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September 6, 2012

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European central bank chief announces bond buying program to stabilize Euro zone

by Rylan Stewart

[Editors note: the ongoing European sovereign debt "crisis" is watched closely by U.S. markets and investors, ourselves included. Equities and U.S. Treasury markets have moved on the slightest rumor about European Union and European Central Bank action to prop up debt-strapped European governments. The "flattened"  modern global economy connects us to this crisis, and the fortunes of your monthly payment can rest on speculation about possible Spanish government debt default. For more on the latest ECB action to prop up the Euro zone and to learn about why a solution is so hard to find, please keep reading.]

The European Central Bank will enact a bond buying program to combat fluctuations in the bond market and ease borrowing costs for Spain and Italy, countries seen as the latest frontline of the European debt crisis.

Spain and Italy have had government bond yields spike on the secondary market. In other words, investors need to see a higher “yield” (payoff) to provide enough incentive to invest in the “risky” proposition of government debt.

ECB action will attempt to stabilize these fluctuations.

Both countries have a vast public sector and extensive social programs that are propped up by the government. High unemployment and a falling GDP has diminished the government income base, thus requiring extensive borrowing to fund the domestic budget, economic stimulus actions, and fulfill debt obligations.

As these debt-burdened countries pay more and more to borrow, the national debt rises and the risk of default increases. Onlookers worry that a massive bailout could be on the horizon.

This is where the Euro runs into the “Central Bank” problem.

During the recession, the U.S. Federal Reserve enacted several fiscal and monetary stimulus measures to foster a low-interest rate environment and inject liquidity into the market.

The Fed could do this because it has sole authority over the domestic economy, but the ECB does not have the same power.

The ECB is funded by the national governments of its member states. Taken further, this means that when the ECB acts, German citizens (for example) are paying to bail Greece out of its self-inflicted crisis.

Although strength of the Euro currency affects all of its member states, safeguards were put in place to limit central bank power and ensure that member states retained national sovereignty. As a result, the ECB is seen as a hesitant, subject to the politics of individual national governments (especially Germany), and unable to respond with forceful action to help rescue member states.

One solution to this problem would be to allow the central bank it to issue its own debt (bonds). Still,  countries are wary to strengthen the ECB, because this is a step towards a stronger Europe and weaker national governments. It would further invest (say) German citizens in the actions of the Spanish government (say) and put them on the hook for bailout actions.

This question of national sovereignty and “where does the buck stop” has followed the European Union since its inception. The ECB is not allowed to fund state budgets, but it is able to protect the Euro, and these two mandates often clash.

In its latest action, the ECB will go to the secondary market to purchase short-term bonds with maturities of up to three years in an attempt to maintain price stability.

Markets have oscillated frequently on the “European debt crisis.”  Investors seem to favor strong ECB action to clean up the crisis. When ECB chief Mario Draghi promised in a recent press conference to protect the Euro by any means necessary, stocks shot up.

For now, the bond-buying program is seen as a temporary stopgap until a more comprehensive solution can be reached.

 

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1 Comment Post a comment
  1. Sep 10 2012

    truly loved the article added to my favourites

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