Europe's new fiscal union: how big a step out of crisis?

Angela Merkel and Nicolas Sarkozy have proposed a pact to form a European 'fiscal union' with strict financial rules in parallel with the EU. But Britain has balked, leaving it the odd man out.

Politicians are praising it as a success, while economic experts see it with skepticism.  Either way, the latest European Union emergency summit in Brussels has agreed on a plan to fight the union’s sovereign debt crisis through further integration of the eurozone. But the proposal – drafted by Germany and France – appears to have done so at the cost of widening the rift between continental Europe and Britain.

After a night-long discussion, 26 of the 27 European leaders agreed to pursue what German Chancellor Angela Merkel and French President Nicolas Sarkozy call a fiscal union – a group of states within the EU which adheres to stricter budget rules and accepts sanctions if these rules are broken.

“What we have achieved tonight is a tremendous step towards a stable Europe,” Mrs. Merkel told journalists in Brussels on Friday. “This summit will go down in history,” President Sarkozy said.

The Franco-German plan was originally to change the Lisbon Treaty, the basic legal framework that governs the EU, making the amendments binding for all 27 members. But the UK refused to back the move on the grounds that it did not get an exemption from a planned financial-transaction tax. Britain's financial services sector accounts for about 10 percent of the country's economy.

To circumvent the British veto, France and Germany instead proposed a new treaty, in parallel with the EU treaty, to implement the proposed changes. Most of the current EU signatories agreed to the proposal. A number of countries like Sweden, Hungary, and the Czech Republic initially said they would first have to get parliamentary approval for the new proposal, but late announced they were prepared to sign the agreement, leaving Britain as the odd one out.

Many European economists were less enthusiastic about the plan than Merkel and Sarkozy. “Europe has moved a step toward solving the crisis,” says Ferdinand Fichtner of the German Institute of Economic Research in Berlin. “Stronger fiscal coordination is an important pillar for a stable currency union. But it does not address the main problem of struggling economies in southern Europe: lack of growth.”

The current course is one of government austerity, which could slow GDP growth even further.  Economists like Mr. Fichtner worry that without measures to stimulate growth, the money won't be raised to pay off debt.

A pact with lipstick?

Mario Draghi, the president of the European Central Bank, welcomed the summit’s outcome. “[The agreement] is going to be the basis for a good fiscal compact and more discipline in economic policy in the euro area members," he said. "We came to conclusions that will have to be fleshed out more in the coming days."

Mr. Draghi had made it clear before the summit that a stronger engagement of the ECB – for example, buying bonds from countries like Greece, Spain, or Italy – depended on the introduction of stricter budget rules. Making the ECB a lender of last resort is seen by many analysts as the only effective tool in solving the crisis.

“What has been agreed is definitely not a fiscal union,” says Simon Tilford, chief economist at the London-based Center for European Reform. “There is no shared budget, no joint debt issuance, no mechanism to transfer money between the participating economies. It is a stability pact with lipstick.”

Fiscal austerity alone would not solve the crisis, Mr. Tilford stressed, and what was needed was economic growth.

The details of the intergovernmental treaty for a fiscal union will be worked out within the next three months. British Prime Minister David Cameron played down the possible consequences of the UK’s absence in these negotiations, saying his country would not profit from taking part in these talks as it was not a eurozone member.

“Cameron’s strategy is very hard to comprehend,” says Tilford. “Britain will not be able to influence policy in a favorable direction if it isolates itself. It also does not help the European single market, which Britain is one of the most potent members of.”

Apart from reaching a deal on a fiscal union, the summit agreed on bringing the introduction of Europe’s new bailout fund, the European Stability Mechanism, forward by a year to July 2012, and that EU countries would provide €200 billion to the International Monetary Fund to help tackle the crisis.

Whether these measures are enough to convince global financial markets that Europe finally has a grip on the debt crisis remains to be seen. Tilford, for one, does not believe so. “A month from now there’s going to be another emergency summit.”