Economic Forecasts

Europe Pulling Back from the Brink

Stronger economic ties show nations' willingness to preserve the euro and presage even more unification in years to come.

Is Europe really getting its act together? It sure seems so, following recent agreements for greater unity on fiscal and banking matters -- critical to saving the common currency.

Of course, the immediate problems persist. The euro zone is facing a recession, with the economies of Spain, Portugal, Italy and others already in contraction. There’s still a good chance Greece will have to leave the euro zone to reverse its fate, and nations need to address bloated national budgets and piles of debt. Also, financial markets are far from settled over rising bond prices in peripheral countries.

But the crisis is convincing Berlin, Paris, Rome, Madrid, Dublin, et al. of the need to relinquish more of their sovereignty to preserve the common currency. Euro-area leaders beat expectations when they announced flexibility for emergency funds to bail out Spain’s banks and agreed to a single euro-area banking regulator. The agreement to give up more autonomy to a centralized European government paved the way for a 0.25-percentage-point rate cut by the European Central Bank.

By year-end, expect a more unified banking system to start taking form. At its core: central oversight of the largest transnational banks by a single regulator, most likely the European Central Bank. National regulators will likely remain the guardians of smaller financial institutions.

Deposit insurance, similar to the U.S.’s Federal Deposit Insurance Corporation, will be needed across euro nations to lessen chances of bank runs. Plus euro-zone regulators will decide how to handle future banking failures and speed up implementation of a global standard of capital requirements, agreed to last year as part of the Basel III accord.

Implementation will be key, though. Euro leaders still need to work out details of more unified banking regulations. There could be significant changes by mid-2013, but reforms could come much more slowly if revisions of euro-zone treaties are needed. Details of a proposed financial transaction tax will also need to be worked out. The tax, to help cover losses at European financial institutions, is likely to chase some business away from Europe to the U.S.

New, tougher common fiscal rules -- agreed to last March -- are likely to kick in at the start of 2013, as more European Union members ratify the pact. The aim: to ensure that European Union members toe the line of fiscal responsibility. Three members have already ratified the new treaties. Seven more, including Germany, are well along the way. When 12 of the 25 signatories ratify it, the pact goes into effect. Britain and the Czech Republic didn’t sign on to the agreement.

Ultimately, a tighter political union for Europe is likely to follow the banking and fiscal pacts. Centralized fiscal policy needs to be supported by the power to tax and spend. Because it requires the sacrifice of national autonomy, this will be the toughest step for European nations, but the handwriting is on the wall and with each new crisis, resistance erodes.

For the U.S, a more cohesive, unified Europe is good news, both in the short and long terms. Cross-border reforms there will help stabilize a global financial system still showing strains. They’ll ease some worries about economic spillover in the U.S., China and India. A more united Europe will be a more robust export market for U.S. products and a more potent ally on the geopolitical front on issues such as Iran’s nuclear ambitions.

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