Europe Needs a Rate Cut. Now.

Europe Needs a Rate Cut. Now.

The main problem of the troubled euro-zone countries is economic growth. The lack of it. A rate cut now is the initial and immediate step that should be taken on the way to solve the crisis. There are at least 5 advantages for such a move.

The ECB may buy bonds. So can China. Such actions, or rumors about them, just supply reasons for temporary relief (or profit taking for euro/dollar shorts), before the next round. The problem isn’t the panic that comes and goes. The underlying situation needs fixing.

Problems and Bad Solutions

Greece, Portugal and Italy have huge government debt. Spain has growing regional government debt. The unlucky Irish have their banks’ debt on their shoulders. They need to balance their budgets.  

So, they make significant cuts, raise taxes and put their countries into an age of austerity. With less spending and more taxes, the budgets will come to a balance.

The result of these measures is extremely slow growth in the best scenarios, and economic contraction in others. Without growth, tax revenues fall short of expectations.

Are these expectations real? It seems that the plans are set to fail.

So what are the next steps? More austerity. The vicious cycle just happens all over again.

These citizens take can take harsh pills if they see prospects of a better future. When this future arrives and more sacrifices are requested, again and again it becomes harder.

No growth = no hope.

Rate cut

But apart from making smarter balancing plans, there’s another step that be taken, in a much easier manner: the ECB can cut the interest rate.

The European Central Bank is doing the exact same opposite. In a Quixotic fight against inflation in some northern European countries, it just raised the Minimum Bid Rate to 1.50%.

Well, the northern countries are slowing down as well. So is China, the US and Japan. There’s no real need for a hike when core inflation is tame, at around 1.5%. Headline CPI is at 2.7%. In Britain, CPI is at 4.2%, and the central bank just leaves the rates unchanged, acknowledging the source of the problem – commodities.

Trying to curb inflation by depressing demand has dire consequences in the euro-zone: the debt crisis is just entering another round.

What is needed is a rate cut. A return to 1.00% will have a strong effect. But even one step back to 1.25% will be of high significance.

What will a rate cut achieve:

  1. More lending: Lower borrowing costs will help the troubled economies grow.
  2. A weaker euro: A lower exchange rate of the euro will make exports to other countries more lucrative and more attractive.
  3. Commodity prices will drop: Last time Trichet signaled a pause in rate hikes, the euro didn’t fall alone. Commodity prices joined.
  4. Relief for banks: In Spain, most mortgages are tied to the euribor: lower interest rates mean less mortgage defaults, meaning stronger banks. It’s not only Spain.
  5. Political will: Perhaps the most important thing. The European leaders will show that they are genuinely willing to act, as a whole.

Is Jean-Claude Trichet ready to act? Are the European leaders ready to push him of out of single mindedness, and to help their citizens? This is still to be seen.

Of course, this is only a short term cure, but a significant one. An orderly Greek default and serious reforms in how the euro-zone works are necessary for the long run.

As many have mentioned before, a monetary union without some kind of fiscal union, or binding fiscal laws, will find it hard to exist. At least with the current countries.

Further reading: Greece should leave the euro-zone

Yohay Elam

Yohay Elam

Yohay Elam: Founder, Writer and Editor I have been into forex trading for over 5 years, and I share the experience that I have and the knowledge that I've accumulated. After taking a short course about forex. Like many forex traders, I've earned a significant share of my knowledge the hard way. Macroeconomics, the impact of news on the ever-moving currency markets and trading psychology have always fascinated me. Before founding Forex Crunch, I've worked as a programmer in various hi-tech companies. I have a B. Sc. in Computer Science from Ben Gurion University. Given this background, forex software has a relatively bigger share in the posts.