Last week, two significant events took place.
One was in Germany and the other in the US.
On September 12, a German court upheld the constitutionality of the government decision to contribute to a commonly set-up fund for bailing out debt-ridden countries in the 17-nation Eurozone. The other was the decision of America's central bank, the Federal Reserve (the US Fed) to increase money supply, known as quantitative easing (QE) by buying private sector mortgage bonds and other assets, until unemployment declines "significantly" from the current level of 8.1 per cent.
Constitutionality upheld
The German court decision was unexpected. It was thought that the judges would decide in favour of the conservatives, who included the opposition Left Party and an association called More Democracy. They were also joined by 37,000 tax payers, questioning the legality of German government using their tax money for bailing out Greece and other governments, who are members of the Eurozone. The number of defaulting nations is likely to rise. They are referred to as PIIGS (Portugal, Ireland, Italy, Greece and Spain), who have been running annual fiscal deficits and incurring debts far in excess of 60 per cent of their gross domestic product, a criterion which was a deciding factor in their admittance to the Eurozone.
A poll conducted prior to the court hearing revealed that more than half of Germans wanted the judges to declare the European Stabilisation Mechanism (ESM), unconstitutional. The ESM was set up with German contribution of $440.8 billion of the total funds of $1.1trillion for bailing out PIIGS. Already there is a temporary fund, the European Financial Stability Facility (EFSF) with $1.02 trillion, which had promised $765.7 billion to Portugal, Ireland and Greece and to Spain for recapitalisation of its banking sector.
Since Italy is likely to be the next victim of enormous debt load, a larger fund on a permanent footing was needed. A permanent bail-out fund, the ESM is the answer, which is now dubbed as the IMF of Europe. Much to the relief of a great many, the court ruled that Germany could go ahead with ESM as constituted but with conditions, including a pre-requirement of parliamentary approval of any increase in the agreed-upon German contribution. The decision was hailed by Germany, the largest economy, as an "intelligent decision in the pro-European spirit of our constitution".
US Fed action
On September 13, Fed chairman Ben Bernanke announced that the Fed would buy private sector doubt including mortgage bonds and other assets, until unemployment declines substantially. The European Central Bank (ECB) president, Mario Draghi declared on September 6 that ECB would buy government bonds with maturities of one year to three years and there will be no limit. The only pre-requirement is that countries needing assistance have to apply for it. The objectives of the two central banks are the same: bring down borrowing costs; no limit to purchase of bonds; and soak the economy with liquidity so the banks cannot sit upon money for a long period. The business of banks is to lend. They cannot afford to lose interest income.
The US Fed, since 2008 has been buying bonds and mortgage backed securities under QE. There were two rounds: $3.94 trillion in the first round during November 2008-March 2010; and $1.3trillion in the second round during November 2010-June 2011, in all for a total of $5.3trillion.
This time, under QE 3, there is no fixed amount. The Fed has planned to add $53.3 billion of mortgage bonds in September and then $92.7 billion in purchases each month until the employment situation improves and as long as inflation remains in check.
The two parties in the US are deeply divided. The Republicans are against any government action, fiscal stimulus and taxes on the rich, and of course against the Fed chairman, a Republican himself and his QE.
In the absence of a compromise, tax increases and spending cuts will take effect by end of 2012, known as fiscal cliff, pushing USA back into recession.
It is a war against recession. The Fed is not worried about niceties.
Recall the words: "All is fair in love and war", attributed to John Lyly, a 16th century English playwright.
* Professor Jayaraman teaches economics at Fiji National University, Nasinu Campus.