On Friday markets in Europe and the United States moved higher after news that leaders in the European Union had reached a new fiscal pact at the EU Summit in Brussels, giving some much needed relief to investors. The newly agreed European pact was approved by all of the 17 countries of the Euro zone (currency countries) and was embraced by 26 of the 27 European Union countries, with Great Britian electing to not accept the new treaty pact.
The new EU pact allows for tighter fiscal integration and sanctions on EU countries that are non-compliant and overspend with their budgets.
European Union countries handed over their sovereignty in a new lanmark fashion that paves the way to greater fiscal accountability and oversight. In the future, tax and spending plans will be handed over to EU officials before their own parliaments and governments.
British Prime Minister David Cameron, a conservative Euro skeptic, was reluctant to approve the new EU treaty. He voiced concerns over Great Britain relinquishing national supervision of British banks and called for additional concessions including veto powers over rules that negatively impact the city of London.
France and Germany have asked for the European Commission to be the primary institution to monitor and implement the governance of the new treaty. More details will be revealed in the days ahead.
Germany’s Chancellor Angela Merkel spoke favorably about the new treaty to reporters on Friday.
“We will achieve the new fiscal union. We will have a Euro currency within a stable union” Merkel said. She later added, ” We will have stronger budget deficit regulations for Euro zone members.”
European Union leaders also agreed to fund an additional 200 billion euros through bilateral credit that they made available to the IMF, International Monetary Fund, which is intended for debt burdened countries in the euro zone.
European Union leaders also supported a new European Stability Mechanism (ESM) “fiscal compact” which will debut in mid 2012 (July). The ESM will succeed the temporary EFSF European rescue fund and will create a 500 billion euro fund for troubled euro countries. There cap on the 500 billion euros was decidely lifted and could move higher in the future to build a stronger backstop around weaker euro zone areas such as Italy and Spain. Located in Luxembourg, the ESM will be operated by an intergovernmental organization that will conform to international law.
European Central Bank
During the EU Summit on Thursday, European Central Bank (ECB) President Mario Draghi confirmed that the view that the ECB is still reluctant to provide additional support to Euro zone debt through aggressive bond buying. His message sent the global markets down on Thursday.
Many economists believe that the ECB is the only institution with the financial resources to prevent market panic that sends Spanish and Italian bonds higher.
The United States in particular advocated for a more aggressive bond buying stance from the ECB because they sense that a debt crisis in Europe can seriously jeopardize global markets and slow down an American economic recovery. The U.S. is also concerned that IMF, which the U.S. has majority control over including veto power, may be placed in an awkward position in the future if there is more need to bail out indebted euro zone countries. The IMF has 380 billion for lending, according to their website.
The U.S. Federal Reserve took an aggressive stance during the Great Recession of 2008 through quantitative easing. Under quantitative easing 1 and 2, known as QE 1 and QE2, the U.S. purchased 2.3 trillion worth of securities. The Bank of England also engaged in some quantitative easing and purchased 275 billion. The U.S. would like to see the ECB follow in the path that the Federal Reserve took in 2008-2010 with their aggressive intervention.
It appears that the ECB is waiting to garner the maximum concessions and fiscal belt tightening measures across the EU and for deflation to become more of a threat before providing any justification for more aggressive bond buying of European debt. They may also be waiting for bond yields to push much higher to intervene and punish speculators.
Meanwhile, the ECB continues to remind their critics of their treaty mandate to not support European governments and only support financial institutions in Europe. However, the real concern that still rests uncomfortably on the table for the ECB is deflation. At the risk of obsessively focusing on containing inflation and only assisting financial institutions, the threat of deflation across Europe could become more palpable in the near future, especially if there are no solid internal monetary policies created which fosters an enviornment of growth. Deflation is a decrease in the price of goods and services and it occurs when there is an economic depression.
As a result of the ECB lowering borrowing costs last Thursday at the EU Summit, Euro zone banks can go to the ECB to get capital at a lower attractive rate of 1.0%. Euro banks can also access these funds over a longer period of time- 3 years. The ECB also lowered collateral requirements to make it easier for lending to occur throughout Europe, especially in the regions of southern Europe where debt levels are high, birth rates have been declining, and the majority of their populations are reaching retirement levels.
Italy and Spain
In 2012 Italy has to refinance 340 billion euros while Spain is faced with having to refinance 120 billion euros. In addition to facing looming debts which need to be refinanced, Italy and Spain need to grow their weak economies at a time when their GDP numbers have been in a period of contraction.
Countries such as Italy, Spain, and Greece are faced with high unemployment and high labor costs (with costly pensions). Their economies are not known for being industrious, innovative, or robust compared to their wealthier neighbors in Northern Europe.
Somehow these countries will have to build and fashion a new capitalist core with the EU’s help to allow new businesses to grow and prosper in the future. They will also need to become more adaptable and efficient with generating tax revenues while maintaining tighter fiscal controls in the midst of potential instability and unrest within their own countries.