BRUSSELS — Any banking system relies on its depositors retaining their faith in the soundness of their banks. Investors have traditionally regarded government bonds as a relatively low interest, but safe place to park their funds. And voters have trusted their governments to deal competently with complex financial questions.

What happens when these components of trust and confidence suddenly erode? A Euro crisis results.

The crisis began, of course, in a quite different way, as the combination of heavy losses on sub-prime mortgages and runaway trading in financial derivatives led to a banking crisis, and a credit crunch which impacted very quickly on the real economy, threatening a major recession. Western governments reacted (except in Iceland) by rescuing the threatened banks to avoid a system collapse and pumping money into their economies in a bid to avoid recession. These measures were successful. But the price paid was considerable.

In Europe the budget deficits which resulted from these measures have resulted in several member states of the Euro reaching accumulated debts around or beyond the limits which markets believe they will be able to sustain. At that point these countries find that the interest rates they need to pay to finance their debts rise, so their budget expenditure on debt servicing rises, and they have to reduce other expenditure or raise taxes as a result. Either way, these deflationary measures (often labelled “austerity”) reduce economic growth, tax revenues decline, and a vicious circle sets in.

This has happened in Europe in Ireland, in Portugal, and in Greece. In the similar case of the United Kingdom the pound sterling was allowed to devalue to provide an offsetting stimulus to growth. This option was however not available to the countries concerned, as they are locked into the common currency of the Euro, together with countries such as Germany, France or the Netherlands, which are strong enough not to be suspected of defaulting on their loans. In fact they were bailed out by the other Eurozone countries, who took over responsibility for their debts through the EFSF, the European Financial Stability Facility.

The proximate cause of the newly acute phase of the crisis which was addressed at the European Summit, which took place this week on Sunday and Wednesday, was two new developments.

First, it became clear that Greece was still caught in a downward spiral. Even savage austerity measures were not succeeding in reducing levels of Greek debt, they had induced the onset of a severe recession, there were signs of the beginning of a run on the banks, and there were serious doubts about whether the Greek government would survive in the face of mounting protests.  A default seemed imminent. This would have created immediate problems for European banks holding Greek bonds, particularly in France, Spain and Italy.

Second, it became clear that the markets had detected that overall debt levels in Italy were too high, and that the weak government under Prime Minister Berlusconi seemed unable to take the necessary measures to reduce its budget deficit and revive economic growth through reforms. The interest rates on its debt rose rapidly. And the EFSF is nothing like large enough to be able to bail it out. For Greece, yes: for Italy, no.

It was in this situation that European leaders came up with a crisis package at 4 o’clock in the morning on Thursday. It contains three main elements:

• European banks have agreed to accept an arrangement through which they agree to swap their holdings of Greek government bonds for bonds worth only 50% of their face value. This “haircut” will considerably reduce the size of the accumulated Greek debts.
• European banks will increase their capital ratios by next June to 9% of total assets, in order to be equipped to deal with any future bad debts
• The EFSF , currently with size of €440 bn will be “leveraged” to be able to provide assistance up to €1 trillion

In addition the summit received a commitment from President Berlusconi to push through a series of economic reform measures in Italy.

Will this package be sufficient to stem the crisis? Will it restore confidence in the markets about the solidity of European banks and the credit-worthiness of European governments?

First signals from the markets are very positive. And the best judgement may well be that of President Obama in today’s Financial Times; “This week, our European allies made important progress on a strategy to restore confidence in European financial markets, laying a critical foundation on which to build.”

In other words, the foundation for renewed confidence is now there, but much work remains to be done. The details of all parts of the package need to be worked out and implemented, Italy needs to deliver on its promises (which may well require a change of government in the near future), the Greek economy needs to begin to recover and its citizens to recover their faith in the future. And elsewhere in Europe skeletons may still be lurking in closets.

But there are grounds for optimism:

• The leaders of the Eurozone have demonstrated that they will take the necessary measures to deal with a threat to any of its countries and not allow them to leave the euro.
• In Germany, which needs to stump up the lion’s share of any financial assistance packages, there is now a broad consensus that it is in the country’s national interest to ensure that the euro is stabilised. This is new.
• There is now greatly heightened awareness that governments must focus on budget discipline and on reforms for growth and not take their eyes off the ball.
• One little noticed element of the banking measures is that the banks will not pay boni until they have achieved their capital ratio targets. This may well go a long way to reconciling citizens with austerity measures.
• The European Task Force helping the Greek government to implement its reforms received the full support of the Summit.

The outlook for a company, which does business throughout Europe, is thus better now than it was last week. The political will to stabilise the euro, and thus to safeguard the Single Market seems indeed to be there. If market confidence is gradually restored,  the stage will be set for growth to gradually recover.

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