Big EU structural problems addressed

Recall that in the springtime this year there was a massive European debt crisis – something that I covered extensively here on the blog.  Financial markets around the world were roiled by the possibility that Greece was going to default on its sovereign debt.  And Portugal, Italy and Spain were considered to be not too far behind in, what was to be, a cascade of non-payment doom.  Or so the theory went.  Then the German government basically came in and underwrote the entire debt problem to stabilize the nerves of jittery investors.  However, there remained big structural problems to be resolved.

For example, the EU charter never had a built in enforcement mechanism to punish nations that didn’t comply with EU budgetary rules.  Another example was that it was unknown by what method enforcement would take place even if permission to enforce existed.  Well this past week many of those problems were resolved and taken care of by an agreement crafted between France and Germany (details below).  Long-term readers of this blog know that I raised concerns about the health of Europe almost two years ago.  My principle concerns were those that have now been addressed.  Thus, going forward, not only is the EU a stronger free-trade zone, but also, the world financial markets are going to be more stable.  But not everyone is going to be happy about this (see below).

On October 19 French President Nicolas Sarkozy and German Chancellor Angela Merkel negotiated changes to fiscal rules regarding the economies of Europe.  Here are the details of the quid pro quo that allowed for there to be a radical change in the way the EU will be run from now on:

1.  The French were demanding that a permanent fund be established that could provide stability for the European economy in case of crisis.  Germany finally agreed.

2.  The Germans were demanding that strict enforcement mechanisms were put in place in case a member of the eurozone should violate the fiscal rules that must be adhered to in order for a nation to be considered a member.  It was important to Germany (and the rest of us) that these mechanisms be put into the EU Constitution.

These new rules have been agreed to in principle without having been formally accepted by the rest of Europe.  In other words, the final language has yet to be determined.  That process is expected to take place at a December EU leaders’ summit.  One of the problems with the eurozone has always been that changes must be approved unanimously by each nation.  Ugh!  Imagine if every state in the United States had to agree on something before it became law.  Nothing would ever get done.  Not only that, but it would also be impossible to respond to crisis.  So how have the French and Germans gotten around this problem?

Earlier this year when the Greeks were about to take down the global financial system the Germans created a European Financial Stability Fund.  This was a €440 billion ($616 billion) fund temporarily established and set to expire in 2013.  Uniquely, the EFSF is established as a limited liability corporation!  By having established this institution as a bank the Germans are able to skirt the treaty law of the EU.  That is, they may act unilaterally without the sticky consensus goo-muck that made the EU a laughable institution.  Additional freedom is granted by this structure for the granting of loans or issuing of bonds to raise money.  In other words, it is essentially a private bank controlled by Germany.  That also means that the EFSF can:

1. Regulate the European banking sector indirectly by cajoling members by using its massive financial leverage.
2. Favor or penalize members of the eurozone as it sees fit; and all without the unanimous vote rules.
3. Bailout fellow members of the eurozone.

It is very important to note that all of these actions are prohibited by the EU Treaty.  However, it is even more important to note that each of these actions is necessary for the eurozone to operate as a legitimate body going forward.  Honestly, for the sake of worldwide stability in the financial system it is necessary, too.  But remember that the EFSF is set to expire in 2013.  So what is being planned?  While not formally named yet, it is likely that the new permanent institution will be similar to the International Monetary Fund – a financial instrument of the political will of the United States.  This European Monetary Fund is expected to look just like its EFSF predecessor, but with one very important exception.

Germany is insisting that default rules be written into the charter of the future institution.  In other words, the Germans, reluctant underwriters of Greek debt during the crisis earlier this year, are saying that they will not be underwriting the shenanigans of eurozone members going forward.  In the future, abusive nations will be allowed to fail rather than be bailed out by the likes of Germany.  Presumably the European Monetary Fund would handle an orderly default the way defaults are handled by the IMF or by major U.S. banks when a big U.S. corporation defaults.

At the gross level the French and Germans have craftily crafted a way of skirting EU rules.  However, at a subtle level, Germany just re-established itself as the unquestioned leader of Europe – a situation that has not existed since the end of World War II.  That power is Germany’s because of its dominant position as financier of the EMF.  That, in turn, allows Germany the exclusive right to bail-out, or allow to fail, other European nations.

In the boring details of seemingly innocuous treaties, the German eagle does screech!

Jason