Prospects Are Good for New Plan from Merkel, Sarkozy

A new plan from Sarkozy and Merkel could be framework for lasting EU stability.

By + More

Finally, the clouds appear to have broken in the European debt crisis.

No, seriously. For real this time.

A new proposal, outlined by German Chancellor Angela Merkel and French President Nicolas Sarkozy this week may contain just the structure and discipline the euro zone needs to finally reach the "endgame" that has been forecasted time and again for months.

[Read analysis of the latest U.S. jobs report.]

The new plan calls for a "golden rule"—a sort of balanced budget amendment—to be written into the constitutions of all 17 euro zone member states. And any deficit those countries might run would have to be small—less than 3 percent of GDP. Any country exceeding this limit would suffer automatic sanctions. In addition, the leaders agreed on measures to again boost the European Financial Stability Facility, the EU's bailout fund.

The combination of enforcement mechanisms amounts to a sort of "belt-and-suspenders approach," says Jacob Funk Kirkegaard, research fellow at the Peterson Institute of International Economics, and he is optimistic about the potential for success.

"When you start addressing the underlying political reasons for a crisis, you are now amending the European treaty, and that's the biggest possible political step you can take. ... I do think that certainly in terms of the political response, this marks a turning point."

So the game plan is laid out, and it is now up to the euro zone members to play along. This week European leaders will again tackle the debt crisis at a meeting in Brussels, and the Merkel-Sarkozy plan could very well be the starting point for a broader agreement.

Fortunately, the prospects for international consensus look bright, despite the difficulties of bringing together 17 euro zone countries, each with its own interests. The European Union's stubborn sense of unity can perhaps best be understood through the analogy of marriage, says Adolfo Laurenti, deputy chief economist at Chicago-based financial services firm Mesirow Financial.

"There's the Kardashian marriages that break down after three months. There are couples that are happily married for 50 years. And there are couples that hate each other, that cheat on each other, they keep fighting, and yet they still stay together. I think Europe belongs to this last category of marriages," says Laurenti. "They fight, they hate each other, but at the end of the day, they love each other enough to still be together."

Of course, markets can also provide strong impetus for change. Though Merkel and Sarkozy's agreement sent stocks upward and helped to lower borrowing costs in troubled Italy and Spain, ratings agency Standard and Poor's yesterday put 15 euro zone countries on negative creditwatch, signaling that downgrades of their debt are possible.

[See what would happen if there were no Federal Reserve.]

Though a new agreement might signal the start to a long-awaited European endgame, Europe's economic troubles are far from over. Reduced government expenditures could easily bring down already anemic GDP figures. Today, the euro zone reported GDP growth of 0.2 percent for the 3rd quarter of 2011, and EU GDP may soon dip into negative territory.

"We expect Eurozone recession to occur in late-2011 and the first half of 2012 in the face of the ongoing Eurozone sovereign debt crisis," wrote Howard Archer, chief UK and European economist at IHS Global Insight, in a commentary on the new GDP figures this morning.

In addition, changing the European Union treaty—not to mention potential referenda and changes to member countries' constitutions—would require a lengthy process. Though the world might applaud a new agreement, says Laurenti, "I think it's very reasonable to be extremely cautious about the timeline and the political process that will need to be followed in order to get the new treaty in place." He believes that it could be two or three years before new measures could be fully implemented.

Indeed, enacting such sweeping changes would likely take considerable time, but it is worth noting that fixing a behemoth economy like the European Union is a daunting task. "Changing the European treaty is a permanent thing," says Kirkegaard. "This is the week in which the permanent political response has begun."