Questions Plague EU Pact

Europe's Leaders Agree to Repair Flaws in Currency, but Bold Strokes Missing

By CHARLES FORELLE And STEPHEN FIDLER

The Wall Street Journal

…Europe's leaders crafted a new "fiscal compact"… But the crucial government bond markets were mostly flat…

… It's unclear how quickly the pact could actually go into effect…

… U.K. Prime Minister David Cameron vetoed an EU-wide treaty… renewing questions about the future of the relationship…

… Euro-zone members who run outsize government deficits will face automatic penalties, … governments will put balanced-budget procedures of some form in their national laws…

… The only question that the market is currently asking is whether the political deal opens the way for more forceful intervention by the ECB…

… The months ahead will be filled with serious challenges…

BRUSSELS—Europe's leaders crafted a new "fiscal compact" to repair flaws in their currency union, but the deal lacked bold strokes investors have been urging and it could be insufficient to halt the region's debt crisis.

Markets reacted with tepid optimism Friday. U.S. stocks rose. The Dow Jones Industrial Average climbed 186.56, or 1.6%, to 12184.26. European stocks were also generally higher, and the euro rose slightly. But the crucial government bond markets were mostly flat.

The positive reactions appeared to be driven by relief that leaders had reached an agreement at all, rather than enthusiasm for the deal itself. If recent history is any guide, the glow could fade fast as investors focus on the details, or on a continued lack of clarity over what role the European Central Bank will play.

"The summit was the first step toward fiscal integration, which is a problem we need to solve, but it will be a long, drawn-out process," said Mohit Kumar, head of European rates strategy at Deutsche Bank in London.

At its core, the pact is a series of relatively small steps. A long-envisaged permanent bailout fund would arrive sooner than planned. The "quasi-automatic" sanctions imposed on violators of budget rules would henceforth be "automatic." A requirement for private creditors of bailed-out countries to suffer losses under certain circumstances would be softened by moving it to the preamble of a legal document.

It's unclear how quickly the pact could actually go into effect. In the best case, Friday's outcome presages months of continued wrangling.

Even as most European Union nations came together for the agreement, the summit also sowed a sharp division: U.K. Prime Minister David Cameron vetoed an EU-wide treaty to enforce the new fiscal rules, further isolating his country from the majority of the bloc and renewing questions about the future of the relationship.

After a marathon session of negotiating that started Thursday and ran until early Friday morning, the leaders emerged with two principal achievements: Euro-zone members who run outsize government deficits will face automatic penalties, and all governments will put balanced-budget procedures of some form in their national laws.

Both provisions have been floated before, and both are designed to address one of the currency union's central flaws: The 17 euro-zone countries share a central bank and a monetary policy but have little practical control over one another's spending decisions.

The final deal was, as most European agreements, a compromise between the Continent's pair of big powers. Germany, the bloc's chief disciplinarian, scored many points by just getting a fiscal pact at all. France, whose banks are big holders of weak euro-zone government bonds, got Germany to relax somewhat its insistence that private creditors of bailed-out countries face the potential of losses on their debt holdings.

In the end, though, the compromise meant no far-reaching changes are in sight. As the crisis accelerated through the summer and fall, a flurry of proposals emerged for big changes to the bloc's core structures—such as common euro bonds for raising debt, or a "European finance minister" with sway over national budgets. The ideas quickly died in the face of resistance from Germany and other countries.

The ECB welcomed the deal but gave no hint that it was prepared—as investors had hoped—to undertake massive purchases of euro-zone debt to prop up the region's bond markets.

In the opinion of most outside economists, and a growing number of policy makers inside the bloc, only the ECB with its unlimited ability to create euros has the firepower to build a backstop capable of ensuring heavily indebted Italy has continued access to financing. But the ECB has said it won't consider such big steps unless governments put their fiscal houses in order.

"The only question that the market is currently asking is whether the political deal opens the way for more forceful intervention by the ECB in the sovereign debt market," said Jacques Cailloux, chief euro-zone economist of Royal Bank of Scotland in London.

It wasn't clear after Friday's session just what the ECB would do. ECB President Mario Draghi, who attended the meeting, said simply that the agreements formed a "good basis" for a fiscal compact.

What was clear was that the euro-zone governments are counting on the ECB to sail to the rescue. They took only minor steps at the summit to beef up their own bailout funds to fight the crisis, agreeing that their permanent €500 billion ($669 billion) bailout fund would start operation in 2012, a year earlier than planned.

But at Germany's insistence they also retained a €500 billion cap on the combined size of the existing temporary fund and the new permanent fund, meaning that accelerating the new fund will have little practical impact on the amount of cash available.

The euro-zone countries, along with several other EU countries that don't use the euro, agreed to provide €200 billion to the International Monetary Fund, generally through their central-bank reserves. Those funds would expand the resources that could be used in the crisis.

Germany had initially pushed for full-scale revisions of the European Union's founding treaties, a move that would deeply enshrine the fiscal pact in EU legislation and, just as critically, give the EU institutions the authority to enforce it.

But treaty changes require unanimous consent of all 27 EU members, and several—including Ireland and the Czech Republic—all signaled they'd have difficulty ratifying the changes. The idea died entirely with the opposition of the U.K. Mr. Cameron sought a laundry list of concessions on banking regulation in return for a treaty change.

There was little appetite to give him that, and EU leaders instead settled on an "intergovernmental agreement" among a subset of countries. Such a deal can in theory be ratified more quickly than treaty change, though it has less legal muscle

"We will make the best of it," EU President Herman Van Rompuy said after the meeting, adding that the pact would be "as binding as possible." Mr. Van Rompuy said at least 23 and as many as 26 countries would sign up to the pact.

The months ahead will be filled with serious challenges. EU lawyers will set to work next week on wording for the proposed new accord, which leaders hope will be ready for approval by March, after which it will be sent to national parliaments for ratification. In the best case, that could take a further two to three months. It's not clear whether a popular referendum will be needed in Ireland, which could seriously delay the timetable.

Finnish officials indicated they are opposed to a plan to permit the new bailout fund to act by supermajority instead of unanimity.

One particular complication is the bid to make sanctions automatic. It recycles an idea that the euro zone rejected in October 2010. At that time, the European Commission, the bloc's executive arm, proposed that penalties for violating the fiscal rules be automatically imposed; unless the countries voted affirmatively to block them, they'd stand.

The longstanding rules work the other way around. Penalties are imposed only if countries vote for them. That led to the ignominious spectacle, in 2003, of France and Germany each breaking the deficit ceiling and each voting against condemning the other, killing enforcement efforts.

—Geoffrey T. Smith, Tom Lauricella and Sudeep Reddy contributed to this article.

Write to Charles Forelle at charles.forelle@wsj.com and Stephen Fidler at stephen.fidler@wsj.com