European Leaders Give Markets What They Wanted, For Now

Markets FOXBusiness

As was widely predicted, European leaders meeting at a critical summit in Brussels forged an agreement early Friday to impose more centralized fiscal discipline across the eurozone in an effort to contain Europe’s two-year-old debt crisis and, perhaps more importantly, prevent another one.

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It was, in effect, an agreement to agree on measures that need to be ratified into place via a treaty at a later date, hopefully in the first few months of 2012.

The announcement of a unified approach to austerity was enough to cheer global markets. The Dow Jones Average was up 163.44, or 1.36%, to 12,161.14 in midday trading. The S&P 500 and Nasdaq stock markets were also up more than 1% on optimism that Europe is making progress stemming a problem that has threatened global market stability for months.

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European approval was not unanimous, however, as Britain, Europe’s third largest economy, rejected the plan that would require countries to tighten their belts and stay within agreed upon spending and borrowing limits or face strict sanctions if they don’t.

Nevertheless, all 17 of the countries that share the single euro currency are on board, as are nine countries that would like to join the eurozone.

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More temporary measures to provide liquidity to rapidly deteriorating economies in Italy and Spain were also agreed to during meetings that ran into the early hours of Friday morning.  An additional 200 billion euros were provided to a bailout fund being administered by the International Monetary Fund geared toward Italy and Spain.

In addition, a 500 billion euro pool of money to be referred to as the European Stability Mechanism will go into effect by mid-2012 to supplement and eventually replace the existing 440 billion euro European Financial Stability Facility. Both are rescue funds set aside for future bailouts, if necessary.

In another key compromise, private sector investors in eurozone debt won’t automatically face losses if future bailouts require restructuring of European sovereign debt contracts. Private investors were forced to take a haircut in a Greek bailout hammered out in October, and it has put a damper on European private investment ever since, adding to the fear of contagion.

The path to European fiscal stability remains a tortuous one, however, even with Friday’s “agreement to agree,” especially in the short-term.

A deal of any kind by European leaders was supposed to act as a sort of quid pro quo with the European Central Bank under which the ECB, in response to the announcement,  would open its coffers for a massive bond-buying program to pump liquidity into countries-on-the-brink such as Italy and Spain.

But that doesn’t look to be the case.

“Unfortunately for indebted eurozone states, ECB President Mario Draghi appeared yesterday to back away from suggestions that the central bank would begin large-scale bond purchases in the primary market,” said IHS Global Insight analyst James Goundry.

If the ECB maintains that strategy and borrowing costs for debt-addled countries stay at their currently elevated levels, curtailing the ability of those countries to borrow and pay down their debts, investors could grow impatient, dragging down global markets.

The ECB has expressed its concern that a huge bond-buying program as a reward for promises of fiscal discipline would have the adverse affect of taking away any incentive for wayward countries to actually impose that discipline. Moral hazard, in other words.

There is also the ongoing threat of credit downgrades by the ratings firm Standard & Poor's, which earlier this week placed all 17 eurozone economies -- including Germany, the zone’s healthiest -- on warning that rating cuts were a possibility if Europe didn’t get its fiscal house in order.

Standard & Poor’s issued a similar threat to the U.S. last summer, and then acted on that threat when Congress and the Obama administration punted on an opportunity to forge a deal to lower the U.S. deficit. The historic downgrade of the U.S. credit rating sent markets into a tailspin for weeks.

Standard & Poor’s had no immediate response to the European agreement.

Another concern is what happens when individual countries attempt to approve and implement the proposed austerity measures at the local level. National leaders, under intense pressure from global markets to reach a deal, did just that. Local politicians feeling only the pressure of their constituents, many of whom are already facing hard times the result of earlier austerity measures, may not be as amenable when it comes to carving up already-thin budgets.

And what happens if a country that signs on to the agreement is later found to be in violation of its terms? It’s difficult to imagine eurozone leaders imposing some form of fiscal punishment on a country already struggling to keep its head above water.

Finally, there is the flip side to austerity -- the very real fear that governments tightening their collective belts will slow growth across Europe, increasing the likelihood of a severe recession.

One thing was certain on Friday: global markets got the headline they were looking for and investors cheered the news. The future is less assured.