Europe to the rescue

The ECB has come to the rescue of Spain and Italy, by buying up their bonds after investors started to sell of the debt of the two troubled southern giants they can once again borrow at an affordable interest rate.

This is probably a good thing since the ECB prevented the sovereign debt crisis from spreading, at least for a while. But is not all good. Depending on the size of the purchases required by the ECB it might not be able to sterilize its bond purchases and be forced to pay for them with newly printed money and thereby increasing the european money supply creating inflation. Unlike a traditional change in the money supply carried out through interest rate adjustments, this increase benefits only Spain and Italy at a cost paid by all other euro members. A lowering of the prime interest rate benefits all euro member by lowering the cost of borrowing, but this bond purchase lowers the borrowing costs of Spain and Italy. Meanwhile the inflation will eat in to value of the money of all Europeans.

Then there is the long run problem, by averting this crisis the central bank might have contributed to a whole slew of future crises. Once the ECB has popped its cherry in the bond market governments will come to expect it to put out again. This takes some of the pressure off them to solve their debt problem. The markets reacted to what they saw as less then satisfactory plans by the Spanish and Italian governments to reduce their debts. By the ECB coming to the rescue they lose some of the incentive to act.