The agreement European leaders reached Thursday night was taken by some as a sign that the eurozone would avoid breakup. Not so fast. Economists, political leaders and other observers caution that the new pact does not go far enough to address the immediate liquidity crisis threatening European banks and governments.
To shore up those institutions, the European Central Bank would have to take more drastic action by buying up large amounts of government debt. And so far it's been unwilling to do that. On Thursday, ECB President Mario Draghi said that he was "surprised" by some observers' interpretation of his Dec. 1 comments that the ECB might buy large amounts of government debt.
Every country in the European Union except the United Kingdom agreed on Thursday to sign a treaty enforcing stricter budget rules on member nations. The treaty would give central European authorities the power to sanction countries that overspend and strike down national laws that break budget rules. The markets rallied only modestly after the news, with the Dow rising 186 points on Friday.
The agreement must be approved by the individual countries' legislatures, which could take three months, according to Reuters. It's unlikely that the ECB would step in to offer more aid until the pact has been ratified.
Some observers said that the ECB is deliberately delaying large bond purchases in order to extract as many concessions from European governments as possible. "It's been brinksmanship," said Diane Swonk, senior managing director and chief economist at Mesirow Financial. "It's an important negotiating lever, and it's important to understand, but it also doesn't rule out that they will do more."
Draghi hailed the agreement in Brussels, saying, "It's going to be the basis for a good fiscal compact and more discipline in economic policy." But he did not hint at any further government bond purchases.
Borrowing costs for troubled European countries eased slightly after the announcement of the agreement, but not nearly enough to stem the liquidity crisis. On Friday, interest rates on 10-year Italian government debt fell to 6.85 percent, and interest rates on 10-year Spanish government debt fell to 5.77 percent, according to Thomson Reuters. Economists say that interest rates of about 7 percent are ultimately unsustainable. Countries such as Italy, Spain and Portugal need interest rates on their long-term debt to fall to about 4 percent for their debt burdens to be ultimately sustainable, according to a July report by Wells Fargo Securities.
Nonetheless, the ECB is likely to bide its time in order to wring more reforms from European governments, Swonk said. She said it probably wants to wait until Italy implements structural economic reforms that would, among other results, make the labor market more flexible, although the ECB is running out of time as the European banking system grows weaker. Once the government debt crisis becomes a banking crisis, Swonk said, "There's no question that they'd step in at a full scale. They'd have no choice."
Swonk emphasized there is "no chance" that the ECB would stand idly by if the eurozone were about to collapse, since the ECB would become "irrelevant" if the eurozone broke up. But she said that because the ECB is concerned about the legality of buying large amounts of government debt and driving inflation, and because it wants to ensure that some governments do not overspend again, it will wait until the last minute to save the eurozone.
For the immediate future, however, the ECB does not appear likely to ramp up government bond purchases. Nicholas Economides, an economics professor at New York University's Stern School of Business, said he expects the ECB to "downscale" its intervention in the government bond market. He noted that Draghi has said publicly he believes European governments first need to get their fiscal houses in order.
"It's disturbing because the problem has not been solved, but they think they have solved it," Economides said of Thursday's agreement.
To actually resolve the liquidity crisis, Economides said, either the ECB would need to ramp up its purchase of government bonds, or the European Financial Stability Facility and the European Stability Mechanism -- two bailout funds -- would have to be expanded to contain enough money to be capable of bailing out both Italy and Spain and still have some money left over. The magic number is about 5 trillion euros, or $6.89 trillion. If the bailout funds were large enough to be credible, he said, they ultimately would not need to be used.
Jay Bryson, global economist for Wells Fargo Securities, said that Thursday's agreement provides some political cover for the ECB to increase government bond purchases, although he does not expect Draghi to announce massive purchases anytime soon. Bryson added that although the ECB is reluctant to cause inflation by printing large amounts of money to buy government debt, it would do so at the last minute.
"In a push-comes-to-shove sort of moment, if they had to do it, they would do it," Bryson said.