Euro in Crisis Essay

Tags: interest rates harvard business school greece milton friedman global economic crisis foreign direct investment debt economic status italy economy currency spain inflation ireland mortgage

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When Draghi pledged to throw everything including the “kitchen sink” at the problem in the EU to sustain the Euro and the economy, it was still only a matter of time before even the kitchen sink failed to make an impact (Hildebrand, 2015). The problem in the European economy was precipitated by the fact that a number of nations simply did not belong in the EU and did not have the economic status to benefit from a common currency with other states, as Milton Friedman and other economists pointed out in the 1990s (Trumbull, Roscini & Choi, 2011). States like Greece, Ireland, Spain and Italy lacked the necessary clout to be anything other than a drag on a Union in which each state shared a currency. Greece had been brought into the EU under dubious pretenses and its debt bomb was now exploding. The ECB had to respond, along with the IMF, to ensure that the debt bomb was contained and did not wipe everyone out. If Greece defaulted, the banks would eat the loss. If Greece was bailed out to the tune of hundreds of billions through a bond-purchasing program similar to that in the U.S. where the Fed spent approximately $2 trillion on mortgage-backed securities and Treasuries to prop up the market, other countries—like Spain, Italy and Portugal would expect to be bailed out, too (Trumbull et al., 2011).

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The ECB could cut rates and effectively kill the savings of everyone in the market, forcing yield-starved investors into risk assets (and the ECB would not stop at bailing out Greece but would also go on to buy corporate bonds, essentially propping up the entire market by giving easy credit to companies that they might go on—over-leveraged—for a short while longer). Now, with the Fed raising the Fed Funds rate and cracks already appearing in the market after barely a 100 basis point move in interest rates, there appears to be a major problem going forward: the banks cannot raise rates because everyone is leveraged to the hilt and cannot afford to pay more interest on their loans. At the same time, the banks have to raise rates in a belated attempt to stave off inflation and to give room for more easing when the next downturn occurs at some point in the next few years. The ECB did not really respond less aggressively than the Fed. It took….....

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References

Hildebrand, P. (2015). Central banks: confronting the hard truths discovered and tough choices ahead. Business Economics, 50(2), 67-74.

Trumbull, G., Roscini, D. & Choi, D. (2011). The euro in crisis: Decision time at the European Central Bank. Harvard Business School.

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