Was the euro summit a game changer?

The pattern is now familiar. After prolonged and very public bickering, European leaders convene in Brussels to try and restore flagging confidence in the eurozone.

They settle market nerves by agreeing the terms of a new 'bail out' to an indebted government – before financial markets digest the contents of the agreement, conclude that the underlying problems have not been resolved, and the nerve-racking cycle starts all over again. Each agreement buys a little more time. But with each successive summit, the stakes become progressively higher.

When eurozone leaders met for the latest of their emergency summits on July 21st, the threat they had to ward off – the risk of contagion to Spain and Italy – was potentially terminal. The sense of foreboding in the run-up to the summit was palpable. A group of European economists called on EU leaders to "act to save the euro". Even the UK's eurosceptic chancellor of the exchequer, George Osborne, exhorted eurozone leaders to accept the logic of the euro and create a fiscal union– although this would marginalise Britain in the EU.

So what did the latest summit achieve? Like CEOs guiding stock prices in the run-up to the earnings season, Eurozone leaders lowered expectations before the summit, then delivered slightly more than observers had anticipated. They approved a new €109 billion loan to Greece; launched a bond buy-back programme designed to reduce Greece's public debt burden; agreed that European Financial Stability Fund (EFSF) loans should be extended at less onerous rates to borrowers; and decided to increase the uses to which the EFSF can be put.

The summit marked the end of the pretence that a combination of contracting economic activity, punitive borrowing costs, and no debt relief might restore a highly indebted government to solvency. But was it a "game-changer", as the IMF's new head, Christine Lagarde, claimed? The short answer is no. True, lower borrowing costs will reduce the size of the fiscal adjustment that Greece, Ireland and Portugal must make. And while it is belated, the recognition that the Greek government is insolvent and needs the face value of its debt to be reduced is still welcome.

The problem with the summit agreement is two-fold. First, the reduction in the face value of Greek sovereign debt falls between two stools: it ensures that the credit rating agencies will declare Greece to be in default, but it is not large enough to restore the country's government to solvency. Banks' participation in bond buy-backs is expected to reduce the face value of Greek government debt by around 20 per cent – markedly less than the current market discount of 40 per cent (which is likely to be the minimum necessary to restore Greece to debt sustainability).

The second problem is that the summit did not erect a sufficiently convincing firewall to arrest contagion to Spain and Italy. EU leaders rightly increased the flexibility of the EFSF. It will now be allowed to buy bonds in the secondary market; to extend credit lines on a precautionary basis; and to lend to countries that are not in an EU/IMF programme but require help in recapitalising banks. EU leaders failed, however, to sanction an increase in the size of the EFSF. In effect, they armed themselves with elaborate new weapons, but forgot about the ammunition.

So the summit marked a welcome shift away from the economically self-defeating view that confidence in the eurozone could only be restored by punishing sinners in the indebted periphery. Positions in Berlin and Frankfurt have become less intransigent. Germany has dropped its opposition to the EFSF buying peripheral sovereign bonds. And the European Central Bank seems to have quietly ditched its threat not to accept Greek government debt as collateral in the event of a default (a move which would have precipitated the collapse of Greek banks).

What this was not, however, was a summit to end all emergency summits. Greece took a step closer to solvency, but it is not there yet – a further debt write-off will almost certainly be needed. Lower borrowing costs will help Portugal and Ireland, but both countries may need a reduction in the value of their public debt. Welcome as it is, a more flexible EFSF will be of limited use as an instrument against contagion unless its size is increased. So far, the new-look EFSF is a mechanism for dealing with Greece, Ireland and Portugal but not Spain or Italy.

Financial markets are not infallible. But their reaction to the July emergency summit is still instructive. Immediately after the summit, long-term interest rates in Spain and Italy fell, and stock markets across Europe surged. This relief rally did not last long. By the middle of the following week, the spread between German and Italian ten-year government bonds had returned to its pre-summit level. Borrowing costs at current levels are unsustainable in Spain and Italy, given these countries' weak growth prospects.

What else must European leaders do to restore markets' confidence in the eurozone? First, they must aggressively recapitalise banks, both in the core and the peripheral countries. Second, they will have to write off more debt to restore Greece (and probably Portugal) to debt sustainability. Third, Southern European countries will have to show that they can grow fast enough within the eurozone to service their debts. And, sooner rather than later, the EFSF will have to be transformed into a debt agency that issues government bonds for the eurozone.

The problem, of course, is that governments are already reaching the outer limits of what their electorates are prepared to accept. Citizens in the creditor countries, for example, never wanted to be part of a 'transfer union' – but fear that one is now emerging through the back-door. Faced with such constraints, policy-makers have understandably proceeded by small steps. In the financial markets, however, such incrementalism raises the fear that eurozone leaders are unwilling, or perhaps unable, to do what it takes to save the single currency.