Yesterday, the European Central Bank (ECB) made a decision to lend support to the troubled economies of the Eurozone, by initiating a bond buying program that is likely to be practically unlimited in scope. The action indicated an attempt to wrestle the region’s long-festering debt problems to the ground.
The European Central Bank and the sovereign countries are to be working together to help restore their economies, which are facing huge debt levels. These have become so high that servicing them for their interest and principal repayments is becoming extremely difficult. In a vicious circle, these difficulties have an impact on the cost of the fresh debt/bonds that these countries need to raise to keep their economies afloat – interest rates rise to record levels, and so it goes on.
By standing by as a bond-buyer of ultimate recourse, so to speak, the European Central Bank ensures that these countries are not faced with a situation where a paucity of subscribers causes the interest rate on their bond issues to go up. In one way, this effectively buys time, and financing at reasonable rates, until these economies get their fiscal house in order. This involves a reduction in expenditures to rein in fiscal deficits, and thereby ultimately reduce the dependence on debt for sustaining the economy. Keep in mind that the European Central Bank would still expect these countries to adhere to fiscal targets in order to avail of the bailout.
This massive purchase of financial assets would help to lower interest rates for countries like Greece, Spain, and Italy. Since the bonds would be paid for, this would result in an expansion of the money supply in the region, and hence cause inflation (more money > chasing the same goods > higher prices). This inflationary effect is of particular concern to financially prudent and stable countries, such as Germany. To avoid this inflation, which could push up prices of food and commodities, the excess money sloshing about in the system would be sucked out through another door – a process called ‘sterilization.’ This, the European Central Bank has done previously by offering deposits of one week maturity to banks at rates that are very low.
However, the redeeming features of the action are that it would restore confidence in the financial system, primarily banks, and help restore the flow of credit in a shell-shocked environment, enable business confidence, and possibly restore GDP growth, so that the region can climb out of its current recession.
But it must be repeated that this action by the ECB is not a panacea for all the troubles of the Eurozone – the respective sovereign member countries also have to work in tandem to get out of the morass, by taking tough steps to rein in expenditure and to boost revenues and growth, while gradually chipping away at the debt mountain.