Optimism in Europe. But how long will it last?

at 04:56 PM ET, 12/05/2011

The markets looked awfully giddy today. Stocks were up in Europe. Italy’s once-terrifyingly-high borrowing costs were tumbling. So should we interpret today’s rally as a sign that Europe’s leaders might just get this euro crisis under control? Perhaps, although there are still plenty of reasons to think that Europe’s nowhere near a lasting solution to its woes.

(Remy de la Mauvinere - Associated Press)
First, a recap of what happened today: As the Financial Times describes, France and Germany reached a tentative agreement to impose mandatory limits on the budget deficits of European Union countries, a process that would require more centralized oversight. A “golden rule” would limit deficits of euro nations to no higher than 3 percent. Of course, the E.U. already had a rule like that, and countries violated it all the time. This time around, though, truant nations would face automatic sanctions — unless a qualified majority of governments voted to overturn the fine. This treaty change still has to be agreed by, at the very least, all 17 euro-zone members.

To put this deal in context, Gavyn Davies notes, there seems to be a broader debate in Europe between those who think the euro zone should be structured more like the United States — a fiscal union in which money flows from strong states to weak ones — and, on the other side, those like Germany, who believe that hard, enforceable budget rules can prevent the need for transfers. So far, Germany is winning this argument, and the deal today reflects that. There would be hard budget rules but no euro bonds or other transfer mechanisms to subsidize struggling states. Yet it’s unclear that stricter budget rules alone can solve the structural problems with the euro zone. After all, as Paul Krugman points out, Spain had its public debt under control before the crisis hit, and that didn’t shield the country from a crippling market panic.

Meanwhile, according to the New York Times, the new deal to solve the debt crisis includes three other provisions. First, there would be a “leveraging” of the current bailout fund, the European Financial Stability Facility, which would involve various financial shenanigans to try to increase the fund’s firepower. (See here for reasons to be skeptical of leveraging.) Second, the International Monetary Fund would chip in money to help out countries facing market panics. And third, the European Central Bank would get “political cover” to keep buying up Italian and Spanish bonds to placate jittery investors. A number of economists have recommended that the ECB be given unlimited power to intervene in this fashion, but Germany and the ECB itself have been resistant to the idea.

So will any of this work? Tyler Cowen argues that the main impact of these proposals will be to “try to fool the markets.” In other words, the plan is to calm down jittery investors and give Italy time to shore up its finances and figure out how to bolster its economic growth. To that end, Italy’s government has introduced budget cuts worth about 20 billion euros, although as Ryan Avent observes, Italy seems to be gambling on the fact that the coming recession in Europe won’t be so bad and that these austerity measures won’t eat into growth.

Risky? It seems that way. But for now, the markets seem optimistic. We’ll see if that will last the week. Already, Europe got a bit of dour news today, after the markets closed, when Standard & Poor’s announced it would put all 17 euro nations on watch for a ratings downgrade.

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