European leaders have agreed on a new plan, which will allow the bailout funds (ESM and EFSF) to inject capital directly into troubled banks, conditional upon the establishment of a new EU banking supervision authority. The markets are pleased, for the moment. Of course the markets have been pleased before, and the euphoria has been short-lived. There are some reasons for optimism this time, however. Since Merkel has ruled out mutualization of debt for the time being (actually, in her words, for as long as she lives), this was the only option available that would not lead to imminent meltdown. Furthermore, there seems to be a consensus that the ECB can support banks via the ESM, an indirect route, but not directly. The ECB seemed to have recognized the need but worried about the legality, which has now been clarified. So this could hold things together for awhile.
Of course, this solution does not remedy the structural imbalances, that is, the fact that the southern tier countries, and even France, import more from the stronger economies than they export. With no devaluation option available in the short term to remedy this, and no willingness of private lenders to finance the resulting current account deficits, the only option is for the deficitary economies to contract sufficiently to reduce their demand for imports. (Increased productivity in the south is another remedy, but increasing productivity takes time, so is not a short-term solution.) The results of this contraction in Greece and Spain have been devastating, with very high unemployment, reduced social spending, etc. How much more of this can be tolerated is of course anyone's guess.
But saving the banks--distasteful as it is to many people to have to save banks whose irresponsible lending during the boom years is at the heart of the crisis--was the first necessity, and this has now been taken care of. I think the European banking system was fairly close to seizing up, so this was really an emergency measure. Let's hope the implementation proceeds smoothly and quickly.
As I discussed earlier, the banks, in protecting themselves against the risks of sudden stops in short-term financing, have largely stopped borrowing across borders. This means that the European financial system is no longer delivering one of the chief benefits that the euro had promised: the ability to move capital from countries where there is too much of it to countries that could make productive use of more. This is unfortunate. But after a period of healing, normal capital flows could resume, but with the tighter controls on bank lending promised by the new supervisory mechanism. There will still be booms and busts, of course, as long as there are human beings, but perhaps--perhaps--the damage can be limited next time. In any case, I'm feeling slightly more optimistic today than I did yesterday. The European agreement, plus the major, major Supreme Court decision in the US, are signs that the tsunami have bad news may have begun to recede.