What started out as sovereign debt concerns in the periphery of Europe two years ago has morphed into a focus of attention regarding the entire concept of the European Union. The fear is that a disorderly unwind of the problems in Greece will move across the rest of Europe, especially Spain and Italy.
Investors lack confidence in the capacity of the political leaders in Europe to implement necessary policy and monetary reforms. European policy makers appear to be waiting for the situation to move closer to the brink before acting.
Reflecting investor nervousness, bond yields in Spain and Italy rose. In May, 10 year government bond yields in Spain rose 0.79%, to 6.54%. Their Italian counterparts rose 0.33% to 6.00%.
These higher yields can create investor concerns surrounding unsustainable debt dynamics in these countries. A higher borrowing cost makes it more difficult for a government to repay its debt. It also means there is less free cash flow available to stimulate the economy. While the issues of Europe are complex, there are an array of tools European policymakers could implement to improve the situation.
First, the Euro-zone rescue fund could be used to recapitalise banks. Unlike during the Financial Crisis in 2008, the issues in Europe are well-known. A Euro-zone ‘bail-out’ fund has been created with the aim to bring stability to the region’s challenges.
Second, policy makers could provide a Europe wide guarantee of bank deposits. One of the fears surfacing across Europe is the availability of cash and implications of exchange rate on currency value if a country leaves the Euro-zone. Guaranteeing deposits could ease fears surrounding the accessibility of deposits and help avoid bank runs.
Third, the European Central Bank could act to reduce bond yields in countries such as Spain and Italy. Aggressive bond buying from the ECB or bailout fund could help bring bond yields in Spain to more sustainable levels.
Fourth, the European Central Bank could aggressively ease monetary policy by cutting interest rates to near zero and engage in aggressive quantitative easing. This should help provide liquidity to the system.
While the challenges of Europe are not easy to remedy, policy makers do have an array of tools to help the situation.
Source: Interview with AMP chief economist Shane Oliver