Germany's parliament has approved reforms to the European Financial Stability Facility (EFSF) that would allow the fund to participate in the primary market and to recapitalize European banks in a much-anticipated vote in the Bundestag.
The vote in the Bundestag, which was set to be another milestone—and another drama in the travelling circus of Europe's crisis response—seems to have passed without major incident, as potential rebels within Chancellor Angela Merkel's ruling coalition were contained. 523 lawmakers voted in favor of the reform, with 85 opposing and three abstaining.
Europeanstocksrose, and bund yields fell as the markets reacted positively to the result. The euro rose against the dollar.
However, the debate on crisis management mechanisms is moving ahead of the politics once again, as the realization that solvency and growth concerns outweigh liquidity shortages begin to creep through.
Early concerns that euro zone parliaments would derail reforms allowing the EFSF—the temporary bailout fund created to shore up the Greek capital markets and limit contagion into the rest of the single currency area—to participate in the primary market for sovereign debt and to recapitalize banks now appear unfounded.
Finland, whose politicians have been amongst the most vocally critical participants in the conversation on financial assistance and institutional reform in Europe, voted on Wednesday to pass the reform of the EFSF, despite their desires for collateral looking decreasingly likely to be met.
Slovenia, whose government collapsed on Sept. 20, saw the reform sail through parliament on September 27.
Austria, which votes on Friday, should also pass the reform, analysts said, with the government and opposition Green party both backing the bill.
Slovakia is perhaps the only remaining real barrier for Europe, as with Radicova saying that she wants a vote before the Oct. 17 EU summit, while the speaker of parliament, Richard Sulik, reportedly told news agency Agence France Presse that a date had been set for Oct. 25.
The German vote was not expected to be a complete formality, but tensions eased as the decision approached and the two-hour debate was shot through with vocal support for the European Union and Germany's role in solving the crisis.
If more than 19 members of Chancellor Angela Merkel's coalition voted against the measure then she would have needed to rely on support from opposition parties. Any such mutiny would have seriously undermined confidence in her leadership, but most of those opposing the vote appear to have been from the opposition, and Merkel's own majority has held.
The Free Democratic Party (FDP), a junior member of Merkel's coalition, had threatened to vote against the EFSF reform, according to local press reports. There was also a distinct possibility that individuals within her own Christian Democratic Union party (CDU) could oppose the measures.
"The question is not whether it will or won't go through, the question is what concessions Merkel has to make to the FDP and other members of the opposition, even the CDU, to get it through," Mujtaba Rahman, Europe analyst at Eurasia Group, told CNBC.com ahead of the vote. "Some of those concessions I think have the potential to undermine the efficacy of the July 21 reforms. I think if you have greater budget committee oversight of secondary market bond purchases, for example, that could undermine the efficacy of the bond buying."
To an extent, the debate over the scale of the EFSF has moved on from the reforms currently under scrutiny. Some market participants have been adamant that the 440 billion euro ($600.3 billion) fund is nowhere near large enough.
Suggestions that 2 trillion euros ($2.7 trillion) would be the minimum amount that would satisfy the market miss the point, Rahman said. The headline scale of the EFSF is less significant than the flexibility that the fund has been given to recapitalize European banks, and to buy bonds in the primary market, he explained.
"I don't think it's about the headline. I think the point is, you want an ambiguous 'bazooka.' You don't want to say 1.5 trillion, or 2 trillion, or 3 trillion, because then the market is likely to challenge the headline. The reason the ECB's SMP is so powerful is because there is a huge liquid balance sheet behind it and there is no headline constraint," Rahman said, referring to the Securities Markets Program, which buys bonds on the secondary market.
"The debate on the headline, the actual nominal number, that's a secondary discussion. What we need is a highly leveraged vehicle with access to resources that can manage systemic risk in larger, systemically important countries—Italy, Spain, France," Rahman added.
"The TARP had headline constraints but only a part of the nominal number was used in interventions because the markets believed that it had the ability to manage contagion risk in a credible way," he said, referring to the US' Troubled Assets Relief Program.
Until that vehicle is ready, however, the pressure will be on the European Central Bank to shore up the Spanish and Italian bond markets. Even once it is complete, it is only one step in containing a crisis that has deeper roots than the bond markets.
Carl Astorri, global head of economics and asset strategy at Coutts told CNBC that such an intervention would come at a price.
“To satisfy markets a large balance sheet needs to be put on the line. In reality only the ECB and the German government have balance sheets large enough to shock the bond market and protect Italy from contagion," Astorri said. “However, protection is never free. The price will be a deterioration in Germany's credit quality. Hence, a clear sign that a euro zone rescue package is succeeding will be a rise in German bund yields relative to those of Italian government bonds. In other words, a spread narrowing.”
EFSF Reform is Just the Beginning
Ernst & Young released its euro zone economic forecast on Thursday, giving a stark assessment of the challenges facing the single currency area. The report cut its growth forecast for 2011 from 2 percent to 1.6 percent, and reduced its 2012 prediction to 1.1 percent. There is a 35 percent chance that the euro zone could be pulled back into recessionif drastic measures are not taken, the study said.
The decision by the ECB to raise interest rates in April and July was a mistake, and the bank should change its strategy, cutting rates to encourage growth, Ernst & Young said.
Current bailout measures have been too focused on liquidity, and not on solvency, Ernst & Young said.
In a statement accompanying the report release, Marie Diron, senior economic adviser, said, “Reliance upon further rounds of austerity to reduce deficits will be self-defeating—much deeper reforms, including labor market liberalization, and faster privatization are needed if the peripheral economies are to escape the unsustainable debt burdens and regain investor confidence. But the benefits of such reforms will take time to be realized.”
Like so many other analyses of the current euro zone sovereign debtcrisis, Ernst & Young's report urges greater fiscal consolidation, but as Diron said, "Many countries will resist this implied loss of sovereignty, but without the ability to monitor, control and finance government spending across the Eurozone, there can be no guarantees that fiscal stability can be maintained after the existing severe problems are resolved.”
Similarly, a research paper published on Monday by UBS economist Larry Hatheway warned that while the policy response appears to be gearing up, it is likely that it will take another obvious worsening of the economic situation in the euro zone before there is the level of coordinated action that would be needed to take the response beyond temporary fixed.
That means subsuming individual economic sovereignty in a way that could go against the wishes of electorates, whose response to the EFSF reforms has not been overwhelmingly receptive.
As Hatheway wrote, "The over-riding challenge for Europeans is to resolve how far they are prepared to re-balance the political fault line between fiscal integration and a loss of budgetary and economic sovereignty."
He, too, pointed out that beyond the liquidity and even solvency concerns, growth remains the most compelling problem for policymakers.
"The crisis is also one of growth. An inappropriate obsession with fiscal austerity to the exclusion of all else is not credible in an environment of weakening growth in Europe’s core and recession in the periphery," he said.
"Eventually, Europe will have to switch to other and more permanent mechanisms to solve its imbalances problem. This is going to get tricky and argumentative because a smoothly functioning Euro system, as today, requires even higher levels of economic and fiscal integration, which intrude uncomfortably into the sovereignty of both creditors and debtors. Changes to European Treaties will be required, and these will have to be ratified by every nation, often by referendum."
History, and current rhetoric, suggests that those referenda would be enormously difficult to push through.
"The key here is for politicians to explain in a coherent, clear and sensible way to their populations why the European Union has been a positive thing for living standards, for growth, for general economic development. That's not a message that politicians have made in a very successful way. Rather, they've blamed Brussels," Rahman said.
"They have implemented tough measures at home and blamed Brussels. It's not surprising that people hate the EU, they hate the institutions, they hate Brussels, and yet they have little real understanding what the integration process has done for a country's economic development and its living standards."
It will also require policymakers and, ultimately, markets, to look beyond the immediate crisis and acknowledge that Europe's problems are not simply that of sovereign indebtedness and cannot be solved with silver bullets—they are those shared with much of the rest of the developed world:
A lost generation of unemployed youth; electorates disenfranchised with apparently failed grand economic and political projects; and demographic shifts that leave and skills and wealth locked into an aging and increasingly dependent majority.