Europe Wins a Battle, but Not Yet the War

(to)...create a new common bank-resolution authority for the euro zone...
The first is political and Italian
The next risk is political and German
A further risk is technical and possibly Spanish
The next risks are Hellenic

Thursday morning's accord to create a single policeman to oversee important banks in the currency bloc capped a difficult year for euro-zone governments. Nonetheless, they succeeded in keeping their currency area intact in the face of predictions that they would lose at least one of their members.

"Those Cassandras have been proven wrong," said Olli Rehn, the European Union economics commission referring to those who forecast a Greek exit from the union. (And perhaps forgetting that Cassandra, prophetess of ancient Troy, was always right.)
Yet the battle to save the euro isn't yet won and any expectation that 2013 is going to be easier for the managers of the common currency is likely to be disappointed—as even Wolfgang Schäuble, the German finance minister, appeared to acknowledge on Thursday. "To say that everything is over now would be wrong—in spite of Christmas," he told reporters in Brussels.

The risks next year come in several stripes.

The first is political and Italian. Financial markets will hang on the outcome of Italy's general election early next year—as plainly shown by the rise in Italian government bond yields this week in reaction to former Prime Minister Silvio Berlusconi's reappearance on the wings of the political stage. Even if some continuity in economic policy now seems the most likely outcome from the election, hints of instability or a resurgence in what investors view as political populism could prove very unsettling.

The next risk is political and German. It's not that German elections in autumn are going to overturn the established order—Chancellor Angela Merkel is a strong favorite to remain in her post. But Germany dictates the pace of the euro zone's action and Berlin's appetite for doing more will probably wane as the election approaches.
That may hamper efforts to create a new common bank-resolution authority for the euro zone—a central power to wind down failing banks. That is needed as the next stage of the euro-zone banking-union project. But negotiations are likely to be more difficult than those for setting up the national banking supervisor—partly because of the more important financial consequences for national governments of ceding the authority to wind down banks.

A further risk is technical and possibly Spanish. Investors and analysts agree that the relative calm that has settled on the euro-zone's troubled bond markets in the second half of this year has been mostly due to the European Central Bank's commitment to step in to support prices of government bonds of those countries that agree to an international aid program.

The Spanish government's heavy financing requirements for next year suggest to many analysts that it can't continue through next year without some form of official help. In fact, calmer bond markets reflect in part the expectation that Madrid will ask for help.

The ECB's Outright Monetary Transactions program is untested. Though it is potentially unlimited, it is also conditional—the beneficiary government must meet economic conditions, which raises the question of what happens if it fails to. The OMT also depends on a government continuing to have access to the bond markets, which raises the question of what happens if access is lost.

The next risks are Hellenic. Greece will continue to struggle with an economic depression, encouraging some "Cassandras"—like Willem Buiter, Citigroup's chief economist—to suggest the country will be forced to exit the euro zone in 2013.

Some experts say even tiny Cyprus could produce difficulties. This country needs a bailout of €18 billion ($23.5 billion)—close to 100% of the country's annual economic output—€10 billion of which is estimated to be needed to return its banks to health.
Among the lessons of Greece for the International Monetary Fund and others is that addressing excessive debt at the front end of a bailout program will reduce costs for public lenders years down the road. Partly as a result, the likelihood of Cyprus getting the full bailout amount without creditors in the country's banks being burned is, say officials in Brussels, zero.

It also looks increasingly likely that, for the first time in a euro-zone bank bailout, senior bondholders—those at the top of the creditor pecking order—will take a hit.

Some experts think Cyprus is a good time and place to put down this marker for the future. It's small and, given that the ECB is also providing long-term funding to banks, market reaction will be muted. But it's an open question.

The last risk is euro-zone-wide—and it may be the most significant: the euro-zone recession. Although they make for depressing reading, the official growth forecasts from the European Commission are widely considered highly optimistic. That means all the forecasts that key off those numbers—including for countries' budget deficits—are also too optimistic. The commission forecasts euro-zone growth at a derisory 0.1% next year, but most private forecasts suggest the bloc's economy will contract as countries like France and others close to the euro zone's core sink into recession.

That suggests a lot of missed budget targets, and economic forecasts that will keep economics reporters busy next year, not to speak of the unforeseeable consequences of the recession on national governments and on the complicated multilateral politics of Europe.

Write to Stephen Fidler at stephen.fidler@wsj.com