Europe's plan: Bold new steps, same old issues

5:24 AM Europes, issues, steps No Comments

  John Schults / Reuters

The future of the eurozone depends heavily on the efforts of French President Nicolas Sarkozy and German Chancellor Angela Merkel. But despite their single nickname of "Merkozy," the Franco-German duo has yet to produce a master plan.

By John W. Schoen, Senior Producer

The latest plan to save the euro zone calls for the boldest moves yet since the crisis exploded on the Continent this year. Yet despite a looming threat of failure, Europe's leaders and citizens remain deeply split over the same issues that that have doomed a series of failed proposals over the past two years. 

The new plan calls for a treaty that would fix one of the most critical, longstanding flaws in Europe’s monetary union: the lack of centralized control over member countries' decisions about taxes and spending. The absence of those controls have allowed free-spending nations like Greece and Italy to run up massive national debts that larger countries, like France and Germany, have refused to backstop.

The new treaty, which would require approval of all 17 countries that use the euro, would include automatic sanctions for countries that fail to keep government deficits in check.

For now, the proposal has given European bankers and political leaders some breathing room, as investors gave the idea a vote of confidence. Following the announcement Monday, the euro rose against the dollar, stocks gained and yields on European government bonds dropped.

“The fiscal stick is being rewarded by the market carrot,” said Douglas Borthwick, a currency trader with Faros Trading. “We continue to expect this going forward. The market rewards fiscal responsibility.”

But markets have rallied before on hopeful pronouncements from the leaders of Europe's "core countries”  only to see proposals dead-ended by the complex political process of forging consensus among 17 countries. In general European  voters tend to be leery of ceding their national independence to a centralized spending authority in Brussels. European leaders are scheduled to consider the latest proposals at a summit in Brussels Friday.

After U.S. markets closed Monday, Standard & Poor's warned that it may carry out an unprecedented mass downgrade of eurozone countries if EU leaders fail to reach agreement at the summit. The ratings agency placed the ratings of 15 euro zone countries, including top-rated nations Germany and France, on credit watch negative -- a move that signals a possible downgrade in no later than three months.

As with past failed proposals, the latest announcement came from French President Nicolas Sarkozy and German Chancellor Angela Merkel, the two strongest “core” economies that are struggling to stem the contagion from the weaker, heavily indebted peripheral economies of Greece, Italy, Spain, Portugal and Ireland.

Despite that common interest, the two countries remain divided over key elements of any bailout plan.

“There are still significant differences between Sarkozy and Merkel, so we're in for a volatile week,” said Patrice Perois, a trader at Kepler Capital Markets. “The risk is that any kind of disappointment could trigger a (market) pull-back."

France has long opposed efforts to dilute its national independence by turning over control of budgetary decisions to a central European agency with the power to veto spending decisions. Various enforcement mechanisms have been considered, including granting the European Court of Justice the power to punish governments that defy centrally imposed spending limits. Just months away from a presidential election, Sarkozy faces rivals warning voters that he is prepared to sacrifice French sovereignty to unelected EU officials.

For their part, German voters are loathe to allow their taxes to be spent bailing out weaker, free-spending countries. Faced with German voters' deep-seated fears of a recurrence of 1920s hyperinflation that sank the Weimar Republic, Merkel has also staunchly opposed the idea of letting the European Central Bank print euros to underwrite massive bond purchases,  

The long-simmering crisis reached a boiling point in the past few weeks as investors became increasingly skeptical about a series of broken promises to get Europe’s fiscal house in order. Those investors have demand higher interest rates on European government debt to offset the risk they won’t get their money back.

The euro is holding firm against the dollar, boosted by optimism on Italian austerity measures and the Merkel-Sarkozy meeting, with Marc Chandler, Brown Brothers Harriman.

Europe’s weaker countries, including Greece, Portugal and Spain, have been paying that premium for months as budget-balancing spending cuts sapped economic growth and cut into revenues, which forced deeper cuts in a downward economic spiral.  European leaders have assembled a collection of war chests to bail out those countries if they reach the end of their fiscal rope.

The crisis entered a new phase last month, when the rate on Italian bonds soared to 8 percent, a level widely acknowledged as unsustainable. With the third-largest pool of debt, behind the U.S. and Japan, Italy’s debt load is far too big to bail out. Various proposals to find bigger pools of bailout funding, including a proposal that the European Central Bank simply print more euros, have run into political, technical and legal roadblocks.

The latest round of proposals also includes a bid to raise Europe’s member country contributions to the International Monetary Fund, which would expand its financial firepower to backstop a debt default. The IMF so far has failed to attract larger contributions from countries outside Europe, including the U.S., China and Brazil.