Financial markets are behaving as though the euro crisis is on its way to resolution. Following Sunday's announcement of Italy's new budget and Monday's joint declaration from Germany's Chancellor Angela Merkel and France's President Nicolas Sarkozy, government bond markets have rallied in Italy, Spain, and Portugal. Global stock markets initially jumped, following the previous week's strong performance. Expectations are running high that the EU summit, due to begin Thursday and run into Friday, will douse the fire that has been spreading across Europe since the first Greek bailout in May 2010.
The optimism about Italy is understandable. Italy is running a rather modest budget deficit, so the proposed €10 billion per year in budget savings may be enough to stabilize its public debt. Italy's economy, and therefore its capacity to repay creditors, is growing at about 1 percent per year, which puts it in a far stronger position than Greece, whose economy is shrinking at an annual rate of around 7 percent. To round off the optimistic story, Italy's technocratic government has broad support among voters, and so its chances of delivering on its promises seem reasonable. The European Central Bank will do what it can to support Italy's reform program, since it knows that the technocrats' failure could usher in a populist government that would drag Italy out of Europe.
Unfortunately, it's hard to be so positive about the other factor underpinning market optimism: the Franco-German accord. In a clear victory for Germany, the agreement rules out the idea of a Eurobond, which would allow some part of eurozone members' national debts to be swapped into joint eurozone debt, spreading the burden so that default becomes unlikely and investors regain confidence.
The accord continues to tout the discredited idea of "leveraging" the eurozone's bailout fund, even though this bullet is not made of silver. And it waxes lyrical about reforming European treaties so that countries would face automatic sanctions if their budget deficits exceeded prescribed limits. That may be a fine idea, but treaty change would probably take years--and might even prove impossible.
The question is whether the combination of brave reform in Italy and continued obduracy from Germany is enough to fix Europe's problems. If other governments, especially Spain's, can stick on the reformist path too, perhaps the eurozone will pull through. But the reformers will have to weather inevitable storms: Their budget projections could be thrown off by anything from a complete meltdown in Greece to the bankruptcy of a major European financial institution. To gamble the stability of the eurozone on the prospect that reforms will succeed in multiple countries across multiple years may seem reckless. But that is the adjective that most aptly describes Germany's behavior in this crisis.