, along with the risk of a sudden credit crunch. They also wanted to preserve the budgets of the Eurozone member states. Ultimately, it is the governments that will most likely have to provide the money needed for the recapitalization.
Eurozone members are betting big. For this approach to work, markets need to calm down. Spanish, and most of all, Italian bonds, need to be taken out of the firing line. Only then will Italian, Spanish, and also French banks (which are heavily exposed to these bonds) be able to avoid a squeeze. But can Italy’s Berlusconi government deliver on its promise to tackle its huge debt and growth problems? Markets still do not trust Berlusconi. At the first auction after the summit, interest rates on Italian bonds spiked to levels not seen since 1997.
Italy could make or break the success of this carefully crafted deal. A newly-bolstered European Financial Stability Facility (EFSF), to the tune of a trillion Euros, would only be sufficient to address the problems in Greece, Portugal, and Ireland. The fund would not have the capacity to stretch to a potential Italian bailout.
This is where the European Central bank (ECB) steps in. The ECB is the only institution with the firepower to keep the crisis under control. As was the case in the U.S. in the wake of the Lehman collapse, the role of the central bank is crucial to any solution. The incoming President of the ECB, Mario Draghi, understands this well. It was no coincidence that on the day of the summit in Brussels, Draghi, while still in Rome and literally packing his bags on his way to Frankfurt, chose to speak out. The ECB stands ready to intervene in order to help troubled Eurozone members, he said, “to prevent malfunctioning in the money and financial markets creating an obstacle to monetary transmission.” In ECB parlance, this means buying bonds on the secondary market, and lots of them if necessary. This was the missing element of the summit in Brussels, and a message that the markets were eager to hear. Draghi made sure that on the day of the meeting in the European capital, his voice was heard.
French President Nicholas Sarkozy had even pushed to include a reference to the ECB’s role in the summit’s final document. German Chancellor Angela Merkel balked and Sarkozy was forced to back down. But Merkel did not necessarily object to the merits of the request. As German Chancellor, she needed to be seen by her fellow citizens as the guardian of the formal independence of the bank from European politicians. Of course, if the “independent” European Central Bank deemed it necessary to buy bonds, she would not stand in its way.
Which brings us to Merkel’s role. Some observers, particularly in the U.S., still believe that she is behind the curve. These critics think that Merkel could stop the crisis in an instant if only she really wanted to. She could bailout her southern European partners, the argument goes, by simply introducing Eurobonds backed by the German taxpayer. But these critics overestimate her room for manouever. Despite its robust economy, Germany’s debt load, at more than 80% of GDP, is not insignificant. Germany cannot bail out all its weaker Eurozone partners. Unlimited funding for the EFSF by Berlin could even jeopardize Germany’s AAA rating. Hence the idea of leveraging the EFSF instead of providing more direct funding and guarantees.
But even leveraging the fund does not mean that the German taxpayer is off the hook. That is why, when voting to bolster the EFSF the last time, just a few weeks ago, many members of the German Bundestag spoke of a red line in the sand.
However, over the last week, there has been an important shift in the political mood in Berlin. On Wednesday, just hours before the start of the summit in Brussels, the German parliament agreed to a plan that goes well beyond that red line. Merkel won the broad support not only of her coalition, but also of the main opposition parties to go forward with the whole package that was to be debated in the European capital just a few hours later.
The question has now shifted from whether to save the Eurozone to the best way to do so. This is a huge change in the political and public mood, not only in Germany, but also in the rest Europe.
Suddenly Merkel appears to have much more political capital. This is significant, because if Europe is no longer a political liability for her, she will be in a position to take further, decisive steps to address the crisis.
Furthermore, by resisting the temptation to paint the summit results as the last and final deal, Merkel has signaled very clearly that she and her partners recognize that the crisis is far from over. This week’s deal removed a giant roadblock. It is by no means the end of the journey.
Alexander Privitera is the Washington based Special Correspondent for the German news channel N24 and is a frequent contributor to AICGS publications and events.
This essay appeared in the October 28, 2011 AICGS Advisor.