November 23, 2011
Euro-zone countries are presently engaged in a dispute about how to come to terms with excessive public debt levels.
Before the start of the Euro-zone in 2001 EU member countries did not pay identical interest rates on public borrowing, Germany paying much less than Italy or Greece. That was considered perfectly normal,interest rates reflecting the relative credit standing of a borrowing country.
Many financiers and fiscal policy makers, however, cherished the hope that the introduction of a single currency would flatten the divergences of interest rates at which governments would be able to borrow.
Indeed, in the first years after the introduction of the Euro the “spreads” narrowed substantially. But as the economic and fiscal situation of member countries diverged over time, especially after 2007, financial markets realised that the risk of Portuguese public bonds was much higher than of German ones. Consequently, the risk the “spreads” between German and Greek, Portuguese, Italian, Spanish and Irish bonds kept rising to reach record values in the course of 2011. Presently, Germany has to pay only one third of the interest rates Italy and Spain have to . Greece would have to pay more than 15 per cent interest if it were to tap the bond market for financing its soaring public debt.
The high public borrowing cost makes further borrowing for countries with a poor economic and debt record increasingly unsustainable. It makes them envious of Germany, Netherlands or Austria paying almost zero real interest rates on their debt.
At the same time, potential lenders have become increasingly reluctant to invest in bonds of Euro-zone countries, unless these offer an attractive interest of at least three percent in real terms.
It is therefore normal that weaker Euro-zone countries ask for the ECB helping them out by buying bonds in the secondary market and thereby bringing down the interest rate. It is equally understandable that the “privileged” countries resist such financing for legal, political and economic reasons:
- The Treaty puts a ban on ECB buying public debt;
- Artificial lowering of the interest rate by ECB purchase of outstanding bonds might slow necessary fiscal and economic reforms;
- ECB buying of public debt will inflate the money supply and reinforce inflationary trends.
However doubtful these arguments, it is necessary to calm the excitement about what should not be divisive issue within the Euro-zone:
- A spread between interest rates will continue to exist in the Euro-zone as long as member countries – or cities and regions – present unequal risks to investors. It is, however, in the interest of all Euro-zone countries to keep the spreads to a minimum.
- The ECB should intervene in the secondary markets to prevent interest rates of highly indebted countries from rising beyond some 6 per cent, as this might render their fiscal consolidation next to impossible.
During the past 18 months the ECB has bought bonds for a cumulative value of € 190 billion, much less than the amount of support granted Greece, Portugal and Ireland by the EFSF and the IMF.
There is nothing wrong for the ECB to continue to doing as long as member governments have not decided to let the EFSF, followed by the ESM, to take over the ECB role.
So far the ECB has intervened very cautiously and only if the beneficiary country engaged in fiscal consolidation. It realises the political and monetary limits of bond purchases. There is therefore no reason to fear that it will ever imitate the USA, Japan or UK with their huge bond purchases.
- This being said, the main responsibility for the level of interest rates must lie with each debtor country. There is no alternative for governments but to convince the markets of the seriousness of their fiscal and economic policies.
Greece, Italy and Spain will test this ability in the coming months under new governments committed to budget consolidation and sweeping economic and social reforms.
Author : Eberhard Rhein