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Sovereign Debt Crisis IW News 15. April 2015

Bond purchases only effective together with reforms

The European Central Bank (ECB) purchases public sector bonds until September 2016 in the amount of monthly 60 Billion Euros. This financial large-scale project will only be effective in the long-run, if conducted together with sustainable supply-side reforms in the Eurozone countries. The ECB should demand these reforms as often as possible.

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The financial market responded already after the ECB communicated its Public Sector Purchase Program (PSPP) at January 22, 2015: In the first 30 days thereafter the Euro depreciated more strongly vis-à-vis the US-Dollar, the Japanese Yen and the British Pound compared to the recent past. Moreover, yields on Italy’s, Portugal’s and Spain’s sovereign bonds decreased more strongly as before. Interest rates on Greece debt, which is not purchased by the ECB, were the only exception.

The responses to the PSPP announcement hint at an increased confidence of market participants in the ECB’s monetary policy. In addition to that, the depreciating Euro and the decreasing sovereign bond yields will transmit positive impulses to the European economy.

The most recent ECB’s policy measures are, however, not without any risk: without supply-side reforms in the Eurozone countries its effectiveness will vanish fast and its side effects will materialize. This follows from the fact that the PSPP leads to lower longer term interest rates in addition to the already low short term interest rates that result from the ECB’s policy rate cuts to recently 0.05 percent. The issue is that an extended period of low interest rates forces savers and investors to expose themselves to higher-risk assets in order to make profits. This, however, fosters the emergence of a new financial crisis.

In order to mild the risks from large-scale asset purchases, politicians’ commitment to a continuance of the reform agenda, to a further reduction in sovereign and public debt as well as to growth-enhancing measures are highly needed. Studies conducted by the Cologne Institute for Economic Research (IW) imply that an exit from the low interest rate environment needs a stable Eurozone as a precondition.

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