The European Summit last week was another frustrating political and diplomatic exercise that, by many scores, failed to deliver the economic and financial solutions needed to respond to growing market distrust.
But, in the eyes of its main promoters – Germany and France – the summit paved the way towards a fiscal union. Changing the configuration of the European monetary union will take years, as Germany’s Chancellor Angela Merkel has said. However, if fiscal union is the way forward it has potentially profound implications on short-term crisis resolution.
EU member states, having agreed on more integration, will now need to accept and implement both an expansion of the role of the European Central Bank (ECB) and the provision of a financial safety net if the eurozone is to be stabilized.
But time is not on their side. The spillover of the sovereign debt crisis to Italy has threatened the survival of the single currency. Eurozone crisis resolution has fundamentally changed, as it now involves dealing with Italy’s need to refinance €114.1bn of its debt early next year. The risk here is in the disconnect between the 'reaction time' of EU decision making (and national politics), and market expectations. How long markets are prepared to wait before seeing convincing measures to tackle short-term crisis issues is an open question.
Necessary short-term measures remain the same, only more costly and complex in their implementation than would have been some months ago. There is a role for the ECB to provide short-term assistance by acting as a fully-fledged lender of the last resort. This means decisive intervention in support of both sovereign bonds and the banking sector. This is what the ECB has been doing. However, the Bank has made it clear that this was not the 'default mode'. To restore market confidence it is necessary that the ECB agrees to provide support for however long and at whatever level is necessary.
In addition, a financial safety net to support Europe’s banking system and firewalls around problematic countries is still absent. The agreement on 9 December for a provision of €200 bn into the IMF is a good start. But this provision, even in addition to the EFSF, is not large enough to withstand the impact of a 'debt event' in Italy – the worst-case scenario. So far talks of additional help from stronger eurozone countries and/or from outside Europe (the IMF or the BRICs) have not resulted in any substantial measures.
Finally, there is the long-term issue of how best to support economic growth in countries that are committed to restore sustainability in their public finances. There is a need for an intra-EMU rebalancing between surplus and deficit countries.
Keeping the EMU afloat implies costs that need to be distributed across members. Countries undergoing considerable fiscal austerity cannot grow without the help of more 'virtuous' countries. And as growth cannot be separated from fiscal consolidation, the latter will have to show some solidarity. Failure to achieve this increases the risk of a euro break-up. However, paying for the mistakes of others is for now a politically unpalatable solution.