Friday, 24 February 2012

Economists save world (for now)

A slight exaggeration maybe but economists at central banks in different countries have been decisive in dealing with the global financial crisis while politicians have been bickering about different ways of dealing with the problems.

Conventionally, lowering of interest rates is the main tool for central bankers to combat weakness in the economy but a new set of tools was deemed necessary after interest rates of close to zero have proven to be inefficient in combating the current economic downturn. Central banks now rely on quantitative easing which is the purchasing of government or other bonds using money which the central banks can print themselves as a way of increasing the money supply. In theory, an increase in the money supply means that there is more money for consumers to spend which is a boost to the economy but may also cause inflation (which is not a problem at the moment).

While the Federal Reserve and the Bank of England have each carried out a couple of rounds of quantitative easing, perhaps the prize for the most ingenious and effective policies in the face of adversity goes to the European Central Bank (ECB) and its new governor Mario Draghi. Central banks are usually set up independently from the governments in each area but governments can still wield a degree of influence over the operations of the central banks. This has been particularly true in the case of the ECB.

While central banks in the US and UK have purchased bonds issued by their government in order to reduce the interest rates on government debt, the ECB has been prevented from doing this by politicians in Europe. Many countries in Europe lead by the Germans are against the ECB purchasing the government bonds of countries in Europe with high levels of government debt such as Greece, Italy, Spain, or Portugal. The resulting lower interest rates on government debt would help relieve the pressure on these countries but Germany would rather that the higher interest rates spur the indebted countries to changes their ways.

The ECB has come up with a way of prompting purchasing of the government bonds of European countries without actually doing the buying itself. Draghi, the new governor, expanded the lending by the ECB to banks in Europe to allow for borrowing at its main interest rate (currently 1.0%) for up to three years. This meant that banks could borrow funds cheaply off the central bank and make easy money by buying government bonds which offered considerably higher returns. The ECB provided 489 billion euros of loans to banks in December and this had the effect of lowering the interest rates on bonds of European countries which have made earnest efforts to reduce government debt while keeping the pressure on other countries which have not.

Funnelling money through the private banks has proved a clever way of realising the policy of quantitative easing in the case of the ECB which has the choice of many different government bonds to buy. By providing private banks with the funds to purchase government bonds, it has meant that which bonds to buy is left in the hands of investors which allows for rational decision making based on market principles rather than being influenced by politics.

So the ECB was ingenious enough to come up with a way of easing the crisis in Europe despite obtrusive politicians. Not exactly saving the world but helping out under difficult circumstances.

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