June 29 (Bloomberg) -- A minor miracle has occurred in Brussels: Germany has signaled that it may be willing to do what it takes to save the euro.
Now the question is whether Europe’s leaders can show enough money to back their words.
In negotiations that lasted through the night, German Chancellor Angela Merkel agreed to allow Europe’s permanent bailout fund -- the European Stability Mechanism -- to provide capital directly to troubled banks anywhere in the euro area.
If the deal sticks, Germany and the other governments of the currency union will accept joint liability for rescuing one another’s banks -- an option that, on the eve of the meeting, Merkel had vowed not to consider. In return, as part of a broader banking union, governments will cede to European authorities, probably including the European Central Bank, the power to oversee, punish and dismantle banks. The agreement also eases austerity measures and allows for direct bond purchases to reduce the borrowing costs of struggling governments, including Italy and Spain.
It’s hard to overstate the significance of what happened in Brussels. By providing an added backstop for banks whose assets often dwarf the economies of individual sovereigns, and by offering financial support for those sovereigns, the deal has the potential to break the debilitating link between the troubles of banks and the solvency of governments. By pooling resources and authority, it represents an important step toward the kind of political union needed to make the euro area viable.
Markets are rallying on the news. Spanish 10-year bond yields, which had been approaching 7 percent, fell to less than 6.5 percent. Italian bond yields crossed back below 6 percent.
The deal could yet run into snags, and remains a far cry from what’s needed to end the crisis. For one, Europe’s leaders still seem to think they have plenty of time. They’re aiming to complete the supervisory part of the banking union by the end of this year. Until they achieve that, direct recapitalizations of banks can’t happen, and Spain will remain on the hook for a banking bailout that could cost 100 billion euros or more. If negotiations on details get bogged down, a paralyzed banking system will undermine economic growth and political stability, making the sovereigns’ predicament even more precarious.
More important, European governments’ commitment to mutual aid is limited to the capacity of its two bailout funds. Taken together, the funds have no more than 500 billion euros available to buy bonds and recapitalize banks, according to Bloomberg. That may be enough to cover banks’ capital needs, but falls far short of the 2.4 trillion euros in Spanish and Italian debt outstanding.
Europe’s leaders will need to display more firepower if they want markets to trust in their allegiance to the common currency. The least bad approach, as Bloomberg View has advocated, would be for the ECB to pledge whatever resources are needed to support recapitalizations and the financing of solvent governments. If the commitment is large enough to restore confidence, the money probably won’t need to be deployed: Markets will provide financing on their own, and governments can get on with fixing their finances, restoring competitiveness and crafting the kinds of risk-sharing mechanisms -- such as jointly backed euro bonds -- required to complete the currency union.
Success still depends on Merkel and Germany. They’ve taken a crucial step in the right direction. Lest the effort be wasted, they’ll have to take the plunge.
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