The fledgling U.S. recovery can breathe a little easier for a little longer. It’s not economic doomsday in Europe—yet.
European leaders ended a high-stakes summit meeting on Friday by announcing an agreement that amounts to the best outcome U.S. officials could have hoped for. The deal would impose strict new rules on the size of European countries’ budget deficits, a move that increases the chances that outside financial institutions—such as the International Monetary Fund or European Central Bank—will throw a lifeline to embattled eurozone governments currently drowning in high borrowing costs.
The agreement is not a panacea, but it’s a first and critical step toward preventing a eurozone meltdown that would send shocks through the global economy.
After all-night negotiations at the summit in Brussels, leaders of 23 of the 27 members of the European Union pledged to impose harsh penalties for countries that run deficits outside of acceptable limits. Their agreement would also accelerate the creation of the European Stability Mechanism, the permanent successor to the current European bailout fund, and provide additional funds to bolster IMF.
Stocks surged in Europe and America on the news. Credit default swap spreads—a barometer of risk of sovereign default—remained unchanged through much of Europe, Markit reported, and they actually rose in Italy.
Obama administration officials have pushed for any European solution to include three components: steps toward greater fiscal union in the European Union, intervention by ECB to bolster countries and banks strained by rising interest rates on sovereign debt, and the creation of a credible “firewall” to prevent financial woes in countries such as Greece and Italy from spreading across the continent and into the U.S. financial system.
European leaders achieved the first of those steps in Friday’s agreement, opening the gateway to the other two. ECB, or even IMF, appear more likely to step in now that a stricter long-term fiscal agreement is in place.
The deal’s long-term success will depend on the willingness of ECB to take the second step. So far, the bank has sent mixed signals.
At a regular monthly news conference on Thursday, ECB president Mario Draghi did his best to quash hopes that the central bank would make large-scale purchases of government bonds or lend to IMF.
But Draghi praised the deal reached Friday, once again raising hopes ECB will step in as a lender of last resort. “It is a very good outcome for euro-area members and it’s going to be the basis for a good fiscal compact and more disciplined economic policy in euro-area countries,” Draghi said on Friday.
ECB sees itself as the “third and last line of defense” in Europe, said Domenico Lombardi, a senior fellow in global economy and development at the Brookings Institution. The first line is safeguards and budget-balancing commitments by individual countries. The second is IMF loans. But many economists say ECB has the most power, by far, to blunt what appears to be a deepening European recession.
IMF has limited funds to pour into Europe, and few palatable options exist for raising more. If things get really bad, ECB will most likely lead the response, said Dean Baker, codirector of the Center for Economic and Policy Research. “I think [ECB] will step forward every time things threaten to spin out of control,” he said.
The agreement reached on Friday requires approval from governments in the 23 nations that signed on, but not a full-scale change to the European Union treaty. That could mean it will be implemented quickly—which is good news for the United States.
How the next year plays out in Europe will be critical for the health of the U.S. economy and the fate of Obama’s reelection bid, which is tied to the economy.
If Europe can’t stop its pain from spreading across the world, “The big loser potentially on the U.S. side is President Obama,” said David Gordon, director of global macro analysis at the Eurasia Group. “If the economy tanks again … it would really make a much tougher road to reelection.”
Recent economic indicators revealed that the U.S. recovery is just beginning to take its first firm—if shaky—steps away from a double-dip recession. The administration is hyperaware that it can’t afford a European financial catastrophe in an election year.
“If Europe does the muddle-through, I think the U.S. can continue to do OK, do this moderate growth-type trajectory,” said Josh Feinman, global chief economist at Deutsche Bank. “Once you get into the realm of full-fledged financial crisis, all bets are off. Could be batten-down-the-hatches time. I don’t think that’s the most likely scenario, but it’s a not-negligible risk.”
Friday was a solid step back from the brink.
Jim Tankersley contributed