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July 2, 2012

Europe’s landmark debt deal explained: implications, and why financial markets sighed in relief

by Rylan Stewart
European-parliament-strasbourg-inside

European Union leaders took a step towards resolving the seemingly ever-present “European Debt Crisis,” which has dragged on global markets and raised doubts as to the viable future of the monetary union for several years. The new plan tests the limits of European integration, suggesting the fundamental question: who pays when Europe-wide collective action is necessary? Should German citizens (for example) pay to bail out failing Spanish banks?

Last Friday, June 29, European leaders agreed upon the guidelines for a plan that supports national regional banks, cuts back on mandatory austerity measures, and reshuffles expectations for debt obligations. The move brings the European monetary union closer to shared economic responsibility, and suggests a greater level of integration and cooperation.

The agreement relieves stress on the governments of Spain and Italy, the third and fourth largest economies in the Eurozone. Caught between growing government debt and struggling national banks, the cost to borrow money to keep the government solvent skyrocketed, reducing the ability to react to recession and bail out the stretched banking industry.

The two aspects of the “European debt” struggles are government debt (and the higher costs of borrowing during the recession) and the banking crisis (compounded by shaky real estate loans and investments in government debt). The Associated Press explains the banking crisis:

“Europe doesn’t just have a government debt crisis. It has a banking crisis, too. A collapse in housing prices buried Spanish and Irish banks in bad real estate loans. At the same time, banks across Europe have been the biggest buyers of their governments’ bonds. So as yields have surged and the bonds have declined in value, banks have suffered losses.”

To cope with bank troubles, the new plan calls for the creation of a wing of the European Central Bank, which will be empowered to loan money directly to European banks, shut down failing banks, oversee loan programs, and insure bank deposits across European borders.

Prior to this plan, the Central Bank could only loan money directly to governments, and compensation came with an expensive price tag: mandatory austerity measures. Now, European institutions are empowered to respond to regional banks and relieve stress from debt-strapped governments without enforcing mandatory fiscal policy.

As a result of this move, government borrowing costs will drop.

The general perception is that German chancellor Angela Merkel ceded ground, despite overwhelming opposition in her own country.

The argument gets down to one of the central problems of the EU organization: should citizens in Germany pay for the speculation and failure of small Spanish banks? Or must investors/lenders take the mark down (thus increasing the cost for struggling European governments to borrow money)?

Put broadly, what happens when a country or a region needs a bailout at the risk of dragging the Euro down and spreading contagion? Who pays? How will individual countries share debt to avoid dragging each other down?

Financial markets responded positively with the move, although it is understood that further steps must be taken before a long-term solution is formed.

 

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