No, the euro hasn't been saved yet

On the Telegraph blog, we argue:

Judging from some media reports across Europe – and some positive market reactions, the eurozone crisis has just been solved. Italy and Spain scored a massive victory over Germany. Angela Merkel has caved in. Berlin has blinked.

Hardly. Though Merkel took a bit of a beating and some unexpected progress (the term is used loosely) was made, the primary achievement was to shift yet more of the burden from banks and governments in the south to taxpayers in the north, via the eurozone bailout funds. Nothing fundamental has been solved. Here’s why:

Recapitalisation of Spanish banks still faces hurdles: In future, the eurozone’s permanent bailout fund, the ESM, will be able to directly recapitalise banks in the eurozone, without first passing the cash through national governments. This could help Spain, as the loans won’t count towards Spanish government debt. But no more money is on the table, and the changes will only happen when the ECB has shouldered the role as supervisor for banks in the eurozone and ESM rules are reworked. Judging on past record, this can take time. Merkel has also indicated that the changes to the ESM will have to be approved by the Bundestag, which won’t be comfortable given the already strong reaction from backbench MPs.

The bailout funds are still not big enough to stand behind Spain and Italy: The two bailout funds – the EFSF and ESM – could be allowed to buy government bonds with only existing EU targets in place, ie. no Greece-style monitoring programme. To consider this a game-changing move is an illusion. First, it is merely activating a previous EU decision – so Germany has agreed to no new instrument. Second, unlike the ECB, the EFSF and ESM don’t actually have the funds to backstop Italy and Spain – their bond buying is likely to be tested by the markets and could prove counterproductive. Perversely, if conditionality is indeed relaxed it would provide a pretty strong incentives for other countries – such as Italy – to tap the bailout fund. Hardly desirable.

EU loans will remain senior: The conclusions suggest that any loans made by the EFSF and then transferred to the ESM (i.e. the Spanish bailout) will not be “senior”, ie taxpayers and financial institutions will take losses simultaneously if a debtor country fails to pay back the cash. In reality though, as the restructuring in Greece showed, official loans have always been treated as de facto senior. This is not necessarily a bad thing since it protects taxpayers, but it simply adds to the confusion and often only delays the pain.

Ireland will get easier terms on its bailout: This is significant for Ireland, and an effective admission that the EU might have been wrong to force the country to bail out its banks and carry the burden on its sovereign debt alone. How much can be done this far down the line is unclear, but the positive sentiment could help the Irish recovery.

The ECB as bank supervisor has merits – but comes with pitfalls: The aim seems now to have the ECB taking over the responsibility as chief bank supervisor in the eurozone by the end of the year, or at least an agreement to that effect. As I’ve noted before, the proposal comes with merits, but for better or worse, could be very significant for the UK if taking to its logical conclusion (resolution fund, deposit guarantee scheme, super-harmonised regulation), with the risk of fragmentation of the single market (as UK itself cannot take part). But this will take a lot of fiddling to sort out.

What’s clear is that Germany has not moved on debt pooling, including eurobonds. The German government firmly denied suggestions this morning that anything had been agreed on this front. But the summit deal has caused a lot of bad blood within Germany. Apparently, Italy and Spain threatened to veto the €120bn growth package proposed by Hollande if Merkel didn’t give way (incidentally, given that these two countries were meant to be the chief beneficiaries of the ‘growth’ package, its a sign of how seriously – or not – people take this proposal). The episode has left Germany seriously frustrated and with a feeling of an ever increasing weight on its shoulders.

Paradoxically, this may have the effect of hardening German resistance to debt pooling in the eurozone. Yet again, the focus shifts to German domestic politics.