COMMENT:

Emmanuel Macron's "grand plan" to relaunch the euro on safer foundations lies in tatters after Europe's northern bloc refused to contemplate any form of fiscal union, and exhausted leaders kicked the crucial issues into touch.

After battling deep into the night over migration there was no energy left at the Brussels summit for a fight over fiscal architecture.

The paralysis means that Europe is likely to stumble into the next global economic downturn disastrously ill-equipped. It will have no shared fiscal instruments of any scale to fight recession, leaving the weakest states vulnerable to collapse.

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The eurozone is no closer to a "fiscal capacity" or proto-treasury able to contend with big shocks, entailing US-style transfers to regions in trouble. It is still the same structure that nearly destroyed monetary union in the banking crisis of 2012.

"The eurozone's death wish has never been stronger," said Yanis Varoufakis, Greece's ex-finance minister.

The Franco-German Meseberg Declaration on eurozone reform published with much fanfare two weeks ago — already a diluted version of Mr Macron's original vision — never even made it on to the summit agenda.

"Leaders only delivered the bare minimum. Decisions were postponed to the December summit. Extend and pretend," said Carsten Brzeski from ING.

Markets have chosen to see the glass half full. The Euro Stoxx index of equities rose 1.2 per cent on relief over the EU deal on migrants. Photo / AP
Markets have chosen to see the glass half full. The Euro Stoxx index of equities rose 1.2 per cent on relief over the EU deal on migrants. Photo / AP

"Perhaps someone should warn them that by delaying, they risk another night-long European summit, this time on how to rescue the eurozone." The global business cycle has not been abolished. The talk at hedge fund gatherings has already rotated from how to play the final stage of the boom, to how to design a "short" strategy to weather the storm. Recession worries are edging on to radar screens.

The eurozone is already in a soft patch. The expected rebound keeps disappointing. German retail sales fell by 2.1 per cent in May, the biggest drop since the onset of the 2011 crisis. European bank stocks have slumped 15 per cent since late January, often a harbinger of trouble.

"A eurozone recession can't be -allowed to happen," said Barnaby Martin from Bank of America. "The idea fills us with a lot of fear. The QE years in Europe have profoundly altered the structure of the euro credit market."

Issuance of BBB bonds has exploded fourfold to €800 billion (£1384b) and many of the borrowers are badly exposed to a combined growth shock and a trade war. "We worry that the ECB is ending QE, but that nothing else is planned to take up the slack."

The eurozone can muddle through without any meaningful fiscal union as long as the global expansion rolls on. Once the cycle turns, it will be dangerously naked.

The European Central Bank has largely run out of monetary ammunition. Interest rates are stuck at minus 0.4 per cent until late 2019.

The ECB has "pre-committed" itself to halting bond purchases by the end of this year. While this can be reversed in an emergency, the political bar is high and the effects of QE are in any case diminishing.

The ECB balance sheet will soon reach 43 per cent of eurozone GDP. German-led hawks will not lightly renew bond purchases if they are seen to benefit a rebel Italian government.

Macron originally called for a proto-treasury commanding "hundreds of billions of euros" to pack a counter-cyclical punch.

Meseberg whittled it down to an investment fund of €30b to help countries through an asymmetric shock, but in the form of loans rather than fiscal transfers. Even this was too much.

Macron has bet his presidency on a grand bargain with Angela Merkel that would force everybody to jump to attention. Europe has ignored him. Photo / AP
Macron has bet his presidency on a grand bargain with Angela Merkel that would force everybody to jump to attention. Europe has ignored him. Photo / AP

Nothing has been agreed. This is courting fate. There is little to prevent debt dynamics spinning out of control in vulnerable economies with high legacy burdens. Italy's debt ratio is 132 per cent of GDP and Portugal's is 126 per cent.

A recession starting from these levels — without a clear lender of last resort — would be devastating. Bond vigilantes would not wait.

The only measure agreed was an EU "backstop" to boost the firepower of the Single Resolution Fund for insolvent lenders. But this will not be fleshed out until December. The 2012 "doom-loop" for banks and sovereign states remains, each threatening to drag the other down in self-feeding crisis if confidence snaps.

Markets have chosen to see the glass half full. The Euro Stoxx index of equities rose 1.2 per cent on relief over the EU deal on migrants. Yet the stormy summit is a warning. It showed that the EU is dealing with a new kind of animal in Italy.

This sets the scene for a bitter fight over Italy's plans for a spending blitz, starting in September when the first budget drafts are prepared. The EU wants tightening of 1pc of GDP under Stability Pact rules.

The Lega-"Grillini" coalition wants net stimulus of 6 per cent: a cancellation of VAT rises, a flat tax, a universal basic income, and reversal of the "Fornero" pension reform. While there can be some accounting fudge over investment spending, this is a political chasm. The market discipline of rising bond yields has lost part of its bite. "We couldn't give a damn about bond spreads," says Lega strongman Matteo Salvini.

Brussels is likely to hit a brick wall if it tries to stop the Lega-Grillini carrying out their core policies. If the ECB ratchets up the pressure by choking liquidity to the banking system a la Grecque, the Italians might respond by activating their "minibot" parallel currency and setting the eurozone on a path towards disintegration.

In some respects it was better that nothing was agreed. Germany had demanded a licence for forced restructuring of sovereign debt before there can be rescue loans. This was a bombshell. It risked a replay of 2010 when France and Germany invoked bondholder haircuts in Greece, ignoring ECB warnings that it would set off systemic contagion. The debt crisis metastasised.

Macron is left with little to show for a year of frenetic diplomacy. He has bet his presidency on a grand bargain with Angela Merkel that would force everybody to jump to attention.

Europe has largely ignored him. The political window for radical reform has closed. Recession is drawing closer.