In that case, Europe would fall into an even bigger trouble. If so, who will reimburse the damage done to the ECB?

Why the European Central Bank (ECB) doesn’t initiate an operation similar to the overnight bond purchase the Central Bank of Turkey (CBT) carried out right after the introduction of the 2001 stability program? Why it cannot end the high interest rate phenomenon that was caused by high risk perception and has the potential to destroy the budget disciplining policies of countries including Italy and Spain?

First, let me remind you off the basics: right after the introduction of the stability program, the Treasury of Turkey paid its accrued debt that had dragged public banks to the edge of the cliff via government bonds. The bonds were useless if just kept in the vault, however. As banks were in severe need of liquidity, they had to sell the bonds to fulfill their cash requirement. Otherwise, they would fail to pay their debt to other banks, pushing the entire banking sector into bankruptcy. The only institution that could purchase bonds at large amounts was the CBT. Indeed, the CBT immediately did so and as a result the value of government bonds in its balances increased from 1.5 billion liras by the end of 2000 to 34.3 billion liras by the end of 2001, a 13.7 percent increase as a ratio to the GDP in 2001.

What were the risks for the CBT? Risks of the mentioned operation would surface if the promised economic program was not implemented and the unhealthy fiscal policy was sustained. Potential risks were that, the CBT would appear as if it supported the continuance of the unhealthy fiscal policy by abundant monetization and thus it would lose credibility. More precisely, its credibility that hit the bottom with the breakdown of the exchange rate regime would not be reversed for a long time. It was fine if it were the CBT management only whose credibility was damaged, as the existing management could be replaced by a new one. In reality, however, the strong economic policy also would lose power. Second, the operation was expected to relieve the Treasury partially and temporarily, but it was possible that the government decided to abandon the promised tight budget policy. A third risk that would reinforce the second was the possibility that the government, instead of sticking to tight budget measures, puts pressure on the CBT for repeating the operation. If the second and the third risks were realized, risk appetite would peek and interest on Treasury bonds would hike (that is, price of bonds would decrease substantially). In that case, the CBT’s assets would shrink and the Bank would suffer losses. In the end, however, the CBT’s loss was also the Treasury’s loss, as it was the key partner of the Bank.

Did the CBT have the chance to stay out of the game, ruling out a major component of a new program backed by the IMF with suitable terms? On which grounds could the CBT reject stepping up? Would it say, “What if you give up the economic program after a few months?” It not only would sound funny but also destroy an important economic program.

This is the main problem with the ECB and Germany currently. The ECB is afraid that if it purchases high amounts of bonds to help Italy and Spain lower borrowing interest rates to reasonable levels; it might suffer from the risks mentioned above. After all, the ECB is not the national central bank of Italy or Spain. What if they give up the tight fiscal policy measures after the ECB purchases their bonds? What is more, Italy will hold general elections in spring 2013. If those responsible of the current state in Italy win the elections, it is quite likely that the risks the ECB is afraid of are realized. In that case, Europe would fall into an even bigger trouble, right? If so, who will reimburse the damage done to the ECB? Basically, these are the possibilities of which the ECB scares. However, the more the ECB refrains from purchasing bonds, the worse the situation gets. Therefore, Europe is in a vicious circle. I will continue.

This commentary was published in Radikal daily on 28.08.2012