Euro Zone Buys Time, Moves Toward Federalism

FRANKFURT (Dow Jones)–The massive European Union financial package should banish fears of government default and a collapsing euro, and was also a giant step toward a more federal Europe in the longer term.

Without greater economic and fiscal integration, the 16-country euro zone faces longer-term instability because of differences in competitiveness and structure.

The enormous EUR720 billion support plan–consisting of EUR440 billion in loans from euro-zone governments, EUR220 billion from the International Monetary Fund and another EUR60 billion from an existing fund in the EU budget–was almost half again as large as the U.S. response to the 2008 crisis. But market watchers stressed that the response is in essence a short-term one, one that doesn’t itself solve the larger need for Europe to push through structural reforms.

In stark contrast to a halting, piecemeal reaction to Greece’s unfolding debt crisis, analysts said the authorities’ actions exceeded expectations, putting an effective safety net under both the single currency and fragile government debt markets in the foreseeable future.

They also bloodied the noses of “speculators,” who had fled the euro and its government bond markets last week in fear that Greece’s debt problems could spread throughout the region.

Across the globe, financial markets also rallied in relief, with equity markets in Asia and Europe rebounding, and with capital returning to all asset classes traditionally viewed as more risky.

“This morning the risk trade is back on, and it will probably remain so for several months,” said Roland Nash, head of research at emerging-market investment bank Renaissance Capital.

However, he warned that the fix is only a short-term one.

“European countries are still spending too much relative to their tax base and the competitiveness of their currency, and it is only a matter of time before the markets begin asking these questions again,” he said.

The deal at least opened up the prospect of profound reforms to the governance of the euro zone, addressing some of the biggest structural weaknesses that have plagued the single-currency project since its beginnings.

“The weekend’s solutions go far beyond the current treaties,” said Sylvain Broyer, an economist with Natixis in Frankfurt. “It’s an enormous display of solidarity, a prototype for federalism.”

Critics of the euro project have always pointed to the asymmetry of its institutions–a centralized monetary policy run by the European Central Bank and a decentralized fiscal policy that effectively allowed 16 governments to do largely as they pleased. With the member states agreeing to guarantee up to EUR440 billion of each other’s debts, that era may now appear to be ending. At the very least, Broyer noted, the European Commission will need larger transfers from member states just to pay the interest on the debt it issues with their guarantee.

The scale of the program dwarfs the immediate funding needs of the more threatened governments in the euro zone. The combined funding requirements of all the five most threatened countries–Portugal, Italy, Ireland, Greece and Spain–total only EUR637 billion this year, according to estimates by analysts at Sweden’s SEB bank.

However, as with the U.S.’s emergency response to the collapse of Lehman Brothers Holdings Inc. in 2008, the package comes with certain implementation risks.

French Economy Minister Christine Lagarde Sunday night acknowledged that “it could happen that a parliament in country X decides not to give its backing,” although she added that EU governments backed the new plan in good faith and are determined to win their parliaments’ backing.

However, German Chancellor Angela Merkel told a press briefing that her government would approve the new measures at a special meeting Tuesday, in a marked departure from the foot-dragging it showed over the much smaller rescue package for Greece.

“Having failed to persuade the ECB to undertake quantitative easing, governments will have to raise this enormous sum of money in the market, should the need arise,” Societe Generale analysts James Nixon and Klaus Baader wrote in a research note. “That may yet end up being a hard sell to Europe’s electorate who ultimately would be assuming the risk of any sovereign default.”

The ECB announced overnight that it would for the first time intervene in the open market to buy debt securities issued by euro-zone member states. However, the action does not equate to the U.S. and U.K. tactics of quantitative easing, the policy of central banks buying government bonds outright with a view to stopping a deflationary collapse in the money supply.

Rather, the ECB stressed that its action would be aimed only at ensuring that government bond markets continue to function, and said it would simultaneously take other measures to “sterilize” the purchases ensure that they made no overall change to its monetary policy.

The EU’s treaty forbids the ECB from simply lending to governments and printing money to inflate away their debt.

However, the ECB did take other steps that effectively loosened its monetary policy, reintroducing the “non-conventional” measures that it had first used in response to the 2008 crisis. As such, it will again offer unlimited credit for three and six months in the immediate future, and it has also reactivated swap lines with the Federal Reserve and other major central banks to ensure that European banks can continue to get access to dollars.