A high-stakes challenge by Germany and France at today's European Union summit will either unify the continent, or spark a backlash among already skeptical debt holders if it fails.
On the eve of the two-day leader summit in Brussels, German Chancellor Angela Merkel and French President Nicolas Sarkozy insisted on vigorous fiscal discipline among the 27 EU countries, to the point that they would have to accept national budget oversight to prevent another round of lavish sovereign overspending.
But deep divisions among the EU countries, including Britain, spell trouble for the German-French proposal, launched amid unrelenting pressure in the bond markets that have driven borrowing costs for embattled governments sharply higher.
The leaders of the two largest EU countries, and main sponsors of the bailouts of Greece, Ireland and Portugal, rejected suggestions made Wednesday by European Council President Herman Van Rompuy that budget discipline could come through legislation that would fall short of an EU treaty overhaul to push the EU toward formal fiscal integration.
Ms. Merkel and Mr. Sarkozy are under extreme pressure from the markets and the credit-rating agencies to ensure success in Brussels after so many false starts since the debt crisis began two years ago. There have been four leader summits this year alone, each of which failed to restore confidence in the bond markets of the euro zone countries, save Germany.
On Monday, Standard & Poor's put 15 of the 17 euro zone members, including triple-A-rated Germany, France and the Netherlands, on negative credit review, suggesting a 50 per cent chance of downgrades. Wednesday, S&P put the EU on watch for a possible downgrade of its triple-A rating.
In a blunt letter sent to Mr. Van Rompuy, Ms. Merkel and Mr. Sarkozy warned that only the strongest measures will save the euro. "These measures must be taken without delay," they said. "We consider that this is indispensable for the credibility and the confidence in the future of the economic and monetary union."
But a senior German government official, reportedly speaking to a group of journalists, said Germany was pessimistic about persuading all 27 EU countries to buy into the French-German treaty change demands. "I am more pessimistic than I was last week on the chances of total agreement," the official said, adding that the more likely scenario is that the 17 euro zone countries, plus a few other EU countries, would agree to meld their economic and fiscal policies.
Markets reflected the apparently waning prospects for an EU-wide agreement.
Almost all of the main European stock indexes fell Wednesday. The euro dipped against the U.S. dollar and investors dumped the sovereign bonds of most euro zone countries in favour of German bonds, considered Europe's safest debt. Last month, investors drove the yields of Italian bonds over the critical 7 per cent level, triggering widespread fears that Italy, a country considered too big to bail out, would get shut out of the debt markets and send the euro crashing.
Traders said Wednesday's market slump was in good part motivated by Germany's refusal to back a proposal that would greatly boost the euro zone's firefighting ability by melding the resources of the European Financial Stability Facility, with €440-billion ($595-billion) of borrowing power, with the permanent €500-million European Stability Mechanism, which has yet to come into force.
The most important elements of the German-French crisis-fighting pact would see the European Court of Justice enforce a rule that would require balanced budgets and automatic sanctions if euro zone countries violate debt and budget deficit reduction rules.
Several EU and euro zone countries are worried that treaty changes would open the door to an unacceptable loss of sovereignty. Britain is one of them. In an interview with the Spectator magazine, euroskeptic and Northern Ireland Secretary Owen Paterson said Britain would have to hold a referendum if EU treaty revisions are agreed on.
London Mayor Boris Johnson had a similar message. "It's absolutely clear to me that if there is a new treaty at 27 – if there is a new EU treaty that creates a kind of fiscal union within the euro zone – then we would have absolutely no choice either to veto it or to put it to a referendum," he told BBC's Radio 4.
Some economists and strategists think leaders at the Brussels summit will be compelled to declare victory by announcing that rigorous fiscal discipline is coming – more austerity, in other words – even though the cutbacks seem to be pushing the EU into recession. Marshall Auerback, portfolio strategist with Denver hedge fund Madison Street Partners, said he expects the Brussels summit to concentrate on deficit reduction instead of boosting aggregate demand or pushing the European Central Bank to ramp up its sovereign bond purchase program.
"All the options on the table will tend to drive deficits higher, which makes matters worse and, as recent history has shown, triggers demands for more austerity," he said. "And if [ECB]funding does come, it will only come conditionally with accelerated austerity."
Finance Minister Jim Flaherty Wednesday shot down a report that the G20 was looking to create a $600-billion (U.S.) package for Europe that would be run through the International Monetary Fund.
"There have been discussions for some weeks about IMF resources and the possibility of increasing IMF resources," he said. "Our position remains that euro zone members need to use their own resources in the first instance to address their issues."
With a file from reporter Bill Curry in Ottawa