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The European Central Bank bought up record numbers of Spanish and Italian bonds last week, taking a more active—and controversial—role in the eurozone’s debt troubles than many experts expected. The $30 billion bond purchase, announced Monday, is expected to temporarily hold down borrowing costs for Spain and Italy—two of the largest nations mired in Europe’s debt crisis—and help reassure global investors of the eurozone’s solidarity.While the ECB’s uncharacteristically aggressive move provided evidence of its brawn—interest rates for the two beleaguered countries eventually dropped a full percentage point after the purchase—it also highlighted the serious challenges facing Europe’s policymakers; challenges some experts say are even greater than those the United States faces.
To be sure, both the United States and Europe continue to grapple with slow economic growth, the crushing weight of enormous public debt, and austerity measures designed to trim government expenditures. Poor fiscal policy choices made leading up to the global financial crisis have been magnified as the ripple effects of the meltdown continue to radiate through markets around the world.
But many of the similarities between the two debt-ridden countries end there. “The eurozone has particular issues that have to do with the nature of the animal, that differ from the U.K. setup or the U.S. setup,” says Jan Randolph, director of sovereign risk at IHS Global Insight. “It really revolves around investors concerned about whether the ECB will act as the true lender of last resort.”
Whereas bond investors remain fairly confident that the central banks of the United States and United Kingdom fully back the government—meaning that there will be enough dollars and pounds to pay investors—the same can’t be said of the eurozone. “For instance, the Bank of England will print money, and I will get paid back for my sterling guild even if I lose money in the process [through inflation or devaluation of currency],” Randolph says. “The same cannot be said for the European Central Bank. Unlike the U.S. and the U.K., [Spain, Italy, Ireland, and Greece] can’t devalue out to weaken their currency and get a bit of an external lift.”
Pooled sovereignty among member countries only goes so far, Randolph says, which makes investors hesitant to invest if they aren’t certain they will be repaid at least the principal of their bonds. Less demand for government bonds means higher interest rates. Higher borrowing costs could exacerbate an already dire debt situation in some eurozone countries.
The concept of Euro bonds has been discussed, but Randolph says the political unpopularity of such a move prevents serious consideration for now. Although Euro bonds might be a viable solution to debt woes, German taxpayers would likely recoil against the idea of being responsible for the debt racked up by less fiscally responsible countries such as Greece, Spain, and Italy, he says. What Europe really needs is a more muscular ECB and for monetary and fiscal policy to work in tandem.
Historically, the German Bundesbank-inspired ECB has maintained a relatively strict separation between monetary policy and fiscal policy, controlling only interest rates. However, with the latest round of bond purchases, fiscal strings were attached for Spain and Italy in the form of austerity measures.
“In the past few days, we have asked the Italian government very clearly to take a certain number of decisions … and in particular to speed up the return to a situation of normal balance [between spending and revenue]. The same thing has been asked of the Spanish government,” ECB chief Jean-Claude Trichet told the Guardian.
However, a more “normal balance” for the European Union hinges on economic growth, and the latest figures out of Europe aren’t too encouraging. GDP for the 27 member countries of the EU, including the 17 that use the euro, grew at a paltry 0.2 per cent quarterly rate, according to estimates from Eurostat, the EU statistics office. Even two of the stronger EU economies, Germany and France, are experiencing a slowdown, which could prolong the process of extracting the eurozone out of its financial mess.
The U.S. is slightly better situated, says Tim Hoyle, director of research at Haverford Investments. Despite the recent credit downgrade by Standard & Poor’s, the U.S. dollar remains the reserve currency and treasuries continue to be considered a safe haven. But the resilience of the U.S. economic recovery hinges on growth as well. “If we can grow this economy, big debt issues become small debt issues,” Hoyle says. “Europe is tackling everything through austerity because they have given up the ghost on growth. They’re taking a much stricter line on austerity, [but] austerity measures don’t translate into pro-growth initiatives.”
In essence, the pendulum has swung severely to the other side of the spectrum in Europe, a move that could cripple prospects for growth and end up making the debt problem worse. “The U.S. is at a crossroads,” Hoyle says, “If you go down that road of strict austerity, we don’t grow, and if we don’t grow we will never be able to handle the debt and the promises Congress has made.”