Susana Vera / Reuters

Europe divided on Friday in a historic rift over building a closer fiscal union to preserve the euro, with an overwhelming majority of countries led by Germany and France agreeing to forge ahead with a separate treaty, leaving the EU’s third biggest economy Britain isolated.

By John W. Schoen, Senior Producer

Europe’s high-profile agreement Friday to get tough on runaway government spending may help prevent euro zone countries from stacking up bigger piles of debt. It will do little to ease the mounting financial pressure on the European banking system from the borrowing binge that has pushed Greece, Italy and Spain to the brink of default.

Europe’s financial crisis has already sapped consumer and business confidence, tipping the euro zone into a mild recession. As the American economy has strengthened in the last few months, the threat has eased that Europe’s recession could send the U.S. back into a “double dip” downturn. But a meltdown of one or more of Europe’s big banks could pose a serious threat to the outlook for global growth. ? ?

Under the deal unveiled in Brussels, the 17 countries bound by a common currency agreed to introduce laws that would cap their national spending deficits. Countries that overshoot that limit would be hit with automatic penalties unless a majority of members overturned them. The inter-governmental pact, which doesn’t require voter approval through national referendums, is supposed to be ratified by mid-March.

The deal may boost investors confidence that Europe’s free-spending ways are over. It does little to head off the risk that one or more governments default on their debts. ??

“This is a great leap sideways,” said Daniel Gros, director of the Centre for European Policy Studies think tank in Brussels. “We now have a framework that in 10 years time could restore a degree of fiscal order to the euro zone. The German view is that this is all that is needed to convince markets to buy Spanish and Italian debt. I have my doubts that it will be enough. I think the tensions continue.”

Earlier this week, credit rating agency Standard and Poor’s also expressed doubts about whether Europe’s leaders could come up with a convincing reponse to the ongoing debt crisis, warning that it might?downgrade 15 euro zone countries, including Germany and France, along with?a number of large European banks. S&P said Friday it was reviewing the plan and woiuld make a decision on any ratings changes int he next few days.

There had been high hopes?that the latest plan, the eighth floated this year,?would be accompanied by more immediate measure to backstop Europe’s banks, which are heavily invested in shaky government bonds. But the summit offered little to reassure investors on that score.

“Germany should feel pretty good about the fact?that they got the promise of long term fiscal discipline,” said David Joy, chief market strategist for Ameriprise Financial. “But that still brings us back to: Who is the lender of last resort until we get there over the next 18 months, 24 months. Is the (European Central Bank) going to?step up? We’ll find out during the first quarter when (European governments) come to markets with a sizable amount of debt to roll over.”

Italy and Spain have the biggest debt piles in need of refinancing early next year; Italy has to sell 150 billion euros worth of fresh debt to cover bonds coming due between February and April. That refinancing has become more costly as investors have demanded higher interest rates to offset the risk of a default. Higher borrowing costs, in turn, add to Italy’s deficit, forcing it to borrow more to make up the shortfall.

Europe’s central bankers continue to balk at the idea of a wider response that would include large purchases of distressed government bonds similar to the market-calming moves engineered by the Federal Reserve when the U.S. banking system seized up in 2008. ?On Friday, ECB sources told Reuters that it has capped its weekly bond purchases at 20 billion euros.

Earlier in the week, Europe’s central bankers announced a series of measures to try to calm the financial markets and head off a looming credit crunch. The ECB cut its key lending rate by a quarterpoint to?record low 1 percent. It also eased its rules on the quality of assets banks can use to back loans, lowered the level of reserves banks have to hold and increased the term of central bank loans to three years from one.?

The moves may have helped stabilize the deterioration of the European banking system, for now. But they don’t go far enough to fix the problem, according to David Malpass, president of economic research and consulting firm?Encima Global LLC and former Treasury Department official.

Britain is cutting an isolated figure in Europe today after Prime Minister David Cameron effectively vetoed a treaty change across the European Union to tackle the Eurozone crisis. ITV’s political correspondent Chris Ship reports.

“These are more of a Bandaid than a fix of the underlying fundamentals,” he said. “The problem is that banks can?t afford any further write-offs of sovereign debt, yet there?s no plan by Germany to stop the contagion from Greece into Spain and Italy.?

European regulators, meanwhile, said this week that?euro zone banks need to raise 115 billion euros of fresh capital, which will put further strain on their ability to lend to businesses and consumers.

Friday’s summit also left unresolved the fate of a patchwork of backup funds that could be tapped if one or more governments default. Germany has opposed expanding these bailout funds, the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM). German Chancellor Angela Merkel blocked a proposal to give the ESM a banking license to allow it to borrow money from the European Central Bank.

The Brussels summit also agreed to allow the International Monetary Fund to lend as much as 200 billion euros to help Italy and Spain work through the refinancing crunch they face early next year. But that, too, is seen as a short-term fix. Those funds aren’t nearly enough to backstop a full-blown default; Italy alone has nearly 2 trillion euro in total debt outstanding.?

Source: http://bottomline.msnbc.msn.com/_news/2011/12/09/9328603-euro-pact-is-a-great-leap-sideways

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