Curb Your Enthusiasm: The EU Summit Fell Short

The EU's summit deal--accomplished after the obligatory drama of another all-night session--delighted financial markets. Stock markets surged and Spanish and Italian bond yields subsided, from the crippling to the merely unaffordable. The leaders exceeded expectations and took steps in the right direction--but if they don't do more, and soon, I doubt the joy will last.

The summit's main achievement was to agree in principle that the ESM, the system's rescue fund, could recapitalize distressed banks directly rather than by lending to their governments. Potentially, this is a breakthrough. Direct support takes debt off the books of distressed sovereigns and passes it to the EU. It's a move towards banking union--and indeed it's a kind of fiscal union. Angela Merkel had previously said it wouldn't happen. The recently announced rescue package for Spain flopped because it failed in this very respect: It offered relief to the banks, but at the cost of adding to the Spanish government's debt load. If the summit had produced nothing on this, Europe's keenly awaited Lehman moment would surely have arrived.

It's good news that Merkel has backed down on this vital point. The leaders' statement opens a new and more promising line of EU response to the euro-area's crisis. But for now there's much less here than meets the eye. The leaders' statement says this new form of support won't start until a new EU bank regulator has been created--and the deal on this has only been sketched. All the summit partners have promised to do is start work on it. Since it's a complex and controversial issue, we have further delay at the very least. There's plenty of scope for things to go wrong in the coming negotiations. At worst, we might get no deal at all.

Quite aside from that there's the question of the scale of the EU's commitment. Support for the banks under the new proposal will come through the ESM. But the ESM is much too small. It will have to be further enlarged, either explicitly or by giving it a banking license and telling the ECB to finance it. The summit left this crucial issue of resources unanswered.

Isn't it significant, on the other hand, that the ESM will now be allowed to buy public debt in primary and secondary markets, if a distressed government asks it to and agrees to conditionality (yet again, details to come)? Some market commentators seemed to think so, and scored this part of the statement as a big victory for Mario Monti. I must be missing something. The ESM already had the power to do this. I can't see what's changed. In any event, the critical issue is not the ESM's rules of procedure, which can be tweaked on the fly given sufficient consensus, but once more the financial capacity of the ESM, which is harder to fudge. When Merkel gives way on that, it might be time to celebrate.