A New D-Day for Europe

On Friday, December 9^th the leaders of the European Union (EU) meet in Brussels, Belgium.  Guidance from these leaders has set market expectations of progress towards achieving agreement in principle of significant revisions to the EU Treaty, bringing about greater fiscal union that enforces fiscal discipline.  The absence of sufficient agreement over fiscal controls has been the core problem within the 17 countries that share the Euro as their currency.

 

There will be many challenges to reaching agreement over greater fiscal union, but the core challenge is that of political courage.  Will the European leaders recognize that some of their sovereign autonomy, possible even their political jobs, must be sacrificed in order to preserve the Euro Zone?

If the leaders can summon sufficient courage and begin to work towards true fiscal union, then the European Central Bank might reasonably be expected to act as the lender of last resort and begin to purchase bonds of the various countries in large enough quantities to stabilize the markets.  They may also move towards issuing Euro bonds backed by all of the countries.  All of this would begin to lessen the huge cloud of Euro concerns that has rocked markets.  This would be no quick fix, but would choose the path that would preserve the Euro Zone.

If the Dec 9th summit proves a bust, it may well be followed with a disorderly process of European common currency implosion and accompanying market volatility.

What will the European Central Bank Do?

Investors are quickly losing faith in one of the world’s largest sovereign-bond markets, driving the yield on the benchmark 10 year Italian bond up to 7.45%.  Rates are at their highest level since the inception of the euro.  Italian Prime Minister Silvio Berlusconi pledged Tuesday to step down after Parliament approves austerity measures intended to reassure investors and ensure that Italy remains able to borrow.

The new President of the European Central Bank (ECB), Mario Draghi may have to aggressively print Euros to buy Italian government debt.  The primary objective of the ECB is to maintain price stability within the Eurozone, which is the same as keeping inflation low. The ECB Governing Council defines price stability as inflation of around 2%.  Mr. Draghi cut short-term interest rates in his first meeting.  Certainly he doesn't want to aggressively expand the Euro, but given the recent interest rate spike, it appears he will have no choice but to buy Italian bonds to support their prices (and bring their interest rate down).  It is somewhat notable that Mr. Draghi is Italian, so he is likely feeling extra pressure.