Significance: The latest European Union (EU) summit has resulted in an early agreement on the establishment in 2013 of a permanent bailout facility, the European Stability Mechanism (ESM).

Implications: The ESM will secure funding contributions and also share the costs of potential crisis packages with bondholders in the private sector.

Outlook: EU agreement on the ESM will help achieve the main objective of Eurozone stability, although discrepancies are apparent between the approaches of Northern European governments and other member states.

A two-day European Union (EU) summit concluding today has resulted in an early agreement on a permanent bailout facility, the European Stability Mechanism (ESM). The ESM is to be established in 2013 and will provide emergency loan assistance for potential future financial crises in the 16 Eurozone countries. EU leaders have also agreed on a change to the Lisbon Treaty to allow for this permanent facility. Following yesterday's meeting, EU president Herman Van Rompuy announced, "Member states whose currency is the euro may establish a stability mechanism, to be activated if indispensable to safeguard the stability of the euro as a whole." He also said that the EU was ready to take the necessary steps in order to protect the euro. However, the president warned that Eurozone governments needing emergency aid would be forced to implement stringent measures to tackle their countries' debt or budget deficits, with strict conditionality clauses applied to the bailout fund. The focus during the summit on safeguarding future Eurozone stability comes after Greece and Ireland have received multi-billion-euro bailouts from the EU and International Monetary Fund (IMF).

Working Out the Details

It was agreed at yesterday's meeting that after 2013 the permanent ESM facility will replace the temporary bailout fund currently in place, the European Financial Stability Facility (EFSF). The EFSF is worth some 750 billion euro (US$997 billion) and is presently providing crisis assistance to Ireland. The main difference between the two funds is that the future ESM facility will share the costs of potential crisis packages with bondholders in the private sector, although restructuring required of Eurozone countries will take place on a case-by-case basis. It is expected that this will be ensured by inserting collective action clauses in new bond issues, raising the chances of obtaining agreement from creditors on changes to bond maturities or values. The ESM will meanwhile follow IMF procedures, in that governments must abide by debt-reduction procedures in cases of insolvency (although this scenario is unlikely, given that no advanced economy has actually defaulted since the Second World War).

EU leaders also agreed to reopen the Lisbon Treaty, which only came into force last year, in order to provide a legal framework for the new ESM facility. The European Commission indicates that there is already agreement over the precise wording for the ESM, which will involve the addition of only two more sentences to the treaty. Fortunately for the EU, in view of the years of trouble securing member state approval for the Lisbon Treaty, it will be possible to approve the treaty change through a technical procedure and the process should be completed quickly.

Leaders at yesterday's meeting also agreed that the United Kingdom and other EU countries that do not use the euro currency are not obliged to contribute to the permanent fund. U.K. prime minister David Cameron has claimed to his domestic audience that as a result of his government's insistence at the summit, the United Kingdom will now be insulated from having to contribute to future bailouts. Cameron says that although the United Kingdom supports the ESM, it should not have to participate in the debt burden. However, although the United Kingdom has secured this commitment, this involves a political arrangement rather than a legally binding agreement.

Northern European Governments Emphasise Fiscal Austerity

Despite the consensus achieved yesterday over the ESM and the extra clauses in the Lisbon Treaty, it appears that a core group of northern member states has emerged with a more fiscally conservative vision for the Eurozone. Germany, the Netherlands, Sweden, and Finland have all demanded that the EU reinforce fiscal austerity across the EU and implement budgetary regulations that would fine governments bending the rules. In fact, Germany was the principal protagonist of the campaign to create a permanent bailout facility. Germany has favoured such a mechanism in view of its large contribution to the EU's multi-billion-euro bailout of member states during 2010.However, as a result of Germany's strong stance over fiscal austerity, the government has been accused of being "un-European" by other member states. Still, German chancellor Angela Merkel does not appear to be backing down.

Germany and other member states have also refused to accept a short-term increase in the 750-billion-euro EFSF emergency fund, as proposed by Belgium. The staunch opposition from some member states to raising the current crisis fund is thought to be behind a negative reaction on the markets yesterday, with most European bond markets falling. Meanwhile Germany, backed by France, has also strongly resisted a recent Luxembourg-Italian proposal suggesting that the release of joint Eurozone sovereign bonds would help reduce borrowing costs of indebted governments. In fact, Germany and France have moved closer over addressing solutions to the Eurozone crisis. Last week, German and French leaders met to discuss labour and tax policy harmonisation in order to create more fiscal convergence and hopefully more stability within the Eurozone.

Outlook and Implications

The EU summit follows months of concern about the stability of the Eurozone, with national budget deficits far exceeding the bloc's limit of 3% of GDP. In particular, after Ireland was forced to request an international bailout in November, the markets have turned to Spain and Portugal for signs of default. Today, the credit ratings agency Moody’s has severely downgraded its Irish sovereign rating. As a result of the continuing fears, the European Central Bank (ECB) is currently taking action to almost double its reserves—from its current 5.8-billion stock to 10.8 billion—by buying sovereign debt of those countries perceived as most vulnerable within the Eurozone. The appearance of differences between member states over measures to tackle the crisis is therefore unhelpful at the present time. International investors will no doubt question why Germany and other member states are not prepared to increase the present EFSF mechanism. Although the EU agreement is intended to induce stability in the Eurozone, the focus is very much on the future. Nonetheless, the attainment of an EU consensus over the ESM is an important achievement and it is useful that the large Eurozone economies—Germany and France—are seeking to co-operate more closely over harmonising tax and labour policies. It is also evidently crucial that profligate governments face more stringent monitoring and penalties in the future.

Over the past week, the bloc's leaders have also agreed to next year's EU budget, so the path is now clear for longer-term discussions over the EU's multi-year financial framework, which covers the years 2013–20. Until now governments have stayed well clear of this issue—even the net contributing countries—because of the potential for discussions to spiral out of control at a time when the crisis in the Eurozone is dominating media headlines.