Bundesbank to Contest ECB Bond Purchases in Court, Pressure Mounts on Spain
Late Tuesday, reports surfaced that the Bundesbank was preparing a lawsuit against the European Central Bank claiming that the ECB is violating its mandate in launching the latest round of bond purchases, known as the Outright Monetary Transactions. Unlike the Federal Reserve, which has a dual mandate of price stability and full employment, the European Central Bank has one primary objective of price stability. Also, the ECB is not allowed to be seen servicing the debts of its member nations.
It is this last section that the Bundesbank is challenging: whether or not the purchasing of bonds of select countries who submit to a full Troika program constitutes financing sovereign debts. ECB President Mario Draghi, when first hinting at the plan over the summer, noted that there was a breakdown in the transmission mechanism of monetary policy. This breakdown appeared in the form of differing inflation and unemployment rates across the member nations of the eurozone.
Consider, Germany's inflation rate, on the last reading of the Consumer Price Index, was stable at 2.072 percent, effectively in line with the ECB's target of two percent inflation. Also, the unemployment rate in Germany was a mere 5.5 percent in the latest report. Compare this to Spain, where the inflation rate, as measured by the CPI, was 2.655 percent, well above the rate in Germany and also well above the ECB's target. Further, the unemployment rate in Spain has risen since the onset of the crisis and now has reached a staggering 25.1 percent. Thus, the data shows a clear dislocation in both employment and inflation in the two countries.
This dislocation is what worries the ECB and is why the bank is targeting bond purchases of only nations in trouble. It is the belief of the ECB governing council (except for Bundesbank President Jens Weidmann) that outright purchases of debt could help rein in yields in troubled nations. By doing so, the bank hopes to restore confidence back into the economies of peripheral nations, attract foreign capital and boost lending and borrowing. Should this be the case, the unemployment rate could fall in nations such as Spain, but with the cost being slightly higher than trend inflation.
Some economists have criticized Germany's stance against inflation in the past, and this will only further stimulate the debate of what is "too much" inflation. Those who believe that German economists and central bankers are too strict against inflation argue that, should core nations such as Germany, France, and Finland accept higher levels of inflation for a few years, it could allow the periphery to become competitive once again. Rather than having the peripheral nations deflate back into competitiveness with lower wages and lower price levels, the economists argue that core nations should accept higher inflation in an attempt to reflate the Eurozone's economy.
It appears as though Draghi sides with the reflationists in this debate, as his newest plan, to buy debt of peripheral nations who submit to a program and offset the purchases by selling debts of core nations, looks to lower the borrowing spread between the nations and hopefully allows for the better transmission of policy. However, higher rates in nations such as Germany may have negative effects, as businesses could put off borrowing and investing in hard assets as rates rise.
The one snag in the plan could be the will of Spanish politicians. Spain and Italy are obviously at the forefront of the crisis at this stage, and yet neither has submitted for a formal program under the Troika of lenders. Italian leaders seem ok with accepting the stigma that comes with such a program, however they also understand that, fiscally, they are stronger than Spain. Therefore, they will not act until Spain does. Spanish leaders, so far, have been reluctant to ask for a formal plan because the government has already taken large steps to cut the deficit through spending cuts and tax hikes. Also, unlike Italy's Prime Minister Mario Monti, who is a technocrat appointed to steer Italy towards a better fiscal path, Spanish Prime Minister Mariano Rajoy is an elected official and submitting for a program that requires draconian spending cuts could very well be the end of his political career.
The bottom line is there are still many hurdles in the way of a solution to the European Debt Crisis. Until these hurdles are cleared, markets will remain jittery of any bad news out of Euroland despite the ongoing liquidity injections of central banks in the U.S., the U.K., and Japan. The crisis has been marked by periods of panic and periods of calm and currently markets are in a period of calm. However, it could just be the calm before the storm.
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