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What the European summit must accomplish

The outcome of the European summit is important not just for the future of Europe and the European Union, but also for the U.S. If Europe doesn't get its problems under control and conditions deteriorate further, that will affect the ability of the U.S. economy to recover.

So far the recovery in the U.S. has been tepid at best. Though there are signs that things are improving, presently we are simply treading water. There is just enough growth to absorb new workers entering the labor force due to population growth, but not enough to allow all the workers that lost jobs during the recession to be reemployed. We need an acceleration in the recovery at some point, and the sooner the better. If things don't pick up, we are looking at years before we get back to a more normal economy.

But an acceleration in the recovery is not going to happen if the troubles in Europe get worse. It may not happen in any case, but as I pointed out in a previous article, the U.S. and European economies are highly correlated, and trouble in Europe will also cause trouble here.

What problems must be resolved in order for the European outlook to improve? First and foremost, the EU must solve the sovereign debt problems that many countries in Europe face. The reasons for the problems vary by country. In some cases, such as Greece, it was excessive spending on social programs. Other countries, such as Ireland, had budgets that were in fairly good shape prior to the recession, but the fall in tax revenue from the recession has made it difficult for them to meet their obligations. But whatever the source, many countries in Europe are now facing debt troubles that must be resolved to calm financial markets.

The plan at this point is to alter the EU to impose debt limits, and, importantly, to add sanctions for failing to meet the debt limits (3 percent of GDP per year and no more than a 60 percent debt to GDP level overall are tentative guidelines). That's not a process that can happen quickly. It will take time to get a new treaty ratified -- if it can be ratified at all -- and the initial reaction of markets was negative. Thus, if that were all there was to the proposal, then the considerable time and uncertainty inherent in writing and approving a new treaty would leave financial markets just as nervous as before.

There is a mechanism in place to deal with this called the European Financial Stability Fund. The ESFS is a 440 billion euro fund backed by European countries empowered to make loans to troubled nations. However, doubts that the size of the fund is sufficient and the fact that it is temporary (it ends in June 2013) make it less than a fully satisfactory solution, as evidenced by the fact that the troubles persist. There is also a plan for a similar fund called the European Stability Mecanism to be established in 2013 to replace the EFSF, but the details of how the ESM will be funded are still unclear, and it is too far away to calm financial markets.

So what can be done? This is where support of the debt by the ECB comes into play. So far the ECB has been reluctant to support the debt of troubled countries through purchases of sovereign debt. However, a solid commitment to alter the EU treaty may give the ECB the political cover it needs to take a more active role in its capacity as lender of last resort. In this regard, market participants were disappointed that the ECB did not announce an asset purchase program at the end of its rate setting meeting on Thursday. It did cut the target interest rate by one percent, but that wasn't enough to calm market participants looking for a signal that the ECB will take a more active role once commitments to a treaty or some other mechanism to force debt reduction are in place.

If the summit fails, and if ECB refuses to act, there is another route that might work: the IMF. If the IMF can secure the necessary funding, then it could make loans to troubled countries. Failing this, there have also been discussions for the creation of Eurobonds, another way for European countries to jointly support the debt of troubled countries. But all of these programs hinge critically upon a credible debt-management program for the future. With a credible plan, there are several ways to proceed. Without a plan, the options are far more limited.

The second important problem the European leaders must resolve at their two-day meeting is how to divide up the losses. Somebody has to pay for the bad debts, but who? This is not an easy problem. For example, one key issue is the degree to which bondholders will be protected in a bailout. If bondholders are forced to take haircuts on their asset holdings, the fear is that they will stop lending and produce a Lehman like event -- and that is to be avoided. But if they aren't held at least partly responsible, then someone has to pay, and that someone is likely to be taxpayers. But why should taxpayers who had nothing to do with causing the problems be responsible for covering the losses?

Much of the fighting among EU countries is over who, in the end, will be forced to absorb the losses. Countries like Germany, who feel they made the hard choices necessary to keep their personal and national budgets under control (and thus had a surplus to lend to other countries), do not believe they should have to pay losses. Exactly how this is resolved is important. As we have seen in the U.S., if policymakers do not pay attention to who benefits from bailouts -- if the perception and reality is that bad behavior got rewarded when the financial system was saved -- the political fallout down the road could be significant. In addition, when bailouts are carried out in a way that is politically objectionable, it makes it all that much harder to help the system the next time it gets into trouble, since people will resist repeating the same set of policies.

I am more confident than I was a week or so ago that Europe will finally find a way out of this mess, but it is by no means certain that this summit will produce the needed changes, or that the ECB will respond as needed and finally fulfill its role of lender of last resort. For an economist, these are incredibly interesting times, but for everyone else, it's a time of great uncertainty. It seems as though a new problem pops up the minute the last one appears under control, and there is no end in sight. I'm hoping the summit in Brussels reduces that uncertainty, and there's a chance that it will. But there's no guarantee that the summit will produce the necessary agreements among European countries. This isn't over yet.

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