Deal Breaker

How badly did Europe just bungle its best shot yet at avoiding economic catastrophe?


It all sounded so promising. In the early morning hours on Oct. 27, German Chancellor Angela Merkel and French President Nicolas Sarkozy emerged from a day of edge-of-their-seats negotiations and announced a historic plan to pull the continent’s economy back from the brink of disaster.

The agreement, acceded to by European governments and the Institute of International Finance, had three parts. Investors — mostly European banks — would write off half of the face value of the Greek bonds they held, a particularly toxic ingredient in Europe’s debt crisis. The banks would raise capital to the tune of 100 billion euros, removing some of the uncertainty over the shaky sovereign government debt on their books. And the European Financial Stability Facility (EFSF) — the continent’s 625 billion-euro bailout fund — would be bolstered to 1 trillion euros in order to protect other vulnerable economies from imploding the way Greece’s had. The politicians involved patted themselves on the back, and stock exchanges on three continents sharply rallied on the news of a deal, with some European bank stocks leaping by as much as 25 percent in a single day.

Unfortunately, it didn’t take long for the expectations from last week’s summit to come crashing down to Earth, and loudly. Putting the pieces back together will not be easy. And the implications are consequential — not least for the upcoming G-20 meeting, the agenda for which will likely be hijacked by Europe’s renewed turmoil.

The markets’ initial euphoric reaction was based on a twofold hope. The first was that Europe would quickly translate the agreements into specific and lasting measures. The second was that Europe would address two big issues that were not on the summit’s agenda and needed to be: the restoration of economic growth and the strengthening of the institutional underpinnings of the eurozone.

Investors were giving policymakers the benefit of the doubt — and as it turns out, it only took a few days for markets to realize that, once again, they had placed too much faith in leaders’ ability to follow through in a decisive manner. The result has been significant market turmoil as three developments essentially unraveled the summit’s achievements.

First, in a surprise move, Greek Prime Minister George Papandreou announced he would hold a national referendum to seek broad-based popular support for the measures agreed upon last week. This baffled other European leaders, who were under the impression that Papandreou and his government had already signed off decisively on the deal. It also cast major uncertainties over the willingness of the European Union and the International Monetary Fund (let alone countries like China) to lend to Greece ahead of the referendum — which is still pending a vote in Greece’ parliament — thereby increasing the risk that the country could run out of money this month to pay some bills.

Second, some banks that hold Greek debt started expressing reservations about the agreed-upon 50 percent debt reduction — a haircut they had initially hoped to keep to 21 percent. This puts back on the table the threat of a very chaotic and disruptive Greek default. It also places a question mark on the robustness of the cooperative public-private approach that is central to solving Europe’s crisis — and the banks’ reluctance has only increased since Papandreou’s announcement of the referendum.

Third, the European Central Bank (ECB) has proved less than fully effective in stabilizing the interest rates on debt issued by other European economies, particularly that of Italy. Despite purchases by the ECB, the interest rate on Italian 10-year bonds has broken above 6 percent, more than double the level considered safe. The spread between the rates on Italian and German bonds — a market measure of credit risk — reached a new eurozone record. While it is not clear whether it is an issue of willingness or ability on the part of the ECB to stabilize markets, the disappointment has added to market jitters.

Markets have predictably plummeted today, and European leaders must again scramble to put the pieces back together. In the process, they will try to catch up, or at least avoid falling further behind, in a crisis that is spreading well beyond the original confines of peripheral countries’ sovereign debt problems. The banking sector is now contaminated, and there are growing concerns about the impact on core countries, including France’s ability to retain its AAA rating.

No wonder there is tremendous pressure on Papandreou to reverse his referendum gamble — and this pressure is coming from both inside and outside Greece. Meanwhile, banks are being reminded that the alternative to the 50 percent debt reduction is an even more drastic loss of value. And I suspect that the ECB is hearing calls to be more forceful in its efforts to stabilize markets.

These issues will undoubtedly feature prominently at the G-20 Summit in Cannes this week. Unfortunately, they will crowd out the type of deliberations needed on other topics that are also of central importance to the wellbeing of the global economy. Leaders who are preoccupied with the sovereign debt crisis are almost certain to once again fail to formulate a much-needed global employment and growth pact. They also may fail to address the historic developments in North Africa and the Middle East — where some economies need support as desperately as Europe’s vulnerable economies — that have occurred since the last G-20 meeting, to say nothing of the still-pressing issue of climate change.

Only last week, the hope was that after endorsing the outcome of the European summit, members of the G-20 would agree to supportive measures and also address the other big issues ailing the global economy. Expectations are now quickly ratcheting down, with the greatest optimists limiting their hopes to a new emergency Band-Aid for Europe. In the process, the outlook for global growth and jobs dims a little more.

Mohamed A. El-Erian is chief economic advisor at Allianz and the designated president of the University of Cambridge’s Queens’ College. Twitter: @elerianm

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