Hugo Radice: Europe’s path to financial stability clouded by fog of political uncertainty

Initial reports of the agreement reached in Brussels suggested the outstanding issues had been settled, and the financial markets gave their immediate blessing in the usual form of a surge in share prices and a fall in the cost of government borrowing in the countries most under threat.

There were three key parts to the Brussels agreement. First and foremost, the new bailout package for Greece involved further support from the IMF and the European Financial Stability Facility (EFSF), extending the period of some loans and reducing the interest rate payable. Greece would also be helped to develop a comprehensive recovery strategy, although talk of a full-scale “Marshall Plan”, a reference to the aid given by the US to Europe after the Second World War, turned out to be premature. Interest rate relief will be extended also to Ireland and Portugal and the UK Government has already agreed to match this with regard to our own special loan to Ireland.

Secondly, there is to be a voluntary contribution from banks in the form of writing off a part (perhaps 20 per cent) of their holdings of Greek debt. It appears that, with new rules of banking regulation expected by the end of the year, the big banks felt that a continued confrontation with the German and other eurozone governments on this “haircut” would not be wise.

Thirdly, to stem the fear of further crises in Ireland and Portugal, and especially of the contagion spreading to Spain and Italy, the size and role of the EFSF is to be expanded substantially.

While the deal does not take up the radical alternative of replacing national bonds with an all-purpose Eurobond, the EFSF will be better able to head off further national crises, to intervene more actively in sovereign bond markets and to recapitalise weaker banks.

All this brought immediate relief to the febrile financial markets, but by the weekend it became clear that many details remained to be agreed, and commentators were asking whether this was anything more than another set of stopgap measures. Amid the fog of uncertainty, finding an answer to this question has to start from a realistic appraisal of the economics and politics of the crisis.

The economics underlying the eurozone’s agonies have certainly been exacerbated by recent bad news from other parts of the world economy. President Obama’s policy of encouraging the faltering US recovery by postponing severe cuts in public spending has come up against the obduracy of the Republican opposition in Congress: their threat to block a routine increase in the permitted level of US government debt has raised the prospect of an abrupt halt to public spending of all kinds, and the risk of financial chaos that would certainly spread across the globe.

There have also been clear signs that the Chinese government is taking steps to slow the breakneck pace of economic growth in that country. While this has led to a welcome halt to the relentless rise in oil, raw materials and food prices, it has also raised the possibility of slower economic growth in other regions. Within Europe, slower growth would not only make it even harder for Greece, Ireland and Portugal to maintain their debt repayments, but would also affect the ability of richer governments – and their banks – to finance the debt relief programme agreed in Brussels.

This week’s UK second-quarter growth figures will provide a good indication of whether the global recovery has indeed slowed, with many forecasting little or no growth in output. This in turn has given greater impetus to the concerns of Ed Balls, the Shadow Chancellor and Morley and Outwood MP, as well as others, that as public sector cuts are implemented we will find ourselves back in recession.

Given these economic concerns, there is clearly a desire among both governments and investors to bring the eurozone crisis to an end. But is this proving politically impossible? Many have derided the incessant quarrels among the EU’s political élites, seeing their prevarications as evidence that the euro currency project, or indeed the EU as such, is fatally flawed.

However, this is how democracy works within the EU: on major issues collective agreement requires the consent of all member states, and given the variety and strength of national interests, this takes a long time, even after more than 50 years’ experience.

Most importantly, the agreement to expand the role of the EFSF means that Europe’s politicians will now seriously examine whether and how monetary integration can be complemented by greater fiscal integration.

Up to now, the collective EU budget has amounted to only a tiny fraction of public spending as a whole, amounting to little more than one per cent of GDP (total economic activity); this compares with total UK public spending, for example, of around 43 per cent of GDP, with similar figures for other member states.

A modest transfer of spending powers to Brussels, say to a level of two per cent of GDP, would still leave the vast majority of public spending under the control of national governments, but would provide Brussels with a vital source of extra assistance to poorer member states.

Surely this would be a small price to pay for providing much-needed stability to European public finances, and thereby a better foundation for economic recovery?