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Still together

27 October 2011 By Pierre Briançon

Euro zone leaders have a deal. They have agreed in principle on the three hot topics at the core of the deep divisions exposed in recent weeks. Greece’s debt burden will be lightened. The region’s banks will be recapitalised. And the euro bailout fund’s firepower will be enhanced.

Markets cheered, as they usually do on the rare occasions the zone’s 17 members agree on something. But it’s too early to celebrate. The monetary union’s leaders have left unresolved many details where the proverbial devil hides.

It wouldn’t matter so much if the euro zone had the credibility needed to convince markets that it will do what it says. But that credibility is lacking, so they will have to redouble their efforts on filling the holes. They must also see that implementation of the agreement will be airtight. Even then, the euro zone’s immediate fate depends on two factors outside its governments’ influence: the European Central Bank’s actions, and global economic growth.

The very substance of the agreement could change depending on the outcome of the detailed discussions on the three most pressing issues. It is still unclear how voluntary the “voluntary” haircuts taken by private creditors on Greek bonds can and will be. Fuzziness surrounds the parts dealing with the banking sector – especially where it concerns improved access to term-funding, a crucial aspect of confidence-building. In addition, the ultimate details on the two options to leverage the European Financial Stability Facility are left up to a meeting of finance ministers next month.

The fact that heads of states or governments have left it to underlings to fill in the details would be of marginal relevance if their overall credibility was seen as strong enough to ensure implementation of their decisions. But after almost two years of hopping from crisis to crisis, the euro zone falls short on this score. Its credibility has been eroded both by the divisions within the imperfect union of the 17 governments. The debate is also constrained by the area’s largest power and payer, Germany.

As seen in previous instances, the divisions don’t stop with a summit and the signing of a communiqué. With implementation, the euro zone is moving into the harder part of the deal. There’s the risk that single countries will raise new obstacles, if governments run into difficulties at home. This could lead to further delays, and more rounds of market jitters.

The summit has also shown that Germany drives the debate. For the euro zone, this is both a relief and a concern. Relief because Angela Merkel at last seems to know what she wants, and has a clearer mandate from the Bundestag. But it is a concern because all the discussions are bound by the taboos Germany doesn’t want to break, notably on the possible role of the European Central Bank in maintaining the region’s financial stability.

ECB action will be crucial in the weeks to come, in relation to term-funding for banks, sovereign bond-buying, and interest rates. Nothing as dramatic as a U-turn should be expected when its new president Mario Draghi takes over – the balance of power at the ECB will remain the same – but if the central bank thinks governments have done their part, it could opt for a more flexible stance.

In the end, the Oct. 26 deal should be judged by the answer to three questions. Does it make Greece’s debt burden lighter? The answer is probably. Does it protect the region, and notably its banks, against the risk that markets might succumb to a panic attack? The answer is maybe. Finally, does it solve Italy’s problems, and take Italian yields down from their current, near-6 percent levels? The answer is no. Italy needs a serious government, intent on reforming the country’s economy – in this case it won’t need to tap the EFSF. But if it doesn’t get the political leadership it needs, the EFSF won’t be of much help when the real trouble arrives. This agreement does nothing to change these facts.

The deal doesn’t signal the end of the crisis, nor even the beginning of its end. But it will help soothe concerns if it is quickly followed by firm indications that every euro zone government will implement it without wavering.

 

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