Europe blunders into a blind, and dangerous, alley

The interests of the City of London were defended – for now – but Brussels summit did not draw a line under eurozone crisis
Herman Van Rompuy and Angela Merkel
European council president Herman Van Rompuy and German chancellor Angela Merkel speak during the eurozone crisis summit at EU headquarters in Brussels. Photograph: Eric Feferberg/AFP/Getty Images

Europe is sleepwalking into a prolonged depression. The prospect of 2012 seeing the start of the break-up of the eurozone is a real one. Financial markets are already starting to pick apart what looks like the latest, if more sophisticated, attempt to kick the can down the road. Britain has isolated itself on the fringes of the European Union, perhaps the most significant development at a summit that assuredly did not draw a line under the crisis in the single currency. But at least the interests of the City of London were defended. For now.

In short, the summit that was supposed to save monetary union has been little short of disastrous. Going into the talks, the markets hoped for a happy ending to the sovereign debt saga: a deal to pave the way for the European Central Bank to ride to the rescue of Italy and Spain, under siege from the bond vigilantes. What they got instead was political schism, half-baked reforms and the complete absence of any fresh economic thinking.

The markets, frankly, were always absurdly optimistic about the outcome for the summit but, even so, it could still have had positive results. Three things were needed to make it a success: there had to be a strategy for growth that went beyond calls for ever-greater austerity and long-term structural reform; there needed to be a real commitment from member states to put their public finances in order; and the ECB had to show a willingness to do whatever was necessary to bring down bond yields in the troubled periphery of the euro area.

Not one of those objectives has been achieved. What was needed was a route map out of a situation that threatens Europe with at least one and perhaps two years of crisis. What we got instead was a blueprint to prevent the next crisis, assuming that monetary union makes it that far.

The fiscal pact is ferociously deflationary in its conception. Europe is going to have its own balanced budget rule, so beloved of US fiscal conservatives, which will prevent countries from running a budget deficit of more than 0.5% of GDP once the state of the economic cycle is taken into account. This gives them a bit of wriggle room to run budget deficits in recession, but not all that much because deficits will not be allowed to go above 3% of GDP, no matter how tough conditions get. This is a purely arbitrary ceiling and is much lower than the current deficits for a host of eurozone countries.

There's more, however. Countries will be obliged to get their debt levels below 60% of GDP, and the plan is for them to reduce annually their gross debt by one 20th of the difference between the current level of national debt and the 60% limit. As James Nixon of Société Générale notes, this may yet prove to be the most draconian of all the new rules.

These curbs would seriously restrict the freedom of action of individual countries to run independent fiscal policies, which is why Angela Merkel proposed them in the first place. Berlin's idea is that the single currency would be better off if everybody played by one set of rules, German rules.

The big question is whether countries will abide by what amounts to a toughened up version of the existing stability and growth pact when they have not done so in the past. Some of the smaller countries, such as Finland, have already expressed reservations about the proposed mechanism for triggering sanctions against countries deemed to have broken the rules, while Nicolas Sarkozy has no great desire to have wait for Merkel's approval before enacting the French budget. There will be much haggling before a deal is finalised and the markets will inevitably be on high alert for any sign of backsliding.

Finally, there's the role of the ECB. In advance of the summit, its new president, Mario Draghi, said that if the participants put Europe's fiscal house in order, "other elements" would follow. The assumption was that this meant the ECB expanding its balance sheet to buy unlimited amounts of Italian and Spanish bonds, mirroring the quantitative easing programmes of the Bank of England and the US Federal Reserve. Draghi said on Thursday, however, that this was not what he had in mind.

What does this all add up to? It is not the big bazooka the markets were hoping for, and was never likely to be. Merkel wants to keep the euro together but is not prepared to take action that she thinks would fundamentally damage the German economy. Unlimited bond buying by the ECB appears to fall into that category.

We have what Steen Jakobsen, chief economist at Saxo bank, calls "extend and pretend": the "grand plan" is not yet in place, but a new deadline of March has been set for delivering one.

By that time, the eurozone will be in recession and the Italians and Spanish will be trying to raise the thick end of €500bn (£427bn) to finance their debts.

Countries on the periphery of the eurozone face a binary choice: either become more like Germany or try to leave the single currency in a manner as orderly and as dignified as possible.

Jakobsen said: "I foresee a "cardinal's meeting" in 2012, meaning that following a major drop in the stock market the EU will close the bond markets for a week or two and work out who is in, at what price, and what the loss is."

Europe is already on the cusp of a nasty double-dip recession, but be in no doubt, closing the markets for a conclave of the cardinals would spell utter disaster.

David Cameron will have spared the City of London from a financial transactions tax but the rest of the country will be laid waste. At that point, the summit will be seen in its true light: another lurch up a blind alley for Europe and a pyrrhic victory for Britain.