ECB Considers Interest Rate Caps: Will it Work?

Economic Times reports European Central Bank mulls caps on borrowing costs

The European Central Bank is considering buying the bonds of crisis-wracked eurozone countries to ensure borrowing costs do not rise beyond a pre-determined level, German newsweekly Der Spiegel said Sunday.

The bank will define an upper limit for borrowing costs in countries such as Spain and Italy and intervene in the markets to ensure it is not breached, Spiegel said, without citing its sources.

At the end of trade on Friday, Spain was paying 6.39 per cent to borrow for 10 years and Italy 5.76 per cent. In contrast, Germany was paying 1.49 per cent, as investors trust Europe's top economy to repay them.

The so-called spread, or difference, between benchmark German bonds and the debt-wracked countries would be decisive for the proposed rate cap, Spiegel said.

ECB President Mario Draghi announced earlier in August that his institution "may" buy bonds of struggling countries if they first apply for EU bailout funds and accept tough conditions in return.

He said the details would be worked out before the next meeting of the ECB, scheduled for September 6. Spiegel said that ECB governors would decide then whether to implement the proposed borrowing cost cap.

Here is a link to a translated article in Der Spiegel:

The European Central Bank (ECB) is considering to establish in its future bond purchases interest rate levels for each country. Thus, they would state papers of the crisis countries always buy when interest rates exceed a certain impact on their yields German Bunds. Sun investors would get a signal that interest rates, the ECB considers appropriate.

Because the Fed has unlimited funds - they can even print the money eventually - it would not succeed even more speculators to drive the returns of the targeted rate also. Thus, the ECB wants to keep not only the financial costs of ailing countries in check, but also to ensure that the general level of interest rates in the euro zone is not too much drifting apart.

At its next meeting in early September, the Governing Council will decide whether the interest rate target is actually installed. One thing is certain, that the ECB will continue to practice their bond purchases more transparent. In the future, they will announce each country, in which capacity she has taken the bonds from the market. This information should be released immediately after the purchases. So far, the ECB had only ever made known Monday how much money she spent on purchases in the previous week as a whole.

Can This Work?

It depends on the definition of "work". In general, if central planners (and it is important to understand that is what we are talking about here) set prices too high there will be unlimited supply.

Likewise, if central planners set prices too low, there will be shortages.

When it comes to money, recall that Switzerland capped the rate of the Swiss Franc vs. the euro. To defend that cap the Swiss National Bank has to offer unlimited money at the target exchange rate.

When it comes to interest rates, the ECB must be willing to buy an unlimited number of bonds (up to the total supply of all bonds).

Theory vs. Practice

So yes, the ECB can "in theory" defend a price target on bonds, but only at the risk of owning every bond.

What about an exit mechanism? How will the ECB get rid of all those bonds down the road? To who, at what price?

Will Germany go along with this ridiculous scheme? For how long?

As is always the case, interference in the free market by central planning fools always fails in the long run.

Source: Global Economic Analysis

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