Investors in financial markets are nervous all across the globe. There is great concern about the potential of another recession as asset prices have dipped substantially over the past few weeks. This concern can clearly be seen in the continent of Europe. Several European countries have faced the risk of defaulting on their obligations over the past few weeks and the European Central Bank has helped to avert those disasters.
What Is The European Central Bank
The European Central Bank (ECB) is the governmental organization that is responsible for setting the monetary policy and regulating the money supply for the 17 different countries that make up the Eurozone. The bank exists to help ensure stability for the Eurodollar and to combat inflation. The responsibilities of the European Central Bank are strikingly familiar to those of its sister institution, the Federal Reserve.
During recessionary times, financial institutions and private sector companies conserve capital and are unwilling to make loans. Central banks like the European Central Bank often become the lender of last resort in order to keep money flowing. The European Central Bank is currently stepping in and helping countries like Italy and Spain avoid bankruptcy by injecting money into the financial systems. (For related reading, see What Are Central Banks?)
Role Of The European Central Bank
The European Central Bank bought the bonds of Greece, Ireland, and Portugal to help the governments of those countries avoid insolvency and to stabilize markets. Now the central bank has started buying the bonds of distressed nations Italy and Spain as well. The ECB believes that buying the debts of these countries will help to keep bond yields low. This should in effect, lower the borrowing costs for these countries which would unclog financial markets and allow them to get access to capital at lower rates.
The European Central Bank has spent the last two years trying to fight contagion. As the debt crisis hits one European country, it can quickly spread to a partner country that owes the bonds and financial obligations of the other country.
Flaws In The Bond Buyback Plan
While the European Union is hoping to squash the fears in the market, the union is pretty much admitting that countries are weak by bailing out nations to a much greater extent. Programs that were meant to be short term financial assistance plans, like the Greece bond buying plan, have turned into long term bailouts. Once the central bank has propped up a market, the government is finding it very difficult to exit that market.
Another issue is the health of the European Central Bank's balance sheet. The central bank is taking on a large amount of risk in buying the debts of distressed nations. Every assistance program implemented limits the bank's ability to get involved in the next major crisis and hinders its ability to deal with its primary job of keeping inflation in check. (For related reading, see Get To Know The Major Central Banks.)
Resistance To The Bond Buying Plan
The European Central Bank is already facing blowback from the stronger members of the European Union. Germany and France have expressed resistance to the continued bailout plans. Germany believes that the bank is putting the financial health of the other nations at risks with this bond buying plan. France fears losing its triple A credit rating because of the latest bailout plan.
The massive debt buys have put the future of the euro in question. This will cause the central bank to use a substantial amount of leverage thereby weakening its own balance sheet. The EU is in danger of a revolt as it is unclear how long stronger nations like Germany and France will tolerate these programs.
The Bottom Line
As you can see the European Central Bank has a dilemma on its hands. The central bank could sit back and do nothing while watching countries spend themselves into insolvency or the bank can assist these countries with bailouts which may in fact, be weakening the whole region. (For related reading, see The Euro: What Every Forex Trader Needs To Know.)