Harvard’s Feldstein: Select Eurozone Bond Buybacks ‘Dangerous’

Monday, 30 Jul 2012 10:17 AM

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A proposal to give Europe’s bailout fund, the European Stability Mechanism, a banking license so it can borrow from the European Central Bank (ECB) to buy sovereign bonds from debt-weary nations is a dangerous thing, said Harvard economist Martin Feldstein.

Any bond buybacks should involve a basket of bonds that would include debt issued by healthier countries like France or Germany, as buying debt from troubled countries alone would give governments too much wiggle room to avoid tough-but-necessary fiscal reforms.

“While any central bank must be able to conduct open-market operations to manage liquidity in financial markets, selective purchases of individual country bonds that bear high interest rates because of current and past fiscal profligacy is both unnecessary and dangerous,” Feldstein wrote in a Project Syndicate column.

Editor's Note: Sept. 18 Cover-Up Is a Final Turning for America

“A better rule for the ECB would be to conduct open-market operations by buying and selling a ‘neutral basket’ of sovereign bonds, with each country’s share in the basket determined by its share in the ECB’s capital,” he added.

Such bond buybacks would resemble similar open-market operations in the United States and the United Kingdom.

The ECB meets this week to discuss monetary policy, and talk of intervention has been growing, especially in wake of soaring borrowing costs in Spanish government debt auctions.

The yield on Spain’s benchmark 10-year note recently shot up above 7.7 percent, well above the 7 percent threshold deemed unsustainable by the markets.

Still, should policymakers intervene, they should intervene broadly and not selectively, according to Feldstein.

“[F]ocusing potential ECB purchases on the sovereign debt of those countries with high interest rates would have serious adverse effects. It would reduce pressure on the governments of Italy, Spain and other high-interest countries to make the politically difficult decisions that are needed to cut long-term fiscal deficits,” Feldstein wrote.

“Spain needs to exercise greater control over its regional governments’ budgets, while Italy needs to shrink the size of its public sector,” he noted. “An ECB policy that artificially reduces their sovereign borrowing costs would make these steps even more politically difficult.”

Talk of ECB bond purchases, known officially as the bank’s Securities Markets Program (SMP), has been growing ever since ECB President Mario Draghi said recently the bank will do whatever possible to defend the euro.

The measure is similar to the Federal Reserve’s tool of choice, quantitative easing, under which the U.S. central bank buys bonds directly held by financial institutions to flood the economy with liquidity, drive down borrowing costs and encourage investing and hiring.

The difference in the past, however, is that the European program removed as much money from the financial system as it pumped in via bond purchases in the open market, while quantitative easing acts more aggressively by basically printing money out of thin air and giving to banks, according to Reuters.

Some experts, however, says the ECB may step it up and roll out a program similar to that of the Fed, which arguably sows the seeds for inflation down the road.

“What would really work is for the ECB to make an unlimited and credible promise to spend as much money as needed, to declare caps on bond yield spreads or actual yields and to give Europe’s rescue funds more leverage,” said Carsten Brzeski, senior economist at ING in Brussels, Reuters reported.

“Unlimited use of the SMP is quantitative easing in my view, but this is all hypothetical,” he said. “Just the idea would give them stomach pains and it is unlikely to happen. Even if they were willing to do it, there are legal and practical considerations, which mean they won’t.”

Editor's Note: Sept. 18 Cover-Up Is a Final Turning for America



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