The attention, at least in Britain, has been on the political rift with Europe. This week the attention turns to what is actually a vastly bigger issue: the very survival of the euro itself. The strategy to save it has three main elements.
First, there is the new "fiscal compact", under which the eurozone countries will promise to stick to strict rules for their budgets, their spending and their tax policies. This will be ready by March next year and will be under a new treaty – this is the business that we are staying out of.
Second, there will be more loans to support countries that cannot borrow on the markets. Quite how this will be done is not yet clear, but the European Union will try and find ways of beefing up its own funds, and there will be some more money via the International Monetary Fund.
Third, the European Central Bank will continue to pump money into the European banking system. It may – although this is contentious – also help governments finance themselves by buying more of their bonds.
So will it work? There are three key determinants. The first is the willingness of the global financial community to finance the weaker European governments and, crucially, the two biggest ones that are struggling, Italy and Spain. The second will be whether the weaker eurozone countries can recover their competitiveness vis-à-vis the stronger ones by squeezing down their wages and other costs. And the third is whether the European banking system can hold together under these strains. We will have some idea about the first issue by the early months of next year; resolving the second will take longer; as for the third, we just don't know.
In the early part of next year, both Italy and Spain have to refinance a vast amount of debt – something like €450bn. This is debt falling due for replacement. Even if those countries were running a budget surplus, which they are not, they would still have to issue billions of new debt. The idea of the fiscal compact is that lenders will have more confidence that the countries will be able to repay. The difficulty is partly that there was already a fiscal compact, called the Stability and Growth Pact, which failed, and partly that if a country cannot repay its debts, no pact will enable it to do so.
Lending weak countries money via the EU or IMF may postpone the problem, but the fact that debts are being piled up in this way may actually discourage other would-be lenders because they would be further down the queue in the event of a default.
As for regaining competitiveness, in theory it is possible for a country to cut its wages and other costs. Germany, which joined the euro at too high a rate, held down its wages and the country's living standards, for most of the past 10 years. Having started the decade with relatively high costs, it is now super-competitive. But that was a gradual process during a period of growth. Crash cuts in wages in a period of no growth, such as Ireland has been doing, are much harder to sustain. Greece clearly cannot manage to do this. As for Italy and Spain, they are being asked to behave like Germans, only more so.
Learning whether Italy and Spain can sustain such austerity may take some time, but there is a potential trigger. Greece is widely expected to default on its debt next year, with a good chance that it will also be forced to leave the eurozone. As and when this happens, that could provoke a swifter resolution for Italy and Spain.
As for the stability of European banks, it is now accepted that many will have to be refinanced. It seems likely both that governments will have to step in and support them (thereby adding to their own debts) and, in addition, the European Central Bank will have to pump even more money in. Its recent joint action with the other main central banks to do this was apparently because of rumours that a large French bank was about to go under. France does still have the financial fire power to rescue its banks, but the potential burden it faces has pushed up its borrowing costs.
So will it work? First, the new fiscal compact is a useful idea and will give more credibility than its predecessor. But the immediate problem is not that governments are being fiscally lax, for they are tightening like mad. So it does not help much in the short term. Getting Italy and Spain through the next six months will be on a knife edge. They may be able to raise funds at an acceptable interest rate; they may not. At the moment, no one can know.
Second, looking longer term, the level of austerity being forced on the weaker countries will cause great social and economic distress. The eurozone will go back into recession next year and will struggle to pull out. Can Italy and Spain regain competitiveness through austerity? Theoretically yes, but in practice it will be extremely difficult.
Third, can the European banking system hold together? Here it is possible to be more optimistic. Mario Draghi, the new president of the ECB, has demonstrated that the bank will, if necessary, pump enough money into the banking system to keep it going. That cannot stop a recession, but it will stop a catastrophic collapse of the European economy. Right now, that is a considerable relief.