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Posted: 13-May-2010
In my previous post I asked the question: “Eurozone: Is it a Stabilization Plan Now and Quantitative Easing Soon After?” The answer came fast. Yes, the ECB has embarked on buying less-than-investment-grade bonds of Greece, Portugal, Ireland and Spain. Last week, it bought about $20-$22 billion worth of these bonds. It bought less very day of this week. The ECB's move came as a result of pressures from the EU governments, the US Fed and the US Treasury. Now by buying government bonds it refused to buy before, it’s bowing to pressures from governments. The ECB has lost credibility and some independence in eyes of many. [1]
The ECB should have taken the lead on its own and acted in the right time with a plan. Now the ECB has expanded its balance sheet and filled it with junk bonds and non investment grade securities. The ECB has to print money to purchase these bonds and is now stocking fears of inflation. This QE policy is different from the one used by Fed when it expanded its balance sheets by buying equities in banks, insurance companies and autos. Here, the ECB does not own equity in Greece, Portugal, Ireland and Spain's governments. Moreover, these governments will end up restructuring their debts, which is a kind of delayed default with a worse problem. The ECB's QE is more complicated.
The ECB should be vigilant of how the increases in its balance sheet will affect money supply. The experience with Japan and the United States says that QE increases the monetary base but it may not increase money supply if banks do not lend and create demand deposits. If it does, the ECB should find a way to sterilize the increase. It seems that yields on the eurozone bonds have dropped and stabilized this week. Will the ECB be able to sterilize the money it printed before it leads to inflation? If it is able to stabilize the bond market and be able to take back the money it has printed, the ECB may emerge from this crisis with little scratches in its credibility and independence. But the eurozone problem is surely getting more complicated as time goes on because the defects involve the basics of the eurozone and the EU.
[1] adam Posner (2010). " When Central Banks Buy Government Bonds: Independence and the Power to say No." http://www.bankofengland.co.uk/publications/speeches/2010/speech436.pdf
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