Europe's Tenuous Breakthrough

We're so used to European summits to produce nothing more than a carefully worded, but essentially meaningless, statement that is easy to dismiss them as nothing more than stagecraft. But the summit that wrapped up at the end of June has played against type. European leaders actually made progress on substantive measures that could actually help mitigate the sovereign debt crisis. However, they hardly solved the crisis. There might be a light at the end of the tunnel now, but that tunnel remains incredibly long.

New Plan Is a Step Forward
Crafting a plan to shore up the European banking system was the most important thing to come out of the summit. Banks, big and small, constitute one of the weak links in Europe at the moment. Unlike banks in the United States that aggressively recapitalized and shed toxic assets, European banks are still burdened with bad loans. Add in the emerging pan-European recession along with worries about the future of the euro, and you've set the stage for a potential banking crisis.

The European Central Bank's move to provide three-year loans to banks has been a big relief so far and has helped buy time, but it did little to solve the long-term banking problem. What banks need now is fresh capital to help absorb future losses. This is the area where the recent summit potentially made some progress. The leaders agreed in principle that money from the European bailout funds can now flow directly into troubled banks and not have to go to national governments first.

If properly implemented, the plan could help break a vicious cycle. Previously, already-indebted nations had to increase their debt loads to bail out their banks, making their precarious positions even shakier. That, in turn, made the banks less secure as investors worried that these nations were going to default or leave the eurozone. This meant the banks would have to raise capital, and the only feasible way to do so would be to keep borrowing from the state, boosting the sovereign debt load even more. Now that banks can get money directly from multinational funds, the banking system can be shored up at the same time that the state works on restoring fiscal balance.

The summit also provided lots of positive talk about the creation of a single banking regulator and actions to craft closer fiscal ties. Combine that with this week's seemingly coordinated move by the ECB, the Bank of England, and the Bank of China to ease monetary policy,and you can see why a small amount of optimism has crept into the market.

Many More Steps Needed
But despite the good coming out of the summit, that optimism might be premature. There is already chatter than the plan won't be ready in time to provide direct funding to struggling Spanish banks. There is even talk that national governments would still be ultimately responsible for the bank bailouts, even if they come directly from European funds. If that comes to pass, it would likely defeat the purpose of the plan. The summit also only paid lip service to the long-term structural changes that are needed in Europe. Actually making those changes is going to be, at best, a bumpy road. 

In order to permanently stabilize the euro, all of the member countries need to share a common fiscal policy to go along with their common monetary policy. This will prevent another country from binging on artificially cheap debt, like Greece did after it joined the common currency. The fiscal union also needs to allow for mutualized debt to kill the default fears. For this to happen, the foundational EU treaties will need to be rewritten; this can't just be wished into place. Changing these documents is going to involve scores of meetings, parliamentary votes, high-stakes referenda, and other moves in order to make it happen. Anyone want to take bets that each of these steps is going to go off flawlessly? Most Germans are skeptical of explicitly taking on the debts of their country's neighbors, and more profligate countries are not too keen on giving up a big chunk of their sovereignty.

The fact that the nations might incrementally move closer to achieving a fiscal union hardly ameliorates the problem. European officials likely will fight endlessly over each step, from relatively small ones like creating a unified banking regulator to massive ones like issuing eurobonds. This is a process that could take decades and could unravel at any number of points.

Europe also needs to figure out a way to improve its underlying growth rates. All of the austerity measures and budget cuts in the world aren't going to help if the continent's economy can't boost its long-term growth rate. In order to accelerate growth, even more labor market and other serious reforms will need to be passed and other markets will need to be liberalized. This was talked about at the summit, but other than some modest stimulus measures, nothing concrete was offered.

This summit did a good job of kicking the can farther down the road than it has been kicked previously. Leaders said the right things, but now they have to actually do the right thing. Given the potential pitfalls in trying to create a closer fiscal union, investors shouldn't get too excited about these moves until the talk gets converted to concrete action.