In my last post I outlined why I think interest rates were rising, absent from that
was a discussion on what monetary policy can do to prevent bank runs, help the
economy, and assist in keeping public interest rates low:
- As defaults happen, central banks can lower interest rates (increasing liquidity, interbank lending, etc), engage in asset purchases (e.g. quantitative easing), act as the lender of last resort, etc. All of these tools help prevent runs on the bank.
- Further, expansionary central bank tools should in theory should encourage banks to lend, stimulating the economy. It also lowers the value of the currency and creates inflation. The former helps exports and competitiveness, while the latter helps inflate away debt (as opposed to default).
- A central bank can create money out of thin air. It can also require banks to bid on Treasury auctions (as in the US). As a result the central bank can set interest rates on public debt if need be.
The problem in the EU is that each country is not in control
of its own currency, they are subject to the ECB. Thus, while the US can do all the above,
Spain for instance is beholden to the ECB.
This is why I believe their interest rates on public debt were rising…
There was no
guarantee the ECB will create the reserves if need be to purchase public debt
(e.g. the ECB will purchase or will have banks purchase public debt), as a result
the government is revenue constrained to what it can procure in tax revenue and
what it can finance in the market. As
tax revenues fall, the likelihood of default increases, which in turn causes
the market to push up interest rates, and again increases the likelihood of
default, so goes the circle…
Again, the contrast here is that the market realizes the Fed
can dare it to sell the Treasury bonds.
The Fed has endless reserves to do so in order to keep interest rates
where they want to (see QE3). The
countries in the EU can’t create their own reserves and thus are dependent on
the ECB to do so.
