ECB to the rescue?

Germany suffered a huge bond failure on Wednesday, highlighting how investors are shunning even Europe's safest haven.

The German debt agency found no buyers for half of a 6 billion-euro, 10-year bond offering at a record low 2.0 percent interest rate.

Earlier this week, ratings agency Moody's warned France that a sustained rise in its debt yields could harm its ratings outlook, fuelling concerns that Europe's second-largest economy might lose its cherished AAA status. It followed a similar warning to Paris in mid-October by Moody's.

Many experts see the events as the latest sign that the sovereign debt crisis is spreading from the the eurozone periphery to the very heart of the 17-nation group sharing the single currency. And it's not just France. The Netherlands, Finland and Austria too are struggling with high borrowing costs as panicky investors dump paper no longer seen as risk-free.

The yield on Italian and Spanish bonds has risen so high that long-term interest rates are no longer sustainable.

ECB as ‘lender of last resort?'

The events have prompted calls for the European Central Bank (ECB) to take a more decisive role and buy eurozone bonds that are shunned by the markets.

The policy of state financing is followed by both the US Federal Reserve and the Bank of England. That's one reason why Britain pays similarly low interest rates as in Germany.

An increasing number of politicians and economists in the eurozone are therefore urging the ECB to finally act as “lender of last resort” to troubled eurozone nations by buying up their bonds without limit.

“We don't have to keep pursuing poor policies,” said Rolf Langhammer, vice president of the Kiel Institute for the World Economy. “All sides, including the US Federal Reserve, have always said, ‘this is an emergency measure - it's not permanent.'”

Crossing the line

But the problem is that the emergency situation can quickly turn into a more permanent one. That's exactly what happened with the ECB's government bond-buying program.

In May 2010, the ECB began to buy up Greek, Portuguese and Irish bonds as an emergency measure to stabilize the financial markets. In August this year, the program was extended to cover Spain and Italy. The ECB now holds bonds of debt-saddled countries worth some 200 billion euros.

In protest against this policy by the Frankfurt-based bank, two prominent German economists have resigned in recent months: Axel Weber, former head of the German Central Bank, the Bundesbank, and Jürgen Stark, the ECB's chief economist.

Some agree that the ECB's government bond-buying plan crossed all limits.

“The genie is out of the bottle and you're not going to get it back in again,” Langhammer said. Once a basic inflationary position is strengthened, he argues, it has devastating consequences for investment decisions and savings. Fear of a currency devaluation, he adds, often drives people to buy gold rather than invest.

Inflation specter still stalks Germans

Eurogroup head Jean-Claude Juncker recently told German media that he understood Germans' deep-rooted fear of inflation.

In the past century, Germans twice witnessed inflation wiping out their wealth, Juncker said. Hyperinflation and currency reform after the World War II forced them to start from scratch, he added.

German fears are completely justified, Langhammer agrees. “We currently have a core inflation rate of three percent, and our economic growth is slightly weakening,” he said. “Inflation can certainly take hold.”

Langhammer and other economists believe that struggling eurzone countries would lose incentives to put their finances in order if the ECB were to announce a general guarantee for all government bonds in the eurozone.

“That would give the Italians a free ticket to to simply continue with business as usual,” Alfons Weichenrieder, financial expert at the University of Frankfurt, told Deutsche Welle. So far Italy has shown little awareness of the challenges it faces, he added.

“To send a signal that the ECB is allowed to buy Italian state bonds on the market would be deadly,” Weichenrieder said.

Past experience seems to confirm the theory. When the ECB began buying Italian bonds in August 2011, the Italian government under former Prime Minister Silvio Berlusconi immediately suspended an ambitious program of spending cuts.

A stronger crisis-fighting role?

German Chancellor Angela Merkel is opposed to the idea of turning the ECB into a lender of last resort, in an effort to keep pressure on debtor countries.

Nor do the ECB's own rules allow it to play that role. Its mandate is strictly limited to fighting inflation and ensuring monetary stability. Economists and politicians in favor of giving the ECB a stronger crisis-fighting role argue that the rules can be changed with the help of a few lawyers.

Others warn that the ECB's very reputation is at stake. “We live in a federation of states in which each one is responsible for its own national budget,” said Hans-Peter Burghof, a financial expert at the University of Hohenheim . “If we use the ECB for other reasons, then we'll ruin it. We'll destroy its reputation.”

That, in turn, woulddestroy the reputation of the euro, Burghof added.

Even as Germany fights to keep the ECB from coming to the rescue of struggling governments, pressure is growing on Europe's policymakers to come up with a convincing solution to combat the escalating debt crisis.

Author: Zhang Danhong (sp)
Editor: John Blau