The European Council of June 28-29th may well be decisive for the future of the euro. Other summits since the beginning of the euro zone crisis two and a half years ago have taken measures to deal with the immediate crisis—measures which have required considerable commitments from the countries backing financial rescue mechanisms, and from the recipient countries in terms of measures to cut their government deficits. They have not, however, been sufficient to prevent the sovereign debt and banking crises from gradually deteriorating. Temporary improvements such as those after the well-regarded technocrat Mario Monti was selected as Italian prime minister in November 2011, have always been subsequently reversed. Whatever the reasons may be, two large countries, Spain and Italy, are now being charged market interest rates on government debt which if continued will force them into insolvency. There is, as the post below points out, room for criticism of some of the non-fiscal reform programmes in Italy. However, the fiscal austerity programme of Italy is a credible one and so is that of Spain’s central government, while concerns about the deficits of Spanish regional governments are being addressed. In both countries the fiscal tightening has brought about a new recession this year. This in turn reduces government revenue and so makes the process of deficit reduction more difficult.
There is an invidious choice that government policy makers have to make between allowing the recession to cause deficit reduction targets to be missed or further fiscal tightening which will make the recession even deeper and so may make the attempt to reach fiscal targets self-defeating. In the situation, both the Italian and Spanish governments can justifiably point out that they are doing everything that can reasonable be expected to address fiscal deficits. Moreover Germany and the creditor nations have obtained their objective of a new fiscal treaty which puts in place irrevocable commitments by all euro zone countries to eliminating deficits by 2016 and bringing down debt.
The situation is a vicious circle of fiscal tightening causing recession, which itself leads to a decline in investor confidence and higher interest rates causing the need for further fiscal tightening and ever deeper recession. The only way for this vicious circle to be broken is for Germany and other creditor nations to act to support Spain and Italy in an effective way at the summit. This could be done through short-term commitments of up to two years which ensure that pressure for continued fiscal prudence is maintained. The alternative is political disillusion with austerity in Italy and Spain and movement towards a break-up of the euro zone involving sovereign debt defaults and bank collapses whose cost directly and indirectly to the public finances of all euro zone countries, including Germany, would be catastrophic.