Stock markets worldwide and the euro made substantial gains yesterday as the weekend decision to shore up Spain's ailing banks provided a boost to the single currency. The deal buys the euro zone time to avert a meltdown within weeks.
But to get the common currency out of a permanent emergency, the 17 member states need to create a banking union and a fiscal union. Unless these political commitments are taken at the European Union summit on June 28-29, the euro crisis will end in a collapse.
Before the Spanish government sought help, the euro zone was on the brink of breaking up. For months contagion had spread from Greece to Italy and Spain. Rome and Madrid have seen their borrowing costs climb towards the 7 per cent threshold, the point of no return that forced Greece, Ireland and Portugal to ask for bailouts.
Spain's financial system is under similarly unsustainable strain. Spanish banks have been hit hard by bad property loans. Following the introduction of the euro in 2002, cheap money fuelled both credit and property bubbles. Since the global crash in 2008, property prices have fallen 20 to 50 per cent. The country faces a vicious circle of falling value, negative equity and a glut of unsold new buildings. This, coupled with no growth and mass unemployment, raises the spectre of depression and debt default.
In recent weeks, market panic over the euro has been fuelled by growing capital flight from the zone's peripheral countries. To stem the outflow, the European Central Bank has provided national central banks €100 billion (Dh464 billion) to assist troubled banks. All this risks turning capital flight into a full-blown bank run that would plunge the euro zone into unprecedented turmoil and trigger another global credit crunch.
Injecting another €100 billion into Spain's ailing banks will do much to calm nerves, but besides providing liquidity support it fails to deal with the country's debt whose real value is growing as a result of the austerity-aggravated recession. As such, bank recapitalisation won't convince financial markets that euro-zone leaders are tackling the structural problems of the single currency.
Growing differences in innovation and productivity have exacerbated commercial and financial imbalances. Surplus countries such as Germany export goods and import capital while the reverse is true for deficit countries like Greece or Spain.
Crucially, most European banks hold large amounts of peripheral countries' bonds to benefit from the interest-rate differential compared with core countries' bonds. When the global recession hit and budget deficits ballooned, investors worldwide became more risk averse. Fearing that some governments might default on apparently riskless bonds, financial markets raised risk premiums dramatically. This, in turn, threatened the solvency of those banks that are most exposed to such bonds. That's why the euro zone suffers a simultaneous sovereign debt and banking crisis, which has required bank recapitalisation and government bailouts.
Rescuing Spanish banks is only the first step towards a resolution of this twin crisis. To restore credibility, euro-zone governments need to agree on a banking union and a fiscal union.
The first element of a banking union is a deposit insurance scheme to reassure savers that their money is safe in all euro-zone banks. To this effect, the EU needs to offer an unconditional commitment guaranteeing individual bank deposits up to an agreed ceiling of €50,000 or €75,000. Ideally, a pan-European deposit insurance structure would have access to the ECB's unlimited liquidity support.
The second element is a centralised recapitalisation and resolution authority that could inject direct equity into failing banks, independently of national politics. That would finally break the collusion of governments and banks that bail each other out at the expense of the taxpayer and the real economy.
It would also introduce transparency and accountability into a system of banks that are partly publicly owned such as the Spanish Bankia or the German Landesbanken, where politicians and managers scratch each other's back. The necessary funding of about €1 trillion could come from a joint debt security that would be the precursor to euro-zone-wide bonds - or Eurobonds.
The third element is common bank regulation and supervision for the entire euro zone, which overlaps with the EU's single market. With non-euro EU members like the UK demanding safeguards, it is not clear how the EU-wide European Banking Authority could fulfil this function or whether the euro zone needs to create a new institution altogether.
Without such a banking union, a monetary union such as the euro zone is ultimately doomed.
A fiscal union, by contrast, is politically complicated but technically more straightforward. It essentially requires close coordination of budget policies and a credible central authority to rein in public spending in good times and expand expenditure in bad times. Crucially, the euro zone needs to mutualise its debt by a common underwriting of all sovereign bonds.
But a centralised fiscal union without national parliamentary participation will exacerbate civic alienation from the European project. This, coupled with austerity, will fuel the growing popular backlash against the ruling elites. The forthcoming EU summit will either put the euro zone on the road to recovery or spell its end.
Adrian Pabst is a lecturer in politics at Britain's University of Kent and a visiting professor at the Institut d'Etudes Politiques de Lille in France