Tuesday, November 22, 2011

Central-bank bail-out through buying government bonds

Let's make this EU crisis hand-wringing easier. Just bail-out the governments by having the central bank buy government bonds. This is the historical tried and true method. Of course, if it gets excessive their will be strong inflation, but this is what governments want anyway.
The interesting comparison is between Britain and Spain. Britain looks like it has a worse gross debt problem and has a similar problem with the budget balance. There is, however, a significant difference between the interest rates that they pay. The British rates are around three hundred bps lower because liquidity can be provided by the central bank through the purchase of bonds. There is less of a risk premium with funding because liquidity can be provided. Given there is a output gap, there is little  reason to worry about inflation today so liqudity is still the key consideration.

The latest speech by ECB president Draghi suggests that he is, like other central bankers, are looking for ways to avoid using liquidity in the short-run to solve fiscal problems. There is a clear bias to have the fiscal ministers provide a solution and holdback liquidty as a last resort.

No comments: