European Leaders Reach Deal Addressing Financial Reforms

Sources:

Financial Times: Eurozone Leaders Reach Deal on Key Reforms

Financial Times: Europe Debt Deal Spurs Relief Rally

WSJ: Debt Deal Provides Wrong Incentives

The 17 eurozone heads of government reached a deal addressing key financial reforms during an emergency summit in Brussels last weekend. Leaders were under additional pressure to come to an agreement on these measures. In the weeks leading up to the summit, new financial issues arose as much of Europe continues to suffer from financial instability. Moody's downgraded Greek debt and Greece removed its chief tax collector from office when the government discovered that he failed to raise tax receipts to the necessary levels in order for the country to close its budget gap. Net revenue in Greece fell from €3.15 billion in February 2010 to €2.85 billion this year, reaffirming that it is unlikely that Greece will meet its revenue target.

Further, interest rates on Portuguese debt are approaching 8% as Chinese rating agency Dagong downgraded the debt. Despite this fact, along with the fact that Portugal's economy has grown at a rate below 1% over the past ten years, Portuguese officials maintain that the country does not need a bailout. Moody's also gave Spain a negative outlook and downgraded Spanish government debt. Spanish officials admit that its banks need to rise just over €15 billion in capital, but Moody's estimates that a more accurate figure lies between €40-50 million.

Eurozone leaders reached an agreement that they hope will address these problems. They increased the lending capacity of the European Financial Stability Facility, the rescue fund that was created in 2010, to €440 billion. This will enable the Facility to bailout additional eurozone countries if necessary. While the Facility is set to expire on 2013, the leaders agreed on replacing it with the European Stability Mechanism, which will be able to lend as much as €500 billion. Some officials, including European Central Bank President Jean-Claude Trichet, argued that the Facility should be able to do more than just bail out struggling economies. However, the leaders settled on a more limited agreement: the funds can only buy bonds directly from a country in a financial crisis, and only once its government agrees to austerity measures.

The leaders also agreed to offer Greece and Ireland, the two countries who have already received EU bailouts, an easing in the terms of their loans in exchange for Greece and Ireland taking on additional austerity measures. Greece already agreed to the deal, and will sell €50 billion of government assets and receive an interest rate reduction on the EU's portion of its €110 billion bailout of one percentage point (to a rate of just over four percent). The leaders also granted Greece an additional three years to pay back its loans, giving it 7.5 years instead of the original 4.5 years. In spite of these adjustments, some have argued that due to the size of Greece's debt, these changes will have a very small effect on whether Greece eventually defaults. Ireland rejected the deal, as Edna Kenny, the new Irish Prime Minister felt that the proposed austerity measure—that Ireland increase its corporate tax rate, which is currently set at 12.5 percent—was too costly.

The deal also includes a pact (an agreement on principle with no enforcement mechanism) committing each country to measures that aim at increased economic coordination. This pact includes caps on government spending, increased monitoring of pension plans, and limits on wage increases for public sector employees. Finally, the deal includes a commitment to force countries to reduce their debts in order to comply with the EU's legal debt limit, which currently stands at 60 percent of gross domestic product. The leaders agreed to reduce debt levels by five percent each year.

At least in the short term, these measures may be successful. On Monday, the euro rose against most currencies and European bank bonds rose as well. Greece's stock market rose by 5.15 percent and its bond market saw its biggest increase in two months.